Why, Toshiba, Why?

Toshiba Corporation has been caught cooking the books, overstating pre-tax profits by ¥1.5 billion over the last seven years. The scandal began with an inquiry by Japan’s market regulator, the Securities and Exchange Surveillance Commission, in February. Toshiba started its own investigation in May, and the committee issued its report in July. The company abused project accounting rules to hide expenses in its construction businesses. It understated the cost of parts sold to contract manufacturers in its computer business. And it failed to wrote-down obsolete inventory in its semiconductor business. None of these tricks was very inventive; they are classics from the expense manipulation playbook. But at Toshiba there were no points awarded for originality, only penalties for failing to meet profit goals. And those penalties could be quite severe. According to the investigating committee’s report, it was standard practice for Toshiba’s last three chief executives to issue impossible earnings  “challenges” to subordinate business chiefs to make up for near-term profit shortfalls. Executives who failed to meet those challenges were disgraced, and their businesses were threatened with closure. Pressure to meet goals is nothing new in business in Japan or anywhere else. So there is nothing really special about Toshiba in that regard. What is special is how comprehensive the breakdown in integrity at Toshiba was: every control against financial misreporting failed. Starting at the top. The last three chief executives at Toshiba, Toshiba Hisao Tanaka, Atsutoshi Nishida, and Norio Sasaki, were all directly involved in hiding expenses. They were aware of and sometimes even approved of the bad accounting. Toshiba’s Corporate Audit Division failed to find the fraud....

Decaffeinating Green Mountain

Last October, David Einhorn, head of Greenlight Capital, a hedge fund famous for taking short positions in Lehman Brothers’ shares before Lehman failed, attacked Green Mountain Coffee Roasters’ in a presentation at an investors’ conference. It was a tour-de-force of financial analysis. Using only publicly available information, Einhorn made a strong case for unrealistic sales growth and overstated earnings. Since then, things have only gotten worse for Green Mountain. The share price collapsed. Robert Stiller, the founder, was forced to sell shares to meet margin calls on $617 million in personal debt secured by his Green Mountain shares and had to resign the company’s chairmanship. The SEC continued with an investigation into the lack of disclosures about a key distributor. And many of David Einhorn’s concerns remain. We’ve looked at one of the issues he raised: capitalizing operating costs. Here’s our own analysis, updated with the latest fiscal year data. As Green Mountain reports it, sales have been growing at an striking rate, propelled by demand for its K-Cup coffee brewers and pods and by acquisitions. After a dip in 2010, Green Mountain’s EBITDA margins expanded along with sales, peaking at nearly 18% in the fiscal year ending in September 2011. One tactic companies use to understate expenses is to capitalize them. That is, they add current period operating costs to property, plant, and equipment — or some other asset with a life of more than a year — instead of treating them as cost of goods sold or selling, general, and administrative expenses. That spreads them out over a number of reporting periods as part of depreciation expense...

Misgovernance at Olympus

Michael Woodford lost his job on October 14. He had been CEO of Olympus, the Japanese maker of medical systems and cameras, only since last July; and as recently as September, the company’s Chairman had said he was “extremely pleased” with Mr. Woodford’s performance. But then the board fired him for “causing problems for decision making.” He definitely was causing problems. He kept asking embarrassing questions about the Olympus’ 2008 acquisition of Gyrus, another medical equipment company. Olympus paid $2.2 billion for Gyrus, including $687 million in advisory fees to AXAM, an obscure Cayman Island firm that vanished from the trade register a few months after the deal. See this interview of Mr. Woodward in the Financial Times for more information. The Olympus case reveals big weaknesses in Japanese corporate governance: unaccountable senior executives, weak disclosure standards, and dangerously passive shareholders. At the heart of these is an issue behind many failed companies and damaged lenders — poor governance. Board Strength Many things contribute to good governance, but the key factor is a strong board of directors. We think there are three dimensions to board strength. Independence. The majority of directors on any board need to be independent of management. There are different standards of independence in use around the world, if not in Japan. Among the most rigorous is one from the Council of Institutional Investors, which defines independence this way: “An independent director is a person whose directorship constitutes his or her only connection to the corporation.” Expertise. Directors of an effective board have relevant industry and management experience. They are well equipped to evaluate the company’s...

Master of the world?

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. 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...

Top 10 Credit Topics of 2010

Here’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...