Seattle-based biotech PathoGenesis was riding high on tobramycin. Trade-named Tobi, it was a promising, easy-to-use new form of inhalant, and the drug had been approved by the FDA in December 1997 for use by cystic fibrosis patients to fight off the chronic lung infections that plague them. Last year, Tobi generated sales of $60.7 mn and, seeing the inhalant as a big moneymaker despite the occasional contrarian view, Wall Street had pushed shares of the company sky-high.
Then, on March 22, 1999, the company announced that a decline in sales, resulting from ‘fluctuations in ordering patterns’ for its drug, had led to a significant first quarter loss of nearly $5 mn. Rather than the earnings of 20 cents a diluted share expected by analysts, there would be a loss of 30 cents.
On March 23, the stock plummeted 65 percent, from about $35 to about $12. The company has also been hit with a barrage of shareholder class action lawsuits. ‘Defendants reiterated their positive comments about product demand throughout the first quarter of 1999, and guided analysts to revenue estimates of $90-100 mn for 1999,’ alleges Wolf Popper LLP, in just one of the lawsuits faced by PathoGenesis.
On March 24, chairman and CEO Wilbur Gantz went on CNBC to do damage control: ‘What occurred in the first quarter is that growth absolutely plateaued out,’ he said in the interview. ‘We have to change the way doctors are treating patients. This change takes time.’
But it was too late for this kind of talk. Investors and analysts were disappointed – and angry.
Shock factor
PathoGenesis provides a cautionary tale about handling ugly earnings surprises. ‘It was a complete shocker,’ says analyst Lesley Wright Marino, who covers the company for BancBoston Robertson Stephens. ‘When it’s something this bad, you have to get it out as fast as possible, or you’re going to run into really big credibility issues.’
Marino says she had been in touch with the company just the Friday before it made the announcement, and had continued to receive bullish signals. She notes that every company needs to know how to handle hot button issues with greater sophistication: ‘Management needs to be in touch with analysts, with their expectations, and with the whisper numbers. They need to proactively review our models rather than waiting for an analyst to come to them.’
In fact, companies are getting better at guiding analysts’ estimates. Niri’s 1998 corporate disclosure survey shows that 86 percent now review and comment on drafts of analyst reports, compared to 78 percent in 1995. Similarly, 79 percent now review and comment on models and projections, compared to 69 percent from the previous study.
One result is that positive surprises no longer always generate a stock price boost, but the shares of companies that disappoint get pummeled. A study last spring from TQA Investors, a New York hedge fund, showed that whether you’re talking about the 1980s or 1990s, a negative surprise meant an 8 percent average price decline for an S&P 500 company. The difference is that in the 1980s, it took three to four weeks. Now, it takes two days.
‘There is never a good time to release bad news,’ avers Warburg Dillon Read European food analyst Mark Lynch. ‘But whatever you do, don’t let it just leak out into the market. If it leaks, and it will, the news probably won’t be best presented, and the company will effectively have lost control of the process.’
There is also another factor to consider. Even if insider trading charges will never be brought, leaking – especially selective leaking – nonetheless creates deep negativity toward a company, says one disgruntled fund manager ‘Well-connected people have a real advantage, and they are able to act on information before others get it. But it’s a sensitive issue – if you’re the CFO and you have a dozen messages – who do you call back first?’
Right foot
Investors and analysts want to hear the best possible construction of bad news, and expect management to put its brightest foot forward. Bad news can sometimes be mitigated by an upbeat explanation from an ardent CEO. But there are limits. London-based Kieran Mahon, who covers European food producers for Schroder Securities, explains: ‘You can do your spiel in marketing, but at the end of the day, all the razzmatazz presentations won’t help if your numbers are bad.’
Company managements often fail to consider that analysts also have a heavy involvement in earnings forecasts. Analysts don’t like to be made to look foolish any more than anyone else, and while there’s a degree of ego involved, they also stand to lose credibility. Since an analyst’s reputation in the financial community is his or her most valuable possession, when an analyst’s judgment proves to be faulty, it’s a serious matter. For all the talk of rational objectivity, future dealings may become clouded by hostility. In the case of PathoGenesis, for example, one analyst suggests that the grim outcome obviously meant ‘management had its head up its butt.’
One place from which earnings disappointments have been coming thick and fast is Latin America. Warburg Dillon Read oil analyst Mary Quinn describes the actions taken by Argentinean company YPF to navigate the treacherous economic turmoil. ‘Early last year, when crude prices had just started to slip, the president, Roberto Monti, said to everyone, We’re preparing to withstand $15 a barrel. He didn’t say it would be that low, but he constantly reiterated his stance at conferences. The company’s investor relations person would also call me up and ask, What are you using for earnings? and then we’d argue over our estimates for the year.’ The price ultimately collapsed to $14.38 a barrel, but YPF management had effectively managed the crisis. ‘All year they outperformed expectations,’ relates Quinn. ‘By the end of the fourth quarter, everyone was thinking these guys were pulling rabbits out of hats.’
Not all companies can manage this kind of market magic. When Mexico’s largest broadcaster, Grupo Televisa, surprised the street by disclosing worse than expected earnings in July 1998, investors punished the tight-lipped media giant with a massive sell-off: shares plunged 18 percent in a single day.
According to Salomon Smith Barney’s Latin American media analyst Whitney Johnson, the company did not even bother to respond when she sent them her earnings estimates, which were based on potential advertising revenue generated by the company’s spectacular ratings. ‘It was a debacle,’ says Johnson. But Televisa quickly changed its tune. ‘There was a real about-face in dealing with the investment community. The chief financial officer, Gilberto Perezalonso, proactively called me to apologize and said this wouldn’t happen again. And it really hasn’t,’ she explains. ‘They’ve even given people a heads-up as to what is coming for the quarter and for the year. They’re much more transparent now and much more willing to open their doors to the investment community.’
One company, Sociedad Quimica y Minera de Chile, seemed like a nice turnaround story until it surprised analysts by reporting a fourth quarter earnings disaster this past March. ‘They should have indicated to us when they knew they were going to disappoint,’ according to Merrill Lynch’s Chile analyst Jane Winslow. But they felt that would be giving away market-sensitive information, which might affect their pricing power.’
The market didn’t buy that rationale and drove the stock down 20 percent in two days. But then Soquimich made a very clever move: it went on a roadshow to repair the damage with investors, and invited along one of its harshest Street critics, Rene Kleyweg, Merrill’s Latin American mining analyst.
Frank admission
‘The company made the best of a bad situation. Management was frank, and pulled no punches,’ says Kleyweg, ‘and I think that’s what investors liked. Not every company publicly accepts that its performance has not been up to scratch. And going forward this one will be a lot more open, I’m sure.’ Kleyweg believes the market has taken one cautious step toward returning favor to Soquimich. ‘But we have to see some results before it becomes a reality.’
Many senior executives now have a compelling reason for taking a far greater interest in the fluctuations of the market. As Mary Quinn notes, ‘What has changed is that a lot of managements are compensated in line with the price performance of their stock.’ More common in the US, this practice is now spreading throughout the globe. In some parts of Europe, like Scandinavia, notes Warburg Dillon Read’s Lynch, ‘Performance-related bonuses are still seen as offensive, not socially acceptable, but more and more we see companies remunerating their managers in line with stock and business performance.’
In order to attract capital in an increasingly competitive marketplace, companies worldwide need to emulate the US and UK models of transparency, begin to speak the language of shareholder value, and develop responsive and sophisticated investor relations practices.
Quinn sums it up: ‘The worst way of managing disappointments is for a company to lead you along saying everything is ok, and then blow you out of the water.’
Once a company has lost the confidence of investors, it is very hard to get it back.
