GMI Ratings, a governance research firm, produces a semi-annual Risk List of companies with a high level of concern regarding future returns. The proprietary accounting and governance metrics used by GMI focus on factors which extend beyond traditional fundamental measures.
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Some of these factors show constancy over time, while others are dependent on recent actions by management. These actions may be a function of a changing business strategy; market conditions that bear on the company’s operations; or an attempt by management to disguise operating problems. In all cases, these companies require a higher level of scrutiny than their peers in order to better understand why they have been flagged for the number of extreme measures they exhibit.
The Accounting and Governance Risk (AGR) rating uses an entirely quantitative, statistical process to identify accounting items associated with fraudulent financial statements, as well as governance characteristics associated with firms prosecuted by the US SEC for accounting fraud.
The AGR Rating is also expressed in two ways, first as a percentile score ranging from 1 to 100, and second in four categories that are associated with ranges of these scores and are expressed as ranging from Conservative to Very Aggressive. Anything that’s ranked from 1 to 10 is considered very aggressive.
The AGR Rating is predictive of the near-term risk of negative events. Low rated companies are more likely to experience different types of negative events – not only regulatory actions, but shareholder litigation, material restatements and other related events – which have a clear impact on investment risks and returns.
Poorly rated companies have lower returns and greater price volatility. The AGR Rating is also a key component of other, more specialised GMI Ratings risk models, such as the Litigation Risk Model and the Financial Distress Risk Model.
This report is for information purposes and should not be considered a solicitation to buy or sell any security. GMI Ratings does not guarantee its accuracy or make warranties regarding its usage. ©2012 GMI Ratings. All rights reserved.
AGR Score: 10
Market cap ($MM): $17,194
Industry: Aerospace / defence
Our concerns with defence contractor Raytheon include the company's executive compensation practices, where internal pay equity issues result from CEO and Chairman William Swanson's fiscal 2011 total summary compensation of $17.1 million compared to the median of $4.5 million for the other named executive officers.
Also, not only may the Compensation & Management Development Committee increase annual incentive awards by as much as 200% solely at its discretion, but Mr. Swanson received such generous 2011 perquisites as his personal use of company aircraft, tax gross-ups, home security system expenses, and spousal travel expenses.
Furthermore, the CEO realised over $11.1 million on the vesting of restricted stock, has accumulated more than $30.8 million in pension benefits, and is entitled to over $32 million in the event of a change in control. Finally, Raytheon's AGR score of 10 indicates more accounting and governance risk than 90% of companies and is partly driven by accounting red flags in the area of Expense Recognition and Asset-Liability Valuation, along with recent high risk events that include a $2 billion share repurchase plan and several high level acquisitions.
AGR Score: 9
Market cap ($MM): $2,011
Industry: Engineering / Construction
At Trinity Industries, compensation policies favour not only Chairman and CEO Timothy Wallace but also his brother (an officer of a subsidiary of the company who received total compensation of $1,178,193 for 2011) and father (former CEO of the company who is entitled to an annual salary of $5,000, reimbursement for out-of-pocket medical expenses, and use of the company's aircraft for up to 30 flight hours for the year).
It is also noteworthy that five of the company's directors (including four members of the Human Resources Committee) with at least two years of service do not share the risk of investors, as they hold zero company shares that are not exercisable stock options.
In addition, annual incentive awards and performance-based equity awards granted in 2011 for 2011-2013 are both based on EPS results, which suggest executives are being paid twice for achieving the same results. Finally, the company's AGR score of 9 indicates more accounting and governance risk than 91% of companies and is driven by the Expense and Revenue Recognition issues of large inventories, large operating revenues, and comparatively low cost of goods sold and SG&A expenses.
AGR Score: 9
Market cap ($MM): $4,192
Lennar Corporation, the third-largest home building company in terms of revenue, is badly rated by GMI for concerns surrounding the composition of its board, accounting practices, and recent investigations into the company by the labour Department.
CEO and President Stuart A. Miller controls almost 50 per cent of Lennar's total voting power with a board that holds substantial connections to management and a roster of directors averaging 18 years of tenure. Moreover, the AGR Rating for Lennar is Very Aggressive, indicating higher accounting and governance risk than 91 per cent of comparable companies, including poor ratios for Selling G&A Expenses/Operating Expense and Other Assets/Assets.
Finally, Lennar Corporation and other large home builders have been targeted in a U.S. Department of labour investigation into possible wage violations that circumvent federal wage laws; the misclassification of workers is a serious offence that has cost the federal government billions in previous years.
AGR Score: 9
Market cap ($MM): $42,355
Industry: Chemicals - Agricultural
Concerns at agricultural biotechnology firm Monsanto Company are generated by a constant swirl of litigation, pending investigations, and environmental issues, along with pay practices not aligned with shareholder interests and concerning financial accounting practices. Notable highlights include routine lawsuits targeting small farmers, the company's responsibility for over 40 EPA Superfund waste sites, and numerous settlements with plaintiffs injured by Monsanto products.
In the meantime, the company has been cited for SOX violations (only four other S&P 500 companies are unable to implement and maintain effective internal control over financial reporting); CEO Hugh Grant's annual pay typically features option grants that vest without performance-based features; and the company's takeover defenses are intended to reduce board accountability to shareholders.
Lastly, the company's AGR score of 9 indicates more accounting and governance risk than 91% of companies and is driven by the company's recent $1 billion share repurchase program, an aggressive acquisitions policy, and several red flags in the area of Revenue Recognition.
AGR Score: 8
Market cap ($MM): $2,353
Industry: IT Services / Consulting
DST Systems, Inc., a provider of information processing and software, is among our most poorly-rated companies due to concerns related to board composition, executive compensation and accounting.
The company's board is classified with a poison pill; there are three directors age 75 and older, suggesting succession planning concerns; and there are no women on the board.
Executive compensation is also a concern, with more than 30 per cent of shares voting against pay plans that include more than $250,000 each year in personal use of company aircraft for CEO Thomas A. McDonnell.
In terms of accounting, DST Systems has higher accounting and governance risk than 92% of companies, including poor ratios versus its industry in Debt/Equity and Cash Ratio as well as Intangible Assets/Assets, a red flag for overvalued assets.
AGR Score: 8
Market cap ($MM): $2,335
Industry: Investment Services
Diversified investment company Chicago Board Options Exchange Holdings, Inc. is among our most poorly-rated companies due to concerns with the compensation of the board, executive compensation policy, and patent-infringement claims brought by the International Securities Exchange in May, as well as various accounting concerns.
CBOE's board includes four directors who are Trading Permit Holders or affiliated with Trading Permit Holders, meaning a substantial portion of their income is derived from activities cleared on company exchanges.
40-per cent of the board is long-tenured, including those in key decision making roles, and the compensation committee continues to award discretionary bonuses on an annual basis and fixed pay in the upper echelons of its peers, including lofty base salary and perquisites.
Finally, CBOE has been flagged as very aggressive in accounting for issues like extreme operating margins and levels of intangible assets.
AGR Score: 8
Market cap ($MM): $3,506
Industry: Chemicals - Commodity
RPM International is notably balanced in its governance-related issues, as indicated by red flags in compensation, board composition, and takeover defenses.
The company's poison pill and classified board structure serve to reduce board accountability to shareholders; its board is dominated by long-tenured directors who are at least 70 years old, including the CEO's father (who is also a former CEO); and pay practices include long-term equity grants that vest simply over time and performance-periods as short as one year.
Luckily, none of these deficiencies are lost on shareholders as all the directors received between 14 and 43% withhold votes at their last election, which represents a considerable amount of shareholder dissent.
Finally, the company's poor AGR rating is dominated by several Asset-Liability Valuation red flags that include relatively high expected returns on assets along with excessively large intangibles and large goodwill, both of which are key indicators of overvalued assets.
AGR Score: 8
Market cap ($MM): $6,783
Industry: Aerospace / defence
Concerns over the composition of the board, takeover defenses, poor compensation policy, and accounting metrics result in a high risk warning for Aerospace/defence Products & Services provider L-3 Communications Holdings, Inc. For example, more than 40 per cent of the board has served in excess of a decade while more than 40 per cent are also at least 70 years of age, re-igniting succession planning issues that came to light when the company's co-founder, chairman and CEO Frank Lanza passed away in June 2006.
The company's compensation policy uses the same performance measures for annual and long-term awards (EPS and Free Cash Flow), rewarding executives multiple times for the same achievements.
In terms of accounting, L-3 Communications is more aggressive than 92 per cent of the companies we cover, with flags primarily relating to Asset-Liability Valuation and including Pension Assets Expected Return Domestic and Goodwill/Total Assets.
AGR Score: 8
Market cap ($MM): $89,621
Industry: Communications Equipment
Technology titan Cisco Systems, Inc. is considered high risk due to concerns regarding executive compensation and accounting.
Despite potential dilution from Cisco's stock option plans that has exceeded 20 per cent for at least the past four years, the company continues to award stock options to executives to the tune of $12.5 million for CEO John T. Chambers in 2011 and grants with a value between $7.2 million and $10.5 million for other named executive officers.
Cisco's financial statements also receive an AGR score of (5), indicating more governance risk than 95% of comparable companies, and the company has had a lower AGR score than most companies since December 2009.
AGR Score: 7
Market cap ($MM): $2,039
Industry: Healthcare Facilities
Healthcare service provider Community Health Systems, Inc. meets the criteria for our riskiest companies due to concerns over low support for executive pay plans and several significant accounting flags.
Indeed, the company's Say on Pay vote managed just 33 per cent support at the May 2012 annual meeting, presumably resulting from poor compensation policy which includes enormous annual pension contributions ($8 million a year for three years running), the use of the same performance metrics for annual and long-term plans, and potential severance payments of nearly $75 million. Community Health's AGR Rating is just seven on a scale of a hundred, due to poor ratios for Inventory/Cost of Goods Sold, Cost of Goods Sold/Revenue, Debt/Equity, and Cash Ratio.
AGR Score: 7
Market cap ($MM): $5,569
Industry: Casinos / Gaming
Casino and resort operator MGM Resorts International is among our most poorly-rated companies due to concerns related to the make-up of the board, costly litigation and other accounting concerns, purported ties to Chinese gang activity, and declining share ownership by the principal shareholder.
The disastrous CityCenter construction project in Las Vegas has resulted in a multitude of securities and derivative lawsuits and the controlling interest in MGM China pairs the company with Hong Kong businesswoman Pansy Ho, believed to have extensive links to Chinese organised crime. Kirk Kerkorian, principal shareholder and CEO of MGM, sold $20 million in company shares in February 2012, reducing his ownership to 18.7 per cent of the company, down from 53.4 per cent as recently as 2008.
Also, with an AGR Rating of just seven, MGM places in the worst 10 per cent of companies in our coverage universe, including poor ratios for Asset-Liability Valuation, Prepaid Expenses/Operating Expense, and Operating Revenue/Operating Expense.
AGR Score: 5
Market cap ($MM): $1,295
Arch Coal Inc. ranks among our worst-rated companies due to abundant legal and sustainability problems, and significant accounting concerns. Incidents and settlements in 2011 included a March 2011 settlement for violations of the Clean Water Act in three states, the death of a miner in Virginia in August 2011, and a wrongful death lawsuit settlement with six families in November 2011.
Arch Coal has higher accounting and governance risk than 95 per cent of companies, including poor ratios for Pension Liability Discount Rate Domestic, Goodwill/Total Assets and Selling G&A Expenses/Operating Expense.
AGR Score: 4
Market cap ($MM): $11,299
Industry: Healthcare Facilities
Health care provider HCA Holdings, Inc. is considered high risk due to concerns related to accounting and compensation, as well as the dominant control of Hercules Holding II, LLC.
Hercules Holding II, LLC nominates all directors, controls the vast majority of all voting stock, and essentially elects the entire board of directors, including the compensation committee. That committee bases bonuses on a single metric-EBITDA- which is also used in the determination of long-term awards.
Finally, the company rates just 4 on a scale of 100 in terms of AGR, primarily as a result of poor ratios for Inventory/Cost of Goods Sold, Costs of Goods Sold/Revenue, and its Cash Ratio
AGR Score: 4
Market cap ($MM): $67,799
Industry: Food Processing
Kraft Foods (soon to be named Kraft Foods Group, Inc. following the completion of its split into two independent companies) is among our most poorly rated companies due to concerns over executive compensation, accounting metrics, and recent legal developments.
For example, Chair and CEO Irene Rosenfeld's fiscal 2011 Total Summary Compensation, $22 million, is more than five times the median of other named executive officers and includes pay untied to performance such as hefty pension payments, mega-grants of stock options, performance-shares that pay out for underperforming peers and annual incentives than can be increased as much as 80 per cent by the compensation committee for a subjective assessment of individual performance.
Furthermore, in October 2011, Germany's Federal Cartel Office imposed fines against Kraft Foods Germany for price-fixing; and lawsuits have been mounting since a Canadian investigation into chocolate manufacturers, including Kraft, turned up violations of antitrust laws.
Finally, the company's financial statements reflect an AGR score of just 4 out of 100, indicating more accounting risk than 96% of companies.
AGR Score: 2
Market cap ($MM): $3,644
Industry: Personal Services
Netflix can't seem to avoid the headlines, but when your stock price falls from nearly $300 to about $60 in less than a year, it's hard to hide behind a little red envelope.
Our concerns are highlighted by a compensation program that is simplistically limited to a cash salary and equity grants of stock options that vest simply after time without performance-based features, along with takeover defenses that reduce board accountability to shareholders.
Furthermore, the company's AGR score of 2, which indicates more accounting and governance risk than 98% of companies, serves to illustrate many of our other key concerns. As an example, a class action lawsuit filed at the beginning of the year alleged that Netflix and certain of its officers and directors issued false and misleading statements regarding the company's business practices and its contracts with content providers, causing the company's stock to trade at artificially inflated prices.
On top of that, the company's restructuring of its online and DVD rental services may have led to a loss of over 5 million subscribers.
AGR Score: 1
Market cap ($MM): $38,845
Industry: Advanced Medical Equipment
Healthcare equipment supplier Medtronic, Inc. meets our criteria for a high-risk company with repeated litigation problems, compensation concerns and the very worst accounting rating that our algorithm will allow.
The company settled a class action suit for downplaying the risks associated with its Infuse bone graft device, in March 2012 for $85 million, amidst allegations that Medtronic paid illegal kickbacks to doctors. These events followed a December 2011 settlement of almost $24 million to settle allegations of kickbacks paid to doctors to encourage the use of its pacemakers and its defibrillators.
The company's compensation committee includes the CEOs of General Mills and Delta Air Lines, Inc. among its four members, and uses EPS and revenue growth for both annual bonuses and long-term awards, potentially rewarding executives twice for the same achievement.
Furthermore, Medtronic's AGR score of 1 indicates higher accounting and governance risk than all but one per cent of our North American coverage universe.
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