For Good Measure

Plus, a raft of proposals for audit reform; Providence takes aim at poison pills; where the bankruptcies are; all aboard the junk-bond bandwagon; and more.

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For Good Measure

CFOs are using what academics consider better measures in their capital-budgeting analysis. According to a recent survey, more than 85 percent say they use net present value (NPV) analysis in at least three out of four decisions.

“Finance textbooks have taught for years that NPV is superior, but this is the first known survey to show it’s the preferred tool,” says co-author Patricia A. Ryan, a professor of corporate finance at Colorado State University. NPV is favored because it allows reinvestment rates to better reflect external capital costs.

There’s still room for improvement. Only 21.9 percent of the respondents said they frequently use modified IRR (internal rate of return), a purer analysis than IRR because it can accommodate differing reinvestment and financing rates. And fewer than 12 percent said they regularly use real options.

Of course, many CFOs don’t limit themselves to a single measure. “It’s situational,” says Howard McLure, CFO of Caremark Rx Inc. While NPV alone is fine for in- vestments that don’t directly create revenue for the prescription benefits management company, he says, “in a revenue-producing situation, I prefer to see both NPV and IRR.” – Alix Nyberg

Accounting Legislation

Pondering Audit Reform

Most everyone agrees the audit process should be improved, but hardly anyone agrees on how it should be done. The Financial Accounting Standards Board, the American Institute of Certified Public Accountants, and both parties in Congress have their own agendas, so real reform seems to be a long way off.

The Corporate and Auditing Accountability, Responsibility, and Transparency Act of 2002, authored by Rep. Michael Oxley (R-Ohio), would create a five-member public regulatory board answering to the Securities and Exchange Commission, to review and discipline accountants. The bill would also limit auditors’ ability to provide certain additional services. It has already been passed by the House of Representatives, but it may have a harder time passing in the Senate, where the Democrats have a one-vote majority.

The Democrats are pushing for more-stringent reform. The Investor Confidence in Public Accounting Act of 2002, introduced by Sen. Christopher Dodd (D-Conn.) and Sen. Jon Corzine (D-N.J.), would also create an independent public accounting board, but would further limit auditors’ ability to provide consulting services. House Democrats are proposing legislation to require companies to rotate auditors every four years.

“If the Democrats pass their bill in the Senate, it could be a showdown,” says John Coffee Jr., a finance professor at Columbia University. Whether reform becomes law “will depend largely on if they can reach a compromise, and that can be tough in an election year,” he adds. Coffee says if it does pass, there will need to be lots of concessions on both sides.

Accounting bodies and finance executives have criticized reform proposals by both parties. FASB, which supports reform, worries that some changes could jeopardize its independence. The AICPA favors public regulation of public-company auditors with SEC oversight. “We think that would go a long way in helping to restore confidence in public-company audits,” says James Castellano, chairman of the AICPA. The institute also proposes a greater role for audit committees, more timely disclosure, and laws against misleading auditors.

Olivia Kirtley, chair of three audit committees and a former CFO, says the auditor-rotation requirement would be “the worst thing that could happen. The highest risk of failure is in the first or second year.” Companies, she argues, need auditors that know their businesses. –Joseph McCafferty

They’re Not Worthy
Moody’s Investors Service reports that it downgraded the ratings of 159 corporations in the first quarter of 2002. The downgrades affected $314 billion of corporate debt.

49% of derivatives-trading companies have now implemented accounting standards FAS 133 or IAS 39, up from 25% in 2000.

Shareholder Activism

Getting Out the Vote

Nine days before Aetna’s annual meeting in April, institutional shareholders of the troubled insurance company were invited to attend or call in to an unusual conference in New York, where Providence Capital president Bert Denton urged them to elect a maverick director–handpicked by Providence–to Aetna’s board.

At issue was Aetna’s poison pill. Providence, a self-professed shareholder advocate, has been waging war on issues it considers signs of poor corporate governance. Although Denton’s pick was defeated, he has successfully used the threat of a proxy battle to eliminate or modify poison pills at Footstar, Airborne, Alaska Air, Great Lakes Chemical, and Navistar.

“The issue isn’t poison pills, it’s corporate democracy,” says Denton. “Now, because the concentration of institutional investors is so high, it allows those like us to wield great influence and power.”

But Providence’s activism is highly unusual. In theory, institutional investors have a lot of weight to throw around, but they often act more like 900-pound weaklings. Although institutional investors hold an average of 61 percent of shares, 60 percent of the CFOs and managing directors polled say these institutions either have no impact on corporate direction or are neutral, according to a survey by PricewaterhouseCoopers of 120 companies with institutional investors.

Together, those numbers suggest that investors place their bets on management, trusting it to do a good job. Richard S. Pzena, president of New York-based Pzena Investment Management, which holds 3.3 million shares of Aetna, says he voted to keep the existing directors even though he’s no fan of poison pills. Still, he applauds Providence’s effort. “It keeps pressure on companies to make sure their governance practices are in line with shareholder interests,” he declares.

Pzena has a simpler approach. “I don’t see why it is such a big deal to pick up the phone and call an outside director,” he says. “We do it all the time.” –Tim Reason

Prep Work

More than 50% of finance executives say their companies are not well prepared for a business interruption.

Credit Review

The Bankruptcy Belt

Amid signs the economy is coming out of the doldrums, there are still rough seas in some sectors. About 200 public companies are likely to file for bankruptcy by the end of 2002, according to “The Phoenix Forecast,” a recent report by PricewaterhouseCoopers. Although that’s fewer than the 257 public companies that filed for bankruptcy in 2001, it’s still historically high.

Most of the bankruptcies are concentrated in a few industries: telecommunications, automotive, computer hardware, metals (steel), chemicals, and retail. “It’s not time to get aggressive and extend new credit in these industries,” says Carter Pate, author of the report. “This year will continue to be tough for them.”

One of the biggest surprises, according to Pate, is that telecom is still one of the weakest industries. Many had expected the sector to recover by now, but Pate doesn’t see that happening until late this year or early next year. “The 2002 telecom bankruptcies will include some surprises,” he says. In April, Williams Communications Group Inc., a Tulsa-based network services provider, unexpectedly filed for bankruptcy. The company was considered more solid than its telecom peers.

Some industries on the list are already showing signs of life. Steel, for example, is beginning to rebound, helped by tariffs enacted earlier this year. “The industry dynamics have changed significantly since the start of the year,” says Mark Parr, an analyst at Cleveland-based McDonald Investments Inc. “A supply shortage, especially in flat-rolled steel, has hastened a recovery,” although additional bankruptcies are still possible at small suppliers of bar steel.

“What we are saying is that you need to keep a close, watchful eye on trade credit in these industries,” says Pate. “When the salespeople are pounding the table and saying that it’s time to pick up market share, you might want to be cautious.” – J.McC.

Tight Times

Public bankruptcies in 2001

Sector

Bankruptcies

Mining and construction 5
Manufacturing 66
Transportation, communications, electric, gas 29
Wholesale and retail trade 37
Financial, insurance, real estate 6
Services 53

 Sources: New Generation Research Inc., Compustat, PWC LLP

Workplace injuries produced $40.1 billion in direct costs in 1999, according to the 2002 Liberty Mutual Workplace Safety Index.

Capital Markets

The Junk-bond Bandwagon
Companies with low credit ratings can expect a warmer reception in the capital markets these days. That’s because high-yield investors are more receptive to smaller, lower-rated companies than they have been in some time. Many companies with a high leverage ratio, a small revenue base, or a recent bankruptcy are getting a second chance.

The high-yield market is set to offer up approximately $100 billion this year, says Tim Conway, managing director for Fleet Capital Markets, largely to companies with some significant risk characteristics. By contrast, the $90 billion junk-bond market last year was “heavily weighted toward larger, more-frequent issuers,” he says.

Indeed, single-B rated companies–small, highly leveraged, or first-time issuers–floated nearly $22 billion in high-yield bonds in the first quarter of 2002. That’s up 28 percent from the fourth quarter of 2001, according to data gathered by Loan Pricing Corp. The trend was also evident in the leveraged-loan market, which ponied up $11 billion to single-B rated companies in the first quarter, up nearly 140 percent from the fourth quarter, even as investment-grade lending slowed.

Television broadcaster Sinclair Broadcast Group Inc., for example, issued $300 million in single-B rated 10-year senior subordinated notes at 8 percent in mid-March to repay a portion of its bank loans, even as Standard & Poor’s maintained its negative outlook on the Hunt Valley, Md.-based company. And Joy Global Inc., a mining equipment and service provider based in Milwaukee, floated $200 million in B+ rated 10-year notes at 8.75 percent in March, only 10 months after emerging from bankruptcy.

The trend portends brighter skies for all issuers. Why? Junk-bond investors tend to “look forward instead of in the rearview mirror,” says Conway. Increased liquidity in the market reflects an expectation of lower future default rates and a healthier economy in general.

Investors do have their limits, though. Several triple-C rated companies have recently pulled plans to raise capital. Nashville-based televised home shopping service Shop At Home Inc., for instance, dropped a planned $135 million senior secured notes offering shortly after S&P affirmed its CCC+ rating on the company in March. Investors are ready to take more risks, but it will be a long time before they are giddy again. –A.N.

ROI of Outsourcing
CFOs who have measured the ROI of outsourcing say that in the past year they reduced pre-outsourcing expenses by an average 17%, reports Hewitt.

Benefits

Nap Time at the Office
As companies look to trim costs, one particularly pricey benefit–work-site day care–appears to be weathering the storm. Although some companies closed on-site day-care centers this year (Honeywell International, for example, closed one), these are isolated instances. A survey by human-resources consultancy Hewitt Associates reveals that 12 percent of large employers currently provide on-site day care. That’s up a notch from 11 percent in 1998.

One reason: according to the U.S. Census, women with children under the age of six are one of the fastest-growing segments of the workforce, and companies are trying to find ways to court them. “Infant and toddler care is at a premium–there is a lack of supply,” notes David Lissy, CEO of Bright Horizons Family Solutions, which provides work-site day care for corporations. The company opened 10 new centers and closed 2 in the first quarter of 2002.

Hewitt consultant Jon Van Cleve says that although few existing work-site child-care centers are closing, companies are being cautious about opening new ones. “On-site centers are certainly the most costly option,” he says. “That can be a multi-million-dollar investment the first year, and some employers are shying away from that right now.”

Other, less-costly alternatives are still popular, however. J.P. Morgan Chase offers flexible-spending accounts where employees can sock away pretax money for child care. The company also has 15 backup child-care centers–which provide parents with emergency child care free of charge when their usual arrangements fail–and plans to open 2 more this year. “Based on the cost of absenteeism alone, the centers pay for their operations in the first year,” says Joy Bunson, senior vice president of human resources.

Better yet, backup centers can provide more bang for the buck than a full-time center. “With a backup center for 50 kids, we can serve 1,800 to 2,000 families a year,” says Bunson. – T.R.

Just-in-time purchasing is expected to increase at more than half (57%) of the companies surveyed by Thomas Register.

401(k) Administration

Handling Small Balances
This fall, the Department of Labor is likely to finalize regulations that will make it more expensive to dispose of small-balance ($1,000 to $5,000) 401(k) plans of ex-employees. But before the rules go into effect, many employers are busy cleaning out the small accounts while they still can do so on the cheap.

The new regulations will require companies to set up individual retirement accounts (IRAs) for 401(k) accounts they want to remove. According to Matt Hutcheson, a Portland, Oreg., pension consultant, that could be expensive. “It’s nearly impossible to find an institution that is excited about receiving these small accounts,” he says. Until the rules are passed, however, employers can jettison plans under $5,000 and avoid having to set up the IRAs. With the market decline, this category is growing. (Accounts with larger balances are required to stay in the plan if the employee chooses.)

The way some companies are cleaning out low-balance plans, though, has angered ex-employees and employee-benefit advocates. Some employers are simply mailing a check for the balance–minus a 20 percent withholding tax–to employees with little explanation. “Most of the participants who get a check spend it and pay a tax penalty,” says Rick Meigs, president of 401khelpcenter.com. “They don’t think it’s enough to affect their retirement, but often it is.”

Meigs advises companies to let ex-employees know about their options in writing. “Giving former employees one last shot at rolling the money into an IRA or new-employer plan is the best thing to do,” he says. Better communication will also save employers the headache of receiving calls from former employees who don’t know what to do with the check. “These small accounts can be an administrative nightmare,” says Hutcheson.

Pay Plus Benefits Inc., a Kennewick, Wash.-based employee leasing company, has a process in place to deal with small-balance accounts. The company runs a monthly list of terminated employees, sends out a notice advising them of their options, and gives them 60 days to take action. “It’s very easy for them to forget about the account,” says controller Diana Minard. She adds that companies that let these accounts build up over time will have a hard time tracking down the former employees later. –J.McC.

Fewer Options
A Hewitt survey found that 34% of respondents plan to decrease the proportion of employee compensation delivered by stock options or other forms of stock.

Pension Law

The Overfunded Defense
In a landmark decision, the U.S. Court of Appeals ruled that participants and beneficiaries can’t sue the sponsor of an overfunded defined benefit plan, even if the plan’s trustees breached their fiduciary duties by making bad investments.

The decision could be far-reaching. Forty-eight percent of corporate pension plans are overfunded, according to a 2002 survey by Plan Sponsor.

Plan participants filed the case against 3M Co. over losses the conglomerate’s defined benefit plan suffered as a result of a $20 million investment in the hedge fund Granite Corp., which filed for bankruptcy in 1994. The plaintiffs contend that 3M did not properly investigate or monitor the fund, thereby breaching its fiduciary responsibilities under the Employee Retirement Income Security Act of 1974. The court ruled that because the plan was overfunded, the losses did not jeopardize its ability to provide retiree benefits to employees.

Critics of the ruling suggest the matter isn’t settled. “It’s hard to imagine that the decision will stand,” says Sherwin Kaplan, counsel in the Washington, D.C., office of law firm Phelan Reid & Priest LLP. “The only technical issue decided in this case is who has standing to sue.” He says the decision doesn’t mean that sponsors of overfunded plans are off the hook: the Secretary of Labor and fiduciaries can still sue them. Kaplan argues that removing participants from the equation will only put more strain on the Department of Labor, which, due to budgetary and time constraints, relies on beneficiaries to bring suits in some cases.

For his part, plaintiffs’ attorney Alan Sandals, of Philadelphia-based Sandals & Langer LLP, filed a petition for a rehearing. If that fails, he says, the case could go all the way to the Supreme Court.

Lynn Dudley, vice president and senior counsel of the American Benefits Council, hailed the ruling, however. “The company did everything within the law it was allowed to do to protect the participants,” she says. “Offering defined benefit plans is voluntary, and we should protect the fiduciary’s right to select investments. Without that flexibility, employers won’t offer the plans anymore.” – Joan Urdang

Hybrid pension plans are currently offered by 33% of the Fortune 100, up from 32% in 2000, according to Watson Wyatt.

Global Confidence Survey

Forecast: Breaking Clouds, Some Sun
CFOs are expecting brighter skies in the near future. With the fallout from Enron finally starting to diminish, first-quarter growth coming in at a robust 5.8 percent annual rate, and with productivity climbing, finance chiefs find reason to believe that the economy is poised for a sustained recovery. Indeed, CFOs are more confident in the short-term prospects of the U.S. economy than they have been in more than a year, according to our quarterly Global Confidence Survey of U.S. CFOs.

A full 46 percent of finance executives polled say their attitude toward the domestic economy is either confident or very optimistic, up from 33 percent in the last quarter. Respondents are basing the rosy outlook on expectations of healthy gains in profits and revenues at their own companies. Nearly 43 percent say they expect next quarter’s profits to beat those of the same period last year by more than 10 percent, and the same number predict revenues will jump by more than 10 percent. Another 26 percent expect profits to grow, but at less than 10 percent.

If CFOs are hopeful for a rebound in the U.S. economy during the next year, they are even more sanguine about a resurgence in the next five years. In fact, 33 percent say they are very optimistic about the economy in the long term, compared with only 20 percent last quarter. Another 57 percent are confident, and only 9 percent say they have a neutral attitude about the long-term economy.

The economic recovery still has its naysayers, however. A modest 19 percent of respondents say they are concerned about the U.S. economy–an increase from 16 percent last quarter. To be sure, concerns about unemployment, tech spending, and fuel costs linger. And economists were quick to point out that more than half of the first-quarter growth came from businesses replenishing their inventories. Even more cautionary is the survey’s finding that more CFOs plan to reduce capital spending next quarter–33 percent said they would make cuts, compared with 20 percent the last time the poll was taken. Capital spending plans for the fiscal year are much brighter; 63 percent plan to increase spending, compared with 40 percent in the last survey.

While survey respondents were encouraged by the economy in general, they still listed the economic downturn as one of their top three business concerns. Apparently, they’re thinking, “It ain’t over till it’s over.” Other high-ranking concerns include access to capital and increased competition. Despite relatively high unemployment, one in three surveyed cited attracting and retaining employees as a chief concern.

CFOs are also less optimistic when it comes to the global economy. Indeed, 26 percent say they are concerned about the global economy during the next year, and 48 percent say they are neutral. Again, they feel better about the long term, with 67 percent indicating that they are confident or very optimistic. – J.McC.

A full 46 percent of finance executives polled say their attitude toward the domestic economy is either confident or very optimistic.

CFOGlobal Confidence Survey Results

Attitudes of U.S. CFOs in the next year:
  Domestic economy Global economy
Very optimistic 7% n/a
Confident 39% 33%
Neutral 35% 41%
Concerned 19% 26%
Very pessimistic n/a n/a
Attitudes of U.S. CFOs in the next five years:
  Domestic economy Global economy
Very optimistic 33% 19%
Confident 57% 48%
Neutral 9% 26%
Concerned n/a 7%
Very pessimistic n/a n/a
Next quarter’s performance predictions:
  Profit Revenue
Increase 69% 67%
Decrease 20% 20%
No change 11% 13%
Capital Spending projections for next:
  Quarter Fiscal year
Increase 35% 63%
Decrease 33% 26%
No change 32% 11%

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