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Financial Fine PrintUncovering a Company’s True Value John Wiley & Sons, Inc... Financial Fine PrintUncovering a Company’s True Value John Wiley & Sons, Inc... BASED ON MYover 40 years o

Financial Fine Print

Uncovering a Company’s True Value

John Wiley & Sons, Inc.

Financial Fine Print

Financial Fine Print

Uncovering a Company’s True Value

John Wiley & Sons, Inc.

This book is printed on acid-free paper.

Copyright © 2003 by John Wiley & Sons, Inc All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey

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Library of Congress Cataloging-in-Publication Data

In memory of Al and Hannah Gilden,

my wonderful grandparents, who taught me that there’s much more to life than money

Throughout this book, material is provided by financial experts asquoted from interviews conducted by the author Identification ofthe source is provided in these instances by an immediate refer-ence to the person interviewed

NOTE TO THE READER

BASED ON MYover 40 years of investing in the stock market

and my career on Wall Street engaged in the full-time

analysis of financial statements, it is my opinion that Financial Fine

Print: Uncovering a Company’s True Value is one of the most

inform-ative books ever written for investors Financial Fine Print enables

investors to become their own forensic accountants, helping them

to navigate the labyrinth associated with the increasingly complexfinancial reports of U.S corporations

What comes out in the footnotes of a company’s financialreports speaks volumes about a company’s real financial health.Details about many of the big corporate scandals that have domi-nated headlines in recent years and which have caused manyinvestors to lose faith in the stock market were actually discussed,albeit in a limited fashion, in the footnotes of the financial reportsfiled with the Securities and Exchange Commission Whether it wasAdelphia Communications, HealthSouth, and WorldCom disclos-ing large loans and loan guarantees to insiders, unusual “relatedparty transactions” at Enron, or aggressive accounting practices atTyco International, investors who read the footnotes probablywould have gleaned enough information to keep away from thesetroubled stocks or at least to sell them before the bottom fell out

FOREWORD

ria over the stock market, particularly here, in the San Francisco Bayarea, where I saw many young companies spring to life Even forsomeone who has built his career observing (and often popping)stock market bubbles, it often seemed hard to believe that thegood times would ever end Why would investors pay any attention

to the “quality of earnings”—something I spent 30 years writingabout—when it didn’t even seem to matter whether a companywas even reporting earnings? Unfortunately, too many people havelearned the hard way—by watching their investments disappear—that the devil often lurks in the details

While I’ve long been known for my skeptical views, even Inever would have imagined that a company as large as Enron—atthe time it was the seventh largest in the country—could havebeen engaged in such financial chicanery I often wonder whatone of my early mentors, Leonard Spacek, the former chairman ofArthur Andersen & Co., would have made of Enron’s confusingfootnote on its “related party transactions”—a footnote that had tohave been approved by Andersen accountants I wish that Mr.Spacek, who was an avid critic of creative accounting, had beenable to hear what must have been an interesting behind-the-scenesbattle between Enron’s management and the Andersen auditorsover what to include in that footnote Given his long-held viewsthat accountants “have a professional responsibility to the public,”I’m sure that things would have turned out differently for bothEnron and Andersen if he had had anything to do with it

When Enron’s former Chief Executive, Jeffrey Skilling, testifiedbefore Congress that he was “not an accountant” and could not pos-sibly be expected to understand the financial statements for a com-pany that he had run, he may have deceived investors yet again

xii

Even if that does prove to be a successful defense for Mr Skilling,investors need to know that having a Harvard MBA or some otheradvanced degree is not a prerequisite to understanding the stocksthat they own.

“The CEO, if he or she wants to obfuscate, they can do that; and

if they want to make it clear, they can do that,” says investing guruWarren Buffett “If they want to provide you with fluff, they can dothat And if they want to provide you with substance, they can dothat too.”*

Investors who read Financial Fine Print will be amply rewarded

with the ability to see through the fluff and develop their own redflags after delving through the footnotes While learning thesenew skills and putting them to use may take some extra time, I

believe it will be time well spent In their best-selling book The

Millionaire Next Door, Dr Thomas J Stanley and Dr William D.

Danko note that people who spend just a little more time analyzingtheir investments achieve much better results than their neighbors

who do not Financial Fine Print is an invaluable tool that will help

investors analyze their own portfolio and teach you how to ask ical questions about the next “must-have” stock

* U.S Securities Exchange Commission, “Roundtable Discussion on Financial Disclosure and Auditor Oversight,” March 4, 2002 (transcript).

Foreword

xiii

THERE WERE MANYpeople who believed in the need for this

book from the start, who believed that in order for individualinvestors to regain their trust, investors needed to gain a betterunderstanding of the stocks in their own portfolios Chief amongthose is Thornton “Ted” Oglove, whom I cold-called one day inthe fall of 2002 and who has since turned into a trusted friend Ted’sknowledge and experience, and his willingness to share both with

me, have been instrumental in writing this book Dozens of moneymanagers and stock analysts, many of whom preferred to speak onbackground, also shared their strategies for reading Securities andExchange Commission filings Pat McConnell at Bear Stearns andRobert Olstein of Olstein & Associates were particularly helpfuland repeatedly made themselves available to answer my manyquestions In my research, I was assisted by two diligent researchassistants, Aixin “Linda” Liang and Gene Ostrovsky, who plowedthrough countless 10-Ks and 10-Qs, despite heavy school workloads

of their own This research was enhanced by the access provided

to us by 10kwizard.com Several people—friends, family, and fellow

journalists—provided critical feedback on early chapters: JohnBicknell, Emily DeNitto, Carole Flegel, Lisa Lee Freeman, LaurenGellman, Louis Gilden, Caitlin Mollison, and Mark Walsh I’d also

ACKNOWLEDGMENTS

to my editor, Tim Burgard, who was excited about this book fromthe start Tim was a calming influence and, together with my agent,Susan Barry, helped me to navigate my first book Production editorSujin Hong went above and beyond the call of duty answering mymany questions and making helpful suggestions to improve thebook’s look My husband, Scott Cooper, who didn’t even have achecking account when we first met, was amazingly supportive andencouraging throughout, as was my stepfather, Barry Montauk.Finally, this book would have been impossible without my mother,Ruth Gilden, who has always been there for me In addition tobeing on call to provide research assistance, editing, and even on-sitecatering, she was and continues to be a constant source of strengthand support

IFIRST LEARNED HOWimportant footnotes were to uncovering acompany’s true financial condition back in 1991, when I was

a business reporter for The Bradenton Herald, a daily newspaper on

Florida’s west coast It was at the height of the savings and loan crisis and rumors had been circulating that a small bank based inBradenton, Key Florida Bank, now long out of business, was cook-ing its books Making the story even more interesting was thatmany of Key’s executives, including the chief executive, hadworked for another nearby bank, Palmetto Savings and Loan, thatfederal banking regulators had charged with cooking its books Ayear earlier, Palmetto’s chief executive had been convicted of bankfraud and sentenced to three years in prison

Even though Key was a public company, it was not listed on any

of the national stock markets and, as a result, did not have to file10-Ks and 10-Qs with the Securities and Exchange Commission(SEC) But the savings bank did put out an annual report that one

INTRODUCTION

Internet and the report was available only to shareholders Insidethe report was a glowing letter from the bank’s president and sev-eral charts that showed how profits at the bank were growing But it wasn’t until I reached the footnotes, where in very smallprint at the end of the report, the bank disclosed that it had beenforced to enter into an operating agreement with the Office ofThrift Supervision (OTS), a federal regulatory agency that wasresponsible for cleaning up the savings and loan crisis The foot-note went on to say that OTS inspectors believed that Key was vio-lating the agreement and would be subject to further regulatoryactions, including possibly closing the bank down Still, even inthose footnotes, Key executives downplayed the situation to share-holders:

The savings bank has been informed by the OTS, that in theopinion of the OTS, the savings bank has failed to comply withthe agreement, which failure of compliance could result in fur-ther regulatory action Management believes the savings bank is

in compliance, in all material respects, with the agreement

Given how regulators were closing savings banks left and right

at the time, that kind of disclosure should have sent Key holders running for the exits When regulators moved to shut abank down, deposits were guaranteed up to $100,000, but share-holders lost everything Yet most of the shareholders I spoke to atthe time, including several of Key’s board members, seemedunaware of the bank’s shaky financial condition Few had takenthe time to read the footnotes, so they weren’t aware that the OTSwas cracking down on the bank One member of Key’s board of

share-directors even told me that it wasn’t his job to read and stand the bank’s financial statements He was simply on the board

under-to try under-to spread the word about the bank under-to colleagues in the areaand, it was hoped, bring new business to the bank

But it was those footnotes that prompted me to take a closerlook at the company’s numbers What I found was that the bankwas eking out a profit each year by selling assets, rather than mak-ing money from its loans and deposits The financials also revealedthat Key’s bad loans had been rising sharply, but that the bank’sreserves for those bad loans were being whittled down

Several months later, OTS regulators forced the bank into amore stringent operating agreement and ordered Key’s board tofire the chief executive and several other top managers But for

me, it was an early lesson in how some companies use the notes as a way to disclose potentially damaging information

foot-Unfortunately, I forgot about the lessons that I learned from Keywhen I began investing Though I had been writing about thestock market for close to a decade as a business journalist andowned several mutual funds, I had never bought an individualstock But, in the mid-1990s, prompted by the ease of being able

to trade online, I bought my first stock, and quickly followed it upwith several more Like many of the millions of other people whowere entering the market for the first time, I was so swept up in theexcitement of watching the few stocks that I owned rise that I for-got to pay attention to some of the warning signs

I relied on optimistic projections from stock analysts whoappeared on television, even though I knew that their loyalties oftenwere tied to juicy investment banking deals And instead of readingthe detailed filings with their audited financial information, I

Introduction

3

words like pro forma earnings and EBITDA,* vague terms thatshould have prompted me to take a closer look at the company’saudited financials

Sometimes the difference between the two numbers was ally night and day For example, Qwest Communications, which Ibought in late 1999, routinely touted its quarterly pro forma earn-ings, as it did in early 2001, when it reported $995 million in what

liter-it called net income for 2000, a 53.6 percent increase over 1999 Ican still remember thinking how impressive that sounded andpractically gloated when the stock started climbing But had Itaken the time to read the 10-K that came out about two monthslater, I would have seen that Qwest had really lost $81 million forthe year, under the rules of generally accepted accounting princi-ples (GAAP), compared with the $1.34 billion in net income itreported in 1999 Such a huge difference between the two figureswould have certainly prompted me—and I’m guessing many otherinvestors—to dump the stock long before it fell as sharply as it did.The Qwest discovery made me begin to wonder whether beingmore diligent and taking more time before pressing the buy but-ton on my computer screen would have prevented at least some of

my losses What I found in several filings, were questionable

relat-ed party transactions with company insiders, options and pensionsbeing used to prop up earnings, and other red flags that probablywould have prompted me to dump the stock, if only I had takenthe time to at least skim the filings

* Earnings before interest, taxes, depreciation, and amortization, or as Lynn Turner, former chief accountant at the SEC, calls them, everything but the bad stuff.