Rule Breaker Portfolio

Learning From Lernout & Hauspie

The Nasdaq halted trading last week on Faker Breaker Lernout & Hauspie after the company said it would restate earnings for the last three years. There are a number of lessons to take away from this one, especially "It's all about management."

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By Brian Lund (TMF Tardior)
November 13, 2000

Rule Breaker investing is often a roller coaster. It provides meteoric rises and spectacular falls. We all like to be on the receiving end of the former rather than the latter, but it's often the latter that proves more informative, as long as one can reflect objectively on the experience.

Lernout & Hauspie Speech Products (Nasdaq: LHSP) appears to have endured its final death throes last week. The Belgian company, which ranked second in the voting during last spring's Rule Breaker Seminar, announced that its third-quarter revenue would be lower than expected. Now it's looking at $125 million to $145 million, as opposed to the $220 million it had forecast before September.

Oh, and L&H will also restate its 1998, 1999, and first-half 2000 financials "as a result of certain errors and irregularities." As The Wall Street Journal pointed out, the American Institute of Certified Public Accountants defines "irregularities" as "intentional misstatements or omissions" in financial statements. The term's meaning includes "fraudulent financial reporting undertaken to render financial statements misleading, sometimes called management fraud."

Whether that's what the term means to Belgians is another question, but that's part of the point. As a result of the announcement, the Nasdaq suspended trading on the stock until L&H has satisfied its request for information.

The future for shareholders is pretty bleak. Even if trading does resume, L&H has lost all credibility on the Street. It's true that most of the parties responsible for the fiasco -- including, but not limited to, Chief Financial Officer Carl Dammekens, Chief Executive Officer Gaston Bastiaens, and Co-chairmen and founders Jo Lernout and Pol Hauspie -- have left their posts. L&H also has some very reputable businesses, including venerable recording and transcription company Dictaphone.

Trouble is, L&H also has some big bills to pay from its acquisition spree during Bastiaens' tenure. With revenues dropping and no access to the equity or bond markets, L&H might not have the cash to pay its short-term debt. Its working capital is dominated by an enormous accounts receivable balance, the collection of which seems more of a pipe dream than ever.

I don't come to bury L&H. I'm not offering recriminations to those who believed in the company and bought the stock. After all, its story was compelling. I only want to use it as a case study, to see if we can glean any valuable investment lessons from its implosion. Here are some things that have occurred to me:

• Foreign companies hold greater uncertainty. American companies implode too (what's MicroStrategy (Nasdaq: MSTR) at these days?), but foreign companies in general present more risk because they are frequently subject to more lax supervision and reporting requirements. That's not to say that we should avoid foreign companies completely, but that we need to understand each country's requirements before investing.
  
  
• Acknowledge critics. Herb Greenberg at TheStreet.com has been on this company like a cat on a wounded rat for two years. Eventually The Wall Street Journal joined in. It turns out they were right to question L&H's accounting. Critics won't always have the right take, but we shouldn't automatically dismiss them.
  
  
• Avoid choppy waters. When there is amassing evidence or even suspicion of "irregularities," consider looking elsewhere. There's no need to take unnecessary extra risks.
  
  
• Sudden changes in revenue sources should raise red flags. L&H saw huge revenue growth in Singapore in 1998. In 1999, Singapore dried up and Korea boomed. That rightfully prompted suspicion of L&H's accounting. Whether those are the sources of the restatement has yet to be seen, but they deserved a very close look.
  
  
• "We use the most conservative accounting practices" doesn't always mean that. L&H frequently claimed that it was extremely conservative in its accounting. (Here's just one example.) It's one thing to say it; it's another to do it.

Finally, and most importantly in my opinion:

• It's all about management. The whole story comes down to management. Great products and wonderful business models don't mean anything if management can't execute or won't play straight. The trouble is that it's difficult to spot bad management before it bites you. Here's one giveaway: When the chairman of the company says, "We're not going to give out their [our clients'] names, even if the SEC asks us for them," it's a bad sign.

Another warning sign of bad management at L&H was the presence of Bastiaens. He had previously orchestrated the running into the ground of Quarterdeck, one of the Fool Portfolio's old shorts. Rest assured that we'll be watching carefully to see where Bastiaens reappears. We'll wait while he runs up the stock price through acquisitions, and then we'll short that company -- hard.

Investing offers some expensive lessons sometimes. Get your money's worth out of them. If you were an L&H shareholder, why not get an L&H certificate from your broker, frame it, and hang it above your computer? It will serve to remind you of what you learned.

Sharing your experience with your fellow investors is another productive outlet. Let us know what lessons you took away from L&H on the Rule Breaker Companies discussion board. If you've got other stories to share, let's hear them on our My Dumbest Investment discussion board.

--Brian Lund, TMF Tardior as long as he can fend off an IRS audit.