Friday, August 15, 2014

My Last Blog Post

First and foremost, I would like to thank everyone who has taken the time to read what I’ve written on Investor Relations Musings over the past 7 years. Over that time period I’ve posted 162 articles on topics that have ranged from the tongue in cheek (essential life skills for the investor relations officer) to the academic (efficient market theory) to the personal (the importance of saying thank you). The blog has been accessed almost 60,000 times by approximately 40,000 different users from 153 different countries, so hopefully I’ve given a few people something to think about.

Now, however, to use a phrase common among startups, I find that my career has “pivoted”. Several months ago, as I was contemplating retirement, a friend of mine from business school called me up and asked if I would like to join him in starting up a medical device company. It sounded like fun, so at the ripe age of 64 I find myself an entrepreneur.

I’m quite excited about the new company we are forming, which will be called Arterium Medical. We’re going to use patented technology to monitor and measure blood flow using Doppler ultrasound. Unlike traditional ultrasound, we will provide doctors and nurses with quantitative data, not images. And also unlike traditional ultrasound, our device is contained in a thin film, which is applied using a bandage, eliminating the need for an ultrasound technician. It’s really a neat little gadget.

In the past, doctors have used blood pressure readings in their diagnoses, but in many instances, blood pressure is a proxy for blood flow. We plan to help them measure what they really care about, which is the blood flow that keeps organs and limbs alive. If we are successful, we think that we can give doctors and nurses a new monitoring tools to help improve the standard of medical care in several areas.

With all of the tasks that come with a startup, from the mundane - setting up offices - to the sublime – raising money – I will no longer have time to rigorously follow and write about investor relations, so I feel I must bring this blog to a close.

Thank you for being a reader.

Friday, March 28, 2014

It’s the Quality of Disclosure, Stupid

When Bill Clinton was running for president for the first time, one of the catch phrases of his campaign was, “It’s the economy, stupid”.  One of the things meant by this (with Bill Clinton, you’re never sure if you’ve captured all of the intended meanings) was that people should focus on the main issue and stop talking about the many smaller peripheral issues that can distract voters from what is important. That’s the way I feel about many earnings press releases I read.
Take, for example, Walgreens recently released second quarter 2014 earnings. Readers of this blog will know that I often write about Walgreens, but when you write, its best to write about something you know, and having worked at Walgreens, I think I know it better than the average investor (I also own the stock). There are a lot of things going on in the second quarter earnings release, and to a certain extent, Walgreens finds itself boxed in by all the adjusted earnings they’ve reported in the past. Having elected to report “adjusted earnings” (see my post from June 26, 2013 “The Slippery Slope of Adjusted Earnings” ) Walgreens now finds itself in the uncomfortable position of reporting that what they consider core earnings reflecting the true underlying nature of the business are 5% lower than they were a year ago. This compares to earnings only being down 1% on a GAAP basis. I give them full credit for continuing to report this way, as many companies would have stopped reporting on an adjusted basis the moment it didn’t serve their purpose, but it just goes to show how you can get boxed in by these adjustment shenanigans. 
However, what really caught my eye in the earnings release was a claim of combined synergies for Walgreen and its strategic partner, Alliance Boots, of approximately $236 million in the first half of fiscal year 2014.  When I see a claim for such a big number, a red flag always goes up in my mind and I start looking for where all this money has filtered into the earnings statement. After all, if you are claiming a synergy, you either have to be buying better and thus reducing your cost of goods, or lowering your expenses, reducing your selling, general and administrative expense. Synergies of $236 million on a base of $37.9 billion should result in savings of .62% in these ratios for the first half of the fiscal year. Yet when I compare the cost of goods and S, G & A ratios from year end 2013 to 2Q2014, I find that cost of goods have actually gone up 10 basis points, so they’re not buying better as a result of the acquisition. The S, G & A ratio on the other hand, has declined 60 basis points to 23.3% from 23.9%. So maybe they are within shouting distance, 8 basis points, but then I have to ask, “Does this synergy number mean that your earnings would have been worse by $236 million if you had not done the acquisition?” I suspect not, and I think you would very quickly get an answer from the company that the calculation of synergies does not tie directly to earnings.
Unstated in all of this is that “synergies” is a non-GAAP term, not constrained by the bounds of normal accounting. Companies can and do throw all sorts of “opportunity costs” and hypothetical savings into the pot when calculating these sorts of things. It is sort of an alternative accounting universe that does not have to tie out to the earnings statement. (I’ve also written about this before, see my post of March 3, 2012, “Where’s the Beef?” )

Which brings me full circle. These types of claims detract from and make it look as if the company is trying to obscure what is really going on - “Look at the great synergies we’re getting, not at the fact that earnings are down”. So my advice to companies that engage in this sort of junky accounting is: “It’s the quality of disclosure, stupid.” 

Monday, March 3, 2014

The Intersection of Law and Financial Theory

When lawyers and judges venture into the realm of financial theory, interesting things happen, often accompanied by unintended consequences. Take, for example the efficient market hypothesis. As anyone with a grounding in financial theory knows, the efficient market hypothesis (in the semi-strong version) holds that the market quickly incorporates all readily available information into stock prices. In 1988 the United States Supreme Court used this theory to create the legal doctrine of “fraud on the market”, which holds that shareholders do not have to directly prove that there is a connection between a shareholder’s losses and the fraud being alleged. Rather, the courts assume that the shareholders have been harmed by an alleged fraud because the market has incorporated the fraudulent information into the stock price, regardless of whether the aggrieved shareholder can show direct reliance on the fraudulent information.

The upshot (and unintended consequence) of this legal doctrine was a surge in the number of securities class actions filed beginning in 1988. In fact, it became so bad that Congress stepped into the fray and enacted the Private Securities Litigation Reform Act of 1995. This act made things tougher on plaintiffs, requiring them to plead the alleged securities fraud with a great deal more specificity than before and creating a “safe harbor” for forward looking statements made by a company. But the act did not specifically do away with the “fraud on the market” doctrine, and plaintiff’s lawyers, being a resilient and resourceful bunch, continued to file securities class action lawsuits. In fact, according to a paper written by Donald C. Langevoort at the Georgetown University Law Center, such lawsuits in the last 15 years have resulted in more than $70 billion in settlements (Judgment Day for Fraud on the Market? Reflections on Amgen and the Second Coming of Halliburton This is because, even with the heightened filing requirements, with the fraud on the market doctrine, all shareholders are part of the class of damaged investors, not just those investors that can show they relied upon the alleged fraud. As a result, the class is so large and the potential damages can be so great that almost all securities fraud class actions that survive the pleadings stage wind up getting settled. Which, coincidentally, generates large fees for plaintiffs’ lawyers.

Now, however, the Supreme Court is taking a second look at the “fraud on the markets doctrine. Arguments in the case of Erica P. John Fund v. Halliburton Co. will be heard shortly and four of the Supreme Court justices are on record as opposing the fraud on the market doctrine. If the court reverses the doctrine, or even if they significantly curtail it, the upshot will be a lessening of class action securities lawsuits. For the first time since 1988, plaintiffs will have to actually prove that they were aware of, relied upon, and were damaged by the corporate statements they allege are fraudulent. Wouldn’t that be something? 

Thursday, February 6, 2014

CVS, Tobacco and the Economically Rational Decision

Yesterday I was interviewed by a reporter for National Public Radio’s Marketplace program regarding the decision by CVS Drugstores to stop selling tobacco products. You can find the article here: I’m always happy to talk to the people at Marketplace, as it’s one of the few programs on National Public Radio that takes an even-handed approach to business affairs.

The issue of drug stores and pharmacies selling tobacco products is not new. The question used to get asked back in the 1990s when I was doing investor relations for Walgreens. The reason the question came up back then is that the provinces in Canada had begun to ban the sale of cigarettes in pharmacies beginning in 1994. Today, all but one province in Canada bans the sale of cigarettes by pharmacies.

What is interesting here to me is the communications aspect of this situation and how it compares with the business realities of selling tobacco. CVS has, of course, positioned their decision as the morally right thing to do. They are a healthcare related company, and they shouldn’t be selling products harmful to the public’s health. The decision has great appeal to a majority of people and earns them lots of good will. 

Underlying all of that may be other reasons that CVS has gotten out of the business of selling tobacco. In business school terms, what CVS has done is to compare the net present value of the profit stream it would receive from continuing to sell tobacco to the potential profit it will receive by virtue of being more closely associated with a healthcare image and the additional business that will bring in, both on the consumer and the health care benefits sides of their businesses. In this case, they have decided that healthcare is a better business choice, plus it makes them appear to be on the side of the angels.

However, here are a few business reasons why CVS may have gotten out of the business:
1. Tobacco usage has been declining in the United States for many years and the trend shows no signs of bottoming out.
2. Cigarettes are a relatively low gross profit margin product, with margins I estimate in the 15 – 16% range compared to an average of 30% for general merchandise in drug stores.
3. Typical sales in drugstores are for one or two packs of cigarettes at a time, meaning that you don’t make up for a low margin sale by having a big dollar sale, as you would by selling a carton.
4. With prices per pack as high as they are, smokers tend to be price sensitive, meaning that they are not your normal, loyal customer.
5. High prices also lead to more internal theft in this category than many others.
6. Local regulations prohibiting the sale of tobacco to minors leads to a headache at the cash register as clerks need to verify the age of many purchasers. 

So when the dust settles, CVS will have given up 2% of its revenues, but much less than that of its profits. Plus they probably looked north of the border and realized that the Canadian drug store industry hasn’t gone into a death spiral since they were prohibited from selling cigarettes.

All of this also helps to explain why you won’t see CVS eliminating the sale of salty snacks, sugary drinks of candy any time soon. All of these products don’t fit with the image of a healthcare provider, but they don’t share the same business trends as tobacco, so CVS will make the economically rational decision to keep selling them.