NYTimes.com Article: The Dangers Behind a Leap of Faith

verfasst von leibovitz, 10.12.2001, 10:36

The Dangers Behind a Leap of Faith

December 9, 2001

By ALEX BERENSON




TRUST me.

They are two of the most common - and dangerous - words on
Wall Street.

Trust-me companies are companies whose financial results
gallop ahead of their businesses, companies with seemingly
perfect control over their quarterly sales and profits.
Companies whose financial statements are loaded with
footnotes, companies that short- sellers often attack but
rarely dent. Companies with executives who sell their stock
every quarter even as they encourage investors to buy more.


They are companies like Enron (news/quote) and Providian
Financial (news/quote) - and Calpine (news/quote) and Tyco
International (news/quote) and, maybe, General Electric
(news/quote). This year, Enron was on track to post $200
billion in sales with only 21,000 employees. That works out
to revenue of almost $9 million a worker, far more than at
other large companies. How did Enron generate such huge
sales? How did Enron's energy trading operations make
money? What was the relationship between Enron and the web
of off-balance-sheet partnerships it created to finance its
investments?

Trust me, Enron's chief financial officer, Andrew S. Fastow
said."We don't want anyone to know what's on those books,"
Mr. Fastow told Fortune magazine in March, seven months
before he was forced out."We don't want to tell anyone
where we're making money."

That explanation was good enough for Wall Street. Between
the end of 1997 and the beginning of this year, Enron's
shares quadrupled, and the company won praise for its
aggressive management and fast growth.

But when a trust-me story goes wrong, shareholders may find
their investments vaporized. Amid questions about the truth
of its financial statements, Enron has filed for bankruptcy
protection; its stock has fallen 99 percent this year.

Investors in these companies are particularly vulnerable
now. Because trust-me companies often depend on easy
financing, they are especially dangerous when the stock
market or economy turns sour, said Douglas Cliggott, the
chief investment strategist at J. P. Morgan Securities.

"We're in a global recession, and it's in recessions where
stretched accounting hurts you," Mr. Cliggott said."I
don't think it's a coincidence we're seeing examples of
stretched accounting running into problems, where two years
ago, we didn't."

Trust-me companies are often strongly supported by Wall
Street, because they pay investment bankers hefty fees to
raise money for them or advise them on mergers, said Howard
Schilit, president of the Center for Financial Research and
Analysis, a firm in Rockville, Md., that breaks apart
balance sheets for institutional investors."Wall Street
likes things that will make them a lot of money," he said.
"The game is always doing transactions."

Every public company depends to some extent on the trust of
its investors. The largest companies, like Home Depot
(news/quote) and AT&T (news/quote), have hundreds of
thousands of employees and tens of billions of dollars in
annual sales. Even medium-sized public companies often have
offices and sales around the world. No shareholder could
personally check all of their operations or be certain that
they have fully disclosed all of their investments and
debts. Some companies use off-balance-sheet partnerships to
raise money or to buy assets without ever telling their
shareholders in their financial statements.

"It's difficult for any investor, even a good investor, to
see what's happening," Mr. Schilit said,"because you're
not doing an audit, you're simply relying on published
information."


ERTAIN companies, and certain industries, are more likely
to tell trust-me stories. Financial services companies and
technology companies, especially software companies, like
Computer Associates, bear special scrutiny, analysts,
short-sellers and others say, because they can manipulate
their earnings more easily than other companies.

Electricity and natural gas companies like Dynegy
(news/quote) and El Paso Electric (news/quote), many of
which have moved rapidly into the volatile business of
trading energy, bear close watching, too, they add. Tyco
and G.E., both giant conglomerates, have also drawn the
attention of some skeptics, because their operations are so
large and complex as to be essentially unfathomable to
outsiders.

Poorly understood businesses and footnote-filled financial
statements are not the only warning signs, Mr. Schilit
said. He pointed to companies that seem to rely heavily on
acquisitions for earnings growth, like Tyco, which is based
in Bermuda.

Short-sellers, who make money when stock prices decline,
took aim at Tyco two years ago, accusing it of stretching
accounting rules by taking big restructuring charges when
it made acquisitions. The Securities and Exchange
Commission opened an investigation, and Tyco's stock
plunged almost 50 percent.

But L. Dennis Kozlowski, Tyco's charismatic chairman,
fought off the accusations, saying his accounting was
proper. In July 2000, the S.E.C. ended its inquiry without
taking action against the company. Tyco's stock has since
hit a new high and remains a favorite of Wall Street.
According to Bloomberg, the company has the highest rating
from each of the 15 analysts who cover it.

Tyco has grown consistently for more than a decade, and its
cash flow is strong, said Jack L. Kelly, an analyst at
Goldman, Sachs. As a result, he said, he has confidence in
Mr. Kozlowski and Tyco's management.

Still, David W. Tice, the short-seller who initially
complained about Tyco's accounting, said he remained
skeptical about Tyco."The underlying growth rate in the
future is going to be less," Mr. Tice said. Tyco uses
"acquisitions and charge-offs," he said."It reads like a
laundry list of the way companies can play games."

General Electric does not depend as heavily on acquisitions
as Tyco, and it is renowned for its strong management. But
Mr. Tice said G.E. was worth watching because of its huge
financial services division and because it seems to be able
to meet or just beat its earnings targets every quarter, no
matter the economic environment.

In addition, like many trust-me stocks, G.E. trades at a
premium to the market and its competitors because of its
fast earnings growth. Having a high price-to-earnings ratio
increases the pressure on management to perform, as well as
increasing the risk for investors if the company falls
short. G.E. is valued at about 24 times its expected 2002
earnings, compared with a multiple of about 23 for the
average Standard & Poor's 500 stock. And almost half of
G.E.'s earnings come from its financial subsidiary - yet
big banks like Citigroup (news/quote) and Bank of America
(news/quote) trade for 13 to 17 times next year's earnings,
much less than G.E.

Mr. Schilit says another sign of a trust-me company is a
rapidly changing business model."You transform the company
into something that is much more sexy," he said."Enron was
transformed from a pretty boring energy company with modest
growth, low price-earnings ratio, to a newfangled energy
trading company." The same is true of many of Enron's
competitors, including Dynegy, El Paso Electric and
Calpine, which have moved aggressively into the business of
trading power.


F course, not every high- growth company is a trust- me
story. With Wal-Mart (news/quote) opening stores around the
world, the company's rising sales are as visible on the
ground as in its income statements. Microsoft
(news/quote)'s high margins are no mystery, and the
company's $31 billion cash hoard proves how lucrative a
monopoly can be.

But Mr. Kelly, the Goldman, Sachs analyst, said he was wary
of companies whose growth rate suddenly accelerates."A lot
of these shooting stars that we've seen over the last
couple of years - it's the new model, the new paradigm,
which turns out not to be the new paradigm at all," he
said.

Earnings that are rising more quickly than cash flow are
particularly worthy of scrutiny, in Mr. Kelly's view. There
are"a number of accounting techniques which will allow a
company to report a certain earnings-per-share figure which
might be noncash earnings," he said.

Enron, whose earnings per share nearly doubled between 1998
and last year after hardly budging between 1994 and 1998,
is just one example. In the late 1990's, Coca-Cola
(news/quote) was a classic trust-me story. The company's
earnings almost tripled from 1992 to 1997, even though its
sales grew much more slowly. Much of that growth came from
one-time gains as Coke restructured and sold local bottlers
to Coca-Cola Enterprises (news/quote), a supposedly
independent bottling company that is 38 percent owned by
Coke.

Coke said the money earned from selling the bottling
business was real and should be considered as part of its
operating earnings. Despite complaints from short-sellers,
who said growth in Coke's core business of selling soft
drinks had slowed, Wall Street agreed, bidding the
company's shares up fourfold, to a high of $87.94 in July
1998.

The shorts were right. In the last three years, fierce
competition and slow growth have cut Coke's profits to
barely half their 1997 level. Its stock has followed,
closing on Friday at $46.60, down 23.5 percent this year.


OR years, Computer Associates also had profits that
outran its cash flow, as it booked as revenue contracts for
which it would not be paid until many years in the future.
Today, the company's reported sales and profits have
plunged as it works off the backlog of sales it made years
ago.

"Reported profits can be confusing," said Chris Galvin, a
software analyst at J. P. Morgan. Some software companies,
like Microsoft, use conservative accounting, while others
are much more aggressive."The devil is in the details," he
said.

Mr. Cliggott advised investors to be wary of financial
services companies, which can hide loan losses by extending
repayment or rolling unpaid debts into new loans but can
run into trouble if the economy sours.

Shares in Providian, a credit-card company that specializes
in lending to borrowers with poor credit histories, have
fallen from $60 in July to $3.20 today because of sharply
rising write-offs on its cards.

"There's a lot of judgment as to when you want to be
provisioning for the recognition of bad credit," Mr.
Cliggott said.

Michael Freudenstein, a brokerage and specialty finance
analyst at J. P. Morgan, disagreed. Mr. Freudenstein said
that financial companies must disclose losses quickly and
that analysts and investors would punish them if they tried
to skimp on their loss reserves."Finance companies are
clear as day," he said.

But Mr. Freudenstein, who had a buy recommendation on
Providian until mid-October, when he downgraded the stock
to long-term buy and then to hold within a week,
acknowledged that Providian's problems had surprised him.
"Do I wish I had downgraded it sooner? Yes I do," he said.

Other finance companies that specialize in lending to weak
borrowers, like Metris and AmeriCredit (news/quote), may
face problems similar to Providian's, said M. W.
Montgomery, partner in a hedge fund that has sold those
stocks short."The amazing thing about the financial
services industry," he said,"is the recurring times the
market buys everything to be O.K. on the way up."

On that, you can trust him.



http://www.nytimes.com/2001/12/09/business/yourmoney/09TRUS.html?ex=1008922606&ei=1&en=33801becd0178caf



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• NYTimes.com Article: The Dangers Behind a Leap of Faith - leibovitz, 10.12.2001, 10:36