FOOL ON THE HILL
Two keys of good public company corporate governance are separation of function and independent directors. When managers own and run the company, minority shareholders can get left behind.
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Three years of a bear market increasingly mean bargains bring buyouts, but a Motley Fool Community member sent me some hair-raising news about the flip side -- stock prices decline; management engages in questionable self-dealing; and shareholders be darned. On one hand, when a company's stock price nears or breaks through cash per share with little or no cash burn, and the business is at least breathing, the downside may be limited. Time to check under the hood -- read the last two years of quarterly and annual reports, shareholder letters, proxy statements, and the like. But there's no guarantee that management will act in the interests of shareholders. Hold onto your seats, but I hope you kept your brokerage account away from New York-based electrical and telecom contractor Lexent (Nasdaq: LXNT). Familiarity breeds... I also briefly mentioned another yellow flag -- managers from the same family. It's not unusual in smaller, newer companies (I've heard of a company started by two brothers, even!), but it should be jettisoned as they become larger, publicly traded entities. Yet biotech drug maker Vertex Pharmaceuticals' (Nasdaq: VRTX) CEO and general counsel are brothers, bringing to mind President Kennedy's controversial appointment of Robert Kennedy as attorney general. I have no doubt that everyone involved was or is brilliant and topnotch, without the slightest hint of anything other than devoted service -- and I say that with no sarcasm (for a change). But every one of these business people knew or knows two key principals of good corporate governance: separation of management functions and independent directors. They and their boards made the best decisions they could, and chances are, everything will be fine. Yet there are risks -- and really bad things can happen to shareholders -- when neither principle is honored, when there is no separation of function (family members with large ownership running both the company and the board). That's what's happening at Lexent. Fiber through the nose After lifting into the mid-thirties that September 2000, the stock hit the telecom downdraft, and over the next two years, declined to below a dollar in December 2002. On Jan. 27, 2003, a company 8-K revealed that director L. White Mathews resigned. On Feb. 13, SEC filings revealed that director Richard Schwab resigned on Feb. 7, followed by director Kathleen Pernoe on Feb. 10. On Feb. 18, the company announced that director Richard Smith -- who had been a 9% owner at one point, according to filings -- resigned the day before. That left the two O'Kanes, who (the company also announced on Feb. 18) were part of a group that offered to buy the company for $1.25 a share. And by the way, the company's earnings announcement the next day would not include a conference call. Would you take questions if your four independent directors left, leaving two owners, managers, and remaining board members voting on their proposed buyout? Does anyone doubt that the directors left to squelch dissent? Minority shareholders are up a creek. Rock bottom The press release stated: "Lexent is evaluating an offer from a management group to purchase all outstanding shares of common stock of the Company, other than those owned by the buying group, at $1.25 per share. Lexent expects to develop procedures and to retain independent advisors to assist in evaluating and responding to the offer." We're supposed to believe that the two remaining directors, who are also the top officers with the company, will direct an independent evaluation of their own offer? I don't think so. It's pretty easy to see that the O'Kane family cashed in with the public offering, and now wants its company back -- at a discount to intrinsic value. Foolish investors likely eschewed this company over the last few years, as it became both a penny stock (under $5.00 a share) and a penny company (below $5.00 a share and under $250 million in market cap) in a distressed industry. The family management and ownership should have served as an additional warning. On the contrary It's happening more and more -- bioinformatics companies and biotech drug makers selling for cash or less. Many went public in the 1999-2000 genomics boom, but Pharmacopeia has a longer history, debuting in December 1995 at $16.00, netting $38 million. At its IPO, the company sold combinatorial chemistry capabilities in drug discovery to drug makers. In 1998, 2000, and 2001, Pharmacopeia acquired software companies and combined them into its Accelrys software business. Accelrys sells molecular modeling and simulation, bioinformatics, and cheminformatics software to the pharma, biotech, chemical, petrochemical, and materials industries. The software business grew, while the drug discovery business stagnated and declined... until last year, when both were flat and overall revenues increased 1.8%. At yesterday's $6.59 close, the company is selling at a 10.5% premium to cash, with margins steady and no debt. Management expects low single growth. Yes, there are fewer and more careful buyers of drug discovery tools -- whether combinatorial chemistry libraries or software -- but as long as this company keeps the burn to almost nothing, somebody ought to sniff around very carefully. Pharmacopeia is no Lexent, that's for sure. I can find no relationship among execs, directors, extended family, or other related ownership share. If I were a shareholder, I would want its CEO, president, and chairman of the board -- all one person -- to give up at least one of those roles as soon as possible (as I want with several companies I own that vest too many roles in one person). Odds are better that if an offer comes, Pharmacopeia shareholders will get a better deal than those at Lexent. Words to the Foolish Never forget that familiarity may breed contempt -- for shareholders. If you find warning signs, ask the company how it plans to address potential conflicts. And please share any experiences on our Fool on the Hill discussion board. Bay Area Fools: Interested in nanobiotechnology? I'll be traveling west, hoping to make a Fool of myself Tuesday night, Mar. 4 at The Analyst Showdown: News and View on Nanobiotechnology panel at Stanford Business School (open to the public; admission charged). Come by, and please introduce yourselves! [This week is your last chance to get both Stocks 2003 and The Motley Fool Select in a bargain bundle. Don't miss our picks for 2003 and monthly analysis of undiscovered gems -- and the occasional contrary view of well-known companies, too!] Tom Jacobs (TMF Tom9) will be watching Survivor tonight, so don't call, but you can post on our Survivor discussion board. Tom owns no shares of companies mentioned in this column, but he does own others. The Motley Fool has a disclosure policy.
I recently wrote about the dangers to investors when an officer occupies too many top corporate management positions, noting the extreme case of the Techne (Nasdaq: TECH) polymath who's chairman of the board, CEO, president, CFO, and chief accounting officer. Quite a salary savings.
Lexent, a public company, is majority-owned by Hugh O'Kane, chairman of the six-member board, and brother Kevin O'Kane, vice chairman, president, and CEO. After almost two decades as a private, family-owned company, Lexent went public on July 28, 2000, closing that day at $25.56. It touted its expertise in setting up metro networks, useful for companies deploying broadband. Customers include AT&T (NYSE: T) and Level 3 Communications (Nasdaq: LVLT).
Management's Feb. 18 offer of $1.25 a share for a company was 37% more than the prior close of $0.91. Sound good? It might be, if the company didn't sport $1.76 a share in cash and equivalents. This isn't cash the business is burning, either, according to the latest balance sheet. Therefore, management has offered to buy the minority shareholders' dollars for $0.71 each. Oh boy.
Consider another company made a target by the bear market. In November 2001, I looked at possible bioinformatics takeover candidates, singling out Pharmacopeia (Nasdaq: PCOP) as a business growing slowly with little or no cash burn, selling for $14.21 a share with an enterprise value (market cap plus debt minus cash) of $181 million. Today, the company's stock is at $6.56; it has had minuscule cash burn for two quarters; and its enterprise value is -- get ready -- $14 million dollars. The market is valuing this business, with $124 million in trailing 12-month revenues, at $14 million dollars.
If a cash-rich company without cash burn has a low valuation, it may become a takeover target. But there's no guarantee management will entertain any offer with shareholders' best interests in mind. Read annual reports and proxy statements and consult online sources to find large ownership shares, and check into relationships among managers and board members.
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