Guidance Lite

The end of quarterly earnings guidance?; wage inflation in India; nonprofit mergers; a new twist on the LBO formula; is the IRS targeting small business?; a look behind Wal-Mart's plans to open a bank; and more.


In the hope of ending the quarterly beat-the-estimates game, more companies are doing away with quarterly earnings forecasts in favor of annual targets.

According to a survey conducted in March by the National Investor Relations Institute (NIRI), 52 percent of companies provide quarterly earnings guidance, down from 61 percent when the survey was conducted last year. Companies that have recently decided to scrap quarterly projections include Motorola, Citigroup, and Best Buy.

Meanwhile, the percentage of companies furnishing annual targets increased from 61 percent to 82 percent. Lou Thompson, president of NIRI, says there is a clear trend away from quarterly earnings guidance. “The expectation is that it will drive longer-term valuations,” he says.

When Best Buy announced in April that it would end its practice of giving quarterly earnings guidance, it said that instead it will offer annual forecasts and provide updates whenever it expects a material change in results. The decision came a few months after Best Buy’s stock dropped 12 percent when the company missed consensus earnings projections by just 2 cents a share. Starting in July, Motorola will also no longer provide quarterly earnings forecasts, though it will continue to offer annual projections and guidance on its revenue expectations. In addition, it will provide company and industry commentary on performance, said CFO David Devonshire in an earnings conference earlier this year.

Motorola’s move reflects a trend toward added qualitative information. “The misconception is that companies aren’t providing any guidance at all,” says Kara Newman, vice president of strategic research at Thomson Financial, which released a study on earnings guidance in April. Thomson’s study finds that 27.6 percent of the S&P 500 provide only qualitative guidance, such as commentary on industry trends and events that could affect sales. Newman says companies are moving away from giving numerical earnings targets or ranges each quarter.

Why? A recent study by McKinsey & Co. shows that firms offering quarterly earnings guidance enjoy no valuation premium compared with companies that do not. Moreover, while some companies might fear that ending the practice could signal trouble and bring a penalty from Wall Street, such fears seem unfounded. When McKinsey looked at 126 companies that discontinued guidance, it found they were just as likely to see higher valuations as lower ones, compared with the market.

Some companies offer no guidance at all. Books-A-Million said in March that it would stop giving quarterly or annual guidance on earnings per share. Google has eschewed earnings guidance completely since it went public in August 2004. Some 16 percent of the S&P 500 now provide no financial guidance. That might not be a bad way to go. It certainly hasn’t hurt Google. — Joseph McCafferty

Talking Points
What type of earnings guidance do you provide?
Quarterly only 13%
Annually only 43%
Both 39%
Midquarter update 1%
As needed 4%
Source: NIRI survey of 654 IR officers

Passing on India?

Rising wages in India are eating into some of the cost advantages of sending work to the popular outsourcing destination.

Wages have increased roughly 11 percent in each of the past three years with little sign of abating, says Michael Spellacy, vice president at The Boston Consulting Group. In major cities like Bombay and Bangalore, inflation has climbed as high as 14 percent, with worker attrition rates now averaging 25 percent. A full-time worker in outsourced financial services in India earns between $22,000 and $27,000, Spellacy says.

So far companies that have tapped India for business process outsourcing (BPO) aren’t leaving in droves, but many are hedging their bets. Companies are diversifying by adding other countries, such as Sri Lanka and the Philippines, to their rosters, says Spellacy. “If you’re building a business case for outsourcing based on cost alone,” he says, “the case for going to India is reduced.” Although wages are comparable in Sri Lanka and the Philippines, companies can negotiate more-favorable deals in those countries because the industry is not as developed there.

But outsourcers still prefer the technical and English-language skills of India’s workforce, according to Dana Stiffler, research director at AMR Research. And they value Indian companies’ investments in technical infrastructure. “It hasn’t reached a point where wage inflation is making India patently unattractive,” she says.

Outsourcers have been trying to offset the impact of wage increases in India by negotiating agreements that link levels of inflation to productivity gains. They are also looking to “secondary” cities, such as Chennai, where attrition and inflation are less severe.

BPO vendors in India don’t appear to be losing sleep over the changing economic dynamics. “Wage inflation is going to be mitigated quickly,” predicts Joseph Sigelman, co-president of OfficeTiger, a BPO division of RR Donnelley with offices in six Indian locations, among others around the globe. With a population of 1 billion, and only 1 million workers in BPO-related industries, India has a large labor pipeline, says Sigelman. And, he adds, the gap between wages in India and the West is still huge. — Allan Richter

Top 10 Most Attractive Outsourcing Destinations*

  1. India
  2. China
  3. Malaysia
  4. Philippines
  5. Singapore
  6. Thailand
  7. Czech Republic
  8. Chile
  9. Canada
  10. Brazil

Source: A.T. Kearney, 2005
*Based on index of costs, workforce, and business environment

Marriages of Necessity

Nonprofits continue to take pages from the for-profit playbook. The latest business practice to make the transition to the nonprofit world: the merger.

Thanks to a spate of new nonprofits and insufficient funding to match that growth, nonprofits are consolidating rapidly by combining regional divisions or merging with like-minded entities. While no one keeps data on nonprofit mergers, Bob Harrington, a senior manager at La Piana Associates Inc., a California consulting firm that specializes in nonprofit mergers and partnerships, says that inquiries about consolidating nonprofits have doubled over the past two years.

“There are about 120 new nonprofits starting every day, and not enough resources to go around,” says Bill Strathmann, CEO of Network for Good. Another reason for the merger push, he says, is that more executives who have worked at for-profit companies in the past are moving to the nonprofit sector and taking their for-profit strategies with them.

Groundspring and Network for Good, the two largest nonprofit providers of Internet-based fund-raising, completed their merger in December 2005. Strathmann says the merger was designed primarily to help the company increase its collective impact and serve more nonprofits. The transaction also placed the company on a path to self-sufficiency, so it could rely less on grant funding.

Merger-minded nonprofits must tackle the usual issues of market share and competitive positions that accompany any merger-and-acquisition deal. But selling the merger can be even more complex than it is with corporate mergers.

“Nonprofits have lots of stakeholders to accommodate, so it’s hard to keep everybody happy,” says Strathmann. Nonprofit mergers are usually completed in one of three ways: an authorized acquisition of assets similar to a corporate transaction, a grant of assets to one of the legal partners of another organization, or the reorganization of the board of the nonprofit being acquired to gain control of the entity.

No matter what path they take, nonprofit mergers have one advantage over those in the corporate world: no taxes. — Laura DeMars

An LBO Twist

With a new spin on the typical leveraged-buyout formula, the private-equity buyers of Dunkin’ Brands, the company behind Dunkin’ Donuts, Baskin-Robbins, and Togo’s sandwich shops, are financing the deal almost entirely with securitized franchise fees. The $2.4 billion deal is the largest of its kind so far.

According to one observer of the deal, Dunkin’ slashed between $30 million and $40 million from annual interest costs by using fees from its 12,000-plus franchisees to secure the loan. The company will pay a fixed rate on the interest-only loan over the first five years.

While such transactions are rare, securitizations of franchise fees could attract more attention. The securities appeal to investors looking for stability in today’s choppy markets, says Jeffrey L. Balash, chair of Comstock Capital Partners LLC, a private-capital firm. “They’re willing to take a lower yield for more certainty,” he says. To pull off the deal, issuers need a revenue stream that’s fairly predictable and secure, and that can be segregated from other income.

It’s not a sure bet that these deals will reduce a company’s overall cost of capital. “You’re taking a fairly safe cash flow and removing it [as security] from other debt,” says Robert Dammon, a professor at Carnegie Mellon University. Holders of the company’s other capital may demand a higher return, he asserts, as they’ll be taking on more risk. — Karen M. Kroll

The Small Fry

Is the IRS unfairly picking on the little guy? One member of Congress thinks so.

During a hearing of the House Small Business Committee in April, chairman Donald Manzullo (R-Ill.) accused the IRS of unfairly targeting small companies with more audits and burdensome rules. “While I understand the push to lower the budget deficit…imposing increased burdens on small business through more audits cannot be the only answer.” Last year, the number of IRS audits on small businesses increased in all categories.

IRS commissioner Mark Everson disagrees with Manzullo’s claim. He says large companies are still much more likely to get audited. Last year, the IRS audited 44 percent of the largest U.S. corporations.

Michael Frederich, president of Manitowoc Custom Modeling, says he has noticed a shift in IRS attention. “They certainly have small businesses in their sites,” claims Frederich, who testified before the small-business committee in April. “The IRS sees small companies as something that they don’t control enough.”

In fact, a massive study launched by the IRS in 2001 found a $300 billion tax gap (the difference between what it is owed and what it collects) and attributed a large portion of the gap to small businesses. Manzullo says the IRS is now targeting small business based on the study. He expects small-company audits to increase this year as well. — L.D.

Four Eyes Are Better

Could a different reporting structure have prevented the WorldCom fraud? Harry Volande thinks so.

The Siemens Energy & Automation CFO reports to the board of directors, rather than to the CEO. He says the structure, which Siemens refers to as the “four-eye principle,” makes it easier for finance chiefs to stay honest. “The advantage is that you have a CFO who does not depend on the CEO for reviews or a remuneration package,” says Volande. “That gives him the freedom to voice an independent opinion.” The reporting structure, which is more common in Germany, applies throughout the German electronics conglomerate. In the United States, such a reporting practice is rare, in part because at many companies the CEO also chairs the board. “Most CEOs would resist such a change in the hierarchy,” says James Owers, professor of finance at Georgia State University.

With a change in the reporting model unlikely, governance watchdogs are advocating frequent and independent meetings between the CFO and the board. Many CFOs have access to the board only when the CEO requests a finance presentation, says Owers.

Espen Eckbo, director of the Center for Corporate Governance at Dartmouth’s Tuck School of Business, says boards should consider taking more responsibility for evaluating the CFO and determining his or her compensation, rather than relying solely on the CEO’s opinion. Such a practice would provide more independence for the finance chief, he says.

Of course, there are drawbacks when the CFO reports directly to the board. Volande admits that it can slow the decision-making process. For example, if there are disagreements about a possible merger, the board ultimately has to make the decision. “You require additional communication, which can be useful, but it takes longer,” says Volande. He acknowledges that the structure is not for everyone, as conflicts can arise when senior executives share power: “It takes a CEO and CFO with a certain amount of humility and flexibility.” — Kate O’Sullivan

Section 404: Where the Weaknesses Are

Companies are still struggling with Section 404. In the second year of compliance with Sarbox’s internal-controls reporting requirement, nearly 10 percent of corporate filers are expected to report an adverse opinion, according to research firm Audit Analytics. While that’s down from 16 percent last year, the areas of weakness haven’t changed much. The issue of tax accruals and deferrals continues to be the biggest bugaboo, followed closely by revenue recognition and inventory.

Areas of Failure 2005* 2004*
Tax accruals/deferrals 34.5% 32.0%
Revenue recognition 28.4 31.3
Inventory/vendor cost of sales 23.7 27.4
Fixed/intangible assets 16.0 18.6
Leases or contingencies 9.3 16.8
Cash flow (FAS 95 error) 8.8
Consolidation (Fin 46 issues) 6.7 9.0
*Numbers do not add up to 100%, because data allows for multiple material weaknesses.

Wal-Mart Savings and Loan?

Wal-Mart’s proposal to run its own bank has rekindled a debate over the separation of banking and commerce.

When the retail giant applied to run a state-chartered industrial loan corporation in Utah, community banks and consumer groups responded with a torrent of opposition. They argued that the charter could offer Wal-Mart an end run around banking regulations, creating unfair competition in the banking sector.

Wal-Mart’s idea is not new: the concept has been around for nearly a century. Today, about 60 industrial banks, with assets totaling more than $140 billion, operate in seven western states and are run by commercial entities like General Electric, Harley-Davidson, and Pitney Bowes. One of Wal-Mart’s main rivals, Target Stores, already operates its own bank out of Salt Lake City.

Some say the controversy over the Wal-Mart application has more to do with the retailer’s history than with concerns about the industrial-banking model. “Much of the furor over the Wal-Mart application is fueled by groups that have unrelated issues with Wal-Mart,” says Mark Hales, president of GMAC Auto Bank, the industrial bank of General Motors’s financial group.

The Federal Deposit Insurance Corp., which held hearings on Wal-Mart’s proposal, has received more than 4,000 letters of comment, says David Barr, an FDIC spokesman. In contrast, Target’s application in 2004 elicited no letters at all. The FDIC is expected to rule on the application later this year.

Banking groups worry that Wal-Mart will open branches to compete with commercial banks, even though it has vowed not to. The retailer says it only wants to process debit- and credit-card transactions and checks. Wal-Mart already offers check cashing and money transfers at many stores through partnerships with outside vendors.

State-chartered industrial banks typically provide auxiliary services to the corporate parent’s business, such as customer financing or credit-card processing. But, they have many of the same powers as commercial banks, Barr says. They can add branches, offer loans, and issue savings and checking accounts. They can’t operate outside the state in which they are chartered, however, and once they reach $100 million in assets, they can no longer offer checking accounts. — A.R.

Fewer Vacancies

The U.S. office market continued to tighten in the first quarter of 2006. The national vacancy rate declined for the eighth straight quarter, to 14.3 percent, from 14.6 percent in the prior period. “We’re in the middle of a classic recovery cycle,” says Robert Bach, senior vice president of research at Grubb & Ellis, a real estate services firm. Demand is up across the major markets, pushing rents up in midtown Manhattan; Washington, D.C.; Orange County, Calif.; San Diego; San Francisco; and Southern Florida. “In the major markets, landlords are starting to get a little more leverage,” says Bach. While there is still excess space, he expects leasing market conditions to shift gradually in favor of landlords over the next 12 to 18 months.

Test Your Contractor IQ

FedEx is currently facing a class-action suit by drivers who say that while they are paid (and taxed) as contractors, they really function as employees. They are demanding the rights and benefits of regular employees. So far, one California court has agreed with workers, and if FedEx eventually loses the class-action suit, it could owe more than $1 billion in compensation and taxes. Companies that treat independent contractors as employees could face similar suits and IRS inquiries. Does your company face such a risk? Take our quiz and find out.

1. Requiring your independent contractors to incorporate will eliminate your audit exposure. True or false?

2. When workers are determined to be misclassified, the company receiving services can not only be held liable for the taxes they should have paid, but for taxes they should have withheld on behalf of the worker. True or false?

3. IRS guidelines specifically forbid retirees from returning to their former employers as independent contractors. True or false?

4. Instituting and strictly abiding by a 120-day length-of-stay policy for all independent contractors will insulate your company from exposure. True or false?

5. Based on Section 302 of Sarbanes-Oxley, officers could be held personally liable for misclassifying independent contractors. True or false?

6. If my independent contractor says he or she wants to be paid on a 1099-basis, signs a contract to that effect, and declines benefits, I am not at risk. True or false?

7. The majority of states use the IRS “Twenty Questions” guide as their main criteria for determining independent-contractor vs. employee status. True or false?

8. The IRS recently estimated that in one year — 2001 — sole proprietors failed to pay how much in taxes they owed: $81 million, $7 billion, $21 billion, or $81 billion?

1. False. While incorporation is recommended in most cases, the taxing authorities will often look further into the actual relationship that exists.

2. True. Companies are liable for taxes they should have withheld on behalf of a misclassified worker.

3. False. Nothing in the regulations specifically forbids retirees from returning, though the control-factor tests used by the IRS make it nearly impossible and a very dangerous practice.

4. False. Independent contractors who work even one day for your company could be determined to be employees.

5. True. Section 302 of the Sarbanes-Oxley Act requires finance officers to certify financial disclosures. Knowingly certifying false disclosures, including the misclassification of workers as independent contractors, could lead to liabilities.

6. False. A contract with an individual is not a good determination of worker status as an independent contractor or an employee.

7. False. While some states use the IRS “Twenty Questions” guide, most use some form of the “ABC Test,” which is generally considered tougher to pass as an independent contractor.

8. $81 billion.

Grade Yourself
8 correct: No worries, take a vacation.
5–7 correct: Good job, but take a closer look at your independent-contractor policies.
3–4 correct: The tax man cometh.
0–2 correct: Press your suit. You’ll need it in court.

For helping us develop this quiz, special thanks to Andrew Schultz, president of PrO Unlimited, which helps companies address contingent-workforce compliance issues.

Look Who’s Talking

The Securities and Exchange Commission would do well to practice what it preaches. A report issued in April by the Government Accountability Office found that the SEC, which has forced companies to follow strict new standards on internal controls, has some internal-control issues of its own.

During an audit of the SEC’s 2005 financials, the GAO found three material weaknesses in internal controls in the areas related to preparing financial statements, recording and reporting payment of penalties, and information security. The same three material weaknesses were found in the 2004 audit but were not fixed. While the GAO acknowledged that the SEC has made progress on the issues, it criticized the commission’s practices: “The SEC’s financial-statement preparation and reporting processes were manually intensive, time consuming, and difficult to follow,” GAO director Jeanette Franzel wrote in the letter to SEC chairman Christopher Cox. In response, the commission says it is making significant progress on adapting the GAO’s recommendations.

The GAO doesn’t think the SEC’s own difficulties with internal controls are any reason to go easy on small businesses. Less than three weeks after issuing the report, the GAO asked the SEC not to exempt small business from 404. In other words, it called on the SEC to tell businesses: “Do as I say, not as I do.” — J.McC.

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