Oct 11, 2020

We see the future through a darkening glass

written by Lisa Eason

Covid-19 and lockdown have affected businesses in many ways. Some have been forced to suspend trading, furlough staff and rely on government handouts to survive. Some have remained operational but face higher costs and lower productivity thanks to social distancing, absenteeism and other frictions caused by regulations and fear.

One common feature across all the businesses with which I’m involved is unprecedented difficulty in planning for the future. Usually firms prepare an annual budget and try to meet it or perhaps beat it. The traditional mantra for a veteran management team is to under-promise and over-deliver when it comes to financial results. This allows a business to decide what capital expenditure makes sense, its hiring intentions and what its cash position is likely to be in the future.

This year, however, has thrown all conventional procedures into disarray: we are in uncharted waters as to the degree of uncertainty ahead for many, or perhaps even most, industries. Predicting revenues for the next six months is extremely difficult. No one knows what the virus will do, what the authorities will do or what consumers will do. Several companies where I’m an owner or director have prepared a new budget almost every month or two since March because circumstances have changed so rapidly.

Public companies usually provide “forward guidance” about their sales and costs expectations to investors and analysts, who then prepare their own earnings projections. Since lockdown, hundreds of companies have abandoned all such guidance, so stakeholders have been left in the dark. Almost all quoted company fundraisings have been executed without any real indication of how profitable they are likely to be this year or next. Despite this, all companies that decided to raise emergency equity appear to have succeeded. Ultra-low interest rates and central banks pumping massive liquidity into the system have helped enormously in persuading investors to back cash calls.

Inevitably, auditors are being especially cautious this year and are focusing on the going-concern prospects for even very secure businesses, because of the unparalleled disruption. The combination of this with the accountants doing their work remotely means many companies have been forced to delay publication of their figures. Shareholders have been relatively forgiving over these postponements, too.

It is probably no coincidence that two sectors much in vogue in America are biotechs and blank-cheque companies — which both, in general, do not provide profit forecasts of any kind when they list. In the week before last, 29 corporations went public on Wall Street, the highest-ever number in a single week. Most fell into those two categories. However, once blank-cheque companies find a business to buy, they can actually publish projections — which is partly why businesses use them to go public. Because investors like profit forecasts.

Every start-up with a glossy business plan produces all sorts of compelling projections. These numbers are never deliberate lies, but they are invariably highly optimistic. This is partly because founders are passionate believers in the prospects for their ventures, but also because investors expect such hyperbolic future growth — and adjust for it. An overly conservative model might be punished because it would not be seen as exciting enough. So financiers give permission to entrepreneurs to be outlandish in their ambitions, especially in places such as Silicon Valley. Everyone wants a huge winner. No one is interested in gentle expansion and a modest success.

In the 21st century, investors really only buy companies for their future earnings potential — income by way of dividends and asset values are very secondary. Yet future income is a complete unknown, as this year has shown. Computer models give an illusion of certainty, but they must never be relied upon in isolation. Britain was reminded of this axiom when the government took seriously the Neil Ferguson/Imperial College model showing potentially 500,000 deaths from Covid-19. That wild exaggeration fuelled lockdown, panic and a disastrous assault on our way of life.

Another occasion when financials are often manipulated is the sale process. M&A advisers are clever at conjuring up all sorts of adjustments to flatter the profit figure to boost the disposal proceeds. There is much focus on the “run-rate ebitda” (underlying earnings) and other highly theoretical numbers. This year, such projections must be even more theoretical.