Benjamin LansfordNorthwestern University

Baruch LevNew York UniversityJennifer Wu TuckerUniversity of Florida

Why do firms issue disaggregated earnings guidance? The archival evidence

Road map

I. The phenomenonII. The literatureIII. What we do?IV. How we do?V. Findings and contribution

Part I: The phenomenonHillenbrand Industries 2003Q4 Earnings Announcement Press Release (11/13/2003, PR Newswire)

Outlook for 2004 Fiscal Year End, September 30, 2004 ($ in millions, except EPS)

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Net revenues $2,225 to $2,265 Gross margin 46.5 % Operating expenses $630 to $645 Tax rate 34.0 % Diluted earnings per share from continuing operations $4.15 to $4.23

Part I: The phenomenonHillenbrand Industries 2004Q4 Earnings Announcement Press Release (11/16/2004, PR Newswire)

Outlook for 2005 (Dollars in millions, except EPS)

Corporate Batesville and other Hill-Rom Casket Expense Consolidated Low High Low High Low High Low High

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Net revenues Health Care sales 778 796 778 796 Health Care rentals 501 518 501 518 Funeral Services sales 646 661 646 661 Total revenues 1,279 1,314 646 661 - - 1,925 1,975 Gross margin 47.0% 56.0% 50.0% Other operating expenses 408 418 170 174 46 47 624 639 Income before taxes from continuing operations 193 200 192 196 (46) (47) 339 349 Tax rate 37% Diluted earnings per share from continuing operations 3.40 3.50 Average shares outstanding - diluted 62.8 Capital expenditures and intangibles 125 20 10 155 Depreciation and amortization 110 20 10 140

Part I: Is the phenomenon new?

Nobody has documented it before!!!The phenomenon is new in the accounting literature. The practice seems to have become popular only recently.

Part I: Examples

coname year rdqe codesALLERGAN INC 2001 22-Jan-02 EG*ALLERGAN INC 2002 29-Jan-03 R, EG, RS, GMS#, XG, XR, OM, R2, EG2ALLERGAN INC 2003 28-Jan-04 RS2, EP2, EG2, EG2, R, RS, GM, XR#, XG, EP ALLERGAN INC 2004 7-Feb-05 R2, EG2, EG2, EG2, R, RS, GM#, XR#, XG, EP ALLERGAN INC 2005 2-Feb-06 EG, XO#ALLERGAN INC 2006 . R, RS, GM, OR, XG, XR#, XA#, EG, T#, R2, EG2, XA2, XABEST BUY CO INC 2001 2-Apr-02 RC2, RC, EG2, R, EGBEST BUY CO INC 2002 1-Apr-03 EG, RC*, R, OM*, XT#, T#, K#, RC2*, EG2, EP2#BEST BUY CO INC 2003 31-Mar-04 EG, RC, OM#, XG*, K#, EG2, RC2BEST BUY CO INC 2004 1-Apr-05 RC, EG, XO#, EG2, XO2#, R#, RC, RC2, XG*, T, K, OM#BEST BUY CO INC 2005 30-Mar-06 RSP*, EG, R, RC, GM, XG, OM#, XT#, T#, NR, EG2#BEST BUY CO INC 2006 . EG, R#, RC, GM, XG, OM#, OM2*, T#, KBIG LOTS INC 2001 27-Feb-02 EG, RC, R, OM, GM, XG, XT#, RC2*, EG2, EG2, EG2, EG2, GM2, GM2, GM2, GM2, XG2, XG2, XG2, XG2BIG LOTS INC 2002 26-Feb-03 EG, RC*, GM#, XG, XT, EG2, K#, EG2, EG2, EG2, GM2, GM2, GM2, GM2, XG2, XG2, XG2, XG2BIG LOTS INC 2003 25-Feb-04 EP, RC*, R*, GM, XG, XT, T, EG2, RC2*, EG2, EG2, EG2, GM2, GM2, GM2, GM2, XG2, XG2, XG2, XG2BIG LOTS INC 2004 23-Feb-05 EP, RC, R, GM, XG, XT, T, CF#, EG2, RC2, EG2, EG2, EG2, GM2, GM2, GM2, GM2, XG2, XG2, XG2, XG2 BIG LOTS INC 2005 22-Feb-06 EG, RC, R, GM*, XT, T, K, XD, CF#, RC2, R2, EG2BIG LOTS INC 2006 . EG, CF#, EG2, RC#, OM, GM#, T, K, XD, CF#, RC2, EG2, EG9#, OM9#, K9, CF9, RC9#, R9#, GM9#

Part II: The literature

A practical view of voluntary disclosure

Nodisclosure

A little disclosure

Some disclosure

Lots of disclosure

Yes disclosure

Group 0 Group 1Earnings Only

Group 2 Group 3Elite

Part II: The literature

Theory of voluntary disclosureThe full-revelation (i.e. disclosure) principle and its violation (Grossman 1981; Verrecchia 1983; Dye 1985) The signaling argument (Spence 1973; Trueman 1986)The cost-benefit argument (many studies)

The above are all on the yes vs. no disclosure decision. There is no economic theory that directly speaks to information disaggregation.

Part II: The literature

Empirical studies that have inspired us: Han and Wild (1991)

Document that half of their earnings-forecast sample firms during 1978-1982 also issued a revenue forecast.

Francis, Schipper, and Vincent (2002)Find that quarterly earnings announcements have become increasingly useful for large firms because of the expanded disclosures in the press releases. Most of disclosures they document are about past performance.

Hutton, Miller, and Skinner (2003)Find that verifiable forward-looking statements accompany annual earnings guidance more often when the guidance is good news than when it is bad news. Two differences.

Hirst, Koonce, and Venkataraman (2007a)Provide experimental evidence that guidance disaggregation enhances guidance credibility, especially when managers are perceived as having incentives to lie.

Part II: The literature

“relative to the vast literature on forecast antecedents and consequences, comparatively few studies examine how managers choose the characteristics of their earnings forecasts.”“In general, prior empirical research does not identify either the circumstances under which disaggregated forecasts are provided or the characteristics of firms that provide such forecasts.”

-- Hirst, Koonce, and Venkataraman (2007b)

Part III: What we do?

Describe the practices of earnings guidance disaggregation by S&P 500 firms. Use archival data to identify the determinants of firms’ decision to provide disaggregated earnings guidance. Examine the stickiness of firms’ practices of earnings guidance disaggregation.

Part IV: Research Design Choices

Sample: S&P 500 firms. A snap shot at 2005Q4 earnings announcements.Annual earnings guidance: issued in quarterly earnings announcements, including press releases and conference calls.

“Hard guidance”: point or range estimate“Soft guidance”: other

Guidance horizon: about 9-11 months. That is, guidance for fiscal year 2006 issued in the 2005Q4 earnings announcement.

Part IV: Econometric model

Ordered probit“earnings guidance only,” “some disaggregation,” and “elite.” DEF=1, 2, and 3, respectively.Our interest is in the observable factors (X) that distinguish the “elite” group from the “earnings only” group.

1 1*i i iXDEF β ν= + ( * 0) (1)iif Guidance >

Part IV: Econometric model

Ordered probit with selection--Jointly estimate (1) and (2) using FIML.

Answers the question, “ Why do firms issue disaggregated earnings guidance?”

1 1*i i iXDEF β ν= + ( * 0) (1)iif Guidance >

* (2)i i iGuidance Z γ ε= +

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Best Buy 2005Q4 Earning Announcement Press Release … Best Buy Expects Fiscal 2007 Diluted EPS of $2.65 to $2.80 [EG] … According to Jackson, the company is forecasting total fiscal 2007 revenue of $34 billion to $35 billion, which represents 10-percent to 13-percent growth [R]. It anticipates opening nearly 90 new stores [L#] and a comparable store sales gain of 3 percent to 5 percent [RC]. The outlook also includes the recently completed acquisition of Pacific Sales Kitchen and Bath Centers. Best Buy anticipates that its gross profit rate will modestly improve by up to 10 basis points [GM], on top of benefits from structural changes made in fiscal 2006. The company expects to lower its SG&A rate by 30 to 40 basis points as it implements and refines its single operating model [XG]. As a result, the company anticipates improving its operating income rate by approximately 40 basis points for the year [OM#]. The company expects its net interest income [XT#] and effective income tax rate to be relatively stable, [T#] year over year. The company expects fiscal 2007 earnings to be in the range of $2.65 to $2.80 per diluted share, which represents an average growth rate of approximately 20 percent. The company's guidance includes anticipated severance and related reorganization costs of $0.03 to $0.05 per diluted share in the first half of the fiscal year [NR]. … Best Buy does not expect its business' seasonality to change, and anticipates that each of the first three quarters of fiscal 2007 will contribute 12 percent to 15 percent of the year's earnings, respectively. Additionally, as stated in February, the company expects fiscal 2007 first-quarter earnings to show a modest improvement over the very strong prior-year period, which generated earnings growth of 85 percent [EG2#]. The company intends to update its earnings guidance if annual results are expected to change materially.

Part IV: Description of guidanceAll Guidance Hard Guidance

(point or range)Guidance Type Count Percent Count Percent

Earnings 313 62.6% 281 56.2%Revenue 275 55.0% 192 38.4%Gross Margin 89 17.8% 49 9.8%Operating Margin 147 29.4% 79 15.8%General Expense 82 16.4% 58 11.6%Depreciation Expense 85 17.0% 78 15.6%Amortization Expense 22 4.4% 20 4.0%R&D Expense 40 8.0% 30 6.0%Other Operating Expense 195 39.0% 148 29.6%Non-Operating items 251 50.2% 219 43.8%

Any above guidance 436 87.2% 405 81.0%

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Part IV: Grouping mechanism

Criteria for Groups 1 and 3

Count all guidance

Count hardguidance only

Benchmark A AH

More strict(robustness)

B BH

Part IV: Disaggregation groupingClassification Group 0 Group 1 Group 2 Group 3 (“elite”)

A or AHNo

earnings guidance

Earning guidance, but no revenue guidance

All remaining

firms

Earnings, revenue, and either an item of specified operating expense guidance (such as COGS, operating margin, general expense, depreciation, amortization, and R&D) or at least two items of other operating expense guidance.

B or BHNo

earnings guidance

Earning guidance, but no revenue guidance, and fewer than 5 items of other annual guidance

All remaining

firms

Earnings, revenue, gross/operating margin guidance, and either an item of specified operating expense guidance (such as general expense, depreciation, amortization, and R&D) or at least two items of other operating expense guidance.

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Part IV: Grouping distributions

Classification

Group 0(“No

Earnings”)

Group 1(“Earnings

Only”)

Group 2(“Some

Disaggregation”)

Group 3 (“Elite”)

A 187 84 54 175AH 219 113 59 109B 187 75 155 83

BH 219 78 162 41

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AH 40% 20% 10% 20%

Part V: Motives for disaggregation

SignalingMore capable and diligent managers are more likely to offer disaggregated earnings guidance.Proxy: a firm’s realized sales as a percentage of total assets (“Sale”).

Enhance credibility of earnings guidanceCredibility is an issue when earnings guidance is good news. Proxy: the nature of the earnings guidance (“Good”).

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Part V: Motives for disaggregation

Demand for additional information when:Earnings are less informative.

Proxy: R2 of quarterly return-earnings regressions (“Relevance”). Proxy: R&D intensity (“RD”)

Demand from institutional investorsProxy: percentage of institutional ownership

Demand from financial analystsProxy: analyst followingNo directional prediction

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Part IV: Motives for disaggregation

Correct stock undervaluationManagers may believe that their stock is undervalued and thus increase disclosures to decrease information asymmetry.Proxy: Market-to-book ratio (“MB”)

Low proprietary disclosure costsProprietary disclosure costs are higher for market leaders than for market followers. Proxy: sales ranking (“Compete”) Proprietary disclosure costs are lower when the barrier to entry is higher. Proxy: percentage of total sales by the top five firms “HardEntry.”

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Part IV: Motives for disaggregation

Complexity of operationsFirms with more complex operations are more difficut to predict earnings components. (the supply side of the story)Proxy: the number of segments (“Segment”)

Corporate governanceFirms with a higher percentage of independent directors have stronger corporate governance. Proxy: percentage of independent directors (“IndDir”)

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Part IV: Summary of predictions

Variable HypothesisPredicted

SignSale Signaling +Good Credibility +Relevance Demand for information -RD Demand for information +IO Demand for information +Analyst Demand for information ?MB Undervaluation -Compete Proprietary costs -HardEntry Proprietary costs +Segment Complexity -IndDir Corporate governance +

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Part IV: Univariate comparisonsGroup 3(“elite”)

Group 1 (“earnings only”) Between Group Test

Variable mean median n mean median n t-test WilcoxonMVE 19,192 9,319 109 22,737 10,488 113 0.61 0.34Sale 1.00 0.92 107 0.84 0.64 110 -1.75 * 2.92 ***Good 0.11 0 109 0.05 0 113 χ2 = 2.42Relevance 0.14 0.08 108 0.19 0.12 110 2.07 ** -1.69 *RD 0.05 0.03 63 0.04 0.03 35 -0.36 -0.16IO 0.79 0.80 109 0.73 0.75 113 -3.12 *** 2.73 ***Analyst 16.28 16 109 13.23 13 111 -3.36 *** 3.04 ***MB 3.56 2.93 108 3.99 2.84 112 0.67 1.04Compete 11.57 9 109 11.40 8 113 -0.13 0.05HardEntry 0.40 0.34 109 0.38 0.33 113 -0.67 1.73 *Segment 3.10 3 109 3.29 3 113 0.77 -0.81IndDir 0.75 0.78 108 0.73 0.75 112 -1.24 1.21

25 Using Classification AH

Part IV: Ordered ProbitClassification AH Classification B

Variable Coeff. z-statMarginal

Effect Coeff. z-statMarginal

EffectSale 0.89 2.58*** 3.4% 0.71 2.33*** 2.3%Good 0.53 2.17*** 20.8% 0.33 1.39* 11.3%Relevance -0.61 -2.36*** -2.3% -0.41 -1.71** -1.3%RD 0.73 2.42*** 2.8% 0.53 2.130** 1.7%IO 0.79 2.75*** 3.0% 0.31 1.17 1.0%Analyst 0.04 3.10*** 1.4% 0.02 1.78* 0.6%MB -0.50 -1.67** -1.9% -0.30 -1.12 -0.9%Compete 0.01 0.54 0.2% 0.01 0.79 0.2%HardEntry -0.01 -0.02 0.0% 0.24 0.70 0.7%Segment -0.02 -0.59 -0.9% -0.06 -1.54* -1.7%IndDir 0.29 1.10 1.1% 0.22 0.94 0.7%Cutoff 1 (μ1) 0.95 0.03Cutoff 2 (μ2) 1.57 1.43

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Part IV: Ordered probit with selectionClassification AH Classification B

Variable Coeff. z-statMarginal

Effects Coeff. z-statMarginal

EffectsIntercept -1.244 -2.67*** -0.191 -0.44Sale 0.942 2.73*** 3.3% 0.208 2.37*** 2.4%Good 0.547 1.96*** 20.4% 0.309 1.43* 10.8%Relevance -0.664 -2.48*** -2.2% 0.780 -1.72** -1.3%RD 0.729 2.26*** 2.5% 0.504 1.57* 1.5%IO 0.783 2.75*** 2.7% -0.431 1.19 0.9%Analyst 0.032 2.58*** 1.1% -0.058 1.75* 0.6%MB -0.367 -1.02 -1.2% 0.328 -0.80 -0.8%Compete 0.008 0.84 0.3% 0.008 0.81 0.2%HardEntry 0.030 0.08 0.1% 0.282 0.87 0.9%Segment -0.017 -0.41 -0.6% -0.259 -1.38* -1.7%IndDir 0.300 1.19 1.0% 0.020 0.85 0.6%

Cutoff 1 (μ1) 0.000 0.000Cutoff 2 (μ2) 0.587 1.374

ρ 0.389 p-value=0.135 0.193 p-value=0.457

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Part IV: Is the practice sticky?

Guidance Practice in 2006Q4Group 0 Group 1 Group 2 Group 3 Subtotal

Group 0 190 (88%) 11 7 9 217Group 1 20 74 (65%) 5 14 113Group 2 14 6 24 (41%) 15 59

2005Q4Sample

Group 3 17 14 10 68 (62%) 109Subtotal 241 105 46 106 Total=498

Using Classification AH

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Part IV: Analysts’ response to earnings guidance

Do analysts revise earnings estimates more quickly for the “elite” group than for the “earnings guidance only” group? Interpretation of a possible difference:

Analysts perceive earnings guidance accompanied by earnings component guidance as more credible.It is possible though not probable that the difference in speed of revisions exists before earnings guidance disaggregation is considered.

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Part IV: Speed of analyst revision

Disaggregation Group

Existing Forecasts

Revision within 2

days

Revision between 3rd-

5th day

Revision between

6th-10th day

Revision after 10th

day

NoRevision

Obs 2,076 801 153 141 577 404“Elite” % 100% 38.60% 7.40% 6.80% 27.80% 19.50%

Obs 1,709 576 124 103 572 334“Earnings

Only” % 100% 33.70% 7.30% 6.00% 33.50% 19.50%

Using Classification AH

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Part V: Findings

Of the S&P 500 firms that issue annual earnings guidance, 38.8% also provide guidance for annual sales and operating costs (“disaggregated earnings guidance). Earnings guidance disaggregation is primarily associated with enhancing the credibility of good news earnings guidance and responding to the demand for additional disclosures. A firm’s practice of earnings guidance disaggregation is somewhat sticky.

Part V: Contribution

Provides the first archival evidence on earnings guidance disaggregation. Complements the experimental study of Hirst, Koonce, and Venkataraman (2007a). Lays the groundwork for future archival research on the emerging issues of earnings guidance disaggregation.