News vs. Noise: Board Changes

October 30, 2007 by Joe Ponzio

Shortly after posting the biggest quarterly loss in the company’s history, Merrill Lynch fired CEO Stan O’Neal. On the news, shares of Merrill Lynch (MER) dropped 2.1% before today’s opening bell – immediately wiping out $1.2 billion of market cap.

Come on – did Merrill’s business really take a $1.2 billion hit this morning? Or is this noise that looks like news?

O’Neil’s Short History

Stan O’Neil became the CEO of Merrill Lynch in 2002 – not surprising since the company’s stock price was sliding down more than 50% since its 2001 high. Since O’Neil’s reign began, the company has grown revenues from $13 billion in 2002 to more than $70 billion in 2006. Earnings grew handsomely – from $1.80 to nearly $8 a share.

Clearly, MER was growing.

And Then…Ouch

Merrill Lynch overexposed itself to subprime loans – ultimately whacking shareholders with a roughly $8 billion “oops, we screwed up” expense and a net quarterly loss of $2.3 billion. Enough history, let’s look at the news…

Was O’Neil The Problem?

Merrill Lynch is down $8 billion, and is expected to lose more as their problems unfold. Right now, they are pointing the finger at O’Neil – the cost-cutting, focus-on-high-profit-business-lines CEO that was working to refocus Merrill, ultimately leading to the company’s doubling in just five years.

Now, I don’t pretend that I know the intricacies of Merrill’s business, but I have a hard time believing that the CEO of a publicly trading company with more than 56,000 employees was sitting at his desk, allocating money to sub-prime mortgages. I know – Buffett allocates Berkshire’s capital; still, Warren is the exception, not the rule.

Instead, I’d be more willing to believe that O’Neil had a conversation similar to the following:

O’Neil: We need to focus on our high profit business lines. No more selling Roth IRAs to college kids.
Manager: We’re making a killing in this real estate boom. We should focus our efforts there. Look at this chart – high profit margins, quick sales, relatively high returns. It is a cash flow dream.
O’Neil: I like it. Let’s run it by the board, and we’ll allocate x% of our capital towards it. It is a little different direction than we’re used to, but we’re in the business of profits.

Or something like that.

Sift Through The Noise To Find The Intent

Okay – I’m a little skeptical. Still, I have a hard time believing that Merrill’s problems consistently fall on the shoulders of one person – a person who is quickly replaced any time the stock price falls drastically or Merrill’s mistakes result in a loss.

Here’s the reality: At most large, public companies, the CEO is the spokesperson, salesperson, face, voice, and cheerleader of a company. As easy as it is to blame O’Neil for the $8 billion write-down, Merrill’s problems run deeper than the guy in the big office.

What was the intent of this action? More than likely, it was as attempt to maintain or restore investor confidence in Merrill so the stock price doesn’t drop too much. “Look at us – we’re firing the CEO because we care about our shareholders!”

The Result…

What will the CEO change do for Merrill? Odds are good that it will do very little. If O’Neil stayed, he would have worked just as hard to rectify the situation as will the new CEO. Still, the business has some problems and some upcoming losses that it will probably have to overcome.

Unless the company is ousting the founder – the person who built the company from scratch and ran it according to his/her vision – management changes do very little in the short-term. At the end of the day, most businesses – at least most good businesses – should run well regardless of who is at the helm.

As Peter Lynch said:

Go for a business that any idiot can run because sooner or later, any idiot probably is going to run it.

Management Changes – When It Is News

When is a change in management news? When the company’s direction will change with new management. When the founder’s vision is traded for the quest for profits. When a major scandal is unfolding and the business won’t be able to survive. Or, when the company is so small (in personnel) that a key individual does have a meaningful impact.

Otherwise, if the business will survive in spite of a tough short-term challenge, a change in management means very little. Rather than focus on the noise, look at the manager. If he or she is some posh, elusive, ?typical? Wall Street executive, and the company is trading one Wall Street executive for another, the news is usually anything but new.

Invest In The Business; Hope For Great Management

If you were blindsided by Merrill’s “shocking” news, you likely didn’t understand their business well enough. I have a hard time valuing complex financial services companies so I skip them. Stick with your sphere of competence and you’ll help protect yourself from being surprised.

A Note From Joe Ponzio

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