What Wall St. hates to hear: top executives downplay earnings guidance--some have kicked the habit altogether--and may force the market to go cold turkey with them.

To the evident chagrin of many analysts, and even before the recent stew of accounting scandals came to a boil, a small group of high-profile corporate chiefs stopped answering questions about what they expected their companies would earn next quarter or next year.

Now the small group is growing into a parade, with some of the most respected management consultants in America cheering it on.

CEOs hardly need to be reminded that the earnings-per-share estimate is arguably the single most influential number in a company's stock price. Although EPS estimates are questionable because they are based on assumptions, they can have a powerful effect on management decision-making. "There's a huge amount of pressure on companies not to come in with negative earnings surprises," says Bill Landuyt, CEO of Millennium Chemicals, a $1.6 billion maker of chemicals that go into flavorings and perfumes in Red Bank, N.J. "It can become a monster. The more you're successful at it, the more it's expected, and the worse the reaction when you don't [meet your estimates] ."

More than one CEO has been terminated for promising more than he or she could deliver. Just look at the truncated corporate careers of Richard McGinn at Lucent Technologies, Donald Roden at Bergen Brunswig, and Martin Grass at Rite Aid. Several factors played a role in each of their hasty departures, but missing earnings expectations didn't help.

In June 2001, newly appointed Gillette CEO James Kilts made a memorable debut. In front of analysts, he excoriated his predecessor Michael Hawley, ousted by the Boston company's board eight months earlier, for raising analyst expectations with EPS estimates and for trying to meet the unrealistic targets by raising prices and cutting advertising. Kilts went on to stonewall question after question about his own expectations, because he blamed the earnings estimation game --the monster to which Landuyt refers --for nearly wrecking the consumer products giant. He says changes made to meet promises resulted in a drop in sales, a buildup of inventory and a turnaround challenge worthy of Kilts, whose resume includes resolving a prior mess at Nabisco.

Despite his illustrious track record, Kilts might have seemed like a lonely voice balking at the market misinformation orgy. But other voices soon joined in.

In October 2001, USA Networks CEO Barry Duller said in a letter to the Securities and Exchange Commission that the earnings estimation game "has little to do with running a business and the numbers can become distractingly and dangerously detached from fundamentals." Duller made it clear he was bent on change. From that point forward, the New York media company would not provide earnings guidance. Rather, it would offer much more detailed information about its business so that analysts could reach their own conclusions.

Similarly, Touch America CEO Robert Cannon, who in mid-February completed his Butte, Mont., company's transition from an energy and communications mini-conglomerate to a telecom pure-play, says that he no longer provides earnings guidance to Wall Street. "Because of the downturn in the sector and the difficult economic environment, it became very difficult to give meaningful guidance, so in the last part of last year we -- like everyone else in our sector--stepped away from doing that," says Gannon.

Although the CEO concedes that "it's hard for people who want guidance to hear this," he also knows from experience the importance of saying no to analysts. "Our stock price in 1997 was about $10 a share, and it moved over a period of a year and a half or two years to the 60s," Gannon says. "We were being compared to other fiber optics companies with even stronger growth in share price." But, he explains, those competitors were knee-deep in debt. Montana Power wasn't, and analysts criticized it for not amassing debt and growing faster. "But now the worm has turned," he says, "and we're applauded for not having gotten into debt, although our stock is now at $5.50. The reality was the market was just overheated."

Sweet dreams

So how do these guys get away with it? As anyone who has taken an accounting course can attest, the relationship of EPS to underlying economic facts is tenuous. Even many people who've never cracked an accounting text are learning that Enron managed to book megamillions in profit today based on assumptions about a distant--and now, clearly, never-to-be--tomorrow. In fact, EPS numbers are so much a creature of assumptions, that skeptics characterize them as made and shaped by accounting rules and loopholes rather than by hard-nosed facts of business life. "If you really want to know about a company, don't look at the earnings statement--look at the statement of changes in cash flow," suggests Millennium CEO Landuyt. "At the end of the day, you can't manipulate the cash number." The emphasis in Millennium's quarterly reports is not so much on earnings as on EBITDA, earnings before interest, taxes, depreciation and amortization -- essentially, cash flow. And Landuyt manages the company according to the gospel of EVA, or economic value added. "EVA is really a proxy for the discounted value of the future cash flow," he explains.

Many market watchers share Landuyt's skepticism about the earnings number. "Earnings is entirely an accounting construct," insists Bill Mann, senior analyst at online investment advice company Motley Fool. "A lot of times you'll see deductions for amortization of capital equipment on a 20-year schedule. Then the company will suddenly push it out to a 30-year schedule, which means they deduct less each year--a very easy way to increase earnings in the current quarter."

Martin Fridson, chief high-yield strategist at Merrill Lynch and author of the widely respected text Financial Statement Analysis, as well as the popular debunking guide Investment Illusions, has even stronger words. "Perhaps in a very well-managed corporation, there's a longer-term notion that having credibility with investors has some value so we'll go the extra mile to present earnings as honestly as we can. But I don't think that's a widespread view and the penalties don't seem to be that great for companies that don't measure up in terms of accounting quality."

Many CEOs share the view of Larry Yost, chairman and CEO of ArvinMeritor in Troy, Mich., who says, "The share owners want integrity." But executives who call for integrity don't necessarily go far with analysts. Just consider the example of The Progressive Corp., a $6.7 billion auto insurance provider based in Mayfield Village, Ohio. "We ended 2001 with $3.2 billion in loss reserves on our balance sheet," says Progressive's chief investment strategist, Tom King. "A 1 percent revision in our estimates -- something that is easy to do in the face of economic uncertainty--translates into a $32 million change in pre-tax earnings, which is over 25 cents per share in after-tax earnings." King offers this example to illustrate earnings estimates' lack of precision, and why Progressive's policy is to abstain from making them. King adds, "We continually update loss reserve estimates as we gather new information. Using the best information we have to set loss reserves means we will have the most accurate auto insurance rates possible, which allows us to grow profitably. Given our preference for accurate pricing and profitable growth, it is simply not practical to give focused earnings guidance."

Refusing to serve up Fishy numbers would seem to be a symptom of integrity. So what is Progressive's reward for honesty? "A lot of people think Progressive is some kind of outlaw," says Fridson. "It's hard to see the upside of deviating from the system. The CEO is in a tough spot."

The dangerous game

Indeed. The Home Depot CEO Bob Nardelli, without a hint of irony, sums up Wall Street's demands on the CEO this way: "They're looking for sustainable, continual growth that will meet shareholder expectations today and tomorrow. They want someone who's not going to surprise them -- positively or negatively. They want people who each and every year will be able to recreate the business, who understand that change is the only constant, and that the corporation with the processes, culture and passion to respond will be successful over the long term."

No surprises, in a world where change is the only constant? Isn't that contradictory? No doubt. And no wonder then that some of the prominent management consultants are warning that attempting to give Wall Street everything on its contradictory wish-list can be a quick route to disaster. "When new CEOs ask the question, 'what does the Street want? they let the tail wag the dog," observes Scott Gillis, managing partner with New York's Marakon Associates, a consulting firm specializing in value-based management.

Some say that the guidance game is dangerous enough to have caused the Enron scandal and the telecommunications industry collapse. "Enron didn't have to end that way. [The executives] put at risk their most valuable assets. They were innovators, but to justify a $70 billion total valuation they took bets and played games with accounting and reporting that destroyed the core asset," says Michael C. Jensen, Jesse Isidor Straus Professor Emeritus at the Harvard Business School as well as managing director of The Monitor Group's Organizational Strategy practice. His firm warns that instead of trying to meet analyst expectations, CEOs ought to rein them in -- even when this means sending the stock price down.

What's the alternative?

Marakon's Gills goes a step further. CEOs, he urges," need to reset the game." Resetting the game doesn't mean that CEOs don't set targets, communicate and manage to them--it does, however, mean that they set the right targets. "In our experience, less than 40 percent of the capital employed in a company is contributing to shareholder value. Often, 30 percent or more is actually consuming shareholder value. If you are playing the EPS game you understand where earnings are coming from, but probably don't understand how much capital is employed to achieve those earnings. Since that's a fundamental driver of shareholder value, you have to know that," elaborates Gillis.

Part of the reason more and more CEOs are refusing to give precise earnings estimates is that such guidance limits their options. Long-time Marakon client Travis Engen, now CEO of Alcan, based in Montreal, believes the earnings game has to be reset. "You have to be doing your best to make progress on many fronts, not just a single one," he says. "Different shareholders have different perspectives on the value of the firm--some are concerned with earnings, some with cash flow, some with future growth.

It's a big mistake to fall into the trap of thinking there's only one star to steer by."

Engen does give analysts some guidance on the range in which he expects corporate earnings will fall. Last October, for example, Alcan offered analysts a 30 percent range on fourth-quarter income estimates - between 15 cents and 20 cents a share. (To put that into perspective, General Electric's CEO Jeff Immelt has provided Wall Street a much more precise earnings target of $1.65 to $1.67 a share for the whole year of 2002.)

Although Engen gives broad guidance to analysts, he says bluntly, "I try to divorce that from each business." He wants the organization to focus not on increasing earnings but rather on maximizing value. The single most important management tool for him is a menu of alternative possibilities for adding value. Last year, for example, when drought gripped the Pacific Northwest, Alcan faced a tough choice. The firm has a reservoir system that provides hydroelectric power both for its own operations and for sale to others. There wasn't enough water to produce power at the usual rate, and the recommendation came up the ladder to Engen that the company should curtail electricity sales to outsiders in order to keep aluminum production up. Understandable, of course, for an aluminum company-but Engen demanded more options, and eventually the firm decided to cut production of aluminum in order to sell more power. "That was a better value alternative than using it to make aluminum," Engen says.

What's more, when Engen does offer guidance, it comes with a strong proviso: The estimates depend on stable raw material prices, and aluminum prices are notoriously unstable. "Alcan's short- and medium-term earnings are greatly affected by the price of aluminum as traded on the London Metal Exchange. By giving an earnings outlook we make it possible for others to use their views of metal prices and other major factors to develop their own projections of our results," Engen explains. He also emphasizes that the most important long-term measure is not earnings, but what he calls "economic profit, returns in excess of the cost of capital." The CEO says that some on Wall Street have applauded his approach.

Compensation based on return on invested capital

Yost of ArvinMeritor has gone so far as to set up a compensation system based on the return on invested capital. The $6.8 billion auto parts manufacturer runs an annual bonus program and a three-year rolling bonus program. For the annual one there are two metrics -increasing earnings per share and improvement in non-cash working capital. Those two fit into return on invested capital and economic profit. But economic profit and return on invested capital can only change modestly in any given year. For the three-year rolling program the metrics are EPS growth and cash flow return on investment. Yost believes those two will, over a longer term, improve return on invested capital and economic profit.

At this point, it's hard to tell just how many CEOs will dispense with the time-honored ritual of EPS guidance. Recent SEC regulations on fair disclosure--which require material information to be immediately released to the entire market -- have added momentum, because they restrict companies from making significant information available to a favored few. And it's hard to argue against Kilts, Diller, Landuyt, Engen and others who have decided to let the future speak for itself. In the post-Enron climate, anything that removes one more fishy number from the market can only be an improvement.

Please send your comments to CE at [e-mail].