Ten Things Your CFO Won't Tell You
Forget CEOs. These days, CFOs are the ones investors need to keep an eye on. Why? They're the ones making companies' numbers look good.
1. "I'm just a spin doctor."
They don't get nearly as much press as CEOs, but chief financial officers today are nearly as powerful as the man or woman at the top. Not only does the CFO act as the company's chief bean counter, crunching numbers to produce quarterly reports, but he or she also is responsible for constructing bond issues or other financial deals — as well as conveying the firm's health to Wall Street. It's that last part that's made them especially important in recent years. The fact is, CFOs are paid to make their companies' financials look good so more people want to invest. Chief Public Relations Officer would be a better title.
Some CFOs take this role to an extreme, making conference calls with Wall Street analysts seem more like pep rallies. Consider a December 2000 conference call, during which Oracle (ORCL) CFO Jeff Henley cheerily dismissed questions about an impending tech slowdown. "All tech companies are not the same," he said, claiming that Oracle was more immune than other companies. Three months later, with Oracle's stock down more than 40%, Henley had to face the music, admitting that sales had "clearly" been hurt by the stalling economy. Oracle spokeswoman Joelle Fitzgerald insists that "everyone at Oracle was surprised" when fourth-quarter deals fell through, forcing the company to warn that earnings wouldn't meet Wall Street's expectations.
2. "'Information' is a relative term..."
There was a time when Wall Street analysts and institutional buyers had an edge over individual investors because of their access to CFOs. Then, last year, along came Regulation Fair Disclosure, a rule created by the Securities and Exchange Commission to level the playing field, giving all groups access to the same corporate information at the same time. Reg. FD, as it's known, was the birth of "open" conference calls, on which any investor can listen in.
The result? The definition of "information" has changed. Because of Reg. FD, complain many professional investors, CFOs won't offer up anything important during conference calls anymore because too many people are listening. For instance, CFOs used to talk about sales and pricing trends before the end of the quarter. No longer. "Reg. FD has been a delight to CFOs because they can hide behind it, and their lawyers encourage them to do so," says Greg Phelps, who runs the Patriot closed-end funds for John Hancock. One bonus of Reg. FD, however, is that some companies, following the rule's spirit, disclose more details than they used to in the 10Q annual reports they file with the SEC. So if the CFO won't tell you, maybe the report will.
3. "...especially if it affects your decision to buy or sell."
Certainly, CFOs are entitled to a little privacy when it comes to conducting the company's business. But what about when it comes to decisions that will fundamentally change the nature of your investment — things like stock splits and dividend changes? Don't expect much.
Consider the case of Potomac Electric Power (POM), a utility company based in Washington, D.C., that traditionally paid high dividends. In July 2000 a SEC filing mentioned that its dividend policy was under review. Investors repeatedly couldn't get a straight answer from the company about what the CFO was thinking. On Feb. 12 the firm announced that it was purchasing Conectiv, a Delaware-based utility, for $2.2 billion and cutting its own dividend by 40%, infuriating investors. "They didn't mislead you, they just left you in the dark," gripes one fund manager who says he got burned. A Potomac spokesman says that it's common practice not to announce the details of a dividend cut before it's actually made.
4. "The law protects my right to sugarcoat."
In 1995, after a wave of crippling litigation against big companies, Congress passed the Private Securities Litigation Reform Act, which contains a clause called the "Safe Harbor" provision. The provision allows company executives to say almost anything they want about the company's prospects as long as they add that the statement is "forward-looking" — in other words, not 100% certain — and include a list of factors that could alter those prospects.
By design, the law protects firms from infuriated investors who feel cheated by overly optimistic statements. In reality, it gives CFOs a free pass — with legal protection — to say whatever they please. On May 16, for example, Hewlett-Packard (HWP) announced in a release that analyst estimates that second-quarter revenue would fall somewhere between flat and a 5% decline were "reasonable," but added that the statement was "forward-looking." On June 6, in the middle of the third quarter, the company backpedaled, saying that those estimates were no longer reasonable. The stock fell more than 4%. Hewlett-Packard did not respond to requests for a comment.
5. "Our 'earnings' are open to interpretation..."
Every quarter Wall Street goes through a tired ritual: Analysts make grand predictions about companies' earnings, then everyone waits to see if the companies meet, exceed or fall short of estimates. Too bad the earnings that firms report are sometimes suspect.
As an investor, you will never really know about the questionable gimmicks that CFOs use to meet consensus earnings estimates until it's too late. Lucent Technologies (LU) shareholders, for instance, now realize that for years the company was lending its customers billions just to buy Lucent products — and then booking the transactions as sales. But you would not have known that if you had listened to Lucent's then-CFO Deborah Hopkins on conference calls, say shareholders. Only when customers experienced their own financial problems did investors see the light, as Lucent had to take a $500 million charge to reflect these unpaid debts, causing its share price to plummet. (A Lucent spokeswoman says the firm's CFOs talk about vendor financing all the time and disclose loans to customers in quarterly and annual reports.)
What's an investor to do? First of all, you should be suspicious when a company's profits grow a lot faster than cash flow, or when methods of calculating revenue and expenses suddenly change. And pay special attention to those footnotes on financial statements, where a company will disclose how it defines an actual "sale" and whether it's made any recent fiscal policy changes.
6. "...and we use creative accounting."
If you see the words "pro forma" on an earnings report, watch out. The term refers to a constantly changing series of accounting techniques — all legal — designed to make a company look better, and it's the hottest smoke screen on Wall Street right now. By using pro-forma methods in Amazon.com's (AMZN) first-quarter earnings release, for example, CFO Warren Jenson managed to exclude millions of dollars in expenses Amazon paid out during that period, making the quarter look better than it really was. Amazon and Computer Associates (CA), among others, have even convinced many Wall Street analysts to accept the numbers as gospel.
How does it work? Generally, pro forma doesn't take into account interest expense, a real cash expense every quarter, and discounts the impact of earlier company acquisitions and capital spending. Using it, Amazon reported a "pro-forma net loss" of $76 million. Without it — and using generally accepted accounting rules — Amazon posted a net loss of $234 million.
If you want to see how a company really performed in a quarter, go to its "cash flow from operations" line on the quarterly cash-flow statement. That number can't be doctored.
7. "No news is often bad news."
It's rare for a company to give investors more information than is required, but retailers have traditionally been different. Because their reports are often read as a barometer of consumer attitudes, most retailers release a monthly sales report, even though a quarterly report is all they're obligated to provide. Unless, of course, sales are down. Then the CFO clams up.
That's exactly what happened recently at McDonald's (MCD). For years the fast-food giant has released monthly information on the company's sales, and for decades those numbers have, for the most part, gone steadily up.
Earlier this year, however, McDonald's dispensed with its widely watched monthly sales numbers. A deeper look shows that those numbers would have brought bad news for the first time in a while. World-wide sales were up 2% in the first quarter, but the number of total stores was up 9%, implying that the company was driving up sales just by opening more restaurants, not by getting more people to eat in existing ones.
The policy change was no coincidence, laments McDonald's watcher David Kolpak at Victory Capital Management. "It's hurt their credibility," he says. "The trend should be toward more visibility, not less." A McDonald's spokeswoman says the company felt investors shouldn't concern themselves with short-term numbers, but only long-term sales.
8. "You own only 100 shares? I'm in a meeting."
In theory a company's CFO — or at least a high-level investor-relations employee who reports to the CFO — is available to everyone, there to answer questions that might affect your investment, no matter how small. In reality, most folks know they'd be crazy to expect a returned phone call from a CFO, unless they're, say, Warren Buffett.
But it's not just small-fry investors who get the cold shoulder. Many CFOs ignore even well-heeled individual investors and small mutual fund companies if they don't happen to own a lot of company shares. "Any company anywhere wants to assess 'What's in it for me?'" says Nick Heymann, an analyst for Prudential Securities. "If you're an individual trying to see someone, you're nobody — that's just how it works." Your best shot, if you really want a CFO to address a concern: Show up at the annual meeting, or get on a conference call and make your question specific. (Firms often publish the conference-call phone number in their earnings releases.)
9. "You're thinking of selling? Talk to the hand."
CFOs really don't like answering questions from investors betting against the company, whether they're Wall Street short sellers or just individual investors thinking of dumping shares for a quick profit. Can you blame them? Sure.
Before Regulation FD, CFOs had been known to throw downbeat investors or unfriendly analysts off conference calls. Now, in the days of open conference calls, CFOs can't be quite so rude, but they can make it clear they don't want to play ball if you hint that you're thinking of selling. Famed short seller David Tice, who runs the Prudent Bear fund (BEARX), says sometimes a CFO comes along who welcomes negative questions, but that's rare. "Most often people don't like to hear from us."
10. "The truth is out there."
What should you do if you're frustrated by your CFO's waffling? Tune him or her out. Indeed, the savviest investors know you can find much better sources of information on a company.
That's how fund manager Prescott Crocker dodged a bullet last year. Back in spring 2000 the prospects for telecommunications-equipment firms such as Global Crossing (GX) looked great, with 400% jumps in sales. But Crocker, a managing director at Evergreen Investment Management, suspected that the supply of broadband fiber far exceeded the demand for its use, meaning that all those sales were going to slow down — and fast. He would have never learned this from talking to companies, however, who were painting only the rosiest of pictures. Instead, he read about a leveling-off in Internet usage and the lack of available broadband television content in industry trade publications, such as Telecommunications magazine, and in market-research reports from firms such as IDC and Gartner.
Crocker directed the funds he oversees to pare back telecom investments, saving his shareholders millions. His advice: Keep asking questions, such as why higher profits aren't showing up as higher cash flow, or where industry demand is heading. If a CFO won't give a straight answer, he says, "don't accept it."