The moment a company announces that some past stock options grants were not properly recorded in its books and that it is opening an investigation, it opens a Pandora’s Box of speculations. Is this a criminal act? Will it cost executives their jobs? Might they even go to jail? Is it technical? Is it only a minor incident? No one knows. A well-known capital market rule states that where there is no information, everyone makes up their own, and converts rumor into fact.
Investors definitely know nothing, so imagine how hard it is for analysts. They have to tell investors whether an accounting scandal is brewing, or if it is merely an accounting technicality. It’s hard to know when there is no information.
Take the case of Mercury Interactive Corp. (Pink Sheets:MERQ) for example. The company was forced to restate its financial reports because of its improper practice of backdating options. Analysts initially stood by the company, and some did not hesitate to assert that no colossal problem was at hand. We all know what happened next. Mercury chairman and CEO Amnon Landan and the company’s CFO and legal counsel paid with their jobs and their prestige. The company has almost completed its restatement, which involved cutting its net profit for 1992-2004 by $570 million. It’s not clear whether all the analysts who thought Mercury’s announcement meant little are happy that they adopted such an unequivocal stance and reassured investors.
What is going on at M-Systems Flash Disk Pioneers Ltd. (Nasdaq: FLSH)? After announcing last month that it was cancelling an offering and opening an internal investigation into past stock options grants, on Monday it said, “M-Systems' internal review found the actual measurement dates of some past stock option grants differ from their previously recorded measurement dates,” and, therefore, “it will restate its financial reports for 2001 to 2005 and revise its financial information for the first quarter.”
In the case of M-Systems, too, it’s hard to know what will come next. It’s hard to know whether a criminal act was involved; in other words, whether M-Systems chairman, president and CEO Dov Moran, and CFO Ronit Maor will pay a price; or whether this is merely a technical matter that will be fixed soon, and everything will go back to normal. The company did not say anything more at the instructions of its lawyers, with the result that all kinds of guesses are being heard in the market. In any event, the flash memory developer has already announced that it will complete its restatement by July 17, which provides some assurance that the problem is only technical.
Before the start of trading on Wall Street on Monday, and after M-Systems filed its 20-F form with the US Securities and Exchange Commission (SEC), the company’s share plummeted over 9% in electronic trading. Investors were worried by what the company had to say, and because it said that the SEC “has begun an informal investigation into the company's stock-option grants.” The share corrected later in the day, and ended the session down 1.2% on a day that Nasdaq rose 0.8%.
Analysts are trying to dispel the fog. Even so, M-Systems certainly did not expect an enthusiastic report like the one published by CIBC Capital Markets. CIBC’s upbeat tone is seen in the headline: “Don’t be fooled by confusing 20-F; executive suite in zero danger”. CIBC kept its “Sector Outperformer” rating, saying, “We still firmly believe that nothing illicit took place, and management is out of harm’s way.”
This is quite a risk for CIBC to take. It goes on to say, “In our opinion, this filing, in spite of its ambiguity, does not indicate that something illicit (i.e. option backdating) took place. Rather (based on our research), we believe said restatements will reconcile the difference between Israeli and US options granting and accounting practices.”
Is this really the whole story? We’ll now in mid-July. CIBC has no doubts: “As a result of said statements likely being a function of accounting formalities, we believe M-Systems management is not at risk. Thus, we feel investors should be more focused on M-Systems’ tremendous long-term prospects…”
CIBC calls the affair a “nagging options overhang/confusion”.
Citigroup analyst Craig Ellis says that, beyond the danger of M-Systems’ restating its financial reports, it can be assumed that the cost of the internal investigation will adversely affect the company’s result for the second and third quarters. The formula is that every $1 million in spending on this matter will cut the company’s earnings per share by $0.02. Experience indicates that an internal investigation can cost $4-5 million. Citigroup kept is “Buy” recommendation for M-Systems.
Published by Globes [online], Israel business news - www.globes.co.il - on July 5, 2006
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