Where do companies go wrong with their financial engineering?

There are so many points that people grossly underestimate. Not having timely information systems (MIS) may not create the right early warning signals for you to react. One of the companies I acquired had a total lack of financial discipline with respect to the business model. They were acquiring a customer at a price greater than the revenue that they were going to earn from that customer over his entire lifetime. That kind of discipline continues as long as you have access to funding, but once the funding shuts down the business is in trouble.

I’ve seen people grossly underestimate liquidity. Liquidity in our system is very much intertwined with the economy. In industries like real estate, or hotels and motels, people have seen incredible bargains, except that during tough times it’s an impossible exit. 12 months ago, owning a hotel in Santa Clara county (San Francisco Bay Area) would be considered a brilliant investment, and if you started building one that is now ready you’re probably having a tough time. So it’s a matter of how quickly you can generate liquidity. People are ignorant about this and underestimate this risk.

I’ve also seen a lack of understanding about the true cost of capital. As an example, in the dot-com era, people were very generous granting equity, they would say, “Okay I’ll grant you 50,000 stock options.” It sounds pretty neat but I had a situation with one entrepreneur who was giving out options like popcorn. For him 10,000 options at 50 cents a share was not a lot of money. But the reality is that I would rather give out $5000 dollars if that satisfies rather than 10,000 options unless I believe that those 50 cent shares are going to end up being worth two cents.

So how do you balance these issues in the short term versus the long term?

What I have seen is that when you have very high growth, because you believe that there is very high demand for your product or services, you need to get more sensitive to all of these variables. Sometimes you have to deliberately cut back growth, especially if you are a public company.

There’s nothing wrong with growing fast, but there is a growth versus size equation that comes into play and even the best and brightest overlook that. In a good economy focused players get valued highly. In a slower economy the equation changes. Diversification and size become more critical to investors on the capital markets. We’ve seen that happen in the telecommunications industry, and we’ve seen that happen in the mortgage industry. If you look at the airline industry right now even the large players are struggling, but the game is pretty much over for smaller players unless the government bails them out.

You want to make the right call at the appropriate time, slow down growth and rebuild. As soon as a high growth company slows down, its stock takes a hit, which nobody likes, But you can then use the currency you have to move the business model from a focused single market company to a more diversified model to balance the risk.

If you take a company like Providian, if we were part of a large company like Citibank, 90 percent of our problems wouldn’t be there, because the diversification would allow us to ride out the cycle. But if you take the same company in a good economy, people would say it was a great thing.

How do you manage from cycle to cycle? I have seen three economic slowdowns in the last 30 years. In 71-72 it was driven by an exogenous event — the oil embargo. Neither the slowdown in the early 80s nor the one in the early 90s was driven by any exogenous event. This time it was a combination. We were slowing down, but there were some indicators that consumer confidence and other variables were allowing us to manage the slowdown. Suddenly consumer confidence tanked after Sept 11. That was an exogenous event that killed the travel industry and shopping and retailing.

Instantaneously people’s focus moved from niche and single market players to size players with diversified businesses.

So how do you go about diversifying? Slowing down growth is a tough thing to do.

It’s very tough. You have to start diversifying. We were working on diversifying. We were expanding internationally. We acquired a company called GetSmart. We got into the collection business. But that was not enough. A strategic acquisition of some sort that was of a real critical mass would have been a big plus.

If we could have bought a mortgage company with $10 billion in assets or if we could have acquired an auto finance business — something with size and magnitude large enough to create the diversification — that would have been important.

But you have to make the right kind of acquisition and you can’t over pay, because that’s terrible. VeriSign bought Network Solutions for $21 billion. If for the next 20 quarters they have to take a billion-dollar write-off how are they supposed to report earnings? But still they tried. If you can’t control your growth you have to use your dollars to make a decent bet, and not lots of small bets.

When do you have to implement this strategy? When things start going poorly, Wall Street punishes big mergers as desperation measures — look at HP and Compaq. And people criticized AOL Time Warner at one time.

People were criticizing AOL, but I think that it was the most brilliant move they made. Yahoo! didn’t make that move, and that’s the difference, right there.

What was your experience with this process?

I realized in late 1999 and early 2000 that we would have to slow down our growth and would have to look for a strategic acquisition. I had the desire that it would be of a decent size. I bid on a couple of things. It wasn’t as if I was sitting idle. As late as March and April of this year I tried to make a $7 billion acquisition.

But we were somewhat handicapped in the marketplace despite the fact that our currency was good, because we were coming out of a very difficult two years of adverse publicity. That created a certain amount of concern on the part of companies wanting to see how we came out of it. It’s not that I didn’t see it, but we just didn’t have the flexibility going in either direction. I could have merged with a larger entity but then there was the same issue. They wanted to make sure we were okay.

Associates First Capital was lucky. They were also sub-prime lenders. They saw the changes in the market and they quickly merged with Citigroup. For us either option was difficult because unless we put a year or two behind us after our settlements and showed a clean slate, our ability to do a major transaction was somewhat constrained. I was forecasting that there would be a slowdown one year earlier than it actually happened. During 1999 we were still going through the adverse publicity — who would buy us?

The slowdown came very suddenly. In March we saw a slowdown and we started preparing for it. Then April fooled the market and looked very good, and people thought there might be a recovery by the second half of the year. By June the market looked completely different because we saw that back to school shopping wasn’t happening. August sales were very low and then Sept 11 hit like a tsunami. It was a perfect storm.

What about Wall Street? How does the way the Street operates impact financial engineering?

Wall Street has a mix of people and a mix of analysts. There are some that are good and some that are shallow. There are long term investors and momentum investors. There are money managers that look for value, and some that look for growth. It’s very important to understand how you establish your communications, because analysts have a tendency to take an attitude that says, “if you can’t answer my question in two minutes you don’t know the answer.”

You have to be careful not to become lecture driven, because analysts don’t want to understand. My advice would be that you need to communicate with total transparency, but you don’t want to over-communicate. The more you say, analysts move from macro business performance to micro variables. If somebody is in manufacturing, suddenly inventory is more important than whether you are selling or not. Suddenly there are secondary and tertiary variables that analysts look for.

Establishing guidance, as you go into secondary and tertiary variables, starts to restrict the degrees of freedom with which you can run your business. If I am a CEO I can’t predict each variable accurately but I can say that in some areas I will be ahead of my plan or in another area I will be behind, but on aggregate I will meet or beat my plan. But if you start saying what your plan is in each area it creates its own feeder system.

Analysts say something like, “You told me you were going to make your UK operation profitable by the end of 2002, so tell me, are you going to be there or not?” If you say you’re not, you worry about your credibility. So the first thing you want to do is do everything you can to become profitable — and you might start making sub-optimal decisions in order to meet the specific requirement.

In the grand scheme, whether that operation is profitable could be totally irrelevant. So how do you keep things focused on the right metrics? Good analysts do, but some analysts think that they can reverse build the model. They all have their models and they want the numbers to be provided. The more elaborate the model the more elaborate set of numbers they need. If you don’t give them the numbers they have a transparency issue, if you give them numbers they want to try and explain variance in every number. Sometimes management tries to be tactical rather than strategic to avoid variances, and so they miss out on the big picture.

If the market environment changes, how you communicate and whether it is received in a positive or negative way is very important, so you have to communicate in a positive way.