Under Scrutiny: Here's why securities analysts view the overly nice and the overly egotistical CEO with suspicion. (Investor Relations).

Not long ago, Covad Communications Group was riding high, building a nationwide network to provide fast Web access. But on October 20, 2000, after spiraling downward for six months, Covad shares plunged from $10 a share to $5 a share. By year-end, the stock, which had hit a high of $64 in March, was trading at less than $2.

The troubled telecommunications upstart, based in Santa Clara, CA, buckled under a debt load of $1.4 billion. Eventually it sought bankruptcy protection, settling with bondholders by agreeing to pay 19 cents on the dollar.

Covad's stock collapse, followed by the resignation of its top executive, provides a classic example of how financial analysts' perceptions of CEOs impact Wall Street coverage, stock-price performance, and the top official's tenure.

Covad was like many other companies providing high-speed Internet access over digital subscriber lines. But after problems with late customer payments resulted in a drastic widening of losses, Covad failed to meet analysts' earnings expectations and lost their trust.

When that happens, companies frequently make changes in leadership. At Covad, Robert E. Knowling Jr., CEO since June 1998, convened his board. "1 posed the question they obviously had to consider," he was quoted as saying. "Is management fit for duty? Meaning me." No, the board decided, and Knowling resigned on November 1.

At the time, neither Knowling nor Covad would elaborate on the change in leadership. Many analysts said the stumble was largely a symptom of turmoil in the telecommunications business, though some said Knowling shared the blame.

Under his leadership, Covad had just completed a large convertible debt offering when it announced it would miss its third-quarter earnings targets. That's when analysts discovered overstated revenue and cash-flow projections underlying the bond offering.

"Almost every analyst who covered the company felt he had been lied to," says an equity research analyst who spoke anonymously. "On Wall Street, this is a cardinal sin." Almost immediately after the stock's freefall, many investment firms dropped coverage of the company.

A CEO respected by analysts will have far more room for error than one who is viewed as arrogant or overconfident, or, worse, dishonest. "If you get into a crisis management mode, it can really help to have analysts on your side," says Richard Bliss, president of BAM Asset Management. He recalls the accounting practices contretemps of $38 billion Tyco International. That's when David W. Tice, the Dallas-based investment manager and short-seller, accused the company of taking overly large charges and delaying some payments in order to mask weakness in its earnings and cash flow. Then Tyco disclosed that the Securities and Exchange Commission (SEC) was investigating its accounting practices. Investors reacted sharply, and the stock fell to its lowest point. But then analysts stepped in and said, in effect, "We know the company and it's not cooking the books."

"That went a long way to stem the stock's decline and create an atmosphere in which it could recover," Bliss says, In July 2000, the SEC announced it was ending its investigation without taking any action. The company announced that it would move some of its accounting charges to different quarters of the year in response to regulators concerns, giving confidence to some investors otherwise nervous about buying the stock.

Carole Berger, a bank stock analyst for TIAA-CREF Investments, recalls problems encountered by Bank One in the mid-1980s. The company made a series of missteps, including a number of acquisitions Wall Street considered too expensive. It also failed to achieve important economies of scale. "If John McCoy, then CEO of Bank One, had not been so well-liked by the Street, the company's valuation would have plummeted a lot faster than it did," says Berger.

Bank One's new CEO, James Dimon, also provides an example of how a CEO's good relationship with the investment community can provide an anchor of stability during a difficult time. Since he stepped in about a year ago, Dimon has taken a number of actions to improve the bank's balance sheet. Nevertheless, the company continues to miss its earnings targets.

"Any other company would have seen its stock decimated--especially in this market," says Berger. "But Dimon has created a constant stream of information to the Street, making it very clear that he is doing all the right things. And he always comes across as articulate and well-informed."

It's One Part Communication...

Admittedly, a few executives with long and impressive track records do manage to get away with having a lukewarm relationship with analysts.

A blunt-talking executive who earns $7 million a year, Wells Fargo's Richard M. Kovacevich has some detractors. "No one is harder to get along with than Dick Kovacevich," says one analyst who spoke on the condition of anonymity. "He doesn't like us, and he sees our role in the functioning of the capital markets as superfluous. But he knows how to run a bank, and the people who work for him are highly motivated and dedicated."

As Kovacevich explains, Wells Fargo doesn't make specific earnings forecasts. Nor does it conduct live, quarterly conference calls with the Street, as most companies do.

"We don't do these things because we believe they lead to misinformation," Kovacevich says. Even before the passage of Regulation Fair Disclosure, Wells Fargo was careful not to disclose material information on a selective basis.

"We didn't need Reg FD to tell us not to provide analysts with material information that was not available to all investors," Kovacevich says. He recognizes that the company's strict policies on disclosure and guidance are "frustrating to many analysts," but he believes that the Wells Fargo's investor relations department is among the best. In March, that department received the Bank and Financial Analysts Association's Best Investor Relations Award.

"We are very responsive to calls, open to analysts' visits, and we participate in most conferences," says Robert Strickland, Wells Fargo's head of investor relations.

Unlike Kovacevich, most CEOs cannot afford to take the risk of alienating analysts and investors. As BAM's Bliss explains, "Poor communications [between a CEO and Wall Street] can lead to poor coverage and poor distribution of the shares, which, in turn, directly affects the shares' price performance."

Among the most important attributes a CEO can bring to his dealings with analysts are honesty and a willingness to address potential problems head-on. "There is nothing more important to a CEO'S reputation than a track record of haymg communicated honestly in the past," says Scott Budde, a director at TIAA-CREF Investments. Bliss adds, "The most common negative situation is one in which analysts feel they have been blindsided by unexpected results or the selling of shares by management."

Some of the most highly respected CEOs, like Sanford I. Weill of Citigroup and Maurice R. (Hank) Greenberg of American International Group, are known for being straight-shooters. Greenberg, for example, has traditionally held fireside chats with analysts once or twice a year. And Weill, known to speak with candor, goes to a lot of conferences. "He never appears to be trying to pull the wool over your eyes, and he gives the appearance of being someone you would like to work for," says Berger.

In contrast, a CEO who says business is great when the company is facing real problems is going to alienate a lot of analysts.

CEOs also need to appear well-informed about their companies. "There is nothing more impressive than a CEO who knows his business inside and out and can start reciting figures from five years ago without looking at a piece of paper or asking someone on their staff," says Andy Walker, a Janus Capital analyst. On the one hand, he says, "if a CEO relies too much on others to answer questions, it's the first hint that maybe they're not as involved in the business as we think." And, as Thomas Brown, a former bank stock analyst who now runs Second Curve Capital, a hedge fund that invests in financial services companies, says, "If a CEO doesn't have the bad news and we do, it's a sign of a big problem." At the very least, he says, "it indicates that bad news doesn't flow up to the top of the organization."

...And One Part Interpretation

A number of analysts agree it's important that CEOs learn how the market works and understand the analyst's role. Not comprehending the analyst's function, some veteran observers say, prevents CEOs from making the most of the little time they have to communicate corporate strategy.

"Some CEOs spend valuable presentation time telling us why their stock is cheap and why it should trade at a higher multiple," says Budde. "This is a futile exercise and a poor use of my time," he says. TIAA-CREF's Berger feels even stronger. "I'd rather have a CEO tell me he just bought 100,000 shares of the company with his own money than tell me how to value the stock," she says.

As Berger stresses, it's critical for CEOs to understand how the market recognizes value. "It's not just a matter of growing earnings," she says. "The market cares even more about the quality of the earnings--where are they coming from and what impact they are having on your margins and your return on equity."

Lauren Fine, a sell-side equity research analyst for Merrill Lynch, believes "CEOs need to understand that analysts are there to interpret everything." In wake of the Regulation Fair Disclosure, which has reduced the amount of information provided by companies to Wall Street, analysts, more than ever before, need to do a lot of leg work and read between the lines.

"When I meet with a CEO," Fine says, "I am there to form an opinion and to pass it on to my clients. I am evaluating everything: content, presentation style, body language, and nuance. If there's something that concerns me and it's of a personal nature, I won't put in it in writing, but I will definitely discuss it with my clients."

One of the most important impressions analysts and investors take away from management meetings are highly subjective judgments about the CEO'S personality. "Presentation style and personality are far more important than most CEOs realize," says Brown of Second Curve Capital. "A big part of equity research is evaluating management." Since analysts don't get to spend a lot of time with most CEOs, "first impressions--how confident someone is, how well he speaks--really count," says Brown. He recalls that his biggest successes as an analyst came from being "right on the people, not the numbers."

"Analysts are increasingly scrutinizing the soft side as well the hard side of a CEO'S personality," says Leslie Mayer, president of Mayer Leadership Group. A year ago they were more easily persuaded by charisma. "Analysts now are more interested in determining if a CEO has substance," she adds.

"It's not personal," says Berger. "We aren't trying to figure out if we like someone or if we think he's a nice person. But we are looking for insights into the CEO'S management style and ability to motivate people and formulate and implement strategy."

Being too nice, in fact, can backfire. "If a CEO is trying too hard to make me see what a good guy he is, it makes me wonder if he isn't in over his head and overcompensating," says Merrill's Fine.

Early impressions formed by analysts can have a farreaching impact on a CEO'S reputation and how a company is viewed by both analysts and investors. Good reputations take a while to build, but bad ones can take even Longer to tear down. For obvious competitive reasons, sell-side analysts typically don't talk to one another. But buy-siders do. "The buy-side analyst community is a very small, closely knit group of people that sees each other regularly and talks," says TIAA-CREF's Budde. Many buy-side analysts also admit they rely on sell-side counterparts for their impression of management. "In the case of many companies, the sell side spends a lot more time with management. So it's often an important off-the-record source of opinions about the people running a company," Budde says. And what analysts say about a CEO in off-the-record, closed-door conversations with investors is often far more powerful than anything ever printed in the official reports.

It is crucial for CEOs to be aware of the degree to which negative personality traits are considered red flags, signaling the need to monitor a company more closely and, in some cases, second-guess decisions.

Many analysts put one alienating behavior at the top of their list: arrogance. "It tells you someone is oblivious to the trends around them and that they [may be prone] to overestimating their own ability to adapt to trends and execute strategies, says CREF's Budde. "Most management failures can be attributed to arrogance or stupidity--and it's a contest for which is worst."

"Hubris is a definite warning sign that makes me start second-guessing a CEO'S decision-making process," says Berger. Carried to the extreme, it can allow a CEO to overestimate a company's ability to digest an acquisition. Many analysts believe it was arrogance that caused former First Union (now Wachovia) CEO Edward E. Crutchfield Jr. to make a number of too-expensive acquisitions.

First Union bought CoreStates Financial in 1997 for $20 billion, six times its book value--still a record multiple for a large bank. Later that year, it paid $2 billion for the Money Store, a lender to consumers considered high credit risks. That also proved to be a mistake. First Union took a $3.8 billion write-off to shut it down.

Another warning signal is defensive behavior. "It's a good idea for a CEO to directly respond to criticism with a point-by-point refutation," says Bliss. But, "attempts by CEOs to strike back at analysts by limiting access, threatening legal suits, or by making public comments almost always backfire. Any time a CEO lowers himself to make attacks on an analyst, it's a sign he's under a lot of pressure and a red flag signaling the need to investigate further."

This proved true for First Union's former boss Crutchfield, who is considered infamous for his attempts to strike back at analysts who criticized his management style and acquisitions strategy. In his early years, Crutchfield was known to go as far as to threaten to have an analyst fired for criticizing him. Second Curve's Brown remembers that after he wrote a negative report about First Union in 1990, the bank stopped doing business with his firm, Donaldson, Lufkin & Jenrette. Years later, after having revived the relationship, Brown criticized First Union's acquisitions strategy and was again blackballed. "Investor relations had been informed not to let me meet with anyone at the firm," he recalls. "It was a very stupid move." Among other things, it told Brown that bad news wouldn't be able to flow up to the top. "If they were willing to shoot an outsider, just imagine what they would do internally," he says.

Crutchfield's apparent inability to tolerate criticism also sent a resounding message to Wall Street that he wasn't confident about the way he was running the company. It didn't help when it became clear that his acquisitions of CoreStates Financial and the Money Store were disasters. In 1999, First Union's stock plummeted 46 percent. Less than six months later, Crutchfield resigned.

The lesson? If the market is telling you that you're doing something wrong, listen. It's almost always right. And if you can't figure out the signals--ask those who make a living studying the market to help you identify the problem.