NetSlaves: Exploring Public Documents (A Forensic Analysis of Failed Internet Companies)

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Exploring Public Documents (A Forensic Analysis of Failed Internet Companies)
Posted Sun Apr 22 15:15:56 2001 by sbaldwin

By Steve Gilliard

OK, we're in the middle of a mammoth project that uses public documents to explore the hidden side of IT companies. We have a few suspects which haven't been covered so far but we, well, I want to explain what the CIA calls "methods and sources".

All public companies have to file two documents, one is the 10-K which is an annual report. Basically, it's the same as the company's Annual Report without the pictures and nice print. With one powerful distinction: an Annual Report is a courtesy; a 10-K is a legal requirement. Then there is the 10-Q - the quarterly report. This is filed every three months with the SEC by all public companies with stock on the market and a set number of employees. If you need to know the details of what each form is for, you can check for yourself at http://www.sec.gov.

Basically, these two documents are the official, legal statements on a company's financial health. The law requires them to be accurate. The company can spin, but they have to explain what their financing and overall financial health is. So these documents can be a goldmine, because they must explain how the company's future plans will play out in their thinking.

When reading them, you have to look at the company to determine how much their cautionary statements matter. If IBM cites competition, you can probably believe there's substance behind the statement. When iVillage cites profitability problems with a deficit of $384 m over the company's life, that statement has weight. Companies stick outrageous statements in their 10K/Q's and hide them from the press (which almost never reads them), even though it takes a journalist 10 minutes to do so.

Together, a 10K/Q constitute a check up, and the information within them reveals how a company is doing and where it has issues.

The key bits of info in a 10K/Q are: profit and loss, how a company spends money, and who the officers are. If there are issues, these sections are where they usually pop up. Of the 100 or so stories on Salon, I would bet not one mentioned that the company spent more on content alone than it took in across the entire company. That is far more relevant than the issue of subscriptions, because the figure indicates that the company is running way out of wack. A subscription plan is unlikely to fix such a serious financial issue.

What companies like to do is hide compensation. It's in the filings and the annual reports, but in most cases, it takes effort to find this out.

These reports are useful, but they do not explain the entire ball 'o wax. Because some data is hidden and you may need more expertise than these reports provide. The next stop is Yahoo and there are two useful bits of information there: insider trades and research reports from Multex
Investor.

Insider trades show when a company is in trouble and who is an investor. Those two tidbits can reveal a lot. They also speak to the level of the loss. You see pension funds involved, then you have real problems. Research reports explain where a company's issues are in English.

The last stop is bankruptcy filings. Here is an excellent example of how a story on bankruptcy filings should be done: http://www.canoe.ca/SlamWrestlingECW/apr11_ecwwoes-can.html

ECW was the third wrestling circuit in the US, after the WWF and WCW, now owned by the WWF. The consolidation of wrestling has been brutal and swift. Three months ago there were three different companies doing wrestling, now, there is one with two promotions and ECW is broke. If you saw stories like this on MarchFIRST, you'd understand a lot more about the circumstances that caused people to get screwed.

All these documents lead people to understand that there are ways to chart a company's failure before the Chapter 11.

The things we look for include executive compensation, which can include sweetheart deals, bonuses based on no externally logical pattern and high payments for key positions. Ancillary information includes Expenditures
(where is that money going and to whom?), Leases and other fixed costs, and Investors.

Why don't more journalists do this? Because they are more interested in getting a story than getting the story. The real story is not in the PR-trained utterances from CEO's, but by looking at the books. The crap in stories is amazing, and it only exists because the people doing the writing are either untrained or uninterested in the truth. Success is a better story than failure and contempt for readers is common in magazines. Writers tend to hate numbers and would rather talk about deals between celebrities. Deals are the phantom lure here. They usually mean less than you'd think because until you check the numbers, they don't mean anything. Editors want stories on deadline, not complex explanations of why their golden boy company is going to fail.

Deals sound great in the press, but when you check the numbers, they can be amazingly bad.

It is MUCH harder to get information on private companies, and one day we'll explain methods you can use to do so. It is much harder and can be expensive. Anyone who says you should know this is a liar or inexperienced.

I only learned how to do this over years of training and research. It was not easy to learn, so there is no reason to feel bad about not knowing it. Examining the earnings of small, public companies can prevent you from making serious errors in the future.

To be continued...

Editor's Note: You can explore Steve Gilliard's unique brand of "10K-ology" by reading How to Read a 10K: Salon and How to Read a 10K: iVillage, both available on this site.

Posted Comments:

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Comment:

Name: The Other Cheek
Email:
Date: Wed Apr 25 14:39:52 2001
Comment: I agree with Money Guy about the importance of positive cash flow as the quickest determinant of a company's health.

I would like to add that the cash flow statement includes three types of cash inflows/outflows:

1. Cash flows from operating activity (the amount of cash left over when the costs of running the company, depreciation/appreciation of assets and other factors are added/subtracted from net net income).

2. Cash flows from investing (derived from such things as acquiring/selling investments and long-term assets, such as land).

3. Cash flows from financing activities (derived from such things as the amount of dividends paid to shareholders, retiring/servicing debt).

You don't need to do any math to get these numbers -- the three figures are subtotaled and a added together for a final figure (Net Increase/Decrease in Cash right there in the Cash Flow Statement.

Once you have these three sub-totals, you can plug them into cash flow ratios:

Cash Flow From Operations divided by Total Debt -- which gives you another way to determine whether the company is going to crash and burn within the next year or so.

Cash Flow From Operations divided by Cash Dividends Declared and Paid -- this tells you how easily the can make good on dividends owed to investors/stockholders. The higher the result, the more likely the company can attract future investors/stockholders.

There are two more cash flow ratios financial analysts look at, but they are a bit trickier to calculate.

The two provided here - together with the three in my earlier posting - should give a job seeker (or a nervous employee) a pretty good idea about whether to take (or leave) a job with a particular company.

Again, a caveat: The Balance Sheet, Cash Flow Statement and other financial information is available only for companies that are "public" - that is, traded on the stock market.

Privately held companies - even those with investors - are not required to furnish this information to anyone, and don't supply it unless asked to by investors, venture capitalists or loan officers. So accepting a job offer from a pre-IPO company is like going on a blind date.

In the absence of such information, try to check out the company's management before taking a job. A Google (or other) search should turn up relevant newspaper and magazine articles. But since most financial journalists don't bother doing any legwork (no, an interview doesn't count as "research") you have to go one step further and do a Lexis/Nexis search (if you have access) of public documents and filings.

Such a search will reveal whether any of the company's officers have previously filed for bankruptcy, have been slapped with tax liens or foreclosures, etc.

If you find documents of this nature in your search, the people running the company are either inept at best or grifters at worst. (Ff the Lexis/Nexis search turns up nothing, that's a good sign).

So many companies these days require applicants to pee in a cup and to agree to a full-body-cavity-search of financial history. It only makes sense for you to have the dope on your future employers, so to speak, before accepting an offer.

Name: MoneyGuy
Email: MoneyGuy@fuckedcompany.com
Date: Wed Apr 25 02:36:56 2001
Comment: Hate to be so long winded but...

This is just one element of the financial understanding shortfalls in our society. People invest their capital in individual stocks yet have no clue about the financial condition of the company and are shocked when they lose their money.

Another example I've seen are senior managers for small (20-500 employee) companies. Some of these people do not understand how to evaluate their cost of capital (equity capital costs versus debt) or how to decide how best to deploy their assets on a projected financial basis. Their is a lot of "gut" instinct running businesses out their...to this day. Forward looking pro formas are nothing more than good educated guesses put into a quantified form. But that is often a much better way to decide when you are deploying capital into events that will have multi-year, variable cash, variable return implications

Name: MoneyGuy
Email: MoneyGuy@Fuckedcompany.com
Date: Wed Apr 25 02:33:03 2001
Comment: This is a nice start and people or the media shouldn't be intimidate by financial statements. One person has added some additional key ratios.

One key point I want to disagree on is your reference to the P&L statement. Profit or loss doesn't mean anything anymore to a well run company. Really good companies focus on cash flow. You can be reporting oodles of losses but if you are cash flow positive and your flow is growing, you have something of value.

Profit (or loss) is the result of accounting. Accounting is part science and part art. As a result, that final "profit" number can be misleading. But cash is always cash. Most investment analysts now normalize statements and look at cash flow. This is why a cash flow summary was made a requirement for a 10K. It's what analysts needed so they could really see what was happening within the organization.

Some posters have made references to stock valuations. First, I think tulips is an appropriate label for most of what we have seen over the past 3 years. That said, the value of a stock is not some fixed static multiplier on trailing earnings. The growth rate (more accurately, the expected growth rate) is the key determinant of how to value a stock on an ongoing basis. The math to this is not insanely complicated either. Though it might throw an Journalism major with no inkling for math into a bit of loop.

Name: The Other Cheek
Email:
Date: Tue Apr 24 19:15:17 2001
Comment: Some other useful (and not-too-complicated) stats to determine the financial health of a company that can be gleaned from financial documents:

Working Capital (Current Assets minus Current Liabilities). Obviously, you want to end up with a sum well above zero because this ratio measures liquidity - that is, a company's ability to pay its short-term debts (like, making payroll).

Current Ratio (Current Assets divided by Current Liabilities). Another measure of liquidity, the higher the result, the better.

Debt Ratio (Total Liabilities divided by Total Assets). The lower the result, the better the company's ability to remain solvent over the long haul.

Obviously, normally useful ratios to determine profitability, such as Operating Income Margin (Operating Income divided by Net Sales) or Gross Profit Margin (Gross Profit divided by Net Sales) are not possible to calculate for many New Economy companies, as they have neither sales (ie, the content for traffic model that everyone is now backing away from as fast as possible) nor income (apart from suckering investors, that is) nor profits (zero sales divided by zero income equals zero profits). [Now you know why Warren Buffet won't touch dot-coms.]

This isn't rocket science - it's addition, subtraction and division - so I am mystified as to why financial journalists seem unable to do the math and tell readers the story behind the numbers. (The lousy state of financial reporting has been a personal pet peeve of mine ever since Business 2.0 ran a lauditory article on APBnews.com that landed in my mailbox the day the company's owners called an all-hands meeting and summarily fired the entire staff.)

Imagine if medical journalists did their jobs as poorly - i.e., unable to read and understand a medical journal paper, and unable to explain the findings (typically expressed in stats and probability ratios) to readers in simplified, yet accurate language.

Name: steve gilliard
Email: sgilliard@netslaves.com
Date: Mon Apr 23 23:26:24 2001
Comment: Kent,

We're trying to see what happened to these companies. What is amazing is that no one looks at the SEC filings unless inspired. We have some other companies in the mix we haven't covered.

But looking into the past is often the best way to find out the future. Call pre-bankruptcy examinations. The Allies didn't build the Nuremberg trials in a day. Watergate took time.

Name: Very Important Person
Email:
Date: Mon Apr 23 21:52:48 2001
Comment: >> Kent Clauwson

Hey Kent, you're right. What's the name of your company. We want to take a look at your shady dealings. That isn't news yet, but without a doubt, you are of the ilk that cheat lies and schemes then laughs at peasants who dare to ask a few questions. Please post your company name. You're dirty. I'd wager money on it.

Because I'm like you. Us VIPs have to stick together before our whole protected status gets derailed by nosy peons.

Name: Kent Clauwson
Email:
Date: Mon Apr 23 19:59:33 2001
Comment: Why waste all this time on companies like Salon, iVilliage and Razorfish? These are dead horses. Why bother beating them up?

The whole dot-com backlash is played out. When the major players' shares are either delisted or penny stocks, what more is there to say?

This reminds me of the people who were still still lashing out against the junk bond craze during the Clinton Administration.

Name:
Email:
Date: Mon Apr 23 13:49:01 2001
Comment: I thought that we're talking Underwriters who actually "created" success by underwriting IPO's with the intention of aquiring stock to sell at a huge profit. . . actually, we're talking all types of criminal activity but If they can publicly punish a few lawyers like Julie Freese and a few embezzlers, the investment syndicates might just escape scot-free. . .

Name: steve gilliard
Email: sgilliard@netslaves.com
Date: Mon Apr 23 12:51:38 2001
Comment: Blank,

No offense taken. The point is that these publications do not do what they should in investigating these companies they write so glowingly about.

Name: B Labor
Email:
Date: Mon Apr 23 11:52:26 2001
Comment: Oh Ho..lookk ..the sleeping giant awakes..maybe

http://washingtonpost.com/cgi-bin/gx.cgi/AppLogic+
FTContentServer?GXHC_gx_session_id_FutureTenseContentServer=
cb4eb25727607d70&articleid=A44469-2001Apr21&pagename=article

Name:
Email:
Date: Mon Apr 23 11:10:02 2001
Comment: Dear Steve
I never meant, in my earlier commentary, to imply that YOU lacked any journalistic/accounting skills. What I wanted the reader to conclude was that you can't depend on the so-called financial journalist in the media. These journalist do not the accounting, finance, economics and statistics skills to conduct a forensic audit of these "new economy" companies. What is needed is precisely what you are doing: Taking it upon yourself to understand the financial disclosures.

Name: MasterPo
Email:
Date: Mon Apr 23 10:45:16 2001
Comment:
Steve - I think it's about speed. That is, being the first reporter and station to "break" the story about some new super-tech company.

Look at how many times over recent years otherwise reputable reports have been hood-winked by cranks and scammers with some juicy (false) info on a wide range of topics. The report/station could have easily contacted someone to confirm it or at least get a second opinion before broadcasting it to millions. Infact you'd think they'd be sure of the info before going public. But they don't.

So why should financial news be any different?

Name: Tony D
Email: http://tony.dowler.com/
Date: Mon Apr 23 10:42:47 2001
Comment: Wonderful work! I think a lot of people feel that journalism is failing them, but they aren't sure how. I think as media gets to be more and more concentrated under a few companies, we're going to need more DYI journalists to take up the slack.

Name: xdroop
Email:
Date: Mon Apr 23 10:26:49 2001
Comment: Interesting:

Because they are more interested in getting a story than getting the story.

Kind of fascinating, in a morbid way, of how economic news ("it's good! it's good! it's good! everybody loves a winner!") contrasts with the rest of the media ("if it bleeds, it leads").

I guess bad news is only good if it doesn't involve money.

Name: steve gilliard
Email: sgilliard@netslaves.com
Date: Sun Apr 22 22:25:56 2001
Comment: Blank,

I make no claims to understand everything in a 10Q/K, I'm not an accountant. But even if you check the basic narrative with news accounts and look at the profit and loss statements, you have a story.

Journalism education bites as a rule, but this is sad. Anyone can read a profit and loss statement and then decide what the hell is going on. When a company suddenly loses more money in one year than the other in an exponential way, something has gone wrong.

But if you put them together with other public data, you can get a very different picture of a company's health and likihood to succeed. The one thing which isn't done is checking the record. You don't have to be a genius to do that. You don't even need to have taken an accounting course to do that.

If you write a story about About and do a CEO porn story and not one about how they just cut compensation to 1997 levels and plan to layoff people, then what are you writing about? Why are you doing that story? A waste of news print.

Name:
Email:
Date: Sun Apr 22 22:06:57 2001
Comment: Most journalists wouldn't even know what to do with a 10k/q report. Most were enlish majors who never took a basic math or accounting class. I have yet to meet a math, engineering or science major that decided on journalism. Reading and understanding the 10k/q forms require a foundation in accounting, particularly the ability to understand an income statement, a balance sheet and cash flow statement. There are lots of tricks that clever accounts use that even the SEC won't catch until an internal audit is done. The narrative that accompanies the 10q/k won't tell you that the company is recording bogus revenue, shifting current expenses (or current revenue) to a later period, recording revenue too soon, failing to record or disclose all liabilities, boosting income with a one-time gain and the list goes on ... A good journalist would, therefore, need to understand the basics of financial reporting. You would be surprised at what passes for journalism today. These lazy journalists simply go into Newsedge and regurgitate and recycle somebody's reporting with barely an understanding of economics, accounting or statistics. I mean you have AL GORE, the Policy WONK, of all people teaching journalism. Now, you tell me if he understands accounting, economics or statistics. It seems like anybody without any training can become a journalist. LOL

Name: Bill Volk
Email: bvolk@youworkit.com
Date: Sun Apr 22 19:09:50 2001
Comment: The hard thing, but the vital thing ... is to find out what the sources of income really were for some of these companies.

If the price-to-earnings ratio of some of the bigger Internet companies was greater than 100:1 (at the peak) ... as I suspect ... then finding a way of getting earnings into your "big bet" ... is a great way of jacking up the stock price ... and illegal as heck I suspect.

Name: me
Email:
Date: Sun Apr 22 18:23:37 2001
Comment: For any UK readers or people interested in UK registered Companies, getting the annual returns for privately owned UK Companies with limited liability is relatively simple and fairly inexpensive.

All you do is ring Companies House (you may even be able to get the info online at http://www.companieshouse.gov.uk/ now?) give a few details like the Company name and reg. no., pay something like ?6 (its a few years since I last did this, so that figure may be wrong) and bingo. There's no hiding.

You can also do a D & B, but it costs quite a bit more. Very revealing!