Companies That Just Don't Get It

While pursuing a Ph.D. at a Big Ten university in what seems like a former life, I spent a fair amount of time as a teaching assistant. One of my duties was explaining low grades to perplexed undergrads who spent their entire high school careers without getting a "C." Many of these kids were simply bewildered. In their minds, they were "A" students, and no one had ever told them there were areas in which they could improve. It was often hard to make them understand I wasn't out to get them--they simply had higher opinions of themselves than I had of them.

As Morningstar has expanded its coverage universe over the past several months, we've had similar experiences with some of the companies we now analyze. Many firms, it seems, have never seen a research report about themselves that was anything but positive and have been quite vexed when we've pointed out that the emperor has no clothes.

Given the cozy relationships between some Wall Street analysts and the companies they cover, I suppose it's not terribly surprising that some firms have relatively thin corporate skins. What's shocking, however, is how little it sometimes takes to motivate a vice president of investor relations or a CFO to make a blustery phone call to one of our analysts--in one case, we merely highlighted a risk that was in the firm's own 10-K filing!

Herewith, a few tales from the front:

• One of our technology analysts received a call from a firm that was upset because he wrote that the company's shares had not performed well over the past several years--the firm helpfully pointed out that its market capitalization had increased markedly during the relevant period. Unfortunately, that's not all that increased, as the firm's shares outstanding more than doubled during that period due to stock options, additional share offerings, and the conversion of some convertible bonds, all of which resulted in massive dilution for existing shareholders. The shares themselves are basically flat over the past five years--bigger has not meant better for the firm's shareholders.
   
• The CFO of a financial-services firm called to say that the company had never experienced the type of litigation we had highlighted as a risk in our analysis. In fact, it turned out that this information was in black and white in the firm's 10-K, and when we returned his call, the CFO admitted as such, noting that "you folks sure read those things front to back." Given that he had to sign the 10-K, you'd think he would have read it front to back, too, but maybe he was too busy calling analysts who said negative things about the firm.
   
• In a similar vein, a biotech CEO called to complain that we should not have highlighted excessive options issuance as a negative corporate-governance issue. He claimed that the firm actually didn't issue that many options and seemed not to realize that he'd given away 6% of the firm the previous year. Because options aren't an expense according to current accounting rules, I suppose you can't blame him too much. I wonder if this CEO would have been more aware of his firm's options policy if he'd had to expense them on the income statement.
   
• We also received a call from a financial-services firm, politely noting that we really didn't have to highlight a particular risk that appears plainly in the firm's 10-K filing. According to the firm's IR representative, this was a problem because investors are more likely to read our Analyst Report on the firm than the 10-K itself. That's exactly the point, I think.
   
• When we initiated coverage on an energy firm earlier this year, we expressed some skepticism over the company's plans to scale back capital spending and increase production at the same time, noting that an increase in capital spending seemed likely. Even though the firm subsequently raised its spending budget by a substantial amount, it still rang our analyst to tell him he shouldn't doubt the firm's plans to keep a lid on spending while boosting production. A couple of weeks later, the firm raised its spending budget a second time.
   
• Finally, the CFO of a financial-services firm called in a huff to complain that our fair value estimate for his firm was "so low that it made the analyst look like an [expletive]." He also noted that our research was "not helping his firm." Curiously, this same firm wasn't interested in talking to us when we initiated coverage a couple of years ago, after we told the firm it was our policy not to allow companies to see our research before it was published. (It's not uncommon for Wall Street analysts to send their research to firms for "fact checking" before publication.) At the time we initiated coverage, the firm also asked whether there was any way it could prevent us from covering it, which seemed like an odd request unless it had something to hide.

This last story highlights just how tight some firms still are with the Wall Street analysts who cover their shares. The very fact that the CFO of a decent-sized, publicly traded firm would seriously think that the purpose of an analysis is to "help" his firm speaks volumes about the conflicted relationship between Wall Street and corporate America. Evidently, some companies still think that analysts should be shills. Anecdotally, this seems to be more the case with smaller and mid-sized firms--I suppose that large companies such as  General Electric (GE) and  IBM (IBM) are more used to having criticisms levied at them--but the trend is disturbing nonetheless.