A Gordian Knot – Investor Relations, Laws, Regulations and Case Laws

The academic part of my year is currently in full swing and that, combined with my other commitments, has caused me to fall behind on my musings. My apologies to those of you who have been eagerly awaiting yet another installment, but as a rational economic person, I’m going to do those things first which pay me, and frankly, this blog is never going to replenish my ravaged 401(K) account.  That being said, it was while I was preparing for one of this week’s classes that the idea for this post occurred to me.

One of my class topics this week focuses on the legal and regulatory framework surrounding investor relations.  It’s not a subject that business school students are naturally attracted to, but it is something that everyone involved in investor relations needs to master.  Back in the 60’s, there was a band by the name of Zager and Evans whose one and only hit was “In the Year 2525” which had the line in it, “Everything you think, do and say, is in the pill you took today”.  Which is a pretty good way to think about the laws and regulations surrounding investor relations – everything you think, do and say is governed by them.

One of the points I try to make in my class is that the laws and regulations surrounding IR are not the result of a coherent codification of the laws, cut from whole cloth.  Rather they have grown and evolved over time, from statutes, regulatory rule making and case law decisions.  The resulting Gordian Knot of laws, rules and case law is enough to send joy to the hearts of lawyers everywhere and give everyone else headaches.  Further, each is enacted from a different set of circumstances.

Statutes, for example, are usually enacted to stop some form of abuse.  This was true of the original securities protection acts, the state “Blue Sky” laws, and it continued to be true with the enactment of the Securities Act of 1933 and the Securities Exchange Act of 1934, which were enacted following the stock market abuses of the 1920s.  More recently, the Securities Litigation Reform Act of 1995 was enacted to curb abusive securities law class action claims and the Sarbanes-Oxley Act was passed by Congress in reaction to the Enron, Adelphia, MCI and Tyco scandals. Those of you who are looking for a common theme among these acts would do well to take up a different hobby. I suggest something much easier – say, along the lines of solving The New York Times Saturday crossword puzzle.

On the regulatory side, I find that the regulations that get enacted by the SEC tend to have a political background to them.  Take, for example, the disclosures surrounding executive compensation in the proxy statement.  As executive compensation has swelled, political pressure has built up, which has resulted in the SEC layering in more and more disclosure regulations surrounding executive pay.  Way back in the dark ages (the 1970s) when I was actually writing proxy statements, it was not unusual for them to be no longer than 8 – 12 pages.  Today, between tables, graphs, Compensation Committee and other reports, Proxy Statements routinely run 4 – 5 times that length.  It has to be extremely frustrating for politicians and the regulators, because the more disclosure they require, the bigger the pay packages seem to get. I have no doubt that if they could have enacted compensation limits, they would have. But the SEC’s regulatory authority only extends to disclosure, so they keep making companies say more and more about how they come up with their pay  schemes in the hope that shareholders will get outraged and rein in the pay packages.  Similarly, other disclosure regulatory requirements have waxed and waned depending on the political climate of the time.  As a result, any hope of consistency regarding how the regulations require you to act is a forlorn one. 

Finally, much of materiality and the definition of fraudulent behavior in the securities laws is the result of case law decisions.  These are instances where, except in the most egregious or fraudulent cases, reasonable people can differ. Yet this is how we come up with our definitions for materiality, how we interact with analysts, when we choose to disclose and a multitude of other things. 

I, for one, would like to see a comprehensive overhaul of the securities laws to bring some semblance of logic to them that would serve to eliminate much uncertainty (and billable law firm hours) from the process of being a public company. Like Alexander the overhaul would cut through the many strands of laws, regulations and case decisions that are tying us up in knots with a clear unified code of securities laws. Then again, given the current administration and the mood of Congress towards Wall Street, maybe its better to leave well enough alone…

How to Use a Computer to Read Company Reports

It has come as somewhat of a shock to me, but I realized the other day that personal computers can actually perform some very useful roles when it comes to reviewing company SEC filings. This is welcome news to someone who labored through the early days of DOS based PCs where it felt like you spent more time trying to get the blasted things to work than you did in actually getting any productivity.  It’s nice to be getting some productivity payback, even if it is twenty years later.

I’ve found that when investors are following a company, what they care about are the changes that are happening on the margin, particularly as it compares with the same period in the prior year.  Companies, of course, are happy to tell them when good things are happening at the margin and will supply lots of reasons why smart management has made good things happen.  The bad things, however, either get buried in the fine print, or, more than likely, omitted.  It’s these omitted things that are toughest to spot.  After all, the previous period was a year ago and who can remember that far back?  I’m lucky if I can remember what I had for supper last night, so good luck spotting that omission. This is where reading the periodic filings of a company with the aid of a computer comes in really handy.

First, let me say that it really helps if you have a very large display monitor, or, better yet, dual screens.  I switched to dual monitors about two months ago and it feels as if I’m saving about 10% of my time because I no longer have to dig through and move around the multiple screens that I’m working on.  With a super-sized viewing area it is then easy to go the Securities and Exchange Commission’s website (www.sec.gov) and search for the most recent filing by the company you’re interested in.  Once you’ve pulled that up, you then open a new window right next to it with the previous year’s filing for the same period in it.  So far, this is nothing you couldn’t do with paper on your desktop if you wanted to print out the documents and kill a lot of trees.  But now comes the cool part.  You can get the computer to search for the word or phrase you’re interested in.  Rather than parsing the document line by line to find out what’s missing, the computer can tell you exactly how many times a word or phrase was used in the company’s discussion.  Then you simply compare what you’ve found with the same search for the previous year’s filing.  If there is a big discrepancy, then a diligent investor will use it as a starting point to start asking questions. I’ve used this technique when writing some of my blog posts to look at the treatment of same store sales by Starbucks and the disclosure of the number of pharmacists working at CVS Drugstores (see Starbucks and Disclosure of Same Store Sales, December 5, 2008 and How to Read 10K and 10Q Reports, September 10, 2008).  My computer will tell me how many times the word or phrase is used in the document and take me right to the spot it’s used. 

 The system works because, by my estimates, 85% - 90% of the discussion material in the 10-K and 10-Q doesn’t change from period to period.  If you’ve ever sat in on a Disclosure Committee meeting, you know that the accountants and lawyers are trying to write the document by making as few changes as possible to the previous document.  Nobody has time to reinvent the wheel every quarter with a totally rewritten filing. So when they make a change, it’s usually because they have to make a revision due to changed circumstances.  Many times those changes, if they don’t favor the company, will get buried in the 10-Q or 10-K and it’s up to the intrepid investor to find them. 

And this is just the beginning of how computers can be used to analyze the textual discussion in company periodic reports.  Those of you who are intrigued by all of this should take a look at a site called Many Eyes (www.many-eyes.com) to see how see how graphics can be used to analyze text and changes to text.

It’s a brave new world…

A “Cultured” Approach to Investor Relations

Last week I had the pleasure of going up to Columbia Business School and giving a talk to some of the second year finance students about a case I helped Professor Laurie Hodrick write a number of years ago.  Professor Hodrick has been most generous over the years in allowing me to go into her class and spout off about what, in my view, the case really tells the students.  And, as readers of this blog will probably know, my opinions don’t always conform to the standard view.

The talk is an opportunity for me to expound on a subject that I am convinced is an important, but underdeveloped, line of inquiry on corporate behavior.  That is, what happens when corporate plans incorporate financial theory that runs counter to a company’s prevailing corporate culture?  It’s always fun to talk about this in a financial analysis class setting, because it’s one of those “soft” issues that drive finance people nuts.  You can’t quantify it very easily and usually wind up talking about it through the use of anecdotes.  But I’m convinced it is very real and contributes considerably to the success or failure of many corporate projects.  

In the case I help teach at Columbia, the subject matter revolves around Walgreens’ plans to generate cash through increasing inventory turns, running counter to their retailing culture of having lots of inventory on hand for their customers.  There are plenty of other examples from real life, including Hewlett Packard’s reorganization a few years back running smack dab into “the H-P way”, Home Depot’s centralization efforts wrestling with the famously decentralized culture of their store managers and Rite Aid drugstores attempts to change from a chain of small stores with tightly controlled expenses to larger, sales driven stores.  All of these proposed changes looked eminently reasonable and logical when they were proposed, but in retrospect, never came close to achieving what was planned for, as the unseen forces of corporate culture threw a monkey wrench into the finely tuned plans. 

Which brings me to the point I want to make as it relates to investor relations.  Corporate culture matters.  One of the principal jobs of an investor relations officer is to bring color, understanding and nuance to the basic information surrounding a company.  Probably the most important piece of nuance that you can help investors understand about your company is the culture in which it operates.  The numbers from the financial statements are there for everyone to see and you don’t bring much value if all you do is regurgitate the numbers.  Where value is added is when you help investors understand why the numbers are the way they are.  This involves the ability to explain a variety of factors, including industry trends and company specific actions.  Placing things in the context of your company’s values is an integral part of this.  For example, the income statement and balance sheet of a company that is sales driven will look very different from one that is expense minded, even if they operate in the same markets.  Engineering oriented firms take a different approach to business than firms that emphasize marketing.  It is the function of the investor relations officer to place how your firm approaches business into this context.

I will finish with the following thought:  One of the hardest edged institutions I know is the United States Military Academy at West Point.  Life there is tough – highly regimented and rigorous.  They are in the business of training combat officers capable of operating under extreme duress.  Further, the curriculum at the Academy is engineering focused.  Yet much of what the Academy stresses to the cadets is not the brutal calculus of war, but “soft issues” such as “Duty, Honor, Country” and leadership.  If you want to understand what motivates our military, you are well served to understand these values. Similarly, if you want investors to understand your company better so that their valuation will properly reflect the long-term value of your firm, you need to explain your operations in the context of your corporate culture.

And You Thought Our Stock Ratings System Was Screwed Up

In the February 8^th Sunday New York Times, the Business section contained an article entitled “Why Analysts Keep Telling Investors to Buy”.  It’s worth a read, even if it covers familiar ground to those experienced in the ways of Wall Street and investment analysts.  The long and the short of the article is that even in the mist of a terrible bear market, analysts still only have sell ratings on 5.9% of all stocks.  Having missed all of the warning signs for the current economic downturn, most analysts are now of the opinion that stock prices are so low that now is the time to buy.  Nobody wants to issue a sell rating just when the markets turn up.

I’ve written about this phenomenon before (see “Stock Ratings from Lake Wobegone”, May 15, 2008).  Leaving aside the tendency of the stock market to rise over time, all of the incentives on Wall Street favor the optimistic, bullish view.  When an analyst issues a sell rating, companies hate him, investment bankers hate him and commission flow goes elsewhere.  The only ones who like sell ratings are short sellers, and they are often viewed as the pariahs of the industry, commonly blamed for all sorts of financial misdeeds and shenanigans.  (My own feeling is that short sellers, like jackals and hyenas, form a natural part of the ecosystem, but that doesn’t mean we have to like them.)

None of this would be worthy of a lot of additional comment on my part, except that about the same time as I read The New York Times article, I also ran across a brief piece in the February 7^th issue of The Economist magazine that made me think that maybe, as skewed as things are here, they’re a lot better than some other markets.  The article, entitled “Bye bye sell” takes a look at research recommendations in the South Korean and Taiwan markets.  In both markets it appears that government regulators actively discourage brokerage firms from issuing critical research.  In South Korea, the Financial Supervisory Service has been known to investigate brokerage firms that issue critical research, while in Taiwan, if the press quotes critical research, the government requests brokers to provide “explanations” as the press is required to receive a securities firm’s approval before quoting research.

The results are predictable, as the research firms quickly learn that critical research brings more trouble than it’s worth.  For example, during 2008, there were 17,335 research reports issued in South Korea, and not a single one was a sell recommendation.  This is not what you think of when you start talking about efficient markets.  As bad as our distribution of stock recommendations is in the U. S. we are not burdened by a government bureaucracy that views stock markets as an instrument of optimistic government policy. Yet.  

XBRL – Part Deux

Much to my surprise, my recent post about XBRL has generated more emails than any other post I’ve written.  People from London and Washington D. C. have offered to help me see the error of my ways, so I’ve decided to continue to try and see the light.  (But, I mean, who would have thunk? This seems like a pretty dry topic to me.) 

I’m at an age where I’m not embarrassed to say that there are some things I just don’t get.  For example, in Game Theory class I never did figure out who was wearing that damned ret hat.  Be that as it may, this stuff is like an unscratched itch and it bothers me until I get some semblance of understanding, dim though it may be. 

So I went back and did some more digging on the web and I found an article about the 18^th XBRL International Conference held in Washington, D. C. last October.  What caught my eye in the article was a presentation where a Microsoft official stated that his company had already installed a XBRL enabled tool on its Investor Central website.  The specific statement was that the site allowed investors to drill down into segment results that sum into top line numbers on the financial statement.  I thought, “Ah ha, here’s a concrete example of XBRL in use that can really help me understand what’s going on.”  So off I went to the Microsoft website to look at the way they report segment results in their Investor Central.

I’ve inserted a screenshot of what I found.  The first page under segment reporting gives you the breakout of revenue and operating income.

If you click on one of the line item headings, it takes you to another screen (shown below) that drills down into the line item detail and the language from the Management Discussion and Analysis section of the 10-Q that discusses that segment.  So far, so good – it doesn’t give you any more information or insight than reading the 10-Q, but it assembles the data in one spot so that you’re not confined to the logic of a governmental filing form as you try and figure out what Microsoft’s various business segments are doing.  Nice, but hardly revolutionary.  Then I took a closer look at the way Microsoft had laid out the information and I lost my appetite for XBRL. 

The segment I had chosen by random to look at was Microsoft’s Online Services Business.  Microsoft starts the page with a headline stating “Online advertising revenue grew 7% in a weak ad spending market” and follows it up with three bullet points about search revenue up double-digits, continued display revenue growth and healthy engagement growth in page views and search queries.  It all sounds very positive until you look down into the actual detail pulled over by XBRL and you see that actual revenue growth for the segment was flat and oh, by the way, operating losses increased by 91% to $471 million.  Maybe that’s just a rounding error to Microsoft and not worthy of a mention, but it sure seems like a lot of money to me. What Microsoft did was to take the opportunity created by having an additional, non-SEC filing page to create some positive, non-XBRL commentary in order to try and spin the results on a horrible quarter in the segment.  If this is XBRL, you can have it; I’d rather try and figure things out without the commentary trying to divert my attention elsewhere.

Also, curiously enough, something appears to be awry with the transporting of data, as the last sentence on Microsoft’s web page refers to “headcourt-related [sic.] expenses” whereas their 10-Q filing gets it right.  If this data is just being moved around automatically, how could that happen?  And how confident does that make you feel that all the numbers have been transported correctly?

Maybe I’m just a skeptic (regular readers of this blog knew that already), but I don’t see what all the fuss is about with XBRL.  It’s just rearranging the data that we already had, which to me seems like a lot of work for not much benefit.  Better understanding and benefit come from working through the data.  Balanced against this we seem to have given companies yet another opportunity to spin the data.

Then again, maybe I’m just an old curmudgeon and this is another instance of not being able to figure out where that damned red hat is…

Walgreens’ CEO – An Inside Job

I have a confession to make.  There is software on this blog that allows me to see statistics about what posts are most popular, where my readers are coming from and how they get here.  I can’t tell down to the exact reader, but because I can see what networks the readers are using and the geographic region they’re coming from, so I get a pretty good idea of who my readers are.  And, much like the authors that check their Amazon book sales rankings, I confess that I regularly check my statistics with great interest to see if anyone is reading this stuff.

I’ve been surprised to find that the post I wrote about the firing of Walgreens’ CEO “Why Not Just Tell Us Why You Fired Him?” continues to be among the top visited posts four months after it was written.  Also surprising to me is that people using the Walgreens network have been among my most frequent visitors over the last month.  So, even though I haven’t worked for Walgreens for ten years, hello out there to all you Walgreens people, it’s nice to be remembered.  Of course, I’m not sure you remember me quite so fondly as I would like in light of some of the things I’ve written, but hang on, I’m about to say some positive things.

Earlier this week Walgreens announced that it was appointing Greg Wasson, its President and COO to the post of CEO following a search to replace their former CEO, who was “retired” last October.  This announcement was followed by catcalls from a number of sell side analysts that follow the company.  The received wisdom of the Street seems to be that Walgreens needs a new perspective, which an insider can’t bring. 

So my question for them is: “What sort of a fresh perspective do they expect an outsider to bring?”  One like Bob Nardelli brought to Home Depot?  Or one like Larry Johnston brought to Albertson’s? Or that Carly Fiorina brought to Hewlett-Packard?  I could go on, but I think you get my point.  Bringing in an outsider to run a company is tricky, and it’s even trickier when the company has a strong culture, as Walgreens does. 

Further, and this seems to be the elephant in the room that nobody’s talking about, Walgreens has an installed base of over 6,500 drugstores.  And those drugstores are performing pretty well, thank you very much.  Not as well as they used to, but better than 90% of all retailers in today’s environment.  So you don’t want someone to come in there and muck it up.  And, no matter what you do, short of a merger with a company equal in size and profitability, (and good luck finding one of those these days) the drugstores are going to be the engine that drives the train of profitability for Walgreens for a long time to come.  All this other stuff that is going on with the drug store/healthcare arena – clinics, specialty pharmacy, home infusion and the like, is at the margin.  It all sounds great, but the sales base in the drugstores is at least $55 billion and it takes a pretty good shift in segment sales to make a dent in the overwhelming weight of the drugstores.  In other words, you better have someone who understands drugstores running the show because they’re going to be what pays the freight, even if you elect to pursue a Boston Consulting type strategy where the drugstores are run as the “Cash Cows” of the business.  And that’s what makes Wasson, an insider, the right choice for the CEO job.  Nobody runs drugstores better than Walgreens does, but in retailing, if you take your eye off the ball, things can spin out of control in a hurry.

Walgreens closest rival, CVS drugstores, recently announced that it was lowering its guidance for next year’s earnings to an expected increase of 4.5%.  The reason given for the disappointing guidance was weakness in the pharmacy benefits management business, which just happened to be their big strategic acquisition (Caremark) of a couple of years ago.  The stock price performance for Walgreens and CVS has been similar over the past year, with both stocks losing between 20% - 25%. Yet I don’t hear any sell side analysts calling for an outside CEO at CVS.  I guess you get more credit with some Wall Street analysts if you go for big “game-changing” acquisitions than if you undertake to do things in a prudent and reasoned manner.

I’ll end by reiterating something I’ve written before:  Wall Street analysts are lousy at strategy.  Walgreens’ Board should be congratulated on keeping their heads when analysts were shouting for an outsider.  It’s rare that a knight can ride in on a charger and fix things with a wave of Excalibur.  More often, it takes someone who knows the system, can work with the culture to implement gradual change and is willing to make the hard decisions.  It’s very early days yet, but it appears that Wasson has a better chance to do that than an outsider would.

XBRL – What Is This Stuff?

I don’t think of myself as a Luddite.  In fact, for someone with as much grey hair as I have, I think of myself as pretty tech savvy.  After all, I have a blog, I also have my own web site, I carry around a Blackberry and I spend much of my day in front of a computer.  But, I have to confess, when it comes to XBRL as it relates to investor relations, I’m lost.  I’ve been to presentations at NIRI conferences where I hear speakers expound upon their theory that XBRL will revolutionize the way we look at and use financial data.  I hear them extol the virtues of how the information will be tagged and prepared for automatic comparisons and I wind up more confused at the end of the speech then when I started listening to them.  I find that when people start talking about XBRL, it’s similar to when I listen to computer programmers – I’m pretty sure they’re talking English, but not in a way that I can comprehend.

Finally, I couldn’t stand it anymore and I decided to try and figure out how all of this will affect me.  So I went out and did a Google search on XBRL (I told you I was half-way tech savvy, didn’t I?)  Here’s what I found:

“XBRL, like XML, applies identifying tags to items of data, which allows them to be processed and analyzed. Like XML, XBRL is a language intended to be read by computers, not humans. The use of XBRL tags enables the automated processing of financial data by specialized computer software, which eliminates the need for the tedious and costly process of manual re-entry and comparison. Once data has been tagged, computer software, rather than human labor, is used to select, analyze, store and exchange information. Moreover, since it is a standardized language, XBRL enables an apples-to-apples comparison across multiple companies and multiple industries.” 

So as I understand it, we’re going to be able to grab all sorts of data and the computer will tell us if the information is comparable.  If it is, then we can drop it into spreadsheets and unlock all that hidden information.  Leaving aside the issue of whether or not companies will code everything in the same manner (which is a pretty big issue by itself), as I see it, there are two potential problems here.  First, the numbers that are being tagged by XBRL are being prepared by humans using accounting.  As we all know, accounting involves a multitude of judgments.  Things that seem straightforward on the surface, such as revenue, can actually be quite tricky when you start to adjust for accrual accounting with its accrued revenues, deferred revenues, advances, long-term contracts and exceptions.  The tagging for XBRL will follow the accounting judgments, so unless all companies start to account for things exactly the same, discrepancies will crop up in the numbers.  In my experience, every company has certain accounting items that they handle differently from other companies.  The reasons for this range from “We’ve always prepared it that way” to “The system can’t handle it that way” to a variety of other excuses, but I assure you these exceptions exist.  Unless you get uniformity, comparisons are an illusion. 

Second, and this goes back to something I learned when I was taught math (or as we used to call it in those days, arithmetic), you can’t just read the problem and say, “I understand it”.  You have to get out your pencil and paper and work the problem to absorb what’s happening.  Maybe I’m a dinosaur, but when I’m examining a company’s earnings report, I pull out a calculator and work out the relevant ratios and changes I care about.  That way, as I work my way through the financial statement, I find I have a better understanding of where the variances are.  Maybe the next generation will be better at letting machines point out these things, but having helped three children learn math, I don’t think so.  

So as I understand it, XBRL will allow people to use software to manipulate numbers easier and faster (because they’re already tagged) for purposes of analysis and comparison.  There is, of course, no guarantee that the analysis will be any better understood or that the comparisons will be meaningful, but hey, you’ve got to start somewhere.

Sounds to me as if the XBRL revolution is being oversold.