The past few weeks has witnessed the resurfacing of the 3 most dreaded words in the stock market: Audit Committee Investigation.
In plain English, this translates to : Accounting Irregularities and was last seen on a regular basis during the dot com bust of the early 2000’s and the crisis era of 2008-2011 as companies scrambled to protect their business models from a near economic collapse.
Perhaps a “canary in the coal mine” warning about current stock market valuation, 3 large and well known companies have all announced whistle blower allegations of alleged accounting improprieties: Flextronics Ltd. (FLEX, a contract manufacturer for tech companies), Symantec Corp (SYMC, a computer security software vendor) and PPG Industries (PPG, a venerable, old line paint and chemical company).
Naturally, the markets first reaction (and probably rightfully so) is to run first, ask questions later, as FLEX got clobbered by over 20%, SYMC cratered 30%, and PPG lost a more modest 6%. But my experience in such matters gleaned from over 30 years of financial market observation leads me to the likely causes of these (and potentially other) occurrences:
1)The huge (and growing) disparity between GAAP accounting numbers (a.k.a. the true numbers) and Non-GAAP accounting numbers (the make believe, get rid of the bad stuff numbers…often referred to as “Adjusted”). The difference between these two sets of figures is at a historical wide of over 20+%, and in many cases is far greater, as it allows companies to report “earnings” rather than losses. As the pressure builds for companies to “beat” earnings estimates on a quarterly basis, the pressure to cut accounting corners becomes ever so greater. In today’s bull market environment, investors seem to be lulling themselves to sleep accepting Non GAAP accounting as the real thing. It is only when shaken awake by tape bombs mentioned above that perhaps investors might start paying attention to this issue.
2)The merger frenzy (both past and on-going) leads to extensive periods of restructurings, consolidations, write-offs and multiple financial reporting metrics by the newly merged parent company. Again, given the pre-merger talk of “synergies, cost reductions, efficiencies, earnings accretion” etc by company management extolling the virtues of the merger, the pressure to produce those figures must be extraordinary on the CFO’s office. Does that lead to creativity being the order of the day to reach those targets?
Lastly that brings us to the often asked question…are the companies infected by the accounting virus all of a sudden “cheap”? Perhaps, and in today’s world of no news is good news, bad news is good news, and good news is good news, a rebound is theoretically possible in these stocks.
But let me leave you with one sobering reminder: There is no such thing as only one cockroach.
With little information forthcoming from management, it is likely that more bad news is to follow. Remember Equifax (EFX) where the massive data breach is still being unraveled and the company continues to add to the list of compromised information months later as their investigation evolves (meaning lets dribble out the bad news as slowly as possible).
It will be interesting to see if more incidents such as the 3 noted above surface in coming weeks, and the effect (if any) on the overall stock market.