FOOL ON THE HILL
How to Spot a Risky Company

Symantec may be a leading computer security company, and it may benefit from all the concurrent advantages of software economics, but investors should take pause at the risks that loom here: high and rising short interest, frequent acquisitions, overly generous stock options, low inside ownership, and selling by the CEO. When you see this many risks, stay away!

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By Matt Richey (TMF Matt)
July 23, 2002

In anticipation of getting my home computer hooked up to DSL (finally!), I installed Norton Internet Security 2002. This antivirus and firewall software is considered a must-have for maintaining a safe, constant connection to the Internet. And with more and more people opting for DSL or cable Internet, I began pondering the investment merits of Norton's parent, Symantec (Nasdaq: SYMC).

As a software company, Symantec has the usual software benefits of high gross and net profit margins and excellent cash flow. A glance at the cash flow statement for fiscal 2002, which ended in March, reveals $2.25 per share in free cash flow (not including stock option tax benefits). At a recent price of $31.50, that puts Symantec at what seems to be a very reasonable multiple of only 14 times free cash flow. And this for a company that grew revenue by 39% in the most recent quarter. 

Upon initially seeing these numbers, my internal stock bargain-o-rometer violently redlined. But as I began sleuthing around Symantec's business, it wasn't long before I found more than a few unnerving signs of looming risk.

High and rising short interest
One of the first things that caught my attention was the high percentage of Symantec shares sold short. A high short interest is one of the surest tip-offs that something's amiss at a company. Short sellers aren't always right in their bearish stance, but a high short interest means that there are concerns -- and it's your job to figure out whether those concerns are legit or not. When the number of shares sold short is more than 10% of float, a yellow flag should pop up in your mind. When that number reaches 20%, consider it a red flag, warning serious problems.

Symantec's short interest is currently 14.5%, according to its Yahoo! corporate profile. Even more telling is that this number has been rising and is now at a high for the year, according to short interest information provided by Nasdaq:

  Date        # Shares Short
06/14/02        16,549,347 
05/15/02        15,607,859 
04/15/02        11,322,277 
03/15/02        12,925,856 
02/15/02        11,532,541 
01/15/02        12,150,842  

Serial acquirer
So what are the short sellers so hot about? I suspect part of the problem is the large number of acquisitions Symantec has made over the years -- 28 in total since the company's IPO in 1989, including three in the most recent quarter alone. This rabid pace of acquisitions has earned Symantec the unflattering label of serial acquirer.

Acquisitions aren't bad, per se. One of Symantec's earliest acquisitions was Norton Computing, Inc. (1990), which Symantec turned into the world's leading consumer antivirus franchise, the well-known Norton family of antivirus products. (Just today, Norton AntiVirus 2002 won CNet's Editors' Choice Award.)

But acquisitions do carry risk, particularly integration risk and overpayment risk. It's hard enough to successfully manage one company, much less manage an ever-expanding empire of new companies. Also, acquisitions muddy the accounting waters and make it difficult to track a company's internally generated growth. Given the crisis of trust that exists today between shareholders and management, investors are right to be increasingly wary of frequent acquirers like Symantec.

Massive stock option grants
Another black mark is the massive pile of employee stock options Symantec has issued in each of the past three years:

Fiscal   Options     Diluted        % of 
 Year    Granted      Shares    Diluted Shares
 2000    10.362M    124.428M        8.3%
 2001    18.334M    136.474M       13.4%
 2002     8.450M    143.604M        5.9%

For a relatively mature company like Symantec, I don't want to see options issuances above 3% of diluted shares. Seeing that number as high as 13.4% in 2001 strikes me as a reckless giveaway of shareholder equity, especially during a year when the stock price was depressed. As I quantified last week, stock options exact a huge price from shareholders through dilution. It's hard to create shareholder value at a market-beating pace when the sharebase is being diluted by more than 3% per year.

Miniscule inside ownership
The past year's corporate scandals have heightened the importance I place on inside ownership. In theory, management should act as an agent for the benefit of shareholders. But this agent form of management is proving unreliable. I'm now highly skeptical of agent management teams -- those paid by high cash salaries, cash bonuses, and stock options. No, I want to invest in shareholder management teams -- those who own a large stake in the company, paid for by their own capital and/or sweat equity. This is management by shareholders, for shareholders. That way, when they make money, I make money; and, just as importantly, when I lose money, they lose money.

As such, I like to see management and insiders own at least 10% of the company -- and the more, the better. That's why I'm uninspired by Symantec's inside ownership of a paltry 1.4%, according to last year's proxy. The lack of meaningful inside ownership doesn't mean Symantec has crooked management; but it does represent a risk that their incentives are far different from shareholders'.

Heavy insider selling
If the low inside ownership thing doesn't have you feeling a bit uneasy, consider the fact that Symantec's CEO, John Thompson, has been a huge stock seller over the past year. Since April 2001, Thompson has sold 590,000 shares, yielding proceeds of nearly $19 million. As of May, Thompson held only 241,896 Symantec shares, meaning he sold over two times the amount of shares he now holds. I'm sure there are all sorts of plausible reasons why Thompson sold his shares, but, regardless, this level of selling has to be interpreted as yet another yellow flag for existing or potential Symantec shareholders.

Conclusion
None of the risk signals I uncovered, on its own or even in sum, represents a damning case against Symantec. Perhaps through acquisitions, the company is rolling up an increasingly strong share of the computer security market. Perhaps future growth of free cash flow will more than pay for the options dilution. Perhaps low inside ownership and heavy insider selling are simply non-issues. But as an investor, I want to be on the right side of probabilities, and there are too many "maybes" for me to be comfortable owning Symantec.

[Want to do more of this kind of analysis? Enroll in our When to Sell online seminar with Matt Richey and Bill Mann as instructors.]

Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he had no position in any of the companies mentioned in this article. Matt's personal portfolio is available for view in his profile. The Motley Fool is investors writing for investors.