inside the buy-side® 4q12

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1 www.corbinperception.com

INSIDE THE BUY-SIDE®

FOURTH QUARTER| ISSUE DATE: OCTOBER 9, 2012 1 2

While markets reversed last quarter’s losses fueled in large part by positive Central Bank actions, renewed fears about the US economy’s pace of recovery on the heels of disappointing manufacturing data tempered enthusiasm on the last trading day. For the quarter, the Dow, which hit its best close since December 2007 on September 11, gained 4.3%, the S&P 500 added 5.9% and the NASDAQ climbed 6.2%. In our ongoing effort to remain at the forefront of current trends in investor sentiment, we recently conducted interviews with 25 global financial professionals across multiple industry segments and investment styles. Participating institutions aggregately manage upwards of $370 trillion in equity assets. Investor tone can best be described as concerned amid continued angst about the global economic recovery. While fears about Europe continue to ease gradually owing to glacial progress made on addressing the euro crisis, investor apprehension over China’s slowing growth and the potential for contagion is at an all time high, according to our channel checks. As well, the looming US fiscal cliff is a growing concern. As earnings season gets underway, most investors we spoke with are “expecting a slowdown” amid tempered management outlooks and preannouncements with several suggesting “top-line will likely come in worse than expected”. While this quarter is in focus, “people are more concerned about 2013”, they assert. Despite some headwinds, the US remains a bright spot.

1 “Multi” comprises coverage of two or more of the following sectors: Consumer, Financials, Industrials, Materials, Technology and/or Utilities 2 Growth includes Core Growth investment style

44%

12% 12%

8%

8%

4% each

By Sector 1

Generalist

Multi

Technology

Energy

Healthcare

Consumer

Financials

Industrials

Biotech

32%

12% 8%

28%

8% 4% 8%

By Investment Style 2

Growth GARP Agg. Gr. Core Value Deep Value Income Value Hedge Fund

72%

16%

4% each

By Country

US UK Ireland France Hong Kong

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Key Trends

• Investors are bracing for a mixed 3Q12 amid forecasts that top-line growth will likely disappoint; bottom-line should come in as expected owing to companies’ acute focus on cost management, productivity and operational lean

• According to contributors, management tone is more cautious this quarter; a large minority now characterizes executive sentiment as increasingly “uncertain”

• In line with executive outlooks, 40% of surveyed investors describe their sentiment as

bearish; this number is nearly double last quarter’s findings • The vast majority, or 82%, believe the equity markets have gotten ahead of themselves and

are “not supported by fundamentals”; according to the group, potential drivers include valuation arbitrage between equities and bonds, European policy developments and QE3

• While the European economy and “a general lack of growth” remain key concerns, fear

about the continued slowdown in China and related implications surge to the top of the list this quarter

• Investors are largely bullish on the US despite growing concerns about the looming fiscal

cliff and “economic fits and starts”

• Somewhat surprisingly, 50% of surveyed investors “have no preference” regarding the US election; those that do are evenly split but add, “Regardless of who wins, we expect volatility and an adjustment period”

– 25% view President Obama as the best choice maintaining that he will “safeguard upcoming regulation in the financial sector” and “rocking the boat would be bad”

– 25% support Governor Romney given his pro-business stance

• Continuing from last quarter, financial professionals see organic and EPS growth metrics staying the same or worsening; cash flow should continue to hold up

• While mainstream financial metrics (i.e., EPS, FCF, etc.) continue to be of interest, investors

are more focused on valuations this quarter in their search for above average returns between equities and bonds

• For the third straight quarter, dividends continue to be viewed as the preferred use of excess

free cash

• In general, canvassed investors advocate pre-announcements when materially missing guidance; the stock price will decline regardless but taking a proactive approach can mitigate damage to management credibility

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Management Tone Continues To Grow More Cautious… For the second quarter in a row, investors report that management’s tone continues to be colored by cautiousness with some executives “seeing projects deferred” and “soft spending patterns in the US”. The outliers seem to be select energy and health care chiefs, who “have continued to stay very positive” amid favorable secular trends.

“Over the last three months, the tone has become a bit more negative. Going into the last downturn, many of the management teams were more confident in their internal estimates. As some went over the falls and were blindsided, many executives are much more humble than they were in 2008. They are a lot more careful before saying everything is fine. They are a little more respectful of what could be around the corner that they might not see yet.” – Growth, Financials/Industrials “There is more uncertainty than anything.” – GARP, Generalist “They seem to be stabilizing and they seem to be able to manage their businesses for the way things are right now.” – Core Growth, Technology

According to contributing investors, dialogues with corporate managers have focused largely on: • 37% | Operational lean, specifically costs and inventories

• 26% | Macro economy and softening end demand

• 26% | Growth opportunities, both organic and inorganic, and putting capital to work

• 21% | US political landscape, including taxes, regulations and the pending election

“They are focused on business as usual. They are making sure that they can manage through the current economic situation, particularly in Europe. In China, they are making sure that the operations are fairly lean in reaction to what’s going on. They are keeping their earnings intact. Even if demand slows down, they want to maintain flexible to react to what’s happening.” – Income Value, Technology

Less Negative,

25%

More Negative,

19%

Current Quarter's Tone

More Negative

50%

The Same (Still Cautious)

50%

Previous Quarter's Tone

The Same (Still Cautious)

44%

More Uncertain

12%

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“They are mostly concerned about the macro economy. Inventories are reasonably lean. Many of these end markets have the ability to shut off ordering for a while, which is what you saw in 2008 and 2009. Many management teams say the hesitation they see in the end markets with their customers is linked to customers being cautious about spending in front of the fiscal cliff and elections.” – Growth, Financials/Industrials “They are most focused on end demand. They are focused on organic growth across a variety of different geographies.” – Core Value, Generalist

…And So, Too, Does Investor Sentiment Our channel checks indicate that a greater number of investors, nearly twice as many as last quarter, are bearish. Indeed, we continue to see cautious optimism recede with no one describing his or her general sentiment as bullish.

Trend in Investor Sentiment: More Cautious

“The US is fairly well positioned but there is a lot of risk around Europe, China and the fiscal cliff.” – Core Value, Generalist

“Our department is cautiously optimistic. We are not bullish on the economy but we are not necessarily seeing a recession either. Maybe there will eventually be some sort of breakthrough in Europe.” – Growth, Biotech “The only beacon of light is that the US is strong right now. I don’t see too much evidence that that strength should accelerate or continue. China is obviously a weakness because it exports a lot of goods to Europe and Europe is weak. It could be difficult for China to pull out of this full force until Europe gets better. On the flipside, we don’t want to discount the positive impact of Chinese consumerism because we have a lot of people living in almost third-world conditions that now are feeling the benefits of wage inflation. They are buying cars and consumer products. You don’t want to discount the value of over one billion people finding their way into the middle class. That could be very powerful. I am cautiously optimistic about

Bearish 22%

Bullish 6%

Cautiously Optimistic

72%

Previous Quarter

Bearish 40%

Cautiously Optimistic

60%

Current Quarter

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China. The US seems fine now but I don’t know how much gas is left in that tank. Europe is very difficult because austerity is a race to the bottom. It doesn’t really work.” – Growth, Financials/Industrials “I am slightly bearish right now because it has had a very good run. Profit taking is bound to ensue.” – Core Growth, Utilities/Technology

3Q12 Earnings Season…Fasten Your Seatbelts Surveyed investors, who were expecting a bumpy second quarter, report that results came in largely in-line (50%) though are quick to point out that “guidance issued was worse-than-expected”. Managements’ cautious outlooks coupled with several preannouncements, including those in previously strong sectors such as technology and industrials, has investors “expecting results to be a little more modest”. Focus will be on revenue, earnings momentum, cash flow and sector-specific growth metrics, such as production (energy), pipeline (health care) and bookings (technology). Indeed, the vast majority of contributors, or 83%, are bracing for moderate growth, with 28% predicting that top-line results will be muted. Still, expectations for solid bottom-line and margin performance are present as companies continue to streamline their businesses.

“We are expecting a slowdown. We expect to see a slowdown more on the sales side. We expect to see good performance on the bottom-line next to higher margins.” – Core Value, Consumer

“I expect moderate growth, some margin expansion in some cases and I expect them to be neutral in their outlook and guidance. I expect them to tell us that they don’t expect the usual fourth quarter budget flush but that they are managing their businesses and are hanging in there.” – Core Growth, Technology

“I have negative expectations. I cover industrials and there have been preannouncements. You have a very strong equity market but the fundamentals don’t seem to support that. You have higher fuel costs and a slowdown in emerging markets. My sense from reading the tea leaves is that things are not that great.” – Deep Value, Industrials “We are looking for signs of stabilization and for signs that demand is growing. Our expectations are fairly muted in that we aren’t expecting a mass rebound at this point. We expect things to be in-line. We don’t expect things to be totally bad but we are not expecting a massive rebound either.” – Income Value, Technology

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Sector Snapshot

“I cover materials, industrials and consumer. I am bearish on materials and China. I am bearish on industrials. China is a big growth driver. I am mixed on consumer depending on the end market. If it is related to US housing then I think 3Q12 will be a disappointment; otherwise, it is a buying opportunity and so I am very bullish.” – Aggressive Growth, Materials/Industrials/Consumer “On the bullish side, I tend to think that energy is somewhat beaten up. You can find some pretty interesting plays out there, especially if you are talking about refiners. They tend to trade with the OSX and the underlying commodity but what many people are missing is that crack spreads are widening to a point where if you are looking at the right thing, these companies will be hugely profitable even with commodity prices soaring. From a refining standpoint, these guys are somewhat insulated.” – Hedge Fund, Generalist “We are relatively bullish on the technology space. We are more bullish because we think growth on a relative basis is better than a lot of other sectors. There is still a lot of cash in this sector and there are a lot of individual companies that are positioned pretty well. We are relatively bullish but we are not looking at a situation of peak growth or anything like that.” – Core Growth, Technology

Are The Equity Markets Ahead of Themselves? A Resounding, “You Betcha” Last quarter, we reported that a majority of investors were taking advantage of market weakness and either adding to or rotating in holdings. Fast forward to this quarter and an overwhelming number of participants believe the equity markets have gotten ahead of themselves with several asserting, “the fundamentals don’t support the run-up”. Indeed, “the potential solution in Europe” is seen as a catalyst though the majority maintains that the momentum is Fed-driven, with an investor3

3 Growth, Generalist II

adding, “This is a bought market move that is not coming from opportunities of growth”.

Frothy 82%

Upside Potential

Exists 18%

Views On Equity Markets

Mixed Consumer

Luxury Goods Technology

Utilities

Bullish Biotech

Health Care Energy

Bearish Industrials

Materials

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“The market is being driven by all of the money that is coming into our system and it is responding to that. I am expecting an overall correction at some point when we come to terms with what we have to do.” – Growth, Generalist II “There are many people who have been underinvested and they don’t want to miss out on the performance. A lot of the run-up in the market occurred on light volumes, particularly in July and August. That might not be totally indicative of what everyone really thinks. Circling back to QE3, interest rates are so low that people are being forced to put their money into riskier assets because you have to find yield somewhere.” – Growth, Financials/Industrials “At some point, it becomes the snowball rolling down the hill and, as it gains steam, it becomes a self-fulfilling prophecy. That is definitely not what started it. There was general euphoria that occurred earlier in the year with regard to China being able to facilitate a soft landing and that engine not slowing, especially given the fact that the government there was stimulating like crazy and is still stimulating like crazy. There were several headline risks that ended up being obviated near-term, including Europe getting something done and US employment and housing numbers not being as bad as people expected. The conjunction of all of those things definitely contributed to the market run-up. By the time all of those had hit, the market had run up quite a bit and there were all of these larger funds not keeping up with the rest of the market, which is when everyone started pontificating that they would have to essentially put all of that money to work, which potentially drove the market up even further.” – Hedge Fund, Generalist “There is still undervaluation from the recent crash so there is still a place for upside and for multiple expansion. I am not sure if it will continue like that.” – Growth, Biotech

Some Concerns Abate While Others Gain Steam Apprehension about the European crisis, which has topped our investor-generated list of concerns for the past three quarters, has been upstaged by fears about China’s protracted recovery and the multiplier effect it could have on other nations. Indeed, 72% of surveyed investors list “the China slowdown” as the leading cause for concern, followed by 61% citing the European crisis. The same number also worries about “negative economic growth” fueled by the “deteriorating demand picture”. Continuing, the looming fiscal cliff is a growing concern for 50% with the majority of this group indicating, “The assumption right now is that it gets implemented and fixed”. Adds an investor,4

“If it doesn’t get dealt with then it will be a pretty big concern, especially for the equity markets”.

4 Hedge Fund, Generalist

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Meanwhile, more than one-quarter of surveyed financial professionals are anxious about US equity valuations. Rounding out concerns is recent violent unrest in the Middle East and Asia.

“I am worried about the risks in Europe and in China but with China nobody really knows how to quantify that.” – Hedge Fund, Energy “I am concerned about the Middle East, Northern Africa, the elections, preserving the rule of law, the relative competitive environment and the economic system in the US versus the emerging countries and the rise in China. I have tons of concerns.” – Growth, Generalist “My top concern is companies not meeting consensus estimates. With valuations the way they are, companies have to at least do that if they are going to continue to see share price appreciation.” – Aggressive Growth, Healthcare “There are still a lot of unsolved problems that we have now that we weren’t considering at prior peaks. You still have to deal with the fiscal cliff, China may not be recovering as quickly as people think and there is still a possibility that the Eurozone could shed a couple of countries.” – Growth, Financials/Industrials

Top Investor Concerns

Views On Performance Metrics Remain Muted Save For Cash Flow In our quarterly channel check on growth trends investors expect to see from companies for organic, EPS and FCF, expectations remain muted, a continuation of last quarter’s downbeat sentiment, which was an about-face from opinions captured during 2Q12, when contributors predicted all metrics to improve.

1Q12 European Crisis

Spillover Effect on US US Government Policy, Debt Levels

China Slowdown Oil Prices

2Q12 European Crisis

US Political Paralysis Pause In US Momentum

Margin Pressures China Slowdown

3Q12

European Crisis US Political Paralysis

Pause In US Momentum Margin Pressures China Slowdown

Current China Slowdown European Crisis

Fiscal Cliff US Equity Valuations

Violent Unrest

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• Outlooks for organic growth remain cautious though some are predicting improvement5

• Building on last quarter’s sentiment, most investors believe EPS growth will remain the same or deteriorate further

• A relative bright spot, cash flow is anticipated to grow as companies continue to build and hoard cash reserves

“Organic growth will be in-line because the economy is definitely slowing outside the US.” – Core Value, Generalist

“Cash flow will be ahead of expectations because companies will be very focused on costs.” – Core Value, Generalist

“Cash flow is likely improving. Companies have shored up their balance sheets, cut back on inventories and have been conservative. Hopefully, things are stabilizing. Cash collections are up and receivables have come down so in general the cash has been doing okay.” – Income Value, Technology

The US – A Beacon Of Light Investors indicate they are bullish on pockets of the world, with more pointing to North America than any other region. The US leads the charge with a contributor6

5 Analysts following Energy, Health Care and Technology

aptly summing up general sentiment, “We were the first ones to experience the pain in 2008 but we were also on the forefront of developing novel solutions to pull us out of the tailspin”. Indeed, they point to the recovering housing market as well as a “manufacturing renaissance driven by energy prices and

6 Hedge Fund, Generalist

0% 10% 20% 30% 40% 50% 60% 70%

2Q12 3Q12 4Q12

Organic Growth

0%

10%

20%

30%

40%

50%

60%

2Q12 3Q12 4Q12

FCF Growth

0% 10% 20% 30% 40% 50% 60% 70%

2Q12 3Q12 4Q12

EPS Growth

Improving Staying the Same Worsening

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labor costs”. Canada for its stability and Mexico for its “growth and competitiveness” are also seen as good bets. Meanwhile, in spite of currency volatility, Brazil maintains its luster given a stabilized political situation and “a new president who is planning to lower taxes and welcome new business”. A recurring theme, investors remain bearish on China as the ongoing soft landing/hard landing debate roars on and, given its close ties, Australia. Not surprisingly, Europe and specifically PIGS remains out of favor. Also on the black list is India owing to its “mild recession with some inflation” as well as Venezuela, Argentina and Bolivia given “the attitude of the government towards private sector companies, the danger of expropriation and foreign exchange controls”.

“As an emerging market that is supposed to be showing some growth, India is having some issues. We are obviously keeping an eye on what is going on in some of the European countries.” – Income Value, Technology “I am fairly bearish on China because the focus of its economy has been on first tier development rather than moving towards becoming a developed market.” – GARP, Energy “I am bullish on the US. If I were to say where I would be putting my own money, I would be investing domestically. The Chinese market seems beaten up right now so I wouldn’t necessarily need to pick the bottom. I would probably be open to investing there as well although they have quite a few restrictions in terms of QFII7

so it is harder for foreign individuals to invest.” – Hedge Fund, Generalist

While Uncertainty Abounds, Cash Payouts Remain Top Preference Amid global uncertainty, “reasonably inflated stock valuations” and “massive cash hoards”, an overwhelming 71% of surveyed financial professionals once again report a penchant for dividends, making its third consecutive appearance as top preference. Of note, this quarter also marks the highest statistic in favor of dividends that we have witnessed since we began tracking capital allocation preferences five years ago. This is even more interesting given the uncertainty surrounding potential US tax policy changes in 2013. Notably, we are also seeing a greater number of investors suggest that companies pay a special one-time dividend.

7 Qualified Foreign Institutional Investor

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59% 52%

71%

41%

21% 29% 27%

42% 29% 32%

21% 24%

5%

42%

6%

2Q12 3Q12 4Q12

Free Cash Flow Preferences - Quarterly Trend

Dividends

Buybacks

M&A

Reinvestment

Debt Reduction

Meanwhile, M&A and share buybacks remain a distant second preferred alternative and reinvestment, which peaked in 2010 with a 43% endorsement rating, has also moved down the priority scale for investors.

“I prefer dividends for two reasons. First, we love to see cash returned to the owners of the business, who are the shareholders, so that would include dividends and/or stock buybacks. The challenge with stock buybacks is that the market isn't always rational so you can buy your stock back and if the stock doesn’t go up then you really haven’t added any value to your shareholders. We would much prefer the cash delivered in a dividend form so then the investor can make the decision whether or not to reinvest it back into the equity of that company or another company.” – Core Value, Generalist “I would like to see companies return the cash. A lot of companies are sitting on massive cash hoards and they should be doing either buybacks or dividending [sic] out the cash to shareholders. If they don’t see the opportunities out there then that cash is burning a hole in their pockets and as a shareholder, it is burning a hole in my pocket. I could put it to better use than whatever they are getting in their corporate savings.” – Hedge Fund, Generalist “If there are growth opportunities then they should use cash for acquisitions to grow. If there are no attractive opportunities, they can return the cash to shareholders through dividends. Otherwise, you can keep a portion of it for future use. If a company has debt, it can get rid of the debt. Whatever remains could be used for buyback activity.” – Core Value, Technology

IR Best Practice: Earnings Pre-announcements A question often wrestled with by executives and IR professionals alike is whether to pre-announce. While we recognize that every situation is different, we posed the hypothetical question to the Street. The majority of surveyed financial professionals, or 78%, advocates pre-announcing though indicates it is up to management to decide what should warrant such a

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release. Materially missing or beating guidance, with suggestions ranging from 5% to 15%, as well as significant company developments, especially if negative, should almost always be pre-announced. Select best practices when pre-announcing include: • Provide adequate context about the miss or beat in the press release as this enables

management and IR to discuss the matter with investors and analysts in greater detail given the information is public

• Consider hosting a conference call to discuss the outcome in greater detail if warranted

– Recognize that investors may have been blindsided and angry; maintaining a balanced (versus defensive) tone when presenting the facts and answering questions is critical

– Management teams can build credibility by being candid about the matter and taking accountability; if appropriate, a mea culpa goes a long way with investors

• Prepare in advance for the possibility of receiving a barrage of inquiries and calls following

the pre-announcement; ensure your website is updated and prepare your Q&A

– Consider drafting a customized letter to retail shareholders if appropriate

• Be proactive and reach out to stakeholders on a one-to-one basis following the announcement; shareholders appreciate companies that take the time to touch base with them and answer any non-material questions they may have

• Avoid a second release indicating that the situation is worse than previously anticipated; build in a significant amount of hedge and nail down figures as closely as possible to ensure there are no further surprises

• Remain in tune with what competitors are saying and doing; if industry peers are releasing earnings warnings and you remain resolute until the eleventh-hour, it could signal to investors that management does not have a firm grip on controls

• Issuing a warning outside normal trading hours is typical as it allows analysts and investors the opportunity to digest the information; that said, pre-announcing on the eve of a holiday or on a Friday evening in the hopes that it will go unnoticed is a worst practice

• Reconfirm annual guidance if appropriate as it will serve to assuage investor and analyst fears about the viability of your longer-term financial performance

To be clear, management teams can build credibility by being forthright and pre-announcing negative news. The stock will sell-off regardless of timing; thus, being proactive by getting in front of the surprise, addressing the reasons for the shortfall on your own terms and hosting a conference call if warranted can actually serve to build credibility rather than tarnish it.

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Proven Methodology, Proven Results Corbin Perception is an IR research and advisory firm assisting public companies with unlocking their full market potential. We recognize the positive impact best-in-class investor relations has on valuation and partner with our clients to develop strategies that positively influence investor perception. Our comprehensive approach to research-driven counsel enables our clients to capture investor mindshare and differentiate their company as an investment. We have deep functional and industry expertise as well as a strong and consistent execution track record of value creation. Our core Advisory Services include: • Perception Studies • Investor Presentation Development • Strategy Communication • Analyst Day Strategy and Execution • IR Diagnostic Reviews, Strategy Development

inside the buy-side® 4q12

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