Greek Classics Revisited

For those of you who may think that the current financial crisis is unique, I would submit that this type of drama goes all the way back to ancient Greece.  In many ways, what we are seeing resembles the Iliad (minus the blood, gore and interventions by the gods, but otherwise pretty close).  Before you claim I’m totally off my rocker, consider the plot of the Iliad:

Agamemnon and Achilles quarrel over the distribution of riches; Achilles goes off to sulk in his tent; the war goes on without Achilles; Patroclus, Achilles friend, goes off to fight pretending to be Achilles; Hector slays Patroclus; Achilles slays Hector; Achilles and Priam, Hector’s father, weep together at Hector’s funeral.

Now consider the current financial crisis:

Congress and the Treasury Department quarrel over the distribution of the $700 billion rescue package; the House of Representatives goes off to sulk and refuses to pass a bill; the crisis goes on without Congress, with the equity markets declining by record amounts the day after Congress fails to pass the package; Paulson and Bernanke attempt to quell the financial markets without the backing of Congress; the markets collapse worldwide; Congress passes a rescue bill that limits some of the damage done and finally, Congress holds hearings and weeps over the failure of Allen Greenspan to warn of the dangers of the deregulation in the financial markets.

It almost makes you think that there may still be Greek gods out there staging all of this for their own amusement.

Just to top this analogy off, students of Greek literature will remember that the Iliad was followed by the Odyssey.  This means that we will still have to deal with the Sirens (think about all those pitches for alternative investments that could diversify your portfolio), witches that turn men into pigs (think about what’s happened to your 401(k) account lately) and navigating between Scylla and Charybdis (found any good place to put your money yet?).  Oh, and by the way, it took Odysseus ten years to get back home.

On that happy note I will bring this post to a close before I sound like a Greek chorus.

Looking at Fact Patterns

The image investor relations people have of investors is that they sit at their computer monitor all day long and review spreadsheets.  The reality is more complex, but many of the most astute investors I know rely as much on tangible fact patterns as they do on crunching the numbers.  A portfolio manager that I have great respect for once told me, “When you hang around this industry long enough, you come to recognize certain fact patterns as red flags that merit greater scrutiny”.  Here are a few that I have encountered over the years:

Sudden Departure of Key Executives

This is most visible when the Board replaces the CEO (See last week’s post, “Why Don’t They Just Tell Us Why They Fired Him?”), but it’s probably just as important when it involves the COO or the CFO.  If a COO leaves unexpectedly, it usually signifies either that the CEO thinks he could run the operations better himself, feels threatened by the COO or there is a strong divergence of opinion between the CEO and the COO on the direction of the company.  None of these is usually good for the investors.  If a CFO leaves unexpectedly, it raises questions about internal controls and accounting systems.

A Sudden Influx of New Executives from Outside the Company

Usually this means trouble as new executives struggle to fit into a corporate culture, or worse yet, try to replace the culture with their own.  For example, one only needs to look at the people Bob Nardelli brought into Home Depot.  They were all performance driven in a GE way, whereas the Home Depot was centered around customer service and decentralized management at the store level.  The result was stores that dropped the ball on customer service and a stock price that went nowhere for a decade.

Constant Turnover in the Executive Ranks

Almost every company will try to tell investors that they have a stable of executive talent that has long tenure with the firm.  These statements usually run along the lines of “Our executive management team has an average of X years with the company.  What they won’t tell you is that they are the ones defining the measurement pool.  What this means is that they can make the measurement pool as large or as small as they want in order to shade the numbers in their favor. It also ignores the people that have been terminated, hired away or even retired.  What investors need to do is to pull out an annual report from a few years ago and see how many of the executives from then are still around.  I did this with a company I’m familiar with and found that of 47 executive positions listed four years ago in the annual report, 19 had left the company, including the COO and the CFO.  That’s a turnover rate of 40%.  If you were an investor that bought that company’s stock four years ago, it could be argued that it’s not the same management team.

A Big New Initiative With Lots of Consultants Directing Events

This usually signifies a large transfer of wealth from shareholders to the consultants.  These projects are usually accompanied by statements from management to the effect that the consultants are only at the company for a brief period of time after which the company will take over the project from the consultants.  About the time the company takes over the project is when the company stops talking about it. (See my September 24, 2008 post, “When Culture Meets Financial Theory”.)  Good luck trying to figure out if the company made a return on their investment.

International Expansion

Usually, when a company makes a big announcement about pursuing international markets, it’s an admission that they are almost out of room in the United States.  Given that international markets are almost always either 1) slower growth (think Western Europe) or 2) higher risk (think emerging markets) and 3) more difficult from a regulatory perspective, this means that shareholders will suffer in one respect or another.  In addition, it may mean that the Chairman and his spouse like to visit Europe a couple of times per year at the shareholders’ expense.

A Sudden String of Acquisitions

Acquisitions are, by their nature, disruptive, both for the acquired company as it attempts to fit into a new corporate system, and for the acquiring company as it siphons off resources to try and integrate the newly acquired company.  When you do a string of these, it has a compounding effect and the risk goes up that management takes their eyes off the ball of the main business. Or worse yet, the combined operations will make the numbers so confusing that rational year over year comparisons can’t be done, leaving investors scratching their heads while they try to figure out what’s really going on.

So if you’re an investor relations officer and are frustrated because you think analysts and portfolio managers don’t understand the underlying value of your company, you might look outside the numbers at some of the surrounding fact patterns to see some other reasons that investors might be leery of your stock.

Why Not Just Tell Us Why You Fired Him?

When a CEO is “Retired” by the Board of Directors investors almost always get the short end of the information stick.  Last week Walgreens Board announced that its then Chairman and CEO, Jeff Rein, retired at the age of 56.  They at least spared us the usual palaver about leaving to spend more time with his family or pursue other interests.  The fact of the matter is that the Board fired the CEO, but didn’t bother to tell investors why.  Readers of this blog may recall that I spent 23 years at Walgreens, 15 of which I had the pleasure of being the principal investor relations contact for the company.  So naturally, I wanted to know more about what went on.  (On a note of full and fair disclosure, I will also tell readers that I am not now, nor have I ever been, a fan of the recently departed CEO.  In fact, disagreement with him was the principle reason I left Walgreens nine years ago.  But then again, in the past few days as I’ve talked to investors, analysts and former employees, I haven’t been able to find anyone who claims to have been a fan.  How do guys like this get to be CEO in the first place?)

When someone as important as the CEO is asked to step down, investors deserve a reason that is credible, not the window dressing we usually see.  In this case I think it boils down to a couple of key issues – performance and strategic direction.  The performance issue is easy to see – under Rein’s watch earnings per share performance became much more erratic and the share price has slumped.  However, I don’t think that alone was enough to do him in.  Probably the deeper and more far-reaching reason for his dismissal was over the future strategic direction of the company and a failure of leadership.

Since the late 1970’s Walgreens has been one of the great organic growth stories in America.  The premise was simple: open ever increasing numbers of drugstores, run them well and ride the rising demographic wave of baby boomers taking more and more prescription drugs as they get older. However, somewhere in the last few years, as the number of new stores opened every year rose to over 300, return on assets and return on equity began to slip and expense ratios began to rise.  This was accompanied by a declared shift in strategy from just running drugstores to investing in other healthcare concepts such as in-store clinics, specialty pharmacy and acquisitions.  If you were viewing this from afar, it almost looked like a Boston Consulting type of strategy – use the drugstores as cash cows to fund faster growing healthcare concepts, but the overall emphasis continued to be on growth. 

Then, earlier this year, interesting things started to happen.  In June, the company hired a new CFO from the outside, an unusual occurrence in a company that prides itself on promoting from within.  One month later the company announce that it would slow its rate of organic drugstore growth and investors started to hear from the new CFO about plans to improve return on assets and rationalization of SKU counts in the stores.  In September, Walgreens announced that it was making a bid to acquire Longs Drugstores, a chain of almost 500 stores on the West coast, which on the surface, seemed to be at odds with the declared goal of slowing growth and increasing returns.  Then it was revealed that earlier this year Walgreens had been in talks with Longs about the possibility of acquiring it.  Finally, in October, Walgreens terminated its bid for Longs after being unable to get Longs to agree and two days later Rein, Walgreens’ CEO “retired”.

So when I try to piece things together, here’s how I interpret things:  There seems to be two competing long-term strategies at Walgreens over the past nine months – one that was committed to growth at any price, and one that recognized the limits to growth and sought slower growth with higher returns.  When the original acquisition talks with Longs did not pan out earlier this year, it would appear that the Board of Directors endorsed a view towards slower growth.  Then, within sixty days of announcing this new strategy, something changed – my guess is that Walgreens’ CEO bought into some new arguments by investment bankers that they could get the Longs deal done – and they decided to publicly pursue Longs.  While technically, the acquisition bid is not at odds with the slowing of “organic” growth previously announced, investors were confused.  Finally, when Walgreens’ CEO couldn’t get the deal done, the Board axed him for both zigging when they had publicly said they were going to zag and failing to be a strong enough leader to get the job done. 

All of this is speculation on my part, and that’s my point as it relates to investor relations.  The Board of Directors at Walgreens did not give any good reason for why the CEO was forced to retire, nor did they offer any indications as to the long-term strategic direction of the firm implied by the ouster.  Investors are left to speculate, which cannot be good for the stock.  These sorts of situations are messy, and I can understand why companies want to keep their dirty laundry hidden.  On the other hand, investors own the company and Boards of Directors act on their behalf.  Clarity on why the Board acted and what it means for the future direction of the company should be the least we can expect in terms of good corporate governance.

Questions You Should Prepare to Answer During This Market Downturn

Wall Street has a saying, “You can’t fight the tape”. What this means is that when the market moves in a given direction, in this case down, any prospect of your stock not getting caught in the downdraft is remote. The best you can hope for is that you suffer less than most. (Of course, there’s another saying that goes “The trend is your friend”, but that clearly isn’t the case these days). As we watch fear ripple through the market, I thought that it might be helpful if we paused and thought about what investor relations officers can do to bring some semblance of rationality to the valuation being assigned to their companies’ stock.  The concerns of investors that need to be addressed revolve around short-term issues and long-term prospects. 

On the short-term side of the equation, the biggest concern is always liquidity. How exposed is your company to the lack of liquidity in the markets?  Obviously, this is a huge concern for financial companies and companies with large amounts of leverage, but there are many other companies out there that routinely rely on short-term borrowings to fund operations.  With the credit markets locked up, how much cash does your company have to fund its operations? What are your alternative sources of credit? How is your cash conversion cycle being impacted?  Are your creditors paying you on time? What sort of write-offs are you looking at from your receivables?  How liquid are your inventories? Are you engaged in a stock repurchase program just when you should be conserving cash?  These are questions that every investor will want your input on, because they will be thinking about these issues. 

On a longer-term perspective, it is likely that we are headed into a recession and the natural questions that come up will revolve around this issue.  How economically sensitive is your company’s business?  What has been its performance in previous downturns?  Will tighter lending standards impact your sales? Is your company tightening the credit it extends to its customers?  What’s the longer term funding status look like for your company – are there large debt repayments coming due in the next few years?  How are you positioned relative to your peers with respect to all of the above? Institutional investors continue to be measured relative to a benchmark, so to a certain degree, they may be more willing to hold your company’s stock if, from a relative viewpoint, either your sector or your company are better positioned to perform during tough economic times.

Now is the time for investor relations officers to communicate more rather than less.  Professional investors are feeling quite a bit of pain these days as the markets gyrate wildly.  They are much more likely to pull the trigger and sell your stock if you don’t have immediate, well thought out answers to their questions. 

What Went Wrong With the Bailout

First of all, let me say that I have the utmost respect for Hank Paulson.  When I worked at Walgreens, Hank was the Goldman Sachs partner in charge of Chicago and I had the pleasure of dealing with him on a number of transactions.  He has a terrific knowledge of the financial markets and knows how to get things done on Wall Street.  However, that doesn’t necessarily mean that he knows how to get things done in Washington.  Herewith are a few modest suggestions that could have helped get the legislation through the halls of Congress, based on my years of dealing with communications issues, investors, and corporate management.

Naming

The people at Treasury never should have let this proposal see the light of day if it was going to be called a bailout.  They should have labeled their efforts the “Financial Securities Reform Act or, better yet, something that made a snappy acronym that highlighted the fact that they were going to take charge of the markets and wrestle down to earth all of these mortgage backed securities and collateralized debt obligations.  The agenda should have been reform, not bailout.

Offer Terms

Treasury treated Congress as if it were corporate management of a bank that was about to be seized by federal regulators.  The original proposal for legislation contained provisions that simply were not politically palatable to Congress – giving huge new powers to Treasury that were not reviewable by Congress or the Federal Courts and putting no limits on corporate compensation of executives of firms that benefited from the legislation.  Yet these were the same people who would have to vote on approving the funds, and are facing re-election in a month.  Then the people at Treasury proceeded to argue about it when Congress tried to make changes.  If the people at Treasury really wanted to get things done quickly, a more middle-of-the-road proposal that recognized some of the political realities would have worked much better.

Educating the Public

Your average American (and Congressman) does not understand the workings of the credit markets and how it affects them personally.  The perception of the legislation was that the U.S. taxpayer was going to buy all of these distressed securities from the big, bad banks leaving the banks free and clear and the taxpayer with the bill.  The reality is far more complex.  Banks are required to mark their securities to market. When fear grabs the credit markets and securities can’t trade, marking to market results in a cascade of lowering valuations that feeds on itself and erodes banks’ capital position.  With eroding capital, banks can’t lend and the economy grinds to a halt, and everybody from Wall Street to Main Street suffers. Treasury should have made it clear that their role was similar to that of a specialist or market maker.  They were going to step in, provide a market for the securities, initially as a buyer, but eventually as a seller as well. Banks, in selling to Treasury are going to take a loss, albeit not as big of a loss as if there were no buyer.  The point that needed to be made to the public was that banks were going to suffer here, not get off Scott free, and the ultimate beneficiaries are all people that borrow from banks, which is pretty much everyone in the U.S.

Treasury is not subject to mark to market accounting rules and can wait until the markets return to a semblance of order before selling.  In all probability, Treasury will probably make money on these trades as they can afford to wait the market out.  We may not know exactly what these mortgage backed securities are worth, but they clearly are not worthless and probably worth more than panicky sellers will unload them for.  One of the axioms of Wall Street is that you can make a lot of money if you can afford to be patient during a crisis.  So the second big educational point that needed to be made was that the intervention into the markets by Treasury would eventually be to the benefit of the U. S. taxpayer.

You can argue that the folks at Treasury and the Federal Reserve were in crisis mode and not thinking about communications issues, but if you want to get things done in Washington, communicating the story in the right way is half the battle.

When Culture Meets Financial Theory

How often have you seen this: A company makes a big public announcement regarding a new strategic initiative designed to bring wiz-bang methods and profitability to the way the company does business.  Investors are intrigued because what the company has announced seems eminently reasonable and conforms to what the analysts were taught in business school. (Of course, the consultants that the company is using all went to the same business schools, so there is a bit of circular reasoning at work here, but leave that for another day.)  Following the initial splash of the announcement, investors clamor for more details on the big new initiative.  What they are usually greeted with are phrases such as “It’s still early days”, “It’s too soon to see anything out of this” or “This is a big project that touches many areas of the company and it’s very difficult to measure”.  Eventually, the amount of information about the project coming out of the company slows to a trickle and then stops.  In the noise of the market, investors forget about the project and look at other things.  No one ever really finds out if the project had an acceptable return on investment.

What’s going on here?  It’s not as if the company is no longer working at trying to implement the new project.  It’s not as if they don’t have internal measures that gauge the progress of the project.  If the news were great, would the company stay silent on the issue?  Maybe, but probably not - they would be much more likely to be trumpeting the triumph of new technology.  I would suggest that what is happening is the corporate version of a shell game: the company would prefer that you direct your attention to something else so they don’t have to explain why their vaunted project is not living up to it’s initial promise.

Large, radical new corporate initiatives almost always represent a break with existing corporate cultures.  I have a favorite saying about this situation: “When culture meets financial theory, culture almost always wins”.  The corporate culture in many organizations is part of the corporate DNA and will fight off attempts to change it.  The result is generally that the big new project will wind up costing more than initially planned, take longer than estimated and do less than the original projections.  When companies start to see this, they begin to build up a barrier around the project by limiting further disclosures.  I’ve seen this any number of times.  For example, during the 1980s Walgreen embarked on a “Strategic Inventory Initiative” designed, among other things, to lessen the amount of inventory carried in the stores.  Millions were spent on computer systems to help achieve optimal inventory levels.  Unfortunately, the culture of the Walgreens store managers was that they wanted their stores to look as if they had lots of inventory.  Their culture was to never to be out of a product if they could help it.  As a consequence, inventory levels never went down.  More recently, Home Depot went through a big reorganization to centralize many functions that had previously been done at the store level, running smack into a culture that had been centered around the store managers.  The result was a lot of dislocation and same store sales that were anemic for a protracted period of time. 

I’m not here to say that corporate cultures are always right – they’re not.  Many times corporate initiatives to change ingrained methods of doing business are both necessary and difficult.  But as I look at the way such projects are disclosed to investors, and the short-lived way that investors pay attention to the projects, I think things could be better.  Herewith, a few modest suggestions: For companies – if a project is important enough to announce to the public, it is important enough to continue to report about it until it reaches maturity.  Recognize that the project will vary from its original projections and provide sufficient metrics to enable investors to judge the progress of the project.  The ability for investors to determine if an adequate return is being achieved on the company’s investment seems to me to be a reasonable goal.  For investors – make the company continue to disclose.  Have a long-term outlook when it comes to this type of project.  Try to figure out how the project fits into the overall fabric of the corporation, not just whether it sounds like something your business school professors would recommend.  

Perhaps if corporations and investors take a longer tern view of these projects both sides will benefit – after all, more disclosure about things the company thinks are important should be better for investors as well.

How to Read 10K and 10Q Reports

The Annual and Quarterly Reports on Forms 10K and 10Q are documents that come under the heading, “Important, but boring”.  If you are an investor trying to read one of these things, it’s equivalent to drinking a glass of warm milk just before bedtime.  It’s guaranteed to induce drowsiness.  And that’s just the way companies want it.  These things are written by teams of accountants and lawyers, whose job it is to comply with the law and regulations set out by the SEC and the courts, while saying as little as possible.  While the SEC may mandate the use of “plain English”, there is no obligation to make the language interesting.  It is yet another example of the focus of our corporate disclosure system on complying with regulation rather than attempting to clearly state what is going on. 

Yet there’s lot of good information in there, if you can persist and find a way to dig it up.  The tricky bit is that often the interesting information is what’s changed from what they used to say or what is no longer being said.  And that’s hard to figure out.  If you are a sell side analyst who has intimate familiarity with the company filing the report, things that are not being said may instantly pop up at you, but for the rest of us, remembering what is not there, but should be, or what has been subtly changed, is a much more difficult task.  As I thought about this it occurred to me that these reports are rather lengthy documents, which no one could write from scratch every quarter.  What the writers of these documents do is take last year’s document from the same time period and mark it up for changes.  Certain things have to get changed – after all, the numbers aren’t going to stay the same every year; but other changes give you some insights into what the company may not be saying and how they view their disclosure obligations.

So the thing to do is to lay out this year’s and last year’s report side by side and work your way through the important sections.  Just to take an example, I looked at CVS, the large drugstore chain.  Picking a subject at random, I went to see how many pharmacists they have on staff, as it might be an important indicator of service levels.  Here’s what I found:

2007 10K

“As of December 29, 2007, we employed approximately 200,000 associates, which included more than 20,000 pharmacists…” 

In and of itself, this snippet of information doesn’t tell me a whole lot – if you combine it with the number of stores they had open at the end of the year, 6,301, you have a ratio of 3.17 pharmacists for every store.  So I laid it next to what they said the previous year:

2006 10K

“As of December 30, 2006, we employed approximately 176,000 associates; of which approximately 20,000 were pharmacists…”

Now things start to get interesting – did CVS really add 24,000 new employees but no net new pharmacists?  Or are they hiding behind the weasel words “more than 20,000” in 2007 versus “approximately 20,000” in 2006.  Further digging showed that CVS completed a big merger with Caremark in 2007, so they could have added a significant number of employees, but they also added 99 net new stores from 2006, so the ratio of pharmacists to stores fell from 3.22 in 2006 to 3.17 in 2007.  Just to maintain the same ratio of pharmacists to stores in 2007, CVS would have had to add 318 pharmacists.  Furthermore, the old Caremark was a pharmacy services provider, so presumably they had pharmacists on staff that transferred over to the new combined CVS. 

So what does this tell me as an investor about CVS?  It sure raises a lot of questions, none of which CVS tries real hard to answer in their filings, to wit:

1.  Did CVS reduce service hours and staffing for pharmacists in their stores?  Have they suddenly gotten more efficient?  Were 2006 staffing levels too high?

2. Is CVS having trouble hiring enough pharmacists?  This was an issue with them several years ago, causing a decline in earnings and should therefore be of interest to current investors.  It might even rise to the level of what an investor would consider important in making an investment decision about their stock.

3.  Why doesn’t CVS use exact numbers when describing how many pharmacists they employ? Can’t CVS be bothered?  Or is it that their systems aren’t good enough?  You would think they would have records and systems that tell them, especially at yearend.

4.  Does the use of weasel language such as “more than” and “approximately” about a key type of employee make you nervous?

5.  Where are all the pharmacists from Caremark?

6.  Should an investor start to look at other numbers CVS uses to see if they tie out?

The drafting of an Annual Report on Form 10K passes through many hands in a large corporation, from the internal accountants, internal securities law lawyer, investor relations personnel, outside securities law lawyers, the General Counsel, senior executives and the Disclosure Committee.  When you see a change such as the one above, you have to conclude that there was a deliberate choice to be vague on the topic and hope nobody would notice.