Article from smartmoney comparing ENE, TYC. Thought you might be interested since TYC was one of your core holdings at one time.--sam
By Robert Hunter
November 30, 2001
Provided By SmartMoney.com
THERE IS business news, and there is Business News. When Lucent Technologies (LU)
delivers its 17th consecutive earnings miss, it's a pretty big story. When Enron (ENE), a pillar of
the energy industry, dries up and blows away in the course of a few hours, it's like the moon
landing for financial journalists.
In Thursday's New York Times, the Enron calamity garnered one above-the-fold Page 1 story, one
below-the-fold story and six other stories in the business section. Six stories graced the pages of
The Wall Street Journal. And if you're one of the 31 people who read Investor's Business Daily, you
probably saw some coverage there as well. Every angle of the Enron debacle has been poked,
prodded and scrutinized like Aunt Pam's creamed chipped beef on toast.
But I think I've come up with a new take. I find it most interesting that just a day before Enron
imploded, another company once tainted by accounting problems, Tyco International (TYC),
reiterated its impressive earnings guidance for the next five quarters. That got me thinking: Looking
back on Enron's demise and Tyco's resurgence, were there any clues that pointed to these
divergent outcomes? And can we apply some of those investing lessons to future cases of
accounting irregularities?
Yes, and yes.
At first glance, Enron and Tyco couldn't have been more different. Tyco was a stodgy old
conglomerate from New England (OK, its legal headquarters are in Bermuda), best known for
alarm systems, while Enron was an audacious New Economy powerhouse from Texas. But the
two companies had a few things in column by the time the Securities and Exchange Commission
came knocking (in December 1999 for Tyco, and on Oct. 22, 2001, for Enron). Both companies'
stocks had soared in the preceding months based on massive earnings growth. Tyco turned in
30% to 40% growth for several years; Enron had beaten the Street like a schoolyard bully quarter
after quarter. And in both cases, skeptics and short sellers had begun lining up to take potshots,
convinced that this magical earnings growth was considerably less than met the eye.
Fortunately for Tyco, the two companies didn't share the same fate. (Enron could file for
bankruptcy as soon as Monday.) Herewith, some suggestions for the next time rumors of
accounting irregularities hammer a stock you care about.
1. Establish a motive.
Let's not kid ourselves: All companies manipulate their earnings numbers to some degree. The
question is, what types of companies are so desperate to impress Wall Street that they may be
willing to risk losing its confidence forever by cooking the books? Ask yourself whether the
company in question fits any of the classic stereotypes. Is it an old, struggling dinosaur like
Xerox (XRX) (which is being investigated by the SEC but hasn't been charged)? Fading giants like
these — particularly those with lots of debt on their books — have a powerful incentive to try to puff
up their numbers. Is the company an arrogant youngling bent on massive growth in untested
markets, such as, say, speech-technology developer Lernout and Hauspie (which has filed for
bankruptcy amid charges of accounting irregularities) or software concern MicroStrategy (MSTR)
(which was forced to restate earnings)? For them, the slightest earnings hiccup can throw their
entire futures in doubt, and creative accounting might be viewed as the only way out.
But what if the company is mature and growing in a quick but controlled manner? This time, the
motives aren't so clear.
Tyco is an acquisitions monster, closing big deals every few months like its role model, General
Electric (GE). If Tyco was buying companies based on Chief Executive Dennis Kozlowski's
personal whims, then a house-of-cards scenario might apply, as it did for Cendant (CD). But Tyco
is famous for exhaustively poring over potential acquirees' books in search of red flags, and
considering only the deals that would immediately be accretive to earnings. Moreover, it shuns
Wall Street's advice on mergers, reducing the possibility that some M&A specialist's fat fees are
tainting the process. And after the deal is done, Tyco systematically — some say ruthlessly —
goes about capturing the economies of scale that made the deal attractive in the first place. Tyco's
approach is aggressive, to be sure, but also deliberate, and based on a sensible growth strategy.
That doesn't seem to fit the bill of a chronic book-cooker.
Enron, on the other hand, clearly got ahead of itself. As I wrote three weeks ago, the company
seemed to be expanding into new businesses every day, and each new foray was bolder than the
last. From energy to weather derivatives to broadband, Enron was bent on capturing trading
volumes in every conceivable market, many of which were crapshoots at best. And how was it
paying for this breakneck expansion? That's where it got hairy. When Tyco wanted to get into
broadband, it issued stock to do so. When Enron wanted to get into broadband, it secured
off-balance-sheet funding with huge strings attached. (See No. 2.) In other words, Enron was a
story of growth at all costs.
2. Run screaming at the first mention of off-balance-sheet transactions.
Enron fueled its growth — no pun intended — largely through a series of complex private
partnerships that made their way onto the balance sheet only after they blew up. In October, Enron
wrote down its shareholder equity by $1.2 billion because of one such partnership, engineered by it
then-Chief Financial Officer Andrew Fastow (who reportedly raked in $30 million in
partnership-related compensation).
Such deals are rare. The more common types of off-balance-sheet transactions involve derivatives
— and when they blow up, the consequences can be devastating, as Procter & Gamble (PG)
and Gibson Greetings (now part of American Greetings (AM)) can attest. The trouble is,
investors hear about these things only after they've wreaked havoc on a company's finances.
Still, selling the stock at the first hint of off-balance-sheet trouble can save you a fortune. After all,
Enron shares changed hands at $20.65 on Oct. 22 — 57 times greater than Thursday's close of 36
cents.
3. Assess the political climate.
I hate to bring politics into this discussion, but it bears some consideration, since the president
appoints the SEC chairman. Arthur Levitt, the man in charge from 1993 to 2001, was a Clinton
nominee and one of the most activist SEC chiefs in memory. (Heck, he even picked on a little kid
named Jonathan Lebed, who made a few hundred grand hyping stocks in chat rooms.) It's safe to
say he had a quick trigger finger when it came to allegations of accounting abuse.
In October 1999, short seller David Tice issued a research report suggesting that Tyco was playing
fast and loose with merger-related write-offs. Specifically, he alleged that Kozlowski & Co. were
intentionally inflating their acquisition-related restructuring charges, and holding that money aside
to pump up earnings later on. The SEC looked into the allegations, and ultimately dropped the
inquiry without penalty to Tyco.
The climate is different now. I don't mean to ruffle any feathers, but it's clear that Harvey Pitt will be
somewhat friendlier to corporate America than was Levitt. He said as much during his confirmation
hearing. That isn't to say Pitt is lax — indeed, he seems to be going after initial-public-offering
offenders with vigor — but Levitt he is not. The fact that the SEC ratcheted up its inquiry to a
formal investigation on Oct. 31 should have been a clear signal that terrible things had happened
inside Enron. Had you come to the same conclusion and sold Enron's shares then, at $13.90, you
would have done well, all things considered.
And as Pitt's tenure progresses, I think it would be wise to assume that all SEC investigations into
accounting irregularities are gravely serious — even more so than during Levitt's reign.
4. A fish rots from the head down.
When accounting issues arise, take a long look at the company's top management.
CEO Kenneth Lay of Enron holds a Ph.D. in economics — and everyone knows that Ph.D.'s make
bad traders. (Most of the principals at Long Term Capital Management boasted doctorates —
including two Nobel laureates — and look what happened there.) Far more troubling, Lay
acknowledged during an August conference call with analysts that one question was above his
head. That suggests that Dr. Lay didn't fully grasp Enron's vast array of dealings. Ugh.
Kozlowski, by contrast, is an accountant by training, and had spent most of his career working in
M&A. He personally pores over potential acquirees' books, and understands the accounting
implications of all the deals he makes. In fact, there's probably no one in America with a more
intimate knowledge of M&A accounting than Kozlowski. I bet he could have recited Financial
Accounting Standards Board rules verbatim to SEC investigators. That's the guy I want at the helm
when regulators start sniffing around.
5. Be ready to pounce.
Companies often try to put SEC inquiries to rest, when appropriate, by voluntarily restating their
earnings. Needless to say, it's important to look at the magnitude of the company's action, and act
accordingly. On Nov. 8, Enron restated its earnings for the previous four years, reducing its net
income by $591 million. Obviously, that's a massive disappearance of corporate wealth — and a
good reason to dump the stock. Had you sold your shares that day, you would have gotten out at
$9.10. Not great, but far better than the current price.
Tyco also restated its earnings, on June 26, 2000. But the restatement was innocuous: It raised
its fiscal 1999 net income by $36.7 million, or two cents a share, and cut its first-quarter 2000 net
income by $34.2 million, or two cents a share. The result: Tyco's total net income actually
increased by $2.5 million. The fact that those earnings seemed to be pushed from the end of one
fiscal year to the beginning of another fiscal year isn't cause for celebration, mind you. But I'd
wager that you could find a greater accounting transgression at just about any large-cap company
in America if you look hard enough. Investors reacted to the news by sending Tyco's shares up
13% that day. Had you bought shares early the next morning, you'd still be sitting on a 19% profit
today.
All of these indicators won't apply in all cases. But if, say, No. 1, 4 and 5 are all working in your
favor, you might have the potential to profit handsomely from the two most feared words on Wall
Street: accounting irregularities. |
