Are They Stupid or Crooked?

How can management project good results for the second half, then 10 weeks later warn of a 50% profit plunge and 25% drop in quarterly revenues? They're either incompetent or mendacious.

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By Tom Jacobs (TMF Tom9)
October 3, 2002

[This column was updated at 1:45 pm on 10/3/02 to add ARM's response to our inquiry, and on 10/7/02 to reflect debate over the percentage of insider holdings.]

I hate days like this. You get up in the morning, click on your portfolio, and one of your stocks has blown up. Just like that. You understood the business, execution has been great, and even in an industry downturn the company lined up quarter after quarter of respectable results. Absolutely no warning.

This is what happened yesterday to semiconductor intellectual property company ARM Holdings (Nasdaq: ARMHY), a significant (but now smaller) part of my own portfolio. (P.S. I haven't sold. Not that I would anyway, but Motley Fool employees cannot trade a stock within five days of writing about it.) ARM shares opened for trading down over 65% from yesterday's close. Why? Oh, just a little bad news from the company in the form of a warning. Profits for the quarter just ending will be 50% lower than projected, with revenues down about 25%.

Clear skies ahead
I really mean that there was "no warning." Here is what management said a mere 10 weeks ago, in its  July 23 press release for Q2:  "In the shorter term, although our reported results are impacted by a weakening dollar, the visibility provided by our sales pipeline and backlog of contracted business gives us confidence that growth in the remainder of the year will be consistent with that achieved in the first half."

Hello? What about that "visibility" is now off course by, oh, only 25% of revenues and 50% of profits? We're not talking about a contract here or there or royalties delayed a few weeks, but obvious change.

ARM licenses its semiconductor intellectual property (IP) to licensees in exchange for upfront fees and royalties on products including the IP. During what we hope is the semiconductor market's cyclical downturn, ARM has continued to sign up new licensees at a fast clip, existing licensees are upgrading to new versions of ARM's IP, and the company maintains it can estimate times from license to product more and more predictably.

ARM has told investors quarter after quarter that the semiconductor market stinks, yet repeatedly and most recently in last quarter's press release touted its own resilience in the face of the heavens fulminating on all below.

Not fooled
So pardon me for saying that the company's official explanation is ludicrous, fooling no one beyond ninth grade:

"In our Quarter-4 2001 earnings announcement in January 2002, we indicated that if the downturn in the semiconductor industry persisted, our visibility could be affected. In our second-quarter earnings announcement in July, we referred to continued challenging market conditions in the industry. These conditions have deteriorated further in the third quarter...."

I used to practice law (I quit because that practice never made perfect, but I digress) and know this one well from writing briefs for the tougher side of many cases. You find whatever hope you can in prior decisions and, while you don't misrepresent or quote out of context, you certainly shade things your way. It's your ethical responsibility. But ARM had no such compunctions or skill, choosing comments out of context that were superseded by contrary ones made later. In January, a persistent downturn could affect visibility, but in July -- which last time I checked a calendar was seven months later -- and with the same downturn "persisting" over a half year longer, "visibility" gave management confidence.

I'm most sorry for the public relations department that has to write this stuff at management's direction, because neither lipstick nor a dress nor subpar lawyering can dress up this pig.

Nope, executives either missed it and are incompetent, or they knew darn well and are, well, pretty close to the crooked side of things (our lawyers won't let me say "crooks"). I contacted the company to ask them which they were. This is their response:

"The entire industry had been anticipating an economic recovery in the second half of 2002 and unfortunately, this hasn't materialised. As this recovery has evaporated, we have experienced an increase in the back-end loading of our quarters. Furthermore, Q3 is a quarter that includes two 'holiday' months, making it effectively a one-month quarter -- this means we didn't expect to see significant bookings until September.

While our sales pipeline and backlog of signed contracts give us reasonable visibility in our business, the persistent difficult market conditions mean that the timing of the close of licensing deals is unpredictable. We were still working up to Monday to close deals, some of which have slipped into Q4. We do fully expect to close these deals, although there is still a possibility that other Q4 deals may slip to Q1 2003."

Subpar lawyering again. Deal timing is an issue every quarter, and Q3 is vacation time every year. How gullible do they think we are? 

D�j� vu all over again
Every bear market unmasks the prior bull's abuse of the U.S. social contract where shareholders hand off management of the business to a professional manager class. We trust them not to fritter away our ownership shares through consuming perquisites, such as former Lucent (NYSE: LU) execs' squandering of company assets on a management country club/playground or former Tyco (NYSE: TYC) CEO Dennis Kozlowski's deploying of shareholder assets in part for his wife's birthday party -- replete with Stoli flowing through an ice-sculpted David's member -- or by outright fraud. Occasionally we are blessed by a Warren Buffett or Charlie Munger of Berkshire Hathaway (NYSE: BRK.A).

But fear is tougher to detect. Business books and B-school fashions aside, climbing the corporate ladder teaches fear of failure. My guess is that ARM's top cheerleaders were paralyzed when confronted with the prospect of bad news. Like anyone else, they put off dealing with it until they could no longer do so. They were afraid of looking bad -- and of what would happen to their 62% insider ownership. [U.S. online sources provide this figure for insider holdings and 12% for institutional investors, but others differ, and ARM as a foreign corporation does not file SEC disclosures required of U.S.-based companies, though of course the U.K. makes other requirements. But the point about appearance of impropriety is the same whether insider ownership is 1% or 100%, or more or less than the percentage of institutional investors. The following has been edited 10/07/02 to make this clear.]  

I am not accusing management of delaying the news so insiders could sell shares. But it's unfortunate that, because foreign companies don't file SEC reports on insider trades, U.S. investors may never know whether management feels our pain or engineered its own analgesic. And if you are not yet convinced that management's stonewalling in the face of the obvious contradiction in its public statements raises integrity issues, listen to Sir Robin Saxbe's failure to address this inconsistency head-on in response to aggressive questioning in a Bloomberg interview and form your own opinion.      

I accept that investing in individual stocks means days like yesterday. And the funny thing is that even a moderate recovery of the semiconductor market and ARM's important wireless component market makes ARM shares more of a bargain today than two days ago -- except for the pesky issue of management's quality and credibility in handling this news.

So I ask again: Are they stupid, or are they crooked? Share your thoughts on our Fool on the Hill or ARM Holdings discussion boards!

Tom Jacobs (TMF Tom9) is a senior analyst at The Motley Fool. At press time, he owned shares of ARM Holdings.  To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.