Silicon Valley Discovers Nuts and Bolts
from
January/February 2002
by John R. Engen
James Morgan, chairman and CEO of Applied Materials, is usually among the first to know when the technology world’s fortunes are changing. When sales of computers or cell phones slow, as they have this year, the diminished appetite for chips quickly hits sales of the semiconductor-manufacturing equipment made by this Santa Clara, California, company. Similarly, when chipmakers see signs that their business is picking up, they call Morgan and ask him to boost production.
So what signals is Morgan getting about 2002? “Until the economy picks up, it’s going to be tough—and we don’t know when that will be,” he says with a shrug. “I’ve never seen a murkier outlook.”
Across the high-tech world, the story is the same. A combination of sagging demand and shareholder wariness about the economy and terrorism has gripped the industry. An October poll of 225 chief information officers by Morgan Stanley found that 30% of the companies surveyed were planning to spend less on technology in 2002, while another 40% were considering similar cuts.
As their companies struggle, directors who signed on for the adventure and potential bonanzas of high tech’s gold rush must now devote more attention to the nuts and bolts of directorship. These include monitoring expenses and balance sheets and making sure that proper audit controls are in place, all while pursuing strategic initiatives with an eye to the future.
“The job has become much more serious,” says Ted Meisel, the CEO and a director of Overture Services Inc., a search-engine firm in Pasadena, California. “People understand that technology companies are just like any other company, and have to be run the same way.”
Investors who once valued growth-driven capital gains are now focused on today’s bottom line. That forces directors to concentrate on those numbers too. John McCoy, former chairman and CEO of giant Bank One Corp., now serves as the chairman of Corillian Corp., a Portland, Oregon, provider of Internet-banking software. His company, which had revenues of $29 million during the first half of the year, has yet to report a profit but hopes to break even in the first quarter of 2002. At board meetings, says McCoy, the primary focus has shifted from product improvements to the question “When are we going to be cash-positive?”
“What’s changed is the sense of urgency,” he explains. “It used to be that money was relatively easy to get and profitability was something you talked about for the future. But the market doesn’t reward these tech companies for ideas anymore. It’s ‘Either turn a profit or we’re not interested.’”
And of course, with revenues slumping across the technology sector, profits are tougher to come by. In mid-October, Thomson Financial/First Call, a Boston firm that tracks analysts’ earnings estimates, was predicting that the fourth-quarter earnings of technology companies in the S&P 500 would fall 56% below the same period last year. The research firm was also estimating an 18% decline in the first quarter of 2002. “The outlook is bleak,” says research analyst Thomas O’Keefe.
All this has placed expenses, once an afterthought for many technology boards, at center stage. Job cuts at the likes of Cisco Systems, Sun Microsystems, and Motorola have been massive. At Applied Materials, Morgan says, “we’ve been in cost-control mode for more than a year.” The company’s revenues for the quarter that ended in July slid 51%, to $1.33 billion. Its earnings dived 93%, to $41 million. One piece of (relatively) good news: In September Applied Materials announced that it would be handing out 2,000 pink slips to 10% of its workforce—not nearly as bad as the 50% employee bloodbath expected at telecom giant Nortel Networks Corp. by year’s end.
This is an environment that sets class-action lawyers a-drooling—and attacking. During the first three quarters of 2001, 301 class-action suits were filed against companies and their boards, a number that outdistanced the annual record of 236 set in 1998, according to Stanford Law School’s Securities Class Action Clearinghouse. Technology firms were the most common defendants, and even big names such as Amazon.com, Cisco Systems, and Oracle were not immune.
The pressure is squarely on tech boards to navigate rocky terrain or face the consequences. “We’re very concerned” about potential shareholder litigation, admits Larry Mitchell, a former Hewlett-Packard general manager and an outside director of Finisar Corp., a Sunnyvale, California, maker of fiber-optic communications gear. Finisar’s experience illustrates how much the firmament has changed. In the months following the company’s 1999 initial public offering, its stock soared from $6.33 per share to as high as $58. Flush with cash, the board oversaw an acquisition binge and gave management a fairly free hand to pursue new products that weren’t always right in line with the company’s core objectives. Says Mitchell, “It used to be ‘That sounds like a good idea. Let’s try it.’”
Today slackening demand from big corporate clients has turned what was once a profit into a loss. Finisar’s stock price is in the single digits, and the mood is much more sober. To safeguard the company’s interests—and their own—directors are tightening controls and ordering that earnings or revenue guidance be immediately disseminated to all investors. “It’s survival time,” Mitchell says. “We’re collecting more data, watching our inventories, and making sure the financial and process controls are in place so we don’t get into trouble.” And the company is still looking for investment opportunities, he adds.
Cash is crucial to riding out the downturn, as it is in other industries. Although large companies such as Microsoft and Cisco can still finance their ambitions, many smaller firms are squeezed. On September 11, Finisar CEO Jerry Rawls was set to meet with investment bankers at the World Trade Center to finalize a $200 million convertible bond offering. Instead he sat on the New Jersey side of the Hudson, watching as the twin towers—and the offering—crumbled. In October Finisar did complete an offering, albeit for just $100 million.
Hindsight has shown that the boards of many technology companies are woefully lacking in depth, objectivity, and real-world experience. Improper procedures or poor monitoring practices, all but ignored during the boom times, are now exposed. “For many of these companies, their boards are their No. 1 underperforming asset,” says Patrick McGurn, a vice president at the proxy advisory firm Institutional Shareholder Services in Rockville, Maryland.
In response, many boards must beef up with outsiders to fill audit and other key committees and provide better oversight. Ted Jadick, a managing partner at the executive search firm Heidrick & Struggles Inc., expects to see many more searches for directors, not only at tech companies but “across the board.”
Of course, “everyone wants a sitting CEO,” says Jadick, who runs the firm’s New York City director-recruitment office. Landing such stars will be difficult, and not only because of sagging equity prospects. Most CEOs are too busy steering their own ships through the shoals to devote much time to another company’s problems. Even retired chief executives, once enamored of the excitement and potential treasure of technology directorships, have grown leery of the risks. Corillian director John McCoy, who also serves on the boards of SBC Communications Inc., Cardinal Health Inc., and the Federal Home Loan Mortgage Corp., recently rejected an offer to become a director of another high-tech firm. “I’m not interested in a job where I might be giving depositions six months later,” he says.
Big technology companies naturally fare better in their director hunts. Jadick recently found two sitting CEOs who agreed to join such boards. Kenneth Freeman of the diagnostic-testing provider Quest Diagnostics Inc. signed up at Cleveland-based TRW Inc., the aerospace and automotive technology giant, and Vince Calarco, CEO of Crompton Corp., a chemical company, is joining New York’s Con Edison.
Smaller firms, on the other hand, are being forced to set their sights a bit lower. Until recently the board of Overture, formerly known as GoTo.com, had only six members—CEO Ted Meisel, former CEO Jeffrey Brewer, and four venture capitalists. In May the company brought in a seventh director, Dun & Bradstreet marketing executive Steve Alesio. Meisel isn’t done yet and hopes to add as many as three more board members in 2002. While he’d like “name-brand CEOs,” he says he’ll settle for “senior executives with marketing or finance skills who have operated through some economic cycles.”
Also in demand: accountants. New rules from the Securities and Exchange Commission require that audit committees be staffed solely by outsiders. Considering the shaky financial prospects of so many tech firms—and recent regulations that appear to make audit-committee members more responsible for financial problems than other directors—it’s small wonder that the demand for retired partners of Big Five accounting firms is especially great.
How will those people be paid? Patrick McGurn thinks that compensation will be the chief challenge confronting high-tech boards in 2002. Many technology directors are remunerated solely with equity—a pay package that has often ended up as good as worthless, thanks to slumping share prices that have left stock options way underwater. McCoy’s package at Corillian, for instance, includes 640,000 options with strike prices as high as $15. The company’s shares were recently trading below $2. Larry Mitchell of Finisar receives all his compensation in options that sank and then regained value. He concedes that the potential of a huge gain on stock was one of the lures held out by tech-company boards. But that was then. “The financial attractiveness from a director’s perspective has evaporated,” he says. (For more, see “Directors’ Compensation: Cash Laughs Last,” page 60.)
Virtually all high-tech firms’ options packages are underwater, for both directors and employees, and many companies have tried to find their way around the problem. Some 150 have repriced their options or accelerated grants. Several large corporations, including Microsoft, Intel, and Cisco, have simply issued vast new layers of “makeup” grants on top of what was already there. Struggling dot-coms such as Amazon.com have repriced all their options. More than 100 outfits have chosen to use a loophole that allows companies to cancel old options, wait six months and one day, and then issue options with a new strike price.
All these risk protest from shareholders, although McGurn says that investors who once decried repricings on principle are now more realistic. If a company stands to lose good talent because of underwater options, he adds, maybe it’s not such a bad idea to “sweeten the pot.” Look for such issues to emerge in the upcoming proxy season.
Meanwhile, technology’s consolidation is expected to accelerate in 2002, and the boards of struggling companies may need to reach difficult decisions about whether, or when, to sell. Some may opt to rescind poison-pill plans to make themselves more attractive to would-be suitors. “This is a time when some boards want to be painting a big bull’s-eye on their companies,” McGurn says.
The buyers will be larger concerns that have relatively strong stock or lots of cash and are intent on strengthening their positions by purchasing complementary technologies on the cheap. Cisco CEO John Chambers, for instance, recently told investors that he plans to acquire as many as a dozen companies to boost the San Jose, California, corporation’s position in the fiber-optics industry.
Having lived through several tech slumps, Applied Materials’ James Morgan has developed a feel for the cyclical nature of the business. In good times or bad, he encourages his board to “think out of phase” with the company’s operations side. During booms, that means contemplating ways to ride out the next downturn. Now, he says, “we’re preparing to take advantage of the growth opportunities that will come with a rebound.”
He offers a precedent: In the late 1980s, with the tech economy in the dumps, Applied Materials set out to build a large plant in Japan. The original plan was to construct only half of the facility, but the board—a group of seasoned global executives—insisted that the whole thing be built. “When business exploded a couple years later,” Morgan recalls, “we were ready.”
In 2001, even as it has tightened its belt, the company has spent $1 billion on research and development. And it plans to continue the pace. In September, it opened a plant in Massachusetts to produce promising new ion-implantation machines for chipmaking facilities.
“Innovation is what brings you out of a recession,” says Morgan. “The companies that get squeezed down today—either because they can’t afford it or because their boards don’t have the courage or vision—could miss one of the great boom times of the century when things turn around.”
That’s a reminder tech companies might want to add to the orientation kits for their new bottom-line-focused board members.
