Buyer, Beware!

By now, we’ve all become well versed in the demise of companies like Enron and WorldCom. But has US corporate corruption really been stamped out? "Welcome to the cozy world of executive compensation," hails Eric Fry. "Questionable corporate governance practices continue at many companies, and that means that investors need to watch their backs…"

The mind-boggling abuse of executive-compensation practices didn’t end with the likes of WorldCom and Enron. Weak and conflicted boards of directors continue to oversee many of America’s largest corporations. That means investors need to watch their backs.

While swarms of hopeful investors are busily buying into what they expect will be a new bull market, many other folks are still sifting through the rubble of the late, great bull market of the 1990s. Most of the rubble will yield absolutely nothing of value to those sifting through it. But they continue their fruitless search like retirees combing the public beach with a metal detector, motivated by the remote possibility of unearthing a cache of Spanish doubloons.

WorldCom Inc. is one of the most prominent piles of rubble on the financial landscape. Its grotesquely large, gnarled, $41-billion heap of liabilities entombs whatever trace of residual value may lie buried underneath. At this very moment, creditors and shareholders are battling one another in court for the right to "excavate" the most promising sections of the debris that WorldCom has become.

On Tuesday, the judge presiding over the WorldCom bankruptcy proceedings approved the company’s proposal to pay $25 million in bonuses to 325 executives and "key" employees. Whether paying the bonuses will "enhance the value" for creditors, as the judge’s ruling asserts, we cannot say. Perhaps it is true that paying these bonuses is absolutely necessary to retain key personnel. Or perhaps the bankruptcy court is merely throwing good money after bad.

But what we find most interesting about the decision is the fact that it overturns an objection by SBC Communications Inc., one of WorldCom’s creditors. That SBC would object to doling out bonuses is a laughable irony. It is the last company in America that should be objecting to "incentive" bonuses. This is the same SBC that has lavished millions of dollars on a CEO with a dubious record of success, having paid Edward Whitacre Jr. $82 million in total compensation during 2001.

How, we wonder, could anything that is so good for the goose be bad for the gander? In other words, if SBC, a WorldCom creditor, objects to paying the relatively paltry sum of $25 million to 325 different individuals, shouldn’t somebody be objecting to the fact that SBC lavished $82 million on one individual? "It’s getting to the point," one commentator observed, "that SBC may have to add another line to the bewildering list of charges on customers’ phone bills – one to cover Whitacre’s pay."

And anyway, how did Whitacre get his hands on all this money in the first place? To judge from SBC’s plummeting share price (down 60% over the last two years) or its eroding profitability (sliced in half over the same period), the man deserves a pink slip, not a multi- million-dollar pat on the back. Well, let’s just say that it helps to have friends in high places – like on your own company’s board of directors, for instance.

"Edward Whitacre, chief executive of SBC Communications Inc., and Charles Knight, CEO of Emerson Electric Co., each had a financially rewarding year in 1999," Bloomberg News remarked recently. "SBC’s board of directors gave Whitacre a 19% raise on salary, bonus and other perks, increasing his annual compensation to $8 million. Knight’s board boosted his pay package 23%, raising his compensation to $4.2 million. The two companies’ shareholders didn’t fare as well – not even close." The shares of SBC, for example, dropped more than 9% in 1999, compared to a 15% gain for the S&P 500.

Is it a coincidence that these two CEOs both received hefty pay raises in 1999? Only if you believe it a coincidence that each sits on the other’s board of directors. In fact, SBC’s Whitacre is a member of the four-person compensation committee at Emerson that blessed Knight’s pay hike.

Welcome to the cozy world of executive compensation – a world in which executive pay steadily skyrockets, no matter how badly the economy or the stock market perform. In 2000, for instance, when the Standard & Poor’s 500 index fell 10%, the average executive compensation package soared more than 60%. Back in 1990, CEOs received 130 times the wage of the average worker – and that was up from only 30 times in 1970. Today, the ratio has ballooned to 575 times. Are these golden boys (and girls) really worth it?

There’s so much back-scratching going on in America’s boardrooms that no executive goes home with an itch of any sort. Indeed, at many companies, back-scratching is the first item on the agenda.

"At WorldCom, the audit committee met five times in 2001," Bloomberg notes. "In contrast, WorldCom’s compensation committee – which gave former CEO Bernard Ebbers a $1.5 million-a-year lifetime pension and $408.2 million in loans and guarantees – had 11 meetings in 2001, filings show."

If this is vigilant oversight, most investors would prefer utter neglect.

But this kind of stuff doesn’t happen anymore, does it? Now that the SEC and the New York attorney general, and even Congress itself, are busy conducting investigations and seeking recriminations, corporate America has cleaned up its act, right? Alarmingly, questionable corporate governance practices continue at many companies, and that means that investors need to watch their backs.

Consider the case of Novellus Systems. As Apogee Research recently observed, "The audit committee [at Novellus] is comprised of three individuals who, according to the filed proxy, all have backgrounds in the technology and telecommunications industry, but apparently not in accounting…An audit committee without accounting professionals is a problem itself. Adding to our concern in the case of NVLS is that the same three audit committee members also sit on the stock-option and compensation committee at a company that compensates all of its outside board members with stock options. In other words, all three sit on the committee responsible for okaying the option grants that they themselves received. That’s what we used to call a conflict of interest."

If you think that the conflicted directors at Novellus may be a rare exception, think again. Apogee combed through the public filings of Mercury Interactive (MERQ) and discovered the following eyebrow-raisers:

"The audit committee is composed of three individuals, none of whom has an accounting background…All members of the audit committee are compensated with MERQ stock options in addition to the standard retainer. Specifically, members of the audit committee receive 50,000 options when they join the board and another 10,000 annually upon reelection to the board.

"More curious even than stock-option compensation for audit committee members are the recent sales of shares by those same committee members…Two out of the three audit committee members appear to have sold all of their MERQ shares…Assuming the options had an exercise price equal to share price on the dates of the grants, the $1.5 million in proceeds from the sale translate into a profit of about $1.26 million for a single member of the audit committee."

Coincidentally – or not – employee compensation at Mercury dwarfs "shareholder compensation." In other words, Mercury’s reported net income in 2001 was $34.2 million. But if the value of employee options had been booked to the income statement, the $34.2 million profit would have turned into a $90 million loss. This is not an inconsequential difference for a company that, even under the most flattering light, sells for more than 40 times "earnings."

If the examples of Enron and WorldCom have taught us anything, it is that weak corporate governance is not merely an annoyance…it is often disastrous. Obviously, conflicts of interest in and of themselves do not cause abuses. But neither does their presence inspire confidence. Buyer, beware!

Regards, Eric J. Fry

The Daily Reckoning’s Eyes On Wall Street

Eric J. Fry, the Daily Reckoning’s ‘man-on-the-scene’ in New York, is the editor of Apogee Research (formerly Grants Investor), an online investment publication devoted to hedge funds and other professional investors. Mr. Fry has been a specialist in international equities since the early 1980s. He was a professional portfolio manager for more than 10 years and authored the first comprehensive guide to American Depositary Receipts, "International Investing with ADRs." Mr. Fry appears regularly on television financial news programs and contributes his insights to selected investment research publications.

See: Apogee Research

The great bull market boom of ’75-’99 was the greatest ever. Not only did it elevate stock prices 2000%, it created a race of geniuses. ‘Never confuse a bull market with genius," goes the old Wall Street dictum. But by the turn of the century, the whole country seemed confused…there were Einsteins in every bar and beautiful minds by the thousands at every baseball game.

Confident to a fault, people came to believe that permanent prosperity was just a matter of making the right choices. Investors only had to choose the right stocks; the Fed just had to select the right short-term rate.

Whatever a bear market’s faults, it has many virtues. Here at the Daily Reckoning, we always look on the bright side. What made the Great Depression so great, we ask ourselves? Well, you could get a table in almost any restaurant in Manhattan without a reservation. Things got cheaper too. Especially stocks; you could buy the stocks you coveted at $10 in ’29 for as little as 95 cents. If you wanted to go out and ‘flaunt it,’ the dog was a lot less expensive to put on. And you didn’t have to make a lot of money in the stock market to be mistaken for a genius; you just had to avoid losing money.

Another thing…as confidence ebbed, humility flowed. People began to think that maybe they weren’t such geniuses after all. Dostoevski thought humility was the most important virtue. We don’t know, but it is surely one of the most attractive.

"Many idiocies were used to puff the bubble," writes Andrew Smithers. "One was the claim that recessions were a thing of the past. The world, it was claimed, is now too well managed to suffer from policy errors.

"Last year’s recession in America and the looming threat of another has killed this idea. We now risk a swing from foolish optimism to excessive pessimism. Some worry that policies for growth no longer work.

"This is silly. Economies are not unmanageable. There is every reason to believe that the world economy today will respond strongly to the right policies."

Which are the right policies?

"Interest rates and taxes should be cut both in America and in Europe," says Smithers. And then, he can’t seem to help himself; he offers advice to everyone: "In Japan, where interest rates can’t be cut any further, money supply should be boosted."

At the peak of a bubble economy, the problem is neither too little confidence nor too little credit. Au contraire, genius investors with too much credit available to them "have been underpricing risk," explains retired fund manager David Richards in Barrons. They priced stocks and corporate bonds as if there would never be a recession…and never a bear market. Now they know better. Risk premiums are rising.

But they still have more to learn about how risky a market may be…and how powerless the Fed may be to save them. Investors and economists still believe that the Fed can produce any outcome it wants – merely by selecting the right interest rate. Credit was too cheap in the boom phase; people used it extravagantly. At today’s meeting, Greenspan & Co. may decide to follow Smithers’ advice – lowering the price of credit even further.

Will that produce a boom in stocks…or in humility? We will see…

Eric Fry brings us the latest from Wall Street…


Eric Fry, reporting from the Big Apple…

– Election Day in America produced a landslide victory for the bulls. Investors voted enthusiastically for a new bull market, as they bid the Dow 107 points higher to 8,678. The NASDAQ gained five points to 1,401.

– Meanwhile, the dollar picked up little more than a few write-in votes as it fell for the fifth straight day to close at 99.78 cents per euro. Gold slipped a dime to $318.60 an ounce, while Treasury bonds also fell slightly. The 10-year Treasury note now yields 4.07%.

– To judge from the stock market’s stellar price action, one would think the economy is "firing on all eight." In reality, however, the economy is badly in need of a tune- up, if not a complete overhaul. Surprisingly, the more it sputters, the more investors seem to love it.

– To extend the metaphor, the semiconductor sector is the 1974 Ford Pinto of the global economy. It wasn’t a great car in the first place, and now it’s rusted out, burning oil and barely making it to the supermarket and back.

– Yesterday, Applied Materials (AMAT) became the latest of many semiconductor companies to release some sort of dismal news. The world’s biggest maker of chip- manufacturing gear announced plans to cut about 11% of its work force worldwide. These latest job cuts come on top of the 4,700 positions AMAT eliminated last year.

– "One company after another in the semiconductor sector has reported…sickly results," Apogee Research observed recently. "KLA-Tencor reported a nearly 40% drop in new orders for its latest quarter. Its CEO Kenneth Schroeder says ‘there is excess capacity at our customers,’ and that the company’s ‘business environment can be expected to remain difficult.’ Texas Instruments expects sales in the fourth quarter to drop 10% from the third…In something of an understatement, its CFO William Aylesworth said, ‘This is clearly a pause in certain of our markets.’ Then, of course, there is Intel, whose shares have inexplicably recovered since its poor results and glum forecast were released last week. CFO Andy Bryant observed that ‘we’re looking at a fourth quarter we think is at the low end of what you would typically expect.’"

– Despite this parade of disappointments and minor disasters, the SOX Semiconductor Index has rocketed 48% since October 9th. Apparently, the tech-stock bulls are clinging stubbornly to the notion of an imminent and powerful recovery in the chip sector. Maybe now would be a good time to stop dreaming and start listening to what the insiders have to say.

– James C. Morgan, chairman and chief executive officer of Applied Materials, calls the latest round of job cuts "a painful but necessary decision to make in order to enable the company to align our operations with the current level of business and position for future growth…The continuing uncertainty in the marketplace makes it necessary for us to take additional action to lower costs…"

– These do not sound like the comments of an industry insider who expects an imminent turnaround. Meanwhile, Novellus Systems, maker of semiconductor processing equipment and kindred spirit to AMAT, is also continuing to struggle. In its third-quarter conference call, Novellus cautioned that net orders in the current quarter could fall as much as 10% from the prior quarter and more than 25% from its sales levels in the June quarter. In other words, there is simply no sign of a turnaround. Even so, NVLS shares have vaulted 64% in less than a month.

– Is somebody missing something? Did a few investors forget to renew their subscriptions to "Semiconductor Magazine"?

– "The boom is over, and the bust is in full swing," Apogee Research concludes. "The explosion of the Internet into everyday life and networking of America all led to a boom not likely to be repeated. So even when demand begins to improve, the enormous market for semiconductor chips that manufacturers experienced from 1999 through 2001 probably won’t be seen again for a very long time.


Back in Elkins, West Virginia…

*** My friend, Dan Ferris, is looking for value in real estate companies. He sends this note:

"What’s better than 90,000 acres in Hawaii at $150 an acre? How about 1 million acres in Texas, currently on the books at about…$12 each?

"Texas Pacific Land Trust (TPL).

"The trust was formed in 1888. No value was assigned to the land. Or to quote the annual report:

"’The fair market value of the Texas Pacific Land Trust’s land and royalty interests was not determined in 1888 when the Trust was formed; therefore, no value is assigned to the land, town lots, royalty interests, Certificates of Proprietary Interest, and Sub-share Certificates in Certificates of Proprietary Interest…’

"Last year they sold 13,579 acres for $6.7 million, or about $495 an acre. One sale in El Paso county was for 569.41 acres at a price of $5.6 million. They still own 19,501.79 acres there.

"The total acreage (1,021,583.86 acres) the Trust still owned at 12/31/01 is located in twenty-one counties in Texas. The market cap of the whole trust today is $94 million, equating to about $92 per acre. I’m looking at a 2001 annual report, so things may have changed a little, but probably not much.

"Last year they made $6.9 million of net income from royalties.

"Sounds like a pretty good deal to me. I thought it sounded like something you might be interested in as well."

*** While all eyes were on the Dow again yesterday, the dollar slipped down a bit more. It is nearly equal to the euro again. Would it surprise us if it fell another 10% to 20%…or more? Would it surprise us if it caused the foreigners to withdraw from U.S. markets? Would it surprise us if it resulted in a drop in the trade deficit? Would it surprise us if more and more investors looked to gold for safety? No, it wouldn’t.

*** "Yecch…what’s that smell? It smells like something dead," said Henry on Sunday. We had just walked into the laundry room. "Oh I forgot to tell you, Dad," he continued. "Francois brought over a rabbit a couple of days ago."

And there it was, still hanging from the rack, as stiff as Italian coffee or a German accountant.

"Don’t worry about it," said the gardener. "You can leave game for weeks before you clean it. It actually tastes better. I’ll clean it later this week and put it in the freezer."

Maybe it is true. Wild game, like wine, women, and autumn leaves, reach their peaks just before they begin to decay.

*** There is plenty of wild game here in West Virginia. There are plenty of animals too. But it is the uncivilized, uncultured and unsophisticated humans that stick in your eye like a speck of sawdust..

Maria and I rubbed our eyes as we drove over the mountains. The scenery was breathtaking. But nearly as amazing was the appalling shiftlessness of the indigenous population.

There are so many rocks in this part of the Appalachians that they practically stack themselves into walls all by themselves. And lumber is everywhere; there is almost always a timber truck in front of you as you make your way around up and down the mountain roads.

In a few weeks’ worth of work, with only a trowel and a shovel, and a few dollars for cement, you could build a beautiful stone house. But do the locals do that? Nope, they live in shacks and trailers, with the carcasses of rusted automobiles spread around the yard.

"And what do they eat," Maria wondered. For there were no gardens, neither ornamental nor vegetable. There is not a single blooming plant in the entire state, as near as we could determine. Even the nicest houses show little evidence of landscaping, architecture or gastronomy. Even this time of year, rural Europeans typically have leeks, cabbages, salads and various other cold-weather plants laid out in military order. We saw nothing of the sort in West Virginia. Even more astonishing, there were no woodpiles worthy of the name. Smoke emerged from a few chimneys, but they were rarely respectable ones. More often, they were nothing more than tin pipes stuck out of the side of ramshackle houses.

People are nice in this part of the world. But it is the niceness of the terminally relaxed. They set very low goals for themselves – and then fail to reach them. Nearly every other man, it seemed to us, dresses as though he were chopping wood, eats as though they at a backwoods’ church supper, and lives in house that would be a disgrace to a pig.

Other than that, it is a wonderful place.