This content was originally published as an Action Alerts PLUS Alert on Jan. 29, 2016. Stock prices, shares held and portfolio positions may have changed.)
Although our portfolio materially outperformed the S&P 500 in Thursday's trading session -- led by spectacular earnings from Facebook (FB) , PayPal (PYPL) , very strong earnings by American Electric Power (AEP) and a major positive announcement by Energy Transfer Partners (ETP) , which maintained its quarterly distribution, slashed spending and lifted its need for capital market funding this year -- we were severely disappointed by two companies, not for their actual earnings report but for their full-year guidance.
It would be easy to focus on all of the positives from yesterday, but doing so would deprive our subscribers of an invaluable teaching lesson: the importance of management's forward guidance in the context of earnings results.
If investors in Stanley Black & Decker (SWK) and Thermo Fisher (TMO) read each company's respective earnings release in the vacuum of their reported fourth- quarter results, and those results alone, both stocks would have traded sharply higher during Thursday's session. Both reported earnings beats; in fact, TMO reported its best quarter -- in terms of organic growth - since 2010. The moment fiscal 2016 guidance was introduced (SWK included guidance in its release; TMO announced it on its call), however, heads rolled, hell was raised and panic ensued. The otherwise positive sentiment screeched to an immediate halt and made a metaphorical U-turn. Shares of SWK and TMO closed the day down 4.5% and 5.5%, respectively.
Therein lies the importance of guidance, and managing expectations. Let's dissect each situation, starting with SWK. The company issued 2016 EPS guidance of $6 to $6.21, the midpoint of which fell dramatically below consensus expectation for $6.40, with the difference driven almost entirely by higher-than-expected currency headwinds of $170 million to $190 million on the revenue side (translating to $0.85 to $0.95 EPS impact) vs. the Street's expectations for around a $130 million to $150 million hit.
Taking a quick step back, last year, nearly all investors were more than willing to overlook FX impacts on company results and guidance as they viewed the headwind as transitory and not reflective of the underlying business. This leniency allowed many companies to get away with reporting earnings on a "constant-currency" basis, meaning they would strip out the FX impact (which, of course, is tangible) in order to demonstrate what earnings would look like in the absence of the currency headwind. This hypothetical exercise was all too easily embraced until, of course, the currency environment failed to recover and instead continued to deteriorate to the point where everyone woke up to the reality that the impact was no longer a transitory nuisance, but a prolonged, dense weight that must be accounted for.
Back to SWK. It is not fair to blame the sell side for missing consensus, as SWK's management team bears the responsibility of better buffering currency volatility into forecasts (this is the CFO's job) and at the very least properly managing expectations when those headwinds intensify (this is a shared responsibility across the CFO, CEO and the head of investor relations). Their prior guidance for $100 million fiscal 2016 top-line currency impact is unacceptable; while the FX environment deteriorated rapidly subsequent to its $100 million pegged drag last October, the absence of incremental communication leads to noise, uncertainty and headline disappointment. At worst, it sows the seeds for a lurking distrust in management.
Now to Thermo Fisher. After reporting outstanding fourth- quarter results, the company issued initial 2016 guidance for $17.36-$17.56 billion in sales (below consensus of $17.60 billion) and EPS of $7.80-$7.96, which came in severely below consensus of $8.19. For a company known for its consistency, transparency and track record of execution, the news was jarring at best. Even though the gap can be bridged -- with the EPS deltas related to FX ($0.19 headwind) and the exclusion of accretion from its Affymetrix (AFFX) acquisition ($0.10 annualized, set to close in 2Q) as well as any incremental buybacks (which leads to another $0.05 to $0.10 delta) -- it does not erase the sense of betrayal investors and analysts experienced at the behest of management. They outright screwed up by failing to manage expectations.
This probably falls on the relatively new CFO, who could and should have warned sell-side analysts that the assumptions underlying their full-year forecasts (which he has full access to) differed from management's internal assumptions (or lack thereof). The sell side relies on the CFO to provide guidance so that this type of very jarring downside surprises does not occur.
So what does this mean for SWK and TMO? Both companies will have to work hard to build back the trust of their investor base and analyst community. Although the expectations have been completely flushed out, it takes time to restore trust and the only way to do so is by acknowledging their mistakes, learning from them, and speaking through results rather than promises. As one of the top-ranked analysts who has covered TMO for over a decade told us last night: "I certainly read them the riot act today, as I'm sure many other analysts and shareholders did as well, and they seemed to take it to heart. There are clearly lessons learned." CEO Marc Casper will make sure of that.
For TMO, the guidance mishap is especially frustrating as it more than overshadowed one of the best quarters in the company's history -- it had been nearly six years since it last reported about 7% organic growth. As for execution, the company has a strong track record: It delivered in 2014 (EPS $0.06 above) and again in 2015 (EPS at the high end of guidance, despite the incremental FX headwind), and we believe they will ultimately deliver this year, though it may take at least a quarter or two to rebuild confidence.
Trading at 15x for what should be a 10% annualized EPS growth trajectory over the coming years, we are not terribly concerned by the downside risk long term. In the near term (more specifically, over the next two quarters), we acknowledge shares could experience some volatility and test levels below $120.
The back half of the year remains compelling with low expectations, strong underlying trends (which -- following deep analysis -- suggest upside to the company's own estimates), powerful capital deployment opportunities (we model over $2 billion in incremental buyback activity this year) and enhanced visibility following the AFFX deal's closure.
In short, for subscribers with at least a six-month investment horizon, we remain bullish long term on both SWK and TMO. Anyone owning shares for a rally between now and 2Q 2016 results should probably sell out of shares now.
The takeaway is simple: Guidance and expectations management is far more important than reported results. Management teams that fail to manage expectations do so at the risk of eroding the invaluable, delicate asset that is trust.