By John P. Gavin, CFA
There is a strong case to be made that Qualcomm (NASDAQ:QCOM) has a material accounting risk that remains largely undiscounted despite the company having first disclosed elements of it over a year ago in November 2010. This could put investors at risk for a negative surprise in 2012.
According to Qualcomm filings, whistleblower allegations made to its audit committee in December 2009 triggered a formal SEC investigation in September 2010. The SEC investigation appears active-and-ongoing as of QCOM’s most recent disclosures. Amazingly, not one person has bothered to ask a single question about this exposure in any of the conference calls that took place since the matter was first disclosed.
In the balance of this note, I explain why Qualcomm’s accounting exposure should be viewed as a material risk. I also review the 6 most common disclosure tactics that we see public companies use, typically with the effect of minimizing bad news or throwing investors off the scent. To date, Qualcomm has used 5 of them, making the risk impossible to assess and discount, even for seasoned investment professionals.
The bottom line is this. Qualcomm is a public company that has disclosed a material risk factor investors cannot analyze. In our view, that means management trust has been compromised as they could give investors what’s needed to analyze this exposure, but chose not to. Investors will have to decide on their own if that is the kind of risk that lets them sleep at night.
Crossing the Materiality Threshold
I often speak to professional groups about risk as it pertains to public company disclosures. In those talks, there is a core concept I teach called “The Materiality Threshold.” It’s a simple way I came up with to help investors better interpret disclosed risk events. It goes like this:
In general, public companies are only required to disclose matters investors would deem material to making an investment decision. Unfortunately, management is the judge and we all know how much they hate disclosing bad news. Therefore, any time a company discloses something bad, a good rule of thumb is to assume the matter is material to making an investment decision. This applies no matter how many soothing words, assurances, or even lack of information may accompany the disclosure. In short, if management thought the matter important enough to disclose, you need to pay attention to it.
So let’s apply this concept to Qualcomm. But first, which of these do you consider material?
- December 2009: A whistleblower goes to QCOM’s audit committee.
- 2009 - 2010: The audit committee retains forensic accountants and independent counsel to conduct an internal review of the matter.
- Sometime between June 2010 - September 2010: The SEC likely begins an informal probe into the matter.
- September 2010: For reasons unknown, the SEC finds it necessary to escalate the informal probe to a formal probe.
Most professional investors would reasonably consider any of the above as potentially material to the investment decision-making process and therefore in need of disclosure. Management at QCOM did not see it that way. In fact, QCOM sat on all of the above until the 10‐K filed 3‐Nov‐2010, when it finally disclosed the following for the first time:
On September 8, 2010, we were notified by the SEC’s Los Angeles Regional office of a formal order of private investigation. We understand that the investigation arose from a “whistleblower’s” allegations made in December 2009 to the audit committee of our Board of Directors and to the SEC. The audit committee has conducted an internal review with the assistance of independent counsel and independent forensic accountants. This recently concluded internal review into the allegations and related accounting practices did not identify any errors in our financial statements. We continue to cooperate with the SEC’s ongoing investigation.
If the leadership at QCOM did not consider an audit committee whistleblower allegation review all the way to a formal SEC investigation sufficiently material to warrant disclosure, one has to wonder/fear what it took for management to finally cross that materiality threshold? Savvy investors should ask what changed to prompt the disclosure of something that management previously judged not worthy of disclosure.
Qualcomm’s Disclosure Tricks
Again, referring to when I speak on the topic of risk, I often refer to disclosure tactics (or what I call “tricks”) that we find commonly used by public companies. These tactics typically have the effect of minimizing bad news or throwing investors off the scent. They include:
1. Not disclosing at all.
2. Disclosures that lack substance.
3. Burying bad news/failure to give prominence.
4. Failure to give meaningful update.
5. Misleading disclosures.
6. Companies claiming, falsely, they can’t discuss investigations and such.
Qualcomm has engaged in all but the last of these tricks. We don’t know if they would use the “Can’t discuss” dodge as in Trick #6 since no one from the analyst crowd has bothered to ask even one question about this exposure on conference calls. We discuss each tactic below.
1. Not disclosing at all.
The timeline for QCOM’s accounting problems demonstrates clearly this is a company that failed to disclose bad news until well after it occurred. We have reviewed thousands of disclosures related to SEC investigations, internal reviews, and other types of regulatory activity. Based on our expertise and experience, we are confident in warning investors that there is a lot of information that QCOM is not providing on this matter that they could provide if they chose to.
We do know that QCOM sat on audit committee whistleblower allegations for almost a year. The company says the whistleblower first came forth in Dec-2009. But the first time investors heard about the whistleblower allegations and the subsequent SEC investigation it triggered wasn’t until the filing of the 10-K in Nov‐2010.
Whistleblowers are by definition insiders who are putting careers, income, and even their freedom on the line by coming forward. Yet to this day, QCOM has never disclosed anything substantive about the whistleblower allegations other than the fact they exist and were serious enough to warrant use of forensic accountants and independent legal counsel in addition to triggering an SEC investigation that remains unresolved to this day.
There was an audit committee review in response to the allegations about which investors have also been told little. Did the review and forensic experts look into allegations of fraud, errors in accounting procedure, or errors or misrepresentation in the financial statements? Qualcomm did not disclose the answers.
Further, it is likely that the SEC had been investigating QCOM longer than the company’s disclosures indicate. Based on data we routinely acquire from the SEC under the Freedom of Information Act, we can say with confidence that the SEC’s first contact with QCOM took place sometime between 21‐Jun‐2010 and 8‐Sep-2010. QCOM’s first disclosure of the SEC investigation was in Nov‐10. At that point, the investigation was already at the formal stage and supposedly had started in Sep-2010. However, we also know that SEC investigations typically start at an informal stage.
2. Burying bad news/failure to give prominence.
QCOM claims it was notified by the SEC in Sep‐10 of the formal order of investigation. Not only did it wait two months before disclosing this, it used the less-prominent technique of burying disclosures related to the whistleblower allegations and formal SEC investigation in the Nov-2010 10‐K. An alternate and more prominent approach would have been for the company to issue a press release as well as a separate 8-K. In the best of cases, a conference call would have been held with investors to address questions or concerns the disclosures may have triggered. In this case, all investors got was a bunch of crickets sitting atop a 10-K.
3. Disclosures that lack substance.
The poor quality of QCOM’s disclosure related to the whistleblower allegations and subsequent SEC investigation leaves us questioning the company’s overall disclosure practices.
As stated above, QCOM has not elaborated on the nature of the whistleblower allegations or the issues in the SEC investigation. All we know is that the allegations were serious enough to warrant an internal review by the audit committee with the assistance of independent counsel and independent forensic accountants.
QCOM’s initial disclosure of an internal review was in Nov‐10, at which point it had already been completed. The company did not say when the review started or the date the review was completed. An important piece of information that we often look for is whether an internal review started before or after the start of the informal SEC investigation. This gives us an idea of how proactive the board has been in addressing the issue. That information is not in QCOM’s disclosure.
Another item that has us curious is why the SEC felt compelled to make its investigation formal. A formal order of investigation is typically initiated to provide the SEC subpoena power. It is during an informal SEC investigation that companies can voluntarily provide information. We think QCOM’s formal investigation could indicate that the company was not cooperating with the SEC’s investigation.
At times like this, it pays to remember that it is the company’s attorneys who are writing its disclosures. Those attorneys have a duty to protect their client, which is QCOM, not you.
4. Failure to give meaningful updates.
There has been no meaningful update since the initial disclosure in Nov‐2010, so we do not know where the SEC investigation stands today. Despite being under SEC investigation for at least a year (during which time one would have to imagine there had been some sort of developments), QCOM’s disclosures have maintained the same form and substance as the original disclosure, as you can see below from the 10‐K filed 2‐Nov‐2011:
On September 8, 2010, we were notified by the Securities and Exchange Commission’s (SEC) Los Angeles Regional office of a formal order of private investigation. We understand that the investigation arose from a “whistleblower’s” allegations made in December 2009 to the audit committee of our Board of Directors and to the SEC. The audit committee completed an internal review with the assistance of independent counsel and independent forensic accountants. This internal review into the allegations and related accounting practices did not identify any errors in our financial statements. We continue to cooperate with the SEC’s ongoing investigation.
5. Misleading disclosures.
QCOM did not report the results of the internal review. This is despite the fact the audit committee deemed it necessary to engage forensic accountants and independent legal counsel to conduct the review. Instead, QCOM played a little word game in which it reported that the internal review of the allegations and related accounting practices “did not identify any errors in the company’s financial statements.”
This is a very specific statement worth parsing out. While no “errors” may have been found (with errors implying a mistake, akin to someone in accounting accidentally transposing a number), QCOM did not indicate that nothing was found in the review triggered by the whistleblower allegations nor did they say what was found.
Moreover, since QCOM did not disclose the whistleblower allegations, we do not know the scope of the audit committee review and whether errors in the financial statements were at the heart of the matter.
6. Companies claiming, falsely, they can’t discuss investigations and such.
If and when investors get around to pressing Qualcomm for answers, it will be interesting to see the company’s reaction. Be forewarned. The last disclosure trick we commonly see is companies hiding behind specious claims of “confidentiality” or statements like “it’s an ongoing investigation” as a means to dodge answering the legitimate questions of investors. You need to know that, in general, there is no restriction to keep a public company from disclosing more information to investors in these matters. Just because their attorneys don’t typically like it doesn’t mean you aren’t entitled to answers
Should you ever encounter one of these “can’t discuss” responses, you can rest assured “can’t” likely means “won’t.” In that case, you are faced with a public company that’s disclosed a material risk factor you can’t analyze. To our view, that means management trust has been compromised.
In light of the foregoing, some investors may find themselves sleeping better at night if they take their money and invest it with someone they can trust. Based on our analysis of its disclosure practices, that’s not Qualcomm at present.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Some of this material was previously disseminated to subscribers and in public presentations in front of professional groups.