Jubak's Journal Recent articles: • Sullied CEOs have lost workers' trust, 10/3/2002 • Why it's taking so long to slay the bear, 10/1/2002 • Why the U.S. isn't Japan, 9/26/2002 More... | Jubak's Journal More surprises ... the bad kind Companies from EDS to Dell Computer have gone out of their way to hedge their bets against the volatile market. The problem is, many of those bets are going awry -- and will cost investors dearly. By Jim Jubak Want to know why the stock market is so frightening in spite of some reasonably valued sectors and technical indicators that show stocks ready for a big bounce? Its the possibility -- indeed the likelihood -- that unwinding the financial excesses of the bubble is about to produce another round of negative surprises. Like the accounting scandals that have rocked the market, these have the power to devastate individual stocks. But unlike the round of revelations that is drawing to a close, the new round of surprises wont be set off by the lies of CEOs or inflated revenue projections. Instead, these surprises will be triggered by the decline in stock prices themselves. In effect, the new bad news that will hurt the prices of individual stocks will be created by the decline in the price of a companys stock that resulted from the old bad news. And ironically -- for those who can still find irony in the midst this market rout -- much of this new round of bad news will result from efforts to protect companies, investors and creditors from risk. Let me describe the new kind of surprises Im talking about. Ill show you two places where theyre most likely to show up, and then suggest what you can do to reduce the chance that youll get surprised yourself by some stock in your portfolio.
The EDS debacle You dont have to look any further for an example than Electronic Data Systems Second, just a few days later, the company had to admit that some of the revenue it had already booked wasnt going to materialize. Thats a big deal for EDS, which booked almost $400 million in revenue for the second quarter from customers that it hadnt even billed yet. The total in this accounting category called unbilled receivables came to $2.6 billion at the end of the second quarter. The problem now is that some customers are canceling contracts outright and others are renegotiating the prices of their deals. It seems investors learned that the long-term deals that the company has booked as revenue allow customers to renegotiate prices as often as twice a year. In the current market for technology services, of course, everybody is renegotiating lower prices. And then third, on the same day, the Wall Street Journal reported that EDS had extended some hefty guarantees to its bond investors -- unless the price of its stock soared. In October 2003, for example, a $1 billion zero-coupon convertible bond would become put-able; that is, investors could sell it back to the company for a guaranteed 80% of its purchase price in cash. Not exactly a small problem for a company thats struggling with falling cash flows. On this combination of news, the stock plunged 62% from Sept. 18 through Sept. 30. Apparently this bad news came as a surprise to investors; it wasnt priced into the already depressed level of EDS shares. Old bad news Now, Id call part of the surprise -- the part that stems from the way the company accounted for revenue from long-term contracts-- the old kind of bad news. This is just the same general kind of accounting shenanigans weve seen from Lucent Technologies The story should sound familiar by now. Ambitious CEO -- Richard Brown in this case -- comes on the scene in January 1999 and the company signs more new business ($90 billion) during his first three years on the job than it had captured in the prior 10 years. Stock soars. But on closer examination, the new business isnt nearly as profitable or as committed as it first seemed. Many of the new contracts require the company to spend big upfront to buy the computer operations of the new customer. EDS would then receive an annual fee for operating that system from the customer. Those upfront costs create a massive mismatch between current costs and future revenues that the company attempted to solve by booking revenue before its actually collected and, in some cases, before its even billed. Unbilled receivables grew to almost $2.6 billion in the second quarter of 2002. This accounting treatment comes apart, though, when customers cancel contracts (whose revenue EDS has already booked) or renegotiate prices (which have already been recorded in EDS' books). So far, nothing new here. The details are different than those at Lucent and Nortel, but the general pattern is the same: growth at all costs until the accounting catches up to the company and its CEO. New bad news But Id argue that the other two surprises from EDS are different. They represent a new wave of bad news that is just starting to play out in the stock market. Notice that the complex strategy EDS employed to protect itself against big stock swings only turned into a huge and expensive mistake because the stock market tumbled so far and so fast. The companys treasurer, Scott Krenz, has said that he tested the strategy for risk against scenarios that assumed a 50% climb and a 50% drop. The odds of either extreme occurring, he told the companys board of directors, were less than 5%. But this grinding bear market made that test against a 50% decline seem hopelessly optimistic. As of Oct. 2, the companys stock is down 81% from its 52-week high of $72.45, and the company faces a massive outflow of cash to pay the price of a strategy that was supposed to save it money. Its certainly true that this outflow -- the negative surprise -- wouldnt have happened if Electronic Data Systems hadnt decided to bet hundreds of millions of dollars on its ability to predict the future price of its stock. But its also true that this negative surprise wouldnt have been triggered except for the massive decline in the companys stock. Thanks to the companys financial strategy, that initial massive drop in the price of company stock triggered events that produced a second surprise -- a drop in the companys stock. Et tu, Dell? Unfortunately, EDS isnt the only company that decided to pursue this strategy of speculating on the price of its own stock. Dell Computer Nor is the practice limited to high-technology companies. Eli Lilly The other surprise out of EDS -- the news that it faces potentially hefty obligations to investors that could eat up more precious cash -- is very similar to the companys hedging strategy, despite the differences in details. Here, too, an attempt to control risk (by guaranteeing that investors would get 80% of their principal back at worst) and to reduce costs (the company would pay a lower interest rate because of the guarantee) has turned into a cash-devouring monster because of a plunging stock and bond price. And again, its the falling price of the financial instrument itself that has triggered the event. Investors wouldnt be interested in selling their bonds back to EDS for 80% of face if the bonds werent depressed. Theyre selling at less than half of face value. Likewise, if bond investors werent also worried about cash flow at EDS, very few people would be interested in collecting cash and taking a 20% loss. These kinds of complex deals intended to control risk and to minimize costs are having unintended consequences all over the stock market. Cigna And theyre cropping up in the oddest places. Last week Delta Air Lines Where to find the risk So where would I look most carefully for this new kind of negative surprise? First, Id look at companies that have engaged in the complicated kind of betting on their own stock price that Ive noted at EDS, Eli Lilly and Dell. How do you find out if a company you own has this kind of potential liability? Read the footnotes to the 10K annual report. And by all means, call investor relations. Companies like McDonalds Second, Id look at companies with large debt loads that include substantial bank credit lines. Many bank credit lines include a requirement that companies maintain a minimum book value or a minimum debt-to-total-capital ratio. Many companies that have written off billions in goodwill (the bookkeeping entry that accounts for the difference in the price an acquirer pays for a company and the book value of that company) are getting close to those minimum levels. And many of these companies still face the task of writing down billions more in assets in the coming months. Companies such as AOL Time Warner And thats a critical caveat as you try to make sure that your portfolio isnt excessively exposed to this new round of potential surprises. As the contrasting story of the share prices of EDS and Dell Computer makes clear, its not just whether a company is exposed to these problems that counts, but also how likely that exposure is to tip the company into a downward spiral. In the case of EDS, a $225 million liability resulting from a failed hedging strategy is a big deal because, according to some Wall Street estimates, that charge wipes out the companys cash flow for the quarter. And cash is a critical commodity at the company right now. For Dell, on the other hand, a much bigger liability -- $500 million -- isnt nearly as big a deal because the company is sitting on almost $9 billion in cash. So in the days after the announcements, EDS shares have plunged, while shares of Dell have edged higher. In the current market, cash in the bank solves a lot of problems. In my next column, Ill take a look at the company that invented many of the tools used to manage risk and whether JP Morgan Chase New developments on past columns 8 companies whose boards need a scare One crisis averted. Last week, Amkor Technology Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index. At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Amkor, AOL Time Warner, Corning, Eli Lilly, Lucent Technologies and Microsoft. He does not own short positions in any stock mentioned in this column. | |||||
|
MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.