Evaluating Earnings with an Eagle’s Eyesight: Refining Forecasts with a Risk Lens
Report Reviews Risks Leading to Calendar 1Q 2012 Negative Earnings Surprises
NEW YORK, May 24, 2012 – Risks abound in a changing and complex world. Despite trends toward better risk oversight and management, sixty-eight S&P 500 companies reported negative surprises greater than 5% below consensus in the first calendar quarter earnings season.
Knowing “why?” can help any company avoid future negatives and make it easier to seize growth opportunities. In contrast to the compliance and financial reporting risks that hit the headlines, about half of negative surprises sprung from strategic risks, about a third from operational risks, and just over 11% from strategic or operational risk-driven one-time situations.
Specifically, of the 68 S&P 500 companies:
- Strategic risks were about half of negative earnings explanations. Strategic risk in general related to business environment and model was pointed to in just over one-third of all reports. Energy companies pointed to weather as primary in another 18% of negative surprises.
- Operational risks related to people, process and systems that implement strategy were the next most frequent primary cause – just under one-third of all reports. Information technology related operational risks were reported as secondary in just over 3% of reports.
- Stemming from strategic and/or operational risks are one-time impacts (e.g., acquisition, legal settlement) that comprised just over 11% of primary causes for negative surprises.
- Market risks mostly related to foreign exchange or overall investment returns were 2.5% of primary causes for negative surprises. Credit risks were 3% of primary causes for all negative surprises, all at banks.
As an observation, these earnings gaps, driven by strategic and operational risk, beg for action to find and fix other lurking risks. Needed action is quite different from tasks to reduce risk to accurate reporting or erect barriers against ‘bad things.’ Such defenses, while needed in certain circumstances, are simply not designed to help companies more safely seize opportunity in a complex and changing world. Investors would be well-served if companies emphasize performance-driven risk management designed to ask “what if?” in dynamic business environments, delve into dependencies, peer into processes, look across systems and create ready-to-go Plan B’s. In a baseball game, neither an accurate scoreboard nor a strong defense actually scores points. Scoring points is about managing risk to performance.
In looking further at the releses, differences were seen in the quality of explanation of what happened, immediate action taken, and how risk oversight and management will be improved. All have implications for lurking risks and the extent to which future earnings must be discounted for risk to calculate a price target. Differences in directness of explanations also speak to investors in terms of management style and company culture.
Companies reviewed were S&P 500 members that missed earnings consensus by greater than 5% in reports released during the 90 days ended 18 May (68 companies). These were reviewed for type of risk to which the company attributed the miss. A primary and, if applicable, a secondary risk category were identified. Full review is at www.valuebridgeadvisors.com/ES1Q12EARN052412.pdf