Character is Destiny - Especially on the Downside

What do Calisto Tanzi, Bernie Ebbers, and Edward Groves have in common? Several things, actually.

For one, they all ran major companies. Tanzi was CEO of Parmalat, an Italian food company; Ebbers was CEO of WorldCom, an American telecommunications firm; and Groves was CEO of ABC Learning Centres, an Australian day care provider.

For another, each was a hard-driver who started small and made it very big. Tanzi built a global company from one pasteurization plant. Ebbers turned a rural telephone exchange into the third largest telecommunications company in the United States. Groves began with a single childcare center and grew it into the largest day care company in the world.

Another thing was they all owned professional sports teams. Tanzi had a Serie A football team, Parma F.C.; Ebbers had a minor league hockey team, the Jackson Bandits; and Groves had a basketball team, the Brisbane Bullets.

Yet another common point is that all of them were involved in massive misstatements of their companies' finances. Tanzi kept enormous amounts of debt off Parmalat's balance sheet, while Ebbers and Groves kept tremendous amounts of costs off their companies' income statements.

The final thing they have in common is prison. Tanzi has been sentenced to ten years, and Ebbers is serving a 25-year sentence. Groves has yet to face criminal charges, but he may end up in jail yet.

So what does all this mean? Is owning a professional sports team an early warning sign of financial fraud? Not really. But it does mean Tanzi, Ebbers, and Groves shared traits that led to their misdeeds, and those traits may be useful signals of misconduct in others.

What these three malefactors had in common is some combination of these behaviors, which are based on Sydney Finkelstein's "Seven Habits of Spectacularly Unsuccessful People" from his book Why Smart Executives Fail.

1. They were domineering. They resisted any outside control, including accounting rules. 
2. They had no sense of a boundary between their interests and the company's. What was good for them must be good for the company.
3. They thought they had all the answers. Since they were always right, they made their own rules.
4. They eliminated resistance. They quashed dissent and had no one to warn them about the risks they took.
5. They were the public face of their companies. They reveled in public attention and professional rewards, and they saw financial statements mainly as public relations tools.
6. They underestimated difficulties. It never occurred to them they eventually would be caught.
7. They relied on what worked in the past. They were sure that if a little bit of deception worked before more would work even better now.

It's a truism of credit analysis that character matters, but it doesn't just matter in small and medium-sized businesses. It's crucial in big companies too.

Tanzi, Ebbers, and Groves did not set out to create criminal enterprises. But their own flaws pushed them and their companies across the boundary between aggressive reporting and fraud, with grim consequences for shareholders, bondholders, and lenders. And disastrous consequences for at least two of them.

How Xerox Fell

In How the Mighty Fall and Why Some Companies Never Give In, Jim Collins lists five stages of corporate decline. We used them to analyze Xerox in our last post. Collins uses behavioral terms to describe how companies falter, not financial measures.

We have a framework for analyzing troubled companies that complements Collins’ approach. It focuses more on financial measures than management behaviors. Ours is a tool for evaluating the symptoms, while Collins’ explains the cause of the disease.

Our Five Stages of Decline
Our financial framework for analyzing a company in decline has five stages.

• Stage 1: Prosperity. A company in this stage is thriving. Sales growth, profitability, and cash flows are all very strong. Liquidity is very high, and leverage is below average for the industry.
• Stage 2: Stability. In this stage, sales growth, profitability, and cash flows are strong. Liquidity is high, and leverage is about average for the industry.
• Stage 3: Difficulty. Sales growth, profitability, and cash flows are decreasing. Liquidity is low, and leverage is above average for the industry and increasing.
• Stage 4: Distress. Sales growth, profitability, and cash flows are negative. Liquidity is very low, and leverage is very high for the industry and increasing.
• Stage 5: Default. Companies in this stage have the same characteristics as Distress. But because they have missed a debt payment, they are in some form of financial reorganization or liquidation.

Xerox in Decline
Xerox is a good example of a company going through most of these stages. Let’s take a look at some key measures as Xerox goes from stability in 1999, to difficulty in 2000, and to distress in 2001.













Xerox’s operating profitability varies some through 1999, but it’s basically stable. In 2000, the trend is much worse, and margins contract in every quarter, ending in a loss – a clear case of difficulty. In 2001, profitability improves on the strength of radical cost cuts. But it remains low, and Xerox remains in difficulty.













Xerox’s debt is stable in 1999. But it increases sharply in 2000 to fund the decline in profits – a sign of difficulty. Although debt decreases in 2001, it shifts from 30% short-term at the beginning of 1999 to 60% by the end of 2001. That is a strong indicator of distress.














Liquidity shows a fall from adequate levels in 1999 (stability) to inadequate levels in 2000 (difficulty). By the end of 2001, it’s reached a dangerously low level (distress). Here we define liquidity position as cash and available committed credit lines less short-term debt and the current portion of long-term debt.

The Company Risk Cycle
We call these five stages the Company Risk Cycle. Comparing the trends in a company’s performance and finances to the Company Risk Cycle gives you a way to anticipate what could happen next. It gives you the early warning signs of credit problems.

Of course, decline is not every company’s destiny. Economic and industry cycles come and go, and companies get worse and better as they do. And companies in trouble on their own often solve their problems and turn around the way Xerox did.

What Makes Companies Fail?

How the Mighty Fall
Jim Collins is among the best researchers and writers on management effectiveness working today. He’s turned his attention from how companies succeed to how they fail. In his new book How the Mighty Fall and Why Some Companies Never Give In, Collins describes five stages of decline.

• Stage 1: Hubris born of success. Success seems automatic, practically an entitlement, and management blinds itself to threats in the market and weaknesses in the company.
• Stage 2: Undisciplined pursuit of more. Without the right resources, leaders chase after more scale, more growth, more acclaim, more of whatever they see as "success."
• Stage 3: Denial of risk and peril. Leaders dismiss the negative, exaggerate the positive, and put a positive spin on the uncertain. They blame external factors for setbacks instead of accepting responsibility.
• Stage 4: Grasping for salvation. When the company goes into a sharp decline, it looks for simplistic solutions -- like a visionary leader, a bold new strategy, a blockbuster product, or a big acquisition -- instead of getting back to basics.
• Stage 5: Capitulation to irrelevance or death. Successive setbacks sap competitive strength, the most capable people leave, and costly false starts sap financial strength.
  

Collins cites Anne Mulcahy’s turnaround at Xerox starting in 2001 as the counter-example to decline. She saw the company’s problems with unflinching clarity, shut down weak businesses to focus on strong ones, and cut costs in spite of the pain. She also restructured the company’s finances, narrowly avoiding bankruptcy.

Xerox's Brush with Death
Xerox may be a case in point for never giving in, but it is also a good example of how a company gets into trouble. In fact, it follows Collins’ stages of decline quite closely.

• Stage 1: Hubris born of success. Xerox created the copier industry, and thanks to its vaunted technological prowess and its famous sales force remained the leader through the mid-1990s. But the large-corporate market became saturated, Xerox was the high-cost producer, and more efficient rivals began eating into its market share.
• Stage 2: Undisciplined pursuit of more. Rather than overhaul its cost structure and cut prices, Xerox tried to grow its way out of trouble by introducing digital copiers and expanding into printers and small copiers for the small-office and home-office markets.
• Stage 3: Denial of risk and peril. Sales growth and profit margins began to shrink. Pricing for digital copiers proved to be much weaker than Xerox expected, and competition in printers and small copiers was ferocious. Xerox blamed economic problems in Russia, Brazil, and parts of Asia instead.
• Stage 4: Grasping for salvation. When growth and profitability fell even more, Xerox’s solution was to bring in Rick Thoman from IBM as CEO. His new strategy was to change from selling copiers to consulting on document processing, and he reorganized the entire sales force to that end. To meet earnings targets, senior managers began manipulating the revenue and expense accounts.
• Stage 5: Capitulation to irrelevance or death. Thoman also tried to cut costs, but at first the cuts created more inefficiencies than they corrected. Inventories shot out of control, and problems consolidating billing centers caused receivables to balloon. Because of the company’s bad accounting, the Securities and Exchange Commission refused to allow Xerox to issue any securities. As its funding dried up, Xerox ran out of liquidity and had to sell assets and renegotiate its bank lines in order to survive.
  

More to Come on Stages 4 and 5 and Risk
Collins looks at decline from a management perspective, but his framework is useful in risk analysis as well. The management mistakes that lead a company to Stage 5 can have dire financial consequences, as they did at Xerox. In our next blog entry, we’ll take a look at a framework for anticipating and evaluating the financial aspects of a company in decline.

Early Warning Signs at Satyam

We mentioned the absence of early warning signs in our earlier post on Satyam – especially the lack of a gap between earnings and cash flow. It turns out there were a few. We can classify them either as behavioral or financial.

Behavioral Warning Signs
Behavioral early warning signs are actions, things key insiders and important outsiders do that signal trouble. In Satyam’s case, the first occurred last December 16, when Satyam agreed to acquire - without proper shareholder approval and at an inflated price - two struggling companies controlled by Chairman Ramalinga Raju’s family.

Then on December 23, the World Bank‘s barred Satyam from doing business with it for eight years for providing “improper benefits to bank staff” in exchange for contracts and providing a “lack of documentation” on invoices. Right after that, four of the company’s six independent directors resigned, another bad sign.

On December 26, Merrill Lynch signed on as advisor, began its “due diligence” research on Satyam, and quit the project after just ten days. Their reason was that, “In the course of our engagement, we came to understand that there were material accounting irregularities.”

This barrage of bad news was a powerful sign that something was very wrong at Satyam. Unfortunately, it came too quickly to be of much use. Raju sent his confession to the board on January 7, 2009, the day after Merrill Lynch mentioned problems with Satyam’s accounting.

Financial Warning Signs
Financial early warning signs are problem indicators based on financial statement analysis. Analysts look for inconsistent trends in related accounts. For instance, a gap between the trend in earnings and the trend in cash flow suggests overstated revenues or understated expenses.

In Satyam’s case, there is a puzzling difference between the trend in the reserve for uncollectable accounts receivable and the trend in the amount of time it takes the company to collect its accounts. In 2006 the provision for doubtful accounts was 8.5% of accounts receivable, in 2007 it fell to 6.6%, and in 2008 in was only 6.0%. Yet over that same span of time, the payments on those accounts began to slow down, as days receivables grew from 89 in 2006 to 101 in 2007 and 103 in 2008.

If the quality of receivables was declining, why was Satyam taking lower provisions? Perhaps to understate expenses. If the quality of receivables was improving, why were they taking so much longer to collect? Perhaps because Satyam was overstating revenues.

The Limits of Early Warnings
Early warning signs are far from perfect. They’re not definite. They can only suggest something’s wrong; they can’t prove it. They’re not precise. They can’t tell you how big the misstatement is.

But taken together, the behavioral and financial warning signs can alert you to an increase in reporting risk. Then you can begin to watch the company more closely, review your exposures, and check your legal agreements. You can be prepared to reduce your risk in case the worst happens and, like Satyam, the company ends up actually committing financial fraud.

Satyam Surpasses Enron

It’s the biggest corporate fraud in Indian history, and the press labeled it “India’s Enron” as soon as the news broke. But Satyam looks to be worse than Enron in scope, if not in scale. How can we say that before the authorities have completed their investigation? We can tell by the absence of early warning signs.

Satyam Computer Services is one of India’s leading information technology companies and ranks 185 of the Fortune 500 companies among its clients. Early last December, the company’s Chairman, Ramalinga Raju, confessed to using fake revenues to inflate profits over a number of years. That led to a build up of what Raju called “artificial cash” of over $1.0 billion (Rs 50 billion) by the end of September 2008.

Through long, bitter experience, investors have developed a set of early warning signs of financial reporting fraud. One of the strongest is the difference between income and cash flow. Because overstated revenues cannot be collected and understated expenses still must be paid, companies that misreport income often show a much stronger trend in earnings than they do in cash flow from operations.

But you can see there is no real difference in the trends in Satyam’s net income and its cash flow from operations over the last five years. That’s not because the earnings were genuine; it’s because the cash flows were manipulated too. To do that, Raju had to forge accounts receivable and falsify collections.

The fake cash flows led to the bogus bank balances. To keep from tripping the income-cash flow alarms, Raju had to manipulate nearly every account related to operations. It was a stunningly comprehensive fraud, likely to be far more extensive than what Skilling, Lay, and Fastow did at Enron.