As companies ditch their earnings guidance during COVID, what can we learn from their fair value disclosures?
Last week, the Wall Street Journal reported that 180 companies in the S&P 500 have “pulled” (i.e., eliminated) their earnings guidance to investors during COVID. The fact that more than one-third of the S&P 500 has thrown in the towel is not surprising; in April, the Bank of Canada suspended its economic forecasts as then-Governor Poloz decided that the environment was too uncertain to bother guessing. Since then, it is apparent that many executive teams have agreed with this logic that and have perhaps concluded that they have better ways to spend their time during the pandemic than to provide investors with revenue or earnings guidance that carries a high chance of being wrong.
This widespread abandonment of earnings guidance has almost certainly made the jobs of equity research analysts more difficult. (What’s an analyst to do if management isn’t giving them a starting point?) Interestingly, according to the WSJ, fewer companies providing forward-looking estimates has led to the “widest dispersion in earnings estimates among analysts since at least 2007”.
In the world of fair value accounting, companies make forward-looking forecasts in order to measure the fair value of balance sheet items such as goodwill or intangible assets like brands, customer relationships, or technology.
As management teams disclose some of the assumptions made in these fair value estimates during the age of COVID, what can be gleaned from them? Can management’s forward-looking estimates (aka, the “guidance” that they stopped giving investors) be reverse-engineered from the various disclosures contained in company’s filings?
Is it possible? Maybe. Is it easy? Definitely not.
To illustrate, let’s take the example of Darden Restaurants, Inc. – the parent company and owner-operator of Olive Garden and other well-known chain restaurants. Fortunately, for the benefit of our example, Darden has a May fiscal year end and recently went through the exercise of revaluing its goodwill and trademark assets. Unfortunately, Darden’s core business — that is, operating full-service restaurants — is a less-than-ideal one to be in during the current coronavirus pandemic.
For the year ended May 31, 2020, Darden released its Q4 2020 earnings announcement on June 25. As one might expect, sales for the quarter were down 43% year-over-year. The company lost $480 million in Q4 2020; $314 million of this loss was due to impairment charges relating the company’s goodwill and trademarks.
In fiscal 2019, Darden did not take any impairment charge on either its goodwill or its trademark assets when it performed its annual impairment testing. In its 2019 10-K, Darden stated that “The fair value of each reporting unit exceeded its carrying value by at least 40 percent and the fair value of each reporting unit’s trademark exceeded its carrying value by at least 20 percent.”
Darden’s comment with respect to goodwill is rather unhelpful: does it mean 40% on an enterprise value basis, or on an equity value basis? There are too many variables to try to figure out: revenue growth, EBITDA margins, capex, and working capital assumptions, to name a few.
On the other hand, Darden’s comment with respect to its trademarks, while unremarkable on its own, may actually be more useful, at least for understanding the change in management’s outlook on future revenues.
For fair value accounting purposes, trademarks are often valued using the “relief-from-royalty” method; indeed, this was the method used by Darden. The premise of this method is relatively straightforward in theory: the value of a trademark asset is equal to the present value of the after-tax royalties ‘saved’ by not otherwise having to pay to license the asset. It is common for the ‘royalties saved’ to be calculated based on a percentage of forward-looking revenues.
That said, let’s take a look at what Darden’s trademark valuation comments from 2019 — and its trademark impairment charges in 2020 — might be telling us:
- At the end of fiscal 2019, the pre-impairment book value of Darden’s trademarks was $950.8 million.
- Darden disclosed that the fair value of its trademarks at the end of 2019 was at least 20% higher than the book value, which implies that the trademarks’ fair value at the end of 2019 was ~$1.141 billion [120% × $950.8 million].
- Darden took a $145 million impairment charge on its trademark assets at the end of fiscal 2020. This suggests that Darden’s estimated fair value of the trademarks at May 31, 2020 was $805.8 million [$950.8 million – $145 million].
- Based on our quick math above, the fair value of Darden’s trademarks likely fell by ~29.3% from the end of fiscal 2019 to the end of fiscal 2020 [$805.8 million / $1.141 billion – 1].
What does this mean?
In 2019, Darden did not disclose its royalty rate, discount rate, or useful life assumptions used to measure the fair value of its trademarks. But if we assume that all three of these other assumptions remained unchanged, we could infer that Darden’s revenue forecasts at the end of 2020 were roughly 29% lower than they were a year earlier.
Darden did not provide full-year guidance for fiscal 2021, but it did disclose its expectations that revenues for Q1 2021 would be 70% of the prior year’s number (i.e., 30% lower compared to the prior year) — which generally lines up with what we deduced from the trademark valuation above. Unfortunately, this example tells us nothing with respect to the company’s expectations of when or how revenues might rebound; expected margins; or any other key metrics. But it is a data point that analysts can use in constructing earnings forecasts in an era when management earnings guidance has largely gone out the window.
That said, the level of disclosure with respect to assumptions made on fair value measurements varies wildly from company to company. So is it possible to draw meaningful inferences from these disclosures? Maybe — the devil might be in the details. But it probably isn’t, so don’t try this at home.
Next article
COVID-19: the struggling business fuels the already struggling marriage