Second Quarter 2020 Amid COVID-19: Investor and Audit Committee Considerations
Evaluating the Business (Looking Back, Looking Forward)
Understanding how business fundamentals have been affected by COVID-19, and even more important, how they will be affected going forward are important to, and essential for, investors as they consider second-quarter and half-yearly results. This installment in our blog series Second Quarter 2020 Amid COVID-19, Investor and Audit Committee Considerations (“Introduction,” “Cash Is Everything,” “Going Concern”)focuses on investor and audit committee considerations as they evaluate the state of the business this interim reporting season — and the disclosures companies should be making to facilitate that analysis.
As we highlight in our post on going concern assessments, in this second quarter, investors should, and will, care less about the precision of reported earnings per share (EPS) relative to consensus estimates than they will care about the strength of the balance sheet and the basics of the business under forward-looking scenarios. The statement of cash flows and the balance sheet will be far more important than the income statement for investors evaluating companies in this and in coming quarters.
Also essential will be disclosures regarding the state of the business. In the United States, for example, the SEC’s quarterly reporting obligation does not necessitate the reconsideration and updating of the disclosures related to the state of the business — provided annually in the Annual Report on Form 10-K — unless, of course, there has been a material change in a company’s business. The COVID-19 pandemic likely presents such a change for many, if not most, companies — some for the better, most for the worse.
As a result, companies should be reviewing all elements of their reporting obligations related to the description of the business and its outlook in the business section as well as describing the effects in management’s discussion and analysis (including liquidity and capital resources, which we covered in our blog “Cash Is Everything”).Risk factors and market risks — which we address in a forthcoming blog — also require updating as these risks have become realities. The pandemic also has shown that human capital management — an element of the business that investors have sought more information on — is something companies should be communicating about and investors paying attention to. Government programs and intervention are elements of the business that companies should be explaining and that investors should be considering. We cover these topics in separate blogs to come.
Investors should be expecting discussion and updates on all key
business drivers. We can’t cover all such drivers here — and they are different
by industry. We have, however, included some “food for thought” about what investors
can learn from these interim historical results that will be useful going
forward and what we should expect to see, or seek, from companies related to
their future business outlook. We have given attention to a few items that may
be distinct to this pandemic and its effect on the business.
God willing, this will never be a quarter to be relived. As such, it won’t have much predictive value. Recognizing this fact, some companies may use this quarter as an “everything-including-the-kitchen-sink” opportunity to clean up the balance sheet and recognize costs because they believe investors will disregard the results.
The dramatic contraction of business may provide an opportunity this quarter for investors. If they dig deeper into these interim results and understand the pandemic’s impact on the revenue and expense drivers, investors may gain insight, possible as never before, into the variability of the company’s results, both revenues and expenses; its cash-generating capacity; and managements’ capability in responding to these challenging circumstances. For this reason, we think historical results may provide insight about companies— beyond the simple communication of interim results. For that reason, we encourage investors to “look under the hood” at the results — not for their predictive ability this quarter per se but rather for the ability of a company’s forward-looking statements to be evaluated and to make their own assessments of future prospects.
Until there is a vaccine, in 12–18 months, company results and outlook will likely be filled with uncertainty, and these interim results can provide insight into the impact of the pandemic and how the business may respond in the future as the pandemic ebbs and flows over the next few years. Investors and audit committees charged with overseeing investor interests may want to consider the following:
- April vs. May vs. June: The Effects Through the Quarter — We noted in our blog, “First Quarter Amid COVID-19: Big Banks Report,”that the first quarter was a tale of two quarters — pre-pandemic (January, February, and early March) and commencement of the pandemic (the last two weeks of March). On a recent SEC webcast Gary Cohn (president and co-chief operating officer of Goldman Sachs and former director of the National Economic Council) made a remark that resonated in the context of our takeaway from the first quarter. Cohn rightly noted that companies and investors need to consider the impact of the pandemic on April, May, and June separately, as each month represents very different stages of the pandemic and its economic impact. April brought a complete shutdown of the global economy with re-openings beginning in May in some jurisdictions and a broader push to reopen in June. For this reason, companies need to give a view of results — and investors need to probe the impacts — over, or through, the quarter — not simply in the aggregate. Investors should want to understand the variation and cyclicality of the company’s results during this period to gain an understanding of the variability of cash flows. Management should describe these effects on their business and in the discussion of interim results. Just as Union Pacific management noted during the first quarter analyst call that they had “shuttered an embarrassingly large number of locomotives in April,” this quarter they need to explain the steepness of the decline in April and into May and the nature of the rebound, if any, in June. With US quarterly reporting, this may be easier than in jurisdictions with half-yearly reporting for which the first two and a half months pre-pandemic are aggregated with the depths of the pandemic and the attempted reopening during the three and a half following months.
- Geography: The Effects Across the Globe May Be More Important Than Ever —We witnessed the spread of the virus globally with peaks and troughs of cases at different times in different jurisdictions. Geographic disclosures have always been of interest to investors. The pandemic highlights their importance. For investors to understand the impact of the COVID-19 virus on the company’s business — and to consider how it may evolve in the future as the spread of the virus ebbs and flows — companies should include the effects of the virus on their geographic results and the sensitivity of their business to these regional outbreaks. The virus has taught us the importance of differences in geography and highlight the need for companies to explain those effects. Maps of the COVID-19 “hot spots” are a part of our daily lives. Companies need to correlate these maps to their geographic results.
- The Top Line: Demand and Revenue Drivers —Understanding the geographic spread of the pandemic and the global shut down and reopening over the three months of the quarter is all about understanding the demand and revenue drivers for the business. The pandemic provides a stress test on demand for a company’s products and their business drivers and it is an opportunity for investors to understand — at a foundational level — the nature of the demand for a company’s products. Are they essential or discretionary? How does physical proximity affect demand? What do these mean to future demand and future hot spots? Investors should expect companies to provide — and probe, if they do not — the pandemic’s impacts on demand for their various products — both positive and negative. The pandemic has created an opportunity to provide insight into the variability and resilience of the “top line.”
- Meeting Demand and Managing Costs —On the cost and supply side, company management should provide a discussion of the impacts of the pandemic on the company’s supply chain and its cost structure.
- Supply Chain —The supply chain was disrupted in many industries from personal, protective equipment; cleaning supplies; meat; and drugs to the supply of Pelotons and coins. The pandemic’s effects on the supply chain were both broad and deep. Investors should expect company management to explain these disruptions on the supply chain, including their impact on costs, and qualitatively, on revenue forgone because of supply problems. The pandemic presents an opportunity for both management and investors to better understand the company’s supply chain and dependencies and what management intends to do as the pandemic ebbs and flows as well as lessons learned for the future.
- Fixed vs. Variable Costs —The extreme fluctuations in business (both positive and negative) and the reported results for this interim period will provide insight into the fixed versus variable nature of a company’s business. With decreases in demand and production or supply, the variable costs will automatically decline. Investors need to understand the degree to which management took actions to cut fixed expenses — and the nature of such costs (i.e., human capital) amid the decline. The income statement — and segment results — will provide a line of sight that investors may not have had in the past on the nature of the expenses and their behavior.
- Tax Effects — While not a business driver per se, tax planning strategies are an integral part of optimizing after-tax returns to shareholders. Governments globally have enacted tax changes (e.g., more generous loss carryback provisions) as well as payment delays that may have short- and intermediate-term effects on results that investors should seek to understand. The interim results should provide insight into such effects that investors should incorporate into their analysis.
This list is not meant to be exhaustive, and every industry will be
different. Rather it is meant to provide some interesting tidbits to glean from
the historical results of this unusual interim period that may serve investors
as they look forward and assess a company’s prospects. This is principally
income statement related. The business’s impact on the balance sheet, other
than cash flows and liquidity covered in our previous blogs, will be described
in a forthcoming blog about accounting considerations in which we will discuss the
impairment of assets and the importance of fair value measurements.
- July vs. August vs. September — Just as April, May, and June have been very distinct so, too, will be July, August, and September — a point also made by Cohn. With the resurgence of the pandemic in various regions this may be even more true than when he said it. Investors should expect or ask companies to provide updates on key performance indicators between the quarter-end and the release date. These are not forward-looking statements but rather an articulation of what has occurred or what they can foresee in the immediate future. This will be important information to the recovery of the business amid the uncertainty of additional surges globally and a company’s actions to respond in the foreseeable future, which will be the third quarter by the time they report.
- Guidance Suspended, Guiding Essential —Most companies have suspended guidance because it is no longer realistic or entails such a high degree of uncertainty. We get that it is impossible to provide precise guidance as to the coming quarters earnings, EBITDA, or EPS. That said, the market, securities prices and investors are forward-looking and market participants will project the future results. Without more nuanced information from company management, investors will be left to their own devices and make assumptions and predictions about the future. The worst thing for a company right now will be no communication. As such, companies need to consider what they will make available to assist and guide investors.
- Economic Outlook and Cross-Company Consistency: Underlying Assumptions Regarding Duration of Economic Shutdown & Recovery —Although companies have suspended guidance, management must — in preparing the interim financial results — make assumptions about the future prospects of the business when making estimates related to revenue recognition, asset impairment decisions (e.g., goodwill), fair value estimates of all sorts, and entity-level going concern assessments. Investors should probe such key estimates and decisions for management’s economic outlook as management provides its view of the future in making such judgments and estimates. Furthermore, it is important that management explain how their economic outlook is consistent across the company’s key estimates and judgments. In most companies, different parts of the organization are responsible for making estimates and doing valuations, and consistency can be challenging. If companies do not provide some insight into their outlook — knowing that it will change — investors should rightly probe for such insights if these assumptions and outlooks related to critical estimates are not disclosed.
- Forward-Looking Information — In the lead-up to the first-quarter reporting season, the US SEC released several documents encouraging the disclosure of forward-looking information (e.g., SEC Division of Corporation Finance Guidance 9). Just this past week, the UK Financial Reporting Council released views and recommendations on forward-looking information.
That said, we have found limited evidence of a robust discussion of forward-looking prospects in first quarter reporting. As we have noted, however, it is essential that companies make assumptions — and that they be consistent — across the business.
We understand companies do not like to provide estimates, ranges, or sensitivities, but against this backdrop of uncertainty, it is necessary for companies, in the United States and globally, to make forward-looking disclosures regarding their economic outlook and — if nothing else — how they have incorporated this outlook into their estimates.
While companies may not be able to provide “guidance,” they should provide something to inform investors and to demonstrate management’s ability to grasp, navigate, and manage this uncertainty and the multitude of outcomes and events that they currently foresee. This foresight not only provides information about the business but also instills confidence in management’s ability to manage these events.
- Reprioritization, Innovation, Resilience, and Accelerating Trends — Also important in assessing the future business prospects amid this pandemic is considering whether and how management has reprioritized business objectives and capital investments and whether existing trends have been accelerated or whether new trends — both positive and negative — are emerging that will affect the business. It is essential that management communicates these shifts in the external environment and the company’s response to demonstrate the resilience of its business and management. Investors should be listening for such shifts and inquire, based upon industry knowledge, regarding management’s actions. Audit committees, as board members charged with strategic oversight of the company, should be encouraging such disclosures.
Integrating the consequences of black swan events, such as this pandemic, into a cohesive communication to investors is challenging for management. Investors, too, are challenged to understand, foresee, and incorporate such foresight into their evaluation and valuation of the company. Investors need to engage with management to understand the business effects of this pandemic. At this time, fundamental analysis will be simultaneously necessary and impossible in evaluating company results and making predictions (i.e., this is made even more challenging by unprecedented economic stimulus that may disconnect market prices from business fundamentals).
If there was ever a time for a long-term view, it is now, but this long-term view must be reconciled with the short-term demands of the dramatic change in the business, and possibly liquidity, and the need to persist through this pandemic. The pandemic is the ultimate test on a company’s sustainability.
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