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Jubak's Journal
Recent articles:
• Jubak's Journal, 3/28/2002
• Jubak's Journal, 3/26/2002
• Jubak's Journal, 3/19/2002
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Throw the rascals out!
Angry that a company you own -- as a shareholder you are a partial owner, remember -- is being run into the ground? Or that the company’s executives are lining their own pockets at shareholders’ expense? Or that the company’s management is just too cozy with relatives, consultants and accountants?
Then vote the directors -- the people who are supposed to make sure the company is managed for the benefit of its shareholders -- out of office. The proxies that companies are sending out right now as part of this spring’s annual meeting season offer investors just that chance.
A lot of names have been slapped on the current crisis in the markets. It’s an accounting crisis, some analysts say, and there’s certainly evidence that hundreds of companies massaged their numbers. It’s a credit crisis, others state, noting the number of companies that hid billions in debt in an effort to keep balance sheets looking good. And still others observe that it’s a profit crisis, as companies come clean on the tricks they used to make it look like earnings were growing faster than they were.
But to me, the underlying theme that stretches from Enron (ENRNQ, news, msgs) to Global Crossing (GBLXQ, news, msgs) to WorldCom (WCOM, news, msgs) to Adelphia Communications (ADLAC, news, msgs) to Elan (ELN, news, msgs) to PNC Financial Services Group (PNC, news, msgs) is a crisis in corporate governance. At company after company, the board of directors has failed in its basic duties of representing shareholders and riding herd on management.
Simple rules, complex violations
What are boards supposed to do? The board’s powers and duties are spelled out in every company’s corporate charter, and you can usually find a reasonable summary of the job in the annual statement that comes along with the proxy ballot. For example, the Johnson & Johnson (JNJ, news, msgs) board’s audit committee is supposed to make sure that management maintains an adequate system of internal controls so that financial reports can be prepared in accordance with generally accepted accounting principles. This committee is also supposed to supervise the work of the independent auditor.
The board, working through its compensation committee, reviews the company’s compensation policies and reviews decisions by the management compensation committee that determine how much, and how, management is paid. The compensation committee also administers the stock option plans at Johnson & Johnson.
And finally a corporate governance committee is responsible for ensuring that the board and the CEO are doing their jobs within the guidelines laid down by the company.
Investors can find similar descriptions at most U.S. companies. (I’ve picked Johnson & Johnson as an example for no other reason than the company does an especially good job in its proxy statement of laying out the duties of the board and reporting on the policies and decisions of the important committees.)
Sounds good on paper, doesn’t it? But the current crisis makes it very clear that many companies didn’t give their own rules much more than lip service.
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Hall of Shame nominations
How bad were the lapses in corporate governance? Well, here are, in alphabetical order, eight companies that make my personal hall of shame. I’m sure you can add more.
Adelphia Communications. Let’s see: The company guaranteed loans of $2.3 billion to the Rigas family, which founded and still owns much of this cable TV company. The loan, the company’s chief financial officer told Wall Street on March 26, is secured by assets that would normally be able to secure no more than $700 million, according to Merrill Lynch. Oh, and by the way, the chief financial officer added, the debt wasn’t included on Adelphia’s balance sheet, even though the company was liable for its repayment. The CFO’s name? Timothy Rigas, son of CEO John Rigas.
Cisco Systems (CSCO, news, msgs) It’s no secret that Cisco Systems has been one of the most acquisitive technology companies over the last decade. But many investors don’t know that high-ranking Cisco executives owned stakes in many of the acquired companies through their investments in two major California venture capital firms, Kleiner Perkins Caufield & Byers and Sequoia Capital.
CEO John Chambers, for example, held a stake in five private companies that Cisco acquired. And eight other Cisco executives owned pieces of 12 companies that Cisco bought. Company policy at Cisco allows such outside venture investments, so nobody violated any company rules. (Chambers even recused himself from voting on a 1999 $7 billion acquisition and has donated the shares he acquired in such deals to charity.) But that’s my point -- company rules ought to rule out conflicts of interest like this, especially when shareholders are questioning the bookkeeping on Cisco acquisitions strategy in general.
Elan. Whoa! Didn’t anybody on the audit committee at Elan see that the company was too deeply in bed with its auditor KPMG? Donal Geaney, Elan’s CEO, is a former KMPG partner. So is Chief Financial Officer Shane Cooke. Hard to see KMPG getting tough with its former partners. The company has been “aggressive” about taking research and development joint ventures off its balance sheet and has used accounting that inflated revenue by investing in tiny biotech firms that would then use Elan’s capital investment to pay for research conducted by Elan. Elan would then book that payment as revenue, thus round-tripping its own capital.
El Paso (EP, news, msgs). What’s the logic in giving top company managers the opportunity to invest in side deals? In 2001 El Paso gave 16 top executives, including CEO William Wise, the chance to buy into El Paso Global Networks, the company’s telecommunications network. Not only did the company loan the executives 80% of the cash but then bought back all the outstanding stock and stock options of Global Networks at a premium, according to a company proxy filing. Shareholders took the risk, it seems, and the CEO and others got a distracting side bet that put them potentially at odds with shareholder interest. Better to just pay the extra money in cash or add more options in the parent company stock, I’d say.
Enron. Exactly why did Enron’s accounting spiral so far out of control? You can find one answer in the makeup of the company’ audit committee, which mixed passivity and conflict of interest. For example, member John Mendelson heads up the M.D. Anderson Cancer Center at the University of Texas -- the recipient of $1.6 million from Enron since 1985. Hong Kong billionaire Ronnie Chan missed more than 25% of meetings in 2000. Lord John Wakeham, who joined the board in 1994, earned $72,000 a year as a consultant to Enron.
Global Crossing. Where to start? Before he joined Global Crossing as executive vice president for finance, Joseph Perrone was in charge of auditing Global Crossing’s books for Arthur Andersen. His new job at Global Crossing? Overseeing the way that Global Crossing booked revenue from its swaps of network capacity with other telecommunications firms. Those accounting methods are now under investigation by the Securities and Exchange Commission and the FBI.
Perrone’s name also figures in two deals that Global Crossing signed with Withit.com, a company run by Joseph Perrone Jr. It’s not clear how much scrutiny accounting issues of that deal with Within.com got from Global Crossing’s board -- but with a majority of the board composed of either company insiders, or lawyers and bankers who did business with Global Crossing, the situation was ripe for abuse.
Tyco International (TYC, news, msgs) I know the reasoning: Loaning money to top executives to help them buy company stock aligns shareholder and manager interests. But the practice also gives such executives an opportunity to avoid exactly the kind of insider trading disclosure that shareholders are entitled to have. Over the last three years Dennis Kozlowski, CEO of Tyco International, used $88 million in loans from the company to buy shares in Tyco. During the company’s 2001 fiscal year, Kozlowski returned $70 million of that stock to the company.
Since the transaction wasn’t a sale on the open market, but rather a swap to repay debt, it didn’t have to be disclosed to investors until 45 days after the close of the company’s fiscal year. A traditional sale, on the other hand, must be reported to the Securities and Exchange Commission by the 10th day of the following month. Technically, Kozlowski was correct in saying that he rarely if ever sold his Tyco shares during 2001. But I think the company’s board of directors was shirking its job when it let him exploit that technicality.
Worldcom. When is a loan to a CEO simply too big? When it becomes a distraction for investors. WorldCom’s $340 million loan to CEO Bernie Ebbers certainly fits that category. The loan is secured only by Ebbers’ shares in WorldCom. (He can’t sell them without company permission.) But the sheer size of the loan has become an issue in the stock market and has depressed the stock’s price. Investors fear that Ebbers will have to dump shares to meet a margin call on the next dip in the stock, or that WorldCom will wind up having to eat the loan altogether.
The board didn’t have to put the company in this jam. $200 million of Ebbers’ loan was originally owed to Bank of America; WorldCom stepped in to cover that sum, and to extend additional credit. (I can’t help but think that Ebbers is occasionally distracted from the job of pulling WorldCom out of the current telecommunications slump by worries over his own highly leveraged bet.)
How to fight the system
Now, getting rid of a director isn’t easy, and winning a vote against the recommended auditor is even harder. (For non-U.S. companies such as Tyco International, the situation can be especially daunting.) If you’ve got a serious gripe with a company’s board, you’ll have to do some organizing.
Use stock chat boards to contact other disgruntled investors. Read the proxy statement carefully to see if a group of shareholders or a large institutional investor has already filed for a vote on governance issues. You can use the Ownership tool on our site (often found, among other places, in the left-hand navigation on our Stock page or on stock-quote pages) to find big institutional owners. A call to some of the big names on the list should let you know if anyone is planning an organized challenge at the company’s annual meeting. And think of going to the annual meeting itself. The question and answer period can be a good time for getting your issues aired.
Don’t worry if you lose the actual vote. In the long run, letting management and directors know that shareholders are watching can be just as important as winning the actual count.
New developments on past columns
Don't dance to the bond market blues
If I'm right, and the Federal Reserve isn't poised to raise interest rates in May but will instead hold off until August or September, what stock groups will do well? Prudential Securities took a look at periods of stable interest rates -- defined as 10 months or more in a row when the Fed didn't change rates -- stretching back into the 1950s. The conclusion of the March 27 study? Mid-cap stocks outgained large company stocks on average by 14.7% to 11.4% during the first six months of stable rates, and growth stocks outperformed value in the first six months by 13.6% to 10.1%. Industry sectors that did well in such an environment included consumer discretionary, energy, health care, consumer staples and technology. Laggards included utilities and financial services. With that study in mind, I'm going to add two stocks to Jubak's Picks that play into a stable interest rate environment and remove one from the picks that would be fighting upstream under these conditions.
Changes to Jubak's Picks
Sell Washington Mutual
Shares of Washington Mutual (WM, news, msgs) have treaded water as the economy strengthened and the Federal Reserve stopped cutting interest rates. In retrospect, I should have sold in mid-2001 when the stock peaked near $42. I'll be taking a very modest 2% profit on this position since I added the shares to Jubak's Picks on December 5, 2000 at $32.208.
Buy J.C. Penney
A period of stable interest rates would work to J.C. Penney's (JCP, news, msgs) advantage since discretionary consumer spending historically remains strong in such a period. But the real story here is the turnaround being engineered by new CEO Allen Questrom. Questrom has closed unprofitable stores and sold the company's direct marketing division (and then used the cash to reduce debt). Analysts project that the company could earn 94 cents in the fiscal year that ends in January 2003, and $1.59 in fiscal 2004. Signs of softness in the current quarter have driven the stock from $28 in January/February to slightly below $20 recently. At that price, the projected 2003 price-to-earnings ratio is just 21 and the 2004 ratio is just 12.5. This mid-cap stock also carries a 2.4% dividend yield. I'm adding J.C. Penney to Jubak's Picks with a target price of $30 a share by December 2002.
Buy Amkor Technology
Amkor (AMKR, news, msgs) seems to be one of the first technology companies to achieve decent visibility for the next six months. Management notes that customer orders have been ahead of plan for each week since mid-January. With more outsourcing deals likely to be announced in the next few weeks -- Amkor has picked up new business at Agilent (A, news, msgs) and in Taiwan and Japan for its chip packaging products and test services -- the company could announce a quarterly loss of less than the 59 cents a share that analysts are now expecting when the company reports on May 1. Even more likely, in my opinion, is strong guidance from Amkor on future quarters with the possibility that the company might reach operating breakeven in the third quarter of 2002 -- a quarter ahead of schedule. Like many semiconductor equipment companies, Amkor is highly leveraged and once it reaches breakeven, it should quickly return to substantial profitability. Wall Street is projecting a loss of $1.40 a share for 2002, but a profit of 50 cents a share for 2003. I'm adding Amkor, a mid-cap technology stock, to Jubak's Picks with a target price of $28 a share by December 2002.
At the time of publication, Jim Jubak owned or controlled shares in none of the equities mentioned in this column.
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