By Damion Rallis, Senior Research Associate
The day after Christmas proved to be a rude awakening for semiconductor manufacturer Marvell Technology Group Ltd. (NASD:MRVL) and its beleaguered shareholders. A jury in Pittsburgh delivered a $1.17 billion verdict against the company in a long-running patent lawsuit with Carnegie Mellon University (CMU). While some shareholders are giving up hope as the decline of Marvell shares has persisted since the beginning of 2011, we take a deeper look to see if the massive penalty is an aberration easily overcome or if Marvell Technology is merely demonstrating a pattern of ongoing accounting and governance risk.
Currently, while Marvell's "C" Home and Sector ESG Rating reflects moderate risk relative to its competitors specifically and US companies in general, its AGR Rating-a measure of corporate integrity based on metrics of reported financial results and corporate behavior-is "Aggressive." Furthermore, GMI Ratings' Litigation Risk model has been showing warning signs about Marvell for several years. The company's score is 1 (on a scale from 1 to 100), meaning "High Risk" with a 10.2% probability of Class Action Litigation occurring within the next 12 months. This places Marvell in the 1st percentile of all companies in North America, indicating higher shareholder class action litigation risk than 99% of all rated companies in this region.
While it is important to note that the $1.17 billion verdict is subject to appeal, there is also a possibility that the damages could triple to about $3.5 billion-an amount that is dangerously close to the company's current market cap value of $4.2 billion-since jurors found Marvell's patent infringement was willful. In addition to the $1.17 billion jury award, Marvell is required to make 50-cent royalty payments on all infringing HD controller chips sold in the future. According to a report on Seeking Alpha, the CMU patents "currently encompass all of Marvell's HD chips [and] the per-chip royalty will result in roughly a 20% hit to operating margins on their HD controller business." The report goes on to say that "since the HD controller business makes up approximately 50% of Marvell's sales, the ongoing impact to earnings will be astounding, and could result in a 25% reduction in net earnings for Marvell as a whole going forward."
In sum, the jury award could prove very damaging to Marvell shareholders. The question is do we have any confidence that Marvell Technology will be able to bounce back? The short answer, after scanning the company's risk profile and our list of company events dating back to 2000, is no. The company is run by a small board of directors dominated by management influence. The recent verdict isn't the first time the company has found itself embroiled in trouble. Moreover, while Marvell has known for some time the risk associated with the CMU patent infringement suit, it has been burning through cash with a seemingly endless share repurchase program first introduced in 2010.
Marvell Technology was founded in 1995 by current CEO and Chairman Sehat Sutardja; his wife, former COO and current Vice President and General Manager of Communications and Consumer Business Weili Dai; and the CEO's brother, Chief Technology Officer and Chief Research and Development Officer Pantas Sutardja. The brothers, who control about 20% of the company's voting power, dominate Marvell's board of directors which includes only four other independent directors, calling into question the board's ability to act as an effective counterbalance to management. So what can go wrong when an entrenched, powerful (and related) management is firmly controlled? A lot, apparently.
In 2006, the same year Ms. Dai was named COO, Marvell received a letter of informal inquiry from the Securities and Exchange Commission (SEC) requesting certain documents relating to the company's stock option grants and practices. Several months later in 2007, a Special Committee concluded that Marvell had backdated options and recommended several remedial actions, including stripping the CEO of his Chairman duties and terminating the services of Ms. Dai, who was said to bear a certain amount "of responsibility for these deficiencies." The board ignored these decisions, choosing instead to "demote" Ms. Dai and to appoint an independent lead director instead of reducing the CEO's firm grip on the board.
That the husband and wife ignored remedial actions despite their highly unethical behavior reflects their unchecked control of the company's operations. A Bloomberg article reported that from 2001 to 2006, CEO Sutardja and Ms. Dai (along with fellow officers and directors) received more than $760 million from the sale of 36 million shares, most of which were backdated. "In a setup that differs from that at most companies, Sutardja and Dai were the sole members of the committee that doled out options. It's unusual to have a married couple occupying the senior executive positions in a company, let alone allow them to be in charge of handing out stock-based compensation"
After the smoke had cleared, Marvell agreed to pay a $10 million fine "for a pattern of backdating that allowed Marvell to overstate its income by $362 million from its fiscal years 2000 through 2006.'" (In 2009, Marvell paid $72 million to settle a related class action lawsuit.) Ms. Dai also entered into a settlement with the SEC in which she consented to a permanent injunction against any future violations of various provisions of the federal securities laws, agreed not to serve as a director or officer of a public company for a period of five years, and will pay a civil penalty of $500,000. According to the Wall Street Journal, the SEC said the size of the fines "partly reflect that the company didn't follow the recommendation to fire her. According to the SEC's complaint, Ms. Dai didn't cooperate with the agency's investigators and invoked her Fifth Amendment right against self-incrimination when asked 'substantive questions' by SEC staff."
Despite the settlement, Ms. Dai (with the benevolent assistance of Marvell's "independent" board members) continues to be generously compensated. For 2012, she received the following compensation package approved by the company's Audit Committee and Executive Compensation Committee:
- a $400,000 bonus;
- an increase in her annual base salary to $510,000 (from 500,000);
- a bonus participation target for Ms. Dai equal to 80% of her base pay;
- a mega-grant of 800,000 options with service-based vesting; and
- a grant of 80,000 restricted stock units with service-based vesting.
Altogether, her fiscal 2012 compensation comes to roughly $6 million, an amount that makes her the second highest paid named executive officer (NEO) at Marvell, if she were allowed to be called an "executive." Furthermore, only the most gullible would interpret Mr. Dai's demotion to mean she was actually demoted: according the company's official leadership page on its website, Ms. Dai continues to be listed as one of the three primary leaders at the semiconductor company. In short, since the board simply refused to make real leadership changes after the company's very public options backdating scandal and is clearly devoid of actually independent oversight to counterbalance its founders' oligarchy, we have little confidence in the current leadership to not only overcome its massive patent trial damages but also its struggling share price and diminished financial returns.
Our assessment of the company centers on its ownership structure as a family firm. For family firms, the key consideration when evaluating risk is whether the family members in leadership positions act on behalf of all shareholders or make decisions which unfairly favor the family interests. In addition, we note multiple multi-million dollar related-party transactions between the company and entities indirectly owned or influenced by Sutardja family members. Also, the Sutardja brothers are the two most highly compensated NEOs at Marvell, despite their equity holdings. In fact, the CEO received total summary compensation worth more than four times the median for the other NEOs, raising concerns about internal pay equity. The bulk of his compensation ($11.3 million) consisted of a mega-grant of 700,000 market-priced stock options that vest simply over time without performance-contingent criteria and a mega-grant of 1.4 million performance-vesting options tied merely to the company's share price over any 200 consecutive trading day period.
While the company maintains faith that its shares are undervalued-evidenced by an ongoing share repurchase program that has already completed $2.1 billion in share repurchase and is authorized for $900 million more-we note that its latest repurchase authorization came less than two weeks before the news of its $1.17 billion fine. In other words, what now? The next time an underperforming company is trying to convince you that everything is going to be all right, check carefully into the company's risks and pending litigation in its 10-K, and then take a trip down memory lane into our list of company events. After a while, a very clear story might start to emerge. If you look closely, you'll notice that Marvell is incorporated in Bermuda. Why would a company headquartered in California founded by three Berkeley graduates be incorporated in Bermuda? According to the New York Times, companies are incorporating in Bermuda "to lower their taxes sharply without giving up the benefits of doing business in the United States." Senator Charles Grassley, the ranking Republican on the Senate Finance Committee at the time of the article, had this to say: "There is no business reason for doing this, other than to escape U.S. taxation. I believe the Finance Committee needs to investigate this activity."
For us, there's just too much evidence that the leadership at Marvell Technology is focused on all of the wrong things.
Disclaimer: GMI Ratings is an independent provider of research and ratings on environmental, social, governance (ESG) and accounting-related risks affecting the performance of public companies. GMI Ratings is a registered investment adviser and is therefore subject to certain reporting requirements. Specifically, per our ethics policy, our analysts are precluded from engaging in any transactions involving any companies we follow. Our ratings and supporting research are intended to provide investors with an effective summary of ESG and forensic accounting factors that can and do impact issuer risk. They are not, however, intended for stand-alone use and should not be considered as simple Buy, Sell or Hold recommendations. We encourage investment professionals to regard these ratings as a specialized, proprietary input to be used in combination with existing fundamental analysis or other approaches and to help comply with the UN-PRI (United Nations Principles of Responsible Investing) and similar standards.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.