It may be disappointing, but it can’t be surprising that Borders Group went bankrupt this week. It was clear some time ago the company was heading deep into distress. What made it so clear? The six classic early warning signs of financial distress. We covered the first three in our last blog post. Here’s a brief video about the last three.
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Posts Tagged ‘Early Warning Signs’Early Warning Signs at Borders Part 2Sunday, February 20th, 2011 by Tim DelaneyEarly Warning Signs at Borders Part 1Friday, February 11th, 2011 by Tim DelaneyWe blogged about Borders Group back on January 4. Even though the company has a new financing commitment, it continues to have problems paying suppliers. It looks like Borders is still circling the drain. Borders’ survival is questionable, but for us the more interesting question is, “How could we have have seen the trouble at Borders coming?” What were the warning signs of Borders’ distress? In this video post we talk about three of the six early warning signs of financial distress and see how they apply to Borders. We’ll talk about the other three in our next post. Master of the world?Monday, January 24th, 2011 by Tim Delaney
He renamed the company Vivendi in 1999. And under Messier, Vivendi’s deal flow was staggering: the company sold 39 businesses and bought control of or stakes in 65 others. The capstone deal was a merger with Seagram-Universal and Canal Plus in 2000. The share price climbed to a record high, and Messier became a darling of the financial press. Time magazine named Messier the 12th most influential businessperson in the world, and the French Government awarded him the Legion of Honor. Articles in Business Week and Fortune compared him to Jack Welch, the legendary CEO of General Electric. The French press called him Jean “Magic” Messier. But Messier preferred J6M, which stood for Jean Marie Messier, moi-meme maitre du monde (“Jean Marie Messier, myself, master of the world”). Massive impairment charges hurt the company’s credit ratings in 2001, which led to problems rolling over short-term debt, which put pressure on liquidity, which hurt the share price. Messier fought back in 2002 with a massive increase in share buybacks, a special dividend, and a request for a big increase in his compensation. Directors began resigning in packs, and Messier lost his job that July. He paid over $2 million in civil fines for misleading investors in France and the United States. Now he’s been convicted on criminal charges for the same offense. In these difficult times, it may be gratifying to see a member of the global business elite in trouble. But what’s the lesson in the Messier mess for risk analysts? How could a manager so brilliant, so accomplished, so successful get himself and his company into so much trouble? We think the answer is at the intersection of management and character. Messier displayed many of the traits of spectacularly unsuccessful people Sidney Finkelstein describes in his excellent book Why Smart Executives Fail. 1. They see themselves and their companies as dominant. Messier overestimated his ability to control events, especially when Vivendi got into trouble in 2001 and 2002. Instead of shoring up the company’s finances, he threw money at the share price and kept insisting Vivendi had more liquidity than it really had, as if his assurances alone were enough to save the company. 2. They identify completely with the company. But the relationship is inverted: the company’s good doesn’t come first, the manager’s does. Messier believed what was good for him must be good for the company. That’s how he could ask for a raise when Vivendi was in the middle of a liquidity crisis. 3. They think they have all the answers. Messier’s self-confidence and vanity were legendary. No one could persuade him to see the mistakes in business and financial strategy that led to Vivendi’s liquidity problems. 4. They eliminate anyone who isn’t 100% behind them. Messier fired the only other widely admired manager at Vivendi, Pierre Lescure, the highly popular CEO of Canal Plus. He stuffed the board with friends and supporters. 5. They are the company’s spokesperson. Messier loved the limelight and cultivated it. He became obsessed with the appearance of success, insisting that there were no real problems at Vivendi, even when losses were growing and financing shriveling away. 6. They underestimate obstacles. Messier refused to admit the extent of Vivendi’s funding problems. His CFO tried to warn him, saying, “I’ve got the unpleasant feeling of being in a car whose driver is speeding up into the bends and that I’m in the death seat.” But Messier ignored him. 7. They rely on what worked for them in the past. When things began to go wrong for Vivendi, Messier just did more of what he’d always done. He increased the pace of acquisitions and divestitures, raised share buybacks and dividends, and made more public appearances. Messier, for all his ability, was a catastrophe masquerading as a hero. Fortunately, he did not destroy Vivendi, the way Bernie Ebbers did at WorldCom or Jeff Skilling did at Enron. But he came close. Analysts and investors who want to avoid the next management disaster should pay attention to character, and these seven traits are a great help for that. Borders circles the drainTuesday, January 4th, 2011 by Ron Carleton
Today, the Wall Street Journal reported that two senior executives had resigned (the General Counsel and the Chief Information Officer). This is another classic early warning sign. Let the countdown begin … Top 10 Credit Topics of 2010Tuesday, December 28th, 2010 by Ron CarletonHere’s our list of the top 10 topics on the minds of credit professionals in 2010: 10) Risk Management – We’ve written many times this year about risk management, both good and bad. Whether it was BP and operational risk, suppliers dealing with customer concentration risk (or “Wal-Mart Risk”), or Lehman just not managing risk. This topic was on our radar in 2010 (and needs to stay there into 2011 and beyond). 9) Games CFOs Play – Aggressive financial reporting (and outright fraud) can happen at any time, but management’s motivation to do it is heightened during an economic downturn when there is pressure to “hit the numbers” (and not breach covenants, etc.). 8 ) Managing High Risk Clients – Sure the recession is over, but many companies are still struggling with high leverage, high competition, low sales growth, and high costs. Lenders and bondholders will be working with many “high risk” clients well into 2011. 7) Intercreditor Priority – When times are good (think the 2003-07 credit bubble), no one pays much attention to collateral and subordination (or covenants, or any other part of credit documentation for that matter). The restructurings and bankruptcies of the great recession reminded us how important these issues are. We fear that the market is already starting to forget these lessons (think covenant lite and second lien!). 6) Cash Flow Analysis – Cash is king. Real cash, not EBITDA. Enough said. 5) Liquidity – Many CFOs (and lenders) have learned the hard way that liquidity can be the most important element of financial strategy. Our favorite analytical tool for looking at liquidity is the liquidity position. 4) Financial Strategy - Leverage matters too. A company’s debt strategy should depend on its business needs and business risk, not just the condition of the capital markets. The levering up we saw in the boom is evidence that some companies forgot this rule – many have been working to delever since 2008. 3) The Credit Cycle - The debt markets have returned (although not to the levels of 2006-07, yet). The return hasn’t been smooth, however. Issuers and investors have been looking closely at the relationships between the loan and bond markets, perhaps venturing where they haven’t been before. 2) Investing in People – While bank compensation levels haven’t necessarily returned to 2006-07 level (or most), we certainly see a lot of hiring at the analyst and associate levels, and more business and opportunities for more senior professionals. 1) New Opportunities – With the economy (slowly) improving (think increasing loan demand), and bank capital on the mend (think increasing loan supply), we think the increasing bond and loan volumes we saw in the second half of 2010 will continue into 2011. Here’s hoping that 2011 brings you many new opportunities. What “hot topics” do you see looking forward – leave a comment… Lehman’s Worst Offense: Risk ManagementTuesday, April 13th, 2010 by Tim DelaneyLast post, we argued that Lehman’s Repo 105 balance-sheet-management tactic was not the worst thing Lehman Brothers did on its way to extinction. Volume 8 of Anton Vakulas’s Bankruptcy Examiner’s report details a bunch of blunders with far more serious consequences. Here are a few of our favorites:
But in our view, Lehman’s biggest missteps were in risk management. Lehman’s opportunistic push for growth changed into an aggressive push to offset declines in its commercial mortgage business late in 2007 and early in 2008, and that led the company to ignore its own risk controls.
This chart from the Examiner’s Report shows how Lehman’s risk appetite grew through 2007 and into 2008. Risk appetite was Lehman’s estimate of the amount it could lose without jeopardizing employee compensation or shareholder returns. The chart also shows how in the last two quarters of 2007 the firm exceeded its own risk appetite limit with hardly any restraint, and then in the first quarter of 2008 solved the problem not by reducing risk but by raising the limit. There are plenty of other instances of management’s undisciplined approach to risk management:
Lehman did not see risk management as a crucial discipline or as a vital safeguard for a company operating with little capital and limited liquidity in troubled markets. For Lehman, risk management was a public relations tool. It was a show put on to reassure clients, regulators, lenders, and the rating agencies but with no substance or bite. And that misuse of risk management was far more misleading and much more damaging than Repo 105. Lehman Brothers: What’s All the Fuss About?Tuesday, March 30th, 2010 by Tim DelaneyA few weeks ago, the world was shocked to learn that Lehman Brothers was guilty of “window dressing” its balance sheet throughout 2007 and 2008. As the New York Times’ Dealbook put it, ”In Lehman’s Demise, Some Shades of Enron.” The outrage is based on information in the examiner’s report on Lehman’s bankruptcy. We’ve read the report, and we think there is less to be upset about than the press coverage suggests. The charge against Lehman is that they used accounting tricks to move assets of its books, making leverage ratios seem lower than they really were. The amounts were $38.6 billion in the fourth quarter of 2007, $49.1 billion in the first quarter of 2008, and $50.4 billion in the second quarter of 2008. These seem like big numbers. They certainly meet the test for materiality set by Lehman’s auditors, Ernst and Young, which was “any item that moves net leverage by 0.1 or more (typically $1.8 billion).” But let’s look at their impact not from a reporter’s point of view, or even a lawyer’s. Let’s look at this the way a credit risk analyst would.
This chart shows Lehman’s net leverage ratio as reported (without the Repo 105 assets) and as adjusted (with the Repo 105 assets). It was a measure the company emphasized in its public reporting and in its presentations to the rating agencies. Net leverage is total assets less restricted cash, securities held as collateral, securities held to resell, borrowed securities, and intangible assets divided by stockholders’ equity less intangible assets. When we analyze financial ratios we like to look at two dimensions of the data: level and trend. Let’s take a look at both for Lehman’s net leverage ratio. Repo 105 does not make a big difference in the level of Lehman’s leverage. It changes from 12.1x to 13.9x in May 2008, for instance, but that’s not a decisive difference. When the examiner told the rating agencies about Repo 105, none of them said it would have made them change their ratings. And Repo 105 does not change the trend in the company’s leverage. From November 2007 to May 2008, it fell by 25% with Repo 105 and by 22% without it. Either way, Lehman was cutting its leverage significantly. Repo 105 makes for exciting headlines and promising legal claims, but it’s just not that big a deal. The public dismay over Lehman’s window dressing is disingenuous: banks and investment banks having been doing it for years. The fuss reminds us of the police captain in Casablanca who is “ Shocked to find there’s gambling going on in here!” just as he gets his winnings from the croupier. Lehman did plenty wrong, but Repo 105 was not the worst by any means. Character is Destiny — Especially on the DownsideTuesday, March 9th, 2010 by admin
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.
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.
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.
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 FellWednesday, July 22nd, 2009 by Ron CarletonIn 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.
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?Monday, July 6th, 2009 by Ron CarletonHow 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.
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.
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 SatyamThursday, February 12th, 2009 by Ron CarletonWe 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
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
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
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 EnronWednesday, February 4th, 2009 by Ron CarletonIt’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. |
Jean Marie Messier became Chairman of Compagnie General des Eaux in 1996 at the age of 38. He was a graduate of elite French universities. At age 29, he held a senior post in the French Ministry of Economy and Finance. At age 32, he joined Lazard Frères, where he became the French investment bank’s youngest general partner.
The Wall Street Journal 
What do Calisto Tanzi, Bernie Ebbers, and Edward Groves have in common? Several things, actually.
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.
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.
