The “Unwritten” Rule of Earnings Preannouncements

A recent earnings announcement from a component of the Dow Jones Index provides a good reminder of the “unwritten” rule of preannouncements. The company reported earnings per share of $0.32 for the third quarter, falling well short of the consensus estimate of $0.47. Making matters worse, the company didn’t preannounce these disappointing results, which exacerbated the negative reaction from Wall Street and unleashed a flurry of criticism about the management team.

Wall Street convention says that if you are going to miss estimates by a significant margin, give the Street a heads up and issue a preannouncement. What’s a significant margin? Some would say at least a 5% shortfall, others would say 10%. So there is a bit of gray area when the miss is smaller. But a miss of this magnitude – 32% – clearly falls into the preannouncement zone.

Even if a company does not give formal earnings guidance, there is a belief that it still has an obligation to warn the Street when it knows it will fall short of expectations. If investors don’t hear from a company during the traditional “preannouncement season,” which usually lasts from the few weeks before the quarter ends to a few days into the next quarter, they tend to assume that earnings will generally come in line with expectations. Based on this belief, some might buy on any dips that occur before the earnings announcement. When the stock tanks after the big earnings miss is announced, these investors will be sitting on losses that they wouldn’t have had if the company had preannounced. How do you think those investors will feel about investing in that company in the future?

When a company doesn’t preannounce, the Street starts to ask some unpleasant questions. Questions like:

• Does management not have its arms around the business?

• Are they unable to make accurate forecasts?

• Were they completely caught off guard by this shortfall?

• If they knew about this earlier, why didn’t they tell us?

• Are they completely oblivious to their obligations as a public company?

In addition to the disappointing financial results, management now has to deal with concerns about its credibility. No one likes doing preannouncements, but they are a necessary evil for preserving credibility and maintaining healthy relationships with the Street. No company should make a bad quarter even worse by ignoring the obligation to preannounce.