The Challenge of Investor Communication: The case of CUC International
Healy and Palepu
Journal of Financial Economics 38 (1995): 111-40.
Executive Summary
CUC international was experiencing difficulties in financial world as a result of accounting policies. The paper discusses the many things the company did to convince shareholders that the firm was solid and in a good position. In doing so, the paper serves as a review of signaling theory and also stresses how investors forecast cash flows. Finally, it suggests that stock prices do fluctuate from "true" value.
CUC Intl (main product is Shoppers Advantage) after being a market favorite (INC magazine top growing firms) was recording marketing expenses as assets (due to increased future sales from them (similar to AOL?). Auditors agreed with management that the accounting treatment was not a problem. However, investors did not! Investors and analysts feared the company was being too aggressive in accounting. Stock price fell a market adjusted 35%.
Managers, who did not want to let competitors know inside information (basically success rates on marketing budgets and retention rates), were unable to persuade investors (or reporters-WSJ)) of the undervaluation. Impetus for change was a takeover the firm wanted to do using equity. Now undervaluation became more of a pressing issue.
Firm did everything right! Changed accounting of expenses to record it in first year (rather than defer it over three years). Thus basically went to cash-basis accounting. Stock (contrary to opinions) still fell on announcement. They then did a leverage recap. $5.00 dividend was financed with private debt (2 good signals!). Market still not totally convinced! Announced stock buyback and early debt repayments as proof they had the cash flow. In total the market did get the hint and stock dramatically outperformed over the next period.
Key points:
- Why investors could not see undervaluation. Even as severe as 35%
- The failure of managers' words to impact market (actions speak louder than words).
- Why firms sell shares publicly in the face of information difficulties (as authors point out one reason is to be able to pay employees with options)
Overall a very enjoyable article that sort of confirms the utility in studying finance and in implementing some of the things we learn in class.
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