Wednesday, October 24, 2007

The Academic Side (or Lack Thereof) of Investor Relations

I’m happy to report that I have recently been appointed a lecturer in management to teach a class on investor relations at the Jones Graduate School of Management at Rice University. Teaching is something I’ve wanted to do since leaving the corporate world about eight months ago, so I’m delighted to have this opportunity, especially at an institution of the caliber of Rice.

Once the first blush of enthusiasm wore off, I started thinking about how to teach the class. Naturally, I immediately decided to do what all investor relations people do, which is to engage in peer comparisons. (Gale Wiley, the teacher of this class at Rice in previous years, has been generous in his advice, but I also wanted to try to get a larger picture.) I freely admit that if I could find good classroom materials and case studies, I would use them, as I had no desire to recreate the wheel. (I prefer to think of this as good research, not copying or plagiarism.) It turns out that the course on investor relations taught at Rice is the only class taught to MBA students that I could find. Northwestern, where I went to business school, chooses to teach investor relations out of the Medill School of Journalism, but beyond that I have found no other graduate school programs. There are certificate programs at several universities and a number of stand alone seminars in the subject, but no other graduate school programs that I could find.

Naturally, this started me thinking, why does this subject sit in academic limbo? Every publicly traded company has to deal with investors and is intimately concerned with its stock price, yet most business schools assume that if you just sort of throw the accounting numbers out there, the market will price the stock efficiently. What this ignores is that the stock price is a discount of future cash flows, and much of the future depends on management and their plans for the future. It is very difficult to figure much of that out without seeing management, hearing what they have to say and placing it in context. To put it another way, past performance coupled with the perception of future performance translates into stock price. The role of investor relations is to provide information both about why past performance was the way it was and what the expectations are for the future. Any finance professor will tell you that lack of information or asymmetric information leads to inefficient markets, so to put an academic spin on it, the role of investor relations is to make the market operate more efficiently by providing more information.

So perhaps this is the start of a campaign to bring more academic respectability to investor relations. When you think about the total value of stocks traded every day, it might make sense to pay a bit more attention to how information gets from companies to investors and the effect that has on investor behavior. On the other hand, it just might be the start for me of a long slide into academically obscure topics. Perhaps “Multidimensional Aspects of Asymmetric Information Flows Between Companies and Investors in the Equity Markets” would be a starting point.

Monday, October 8, 2007

WAG the Investor

A few years back there was a film called “Wag the Dog” starring Robert De Niro and Dustin Hoffman that was all about using misinformation to distract people from the real issues. I was reminded of it last week when Walgreen Co. (WAG) announced that it was reporting a down quarter. (A note of disclosure here – by virtue of having worked at Walgreens for 23 years, Walgreen stock forms a significant portion of my net worth. I am not a disinterested observer here; in fact, I am quite interested.) Walgreens reporting a down quarter is big news. You have to go back to the November, 1997 quarter to find a down quarter, and that was for a change in accounting. My data base only goes back to 1994, so I have to rely upon memory and some old notes, but in 1993, there was a down quarter caused by a charge for early prepayment of debt. It is possible that the last down quarter Walgreens reported for operating reasons was in fiscal 1987, the year the company acquired 88 Medimart drugstores in New England, and I only say that because EPS was only up $.01 for the year and it stands to reason that one or more of the quarters reported was down. You would think I would remember, as I was the investor relations officer back then, but it’s been twenty years. The point here is not my memory, however, but that it has been a very long time since Walgreens reported a down quarter for operating reasons – at least twenty years.

To further compound the bad news, it wasn’t a small miss; the Street was expecting EPS of $.47 and Walgreens reported EPS of $.40 (actually $39.65, but it rounds up to $.40). At $9.125 million per penny of EPS, that means that Walgreens missed the Street’s profit expectation by $69.39 million. Wall Street reacted in a predictable manner by trashing the stock, sending it down 15% over 3 days. So I thought that I would use this as a case study from an investor relations viewpoint: what did Walgreens publicly say, was it intelligible and could it have been done better.

Investor relations is like exercise or writing – the more you do of it, the better you get at it. Walgreens has had lots of practice talking about good news, but sad to say, they are sorely out of practice when it comes to handling bad quarterly results. Uniformly, the analysts and investors of Walgreens that I have spoken to express puzzlement and frustration with the information provided about the quarter. I also had trouble trying to understand what they were trying to say and I used to work there.

The lead statement by the Chairman concerning the problems in the quarter was: “This quarter was negatively impacted by lower generic reimbursements, combined with higher salary and store expenses, and higher advertising costs.” The release then discusses lower generic reimbursements in five of the first six paragraphs of the release, specifically using simvastatin (generic Zocor) as an example. A quick read seems to suggest that simvastatin was the chief culprit for the down quarter. After I’d spent some time working my way through the numbers, I think the generics discussion obscures the real issue.

Interestingly, when you look at the press release for the third quarter, Walgreens cites generics as having a negative 3.4% effect on total sales, more than the 3.1% they call out in the fourth quarter. So the overall impact on sales is not new. If you assume that reimbursement rates are what is being recorded as the sales price of the drug, this is an issue that existed in the third quarter, but does not appear to have affected profits. Additionally, my estimates, based upon publicly available information, of percentage of total prescription sales dollars at Walgreens represented by simvastatin is that they are less than 1.5%. So my conclusion is that this is the lesser issue, although it gets much more ink in the press release.

The second part of the statement seems to imply that higher salary, store expense and advertising were confined to the fourth quarter, but if you look at Walgreens fiscal year, growth in expense dollars has outpaced growth in sales dollars in 3 of the last 4 quarters. Clearly, that’s something they don’t want to direct you attention to in the release, but it would go a long way to explain what happened if they did. In essence, what has been happening is that over the course of the past year, Walgreen has been benefiting from a surge in prescriptions due to Medicare and a surge in gross profits per prescription as some “blockbuster” drugs have come off patent. They have been using that surge to mask the fact that they have gotten away from their traditional expense controls. Now the tide has gone out and they find themselves somewhat exposed.

Many analysts have chosen to characterize this as an expense issue and on the surface it is. But further down, this is also a management issue. Let’s consider the following: 1.) This was not the first generic drug to come off patent and become available to multiple manufacturers. Walgreens is the nation’s largest pharmacy chain and has been dealing with this issue for decades. They should have seen this coming, and been ready for it. 2.) Salary schedules are approved at the very top in this organization. If salaries have risen, it’s because that directive came from the top. 3.) Store expense is something that is reviewed at least weekly at the district level and monthly at the corporate level. If store expense was going up, people knew about it well in advance of the end of the quarter, yet it looks like nothing was done about it. 4.) Advertising dollars are not spent in a vacuum at Walgreens. The overall spend is approved right at the top by senior management.

So overall my conclusion is that full and accurate disclosure was not achieved in the Fourth Quarter earnings release. I’m not saying that Walgreens is intentionally attempting to mislead investors; it’s just that it is always easier to focus the blame on external issues than to point the finger at yourself.