FOOL ON THE HILL
Spontaneous Combustion Investing

While the Enron implosions might be thankfully few and far between, there's a little Enron in way too many publicly traded companies. Companies are repricing employee stock options. Others are managing earnings. What's a shareholder to do? As an investor, when you get that first whiff of smoke, it's time to stop, drop, and roll with the changes. Rick Munarriz offers a primer on spontaneous combustion.

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By Rick Aristotle Munarriz (TMF Edible)
February 27, 2002

I remember when I realized that I had been had. It was 1998 and I was at a Rainforest Caf� analyst meeting in Orlando. With the stock sliding and the company's employee stock options more out of the money than those who wagered on the St. Louis Rams earlier this month, Rainforest Caf� stared ethics in the face and flinched. It went ahead and repriced the options of executives and employees alike to lower strike prices.

I was flabbergasted. Who ever heard of an incentive program that subsidizes failure? Shareholders certainly don't have a right to give their cost basis a similar tweak. If a patron at one of the urban zoo eateries realized that she wasn't as hungry as she had first hoped, could she similarly mark down the menu item prices? It wasn't right. It's still not right. If you water incompetence, what grows out of it?

Well, rather than contain my displeasure, I confronted the company at the meeting. What kind of message was the company trying to send out and was it worth shedding its credibility in order to do so? As the company tried to explain the incident away, the analysts around me were nodding their heads. They bought it. They were hooked on the concept of tossing out Scooby Snacks to reward ineptitude. Like the bully who calls "Do Over" when the game isn't going his way, they yielded the right of way on a one-way street to a car going the wrong way.

History is cruel to be kind. Time and time again you find companies like Lucent (NYSE: LU), Ciena (Nasdaq: CIEN), and Cendant (NYSE: CD) take a weedwhacker to option strike prices -- sometimes more than just once -- only to continue their miserable trading ways. Get the feeling that these repricing events are bad news all around?

Constipation, Sherlock! The out-centive incentive plans are worthless. If you're a teacher with a grade scale, and someone flunks a test, what would you accomplish by reworking the scale to make an F a C retroactively? I mean, even Artistotle knew that an A was an A, but what good is applying his Law of Identity to a market that has been reluctant to card at the door?

So how can you protect yourself against a company that lowers the bar? I'll tell you how. You change the name of the game from pole-vaulting to limbo. If your investments and integrity aren't on talking terms, ethics won't be there to provide marriage counseling. Get it? It all boils down to accountability. It all boils down to investing in companies who have earned your trust. When a company draws a line in the beach sand, make sure you check the tide.

If you make it a point to avoid buying into companies that hand out options on contracts with erasable ink you'll sleep better in the morning. If a company is coming undone, shouldn't the incentive be to NOT retain the executive ranks? While I'm opposed to sweetening severance packages, when a child goes graffiti gonzo with crayons on the wall the last thing that kid needs is a new Crayola box. Am I right or not?

But it gets worse. It gets bigger. You see, while Enron (Nasdaq: ENRNQ) is getting raked over the coals due in part to issues over auditor independence, there's bigger fish to fry. Guess what? Every company's Chief Financial Officer is compensated. In many cases, they are paid quiet well, thank you very much for caring.

What's the problem with that? Does this schmuck Rick think that CFOs should work for free? Of course not. However, if a CFO's compensation and company options rely on keeping Wall Street happy, what is to stop a CFO from managing earnings? I mean, forget the auditors for a second. Who cares about having the fox guard the hen house when you have Colonel Sanders inside with a skillet?

Please don't think I'm getting grassy knoll on you here. Poor CFOs. They spend decades out of the limelight and it's now that the post is in vogue under the most unwelcome of circumstances. But it's a position of power that is easily abused. The accusations of managing earnings have been lobbed at some of the market's heaviest hitters for quite some time. Companies like Microsoft (Nasdaq: MSFT) and Pfizer (NYSE: PFE) may very well have tweaked results to consistently edge out profit projections. It's not rocket science. Worse, it's completely legal. If you can juggle inventory levels, order deliveries and chew gum at the same time you have what it takes to make the appropriate revenue and earnings recognition model stick.

A year ago, Cisco's (Nasdaq: CSCO) massive write-offs included $2.5 billion in a one-time inventory charge, in line with the supposedly impaired assets' cost of goods sold. Did the company pack the merchandise in 30-gallon trash bags and haul it over to Goodwill? Not really. It just marked it down to a margin-friendly cost basis of zero.

What's frightening is that these acts aren't even the "pro forma" lay-up cheats that anyone can make out with a penlight and the naked eye. These are generally accepted accounting principles (GAAP) at play here. In other words, these maneuvers are anabolic steroids that don't show up in the bloodstream come athletic testing. Knowing full well that most investors won't note the wide discrepancies between the income and cash flow statements, companies feel that they have every reason to serve the shareholder's interest by managing the bottom line -- even if it's done courtesy of an extra puff or two from the helium tank and holding the mirror at just the right angle.

Where does that leave you? Most of you didn't own Enron, but here I am telling you that the prank phone calls you've been receiving may be coming from inside your house. How clean are your companies? Do you know? Do you care? You should.

Does that mean that you should embrace the ways of the investing scared? You cash out? You move on until that 20/20 report comes on showing that bed lice are gnawing away at the dollars stashed under your pillow? No, that's not the solution to your portfolio. That's like jumping out of the frying pan and into the formaldehyde jar.

When I was young I was fascinated by the concept of spontaneous human combustion. Just the very notion that someone's internal chemical action can lead to personal ignition -- whether you believe in it or not -- is an amazing concept. The possibility consumed me but it never slowed me down. After all, I had places to go and people to seethe.

In many ways, Enron was a case of spontaneous combustion. Everything seemed on the up and up until, bam, it burst into flames. All that's left is a boot, a chair, and scorched earth that will become more urban legend than unexplained phenomenon as the years roll by. While there were a few naysayers who were able to smell the flames early, that camp also sees fire in everything. You can't grow a portfolio that way. However, you can brush up on legal accounting tricks and broker-sanctioned chicanery. It will level the playing field. It won't fan the flames.

You've got options, Fool. Don't let anyone mark them down for your benefit.

Rick Aristotle Munarriz really was mesmerized as a kid when "In Search Of" profiled spontaneous combustion. After all, that Spock guy is pretty darn smart, you know? Rick's stock holdings can be viewed online, as can the Fool's disclosure policy.