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The long road to recovery
by Cheryl Meyer
Updated 01:41 PM EST, Jun-24-2005
 

A year has passed since Sanjay Kumar, the former apprentice-turned-CEO at Computer Associates International Inc., stepped down from his post at the scandal-ridden software company.

Now, as Kumar awaits trial on charges of securities fraud and obstruction of justice, CA is touting its transformation as a cleaned-up enterprise. Since last year, the Islandia, N.Y., company has hired a new management team, signed a settlement with shareholders and the government and put in checks and balances to avoid future predicaments. It also underwent a restructuring, refocused its product line and is trying to improve customer service, where its reputation has suffered for years. It is also acquiring again.

"This is a new day at CA and I'm excited about what lies ahead for the company," former interim CEO Kenneth Cron boasted during a conference call last October.

While outside observers applaud all that, CA is still a long way from becoming the revitalized, unsullied software powerhouse that it so desperately wants to be. For starters, the company can't seem to get its financial house in order. In late May, CA reported an 81% drop in fourth-quarter net income and announced it must readjust its financial statements one more time after it discovered questionable transactions that occurred between 1998 and 2001. The news prompted Standard & Poor's on May 27 to revise its outlook on the company from stable to negative. Three Wall Street analysts have downgraded CA's stock since January. Experts say the restatement, which amounts to around $100 million, is a financial hiccup for CA. But it's one the company didn't need.

"We know this song and we don't want to hear it again," says Nitsan Hargil, a senior technology analyst with Friedman, Billings, Ramsey & Co., which downgraded CA's stock twice last year. Analysts are also concerned the company is relying too much on its mainframe management business, a technology poised for decline, which comprised about 52% of CA's sales in the fourth quarter.

CA also has been unable to escape shareholder Sam Wyly, the Texas billionaire who has launched numerous lawsuits against the company. Wyly has criticized CA's board for being slow to take action against former executives, and he wonders why those board members remain on the job.

Finally, some question whether John Swainson, the new president and CEO, is up to the task of turning around a battered software company. Swainson ran IBM Corp.'s sales force for several years but never an entire company, let alone one this size. He took Cron's place in February; Cron stayed on as a company director.

Computer Associates could be a proxy for many companies felled by scandals and legal woes — though it's not had to suffer through the purgatory of Chapter 11. It's one thing to stop the bleeding from investigations and civil — or even criminal — charges, or take the company out of the headlines. It's another to remake the company with new senior executives, to repair damage inflicted on customers, vendors and workers, then strategically make sense of operations. That's the task that CA now faces.

Computer Associates' problems surfaced in 2001, when Wyly, who had sold his company, Sterling Software Inc., to CA in 2000 for $4 billion in stock, alleged corporate mismanagement at CA and launched two consecutive, highly publicized proxy fights, costing both sides millions of dollars in lawyers' fees and advertising expenses. The Texan eventually abandoned his quest after reaching a $10 million settlement with the company, but the contests put CA in the spotlight. In 2002, federal investigators began an extensive probe into the company's accounting methods.

Kumar denied wrongdoing at CA and continually bragged about the company's ethics. "I truly am committed to be the gold standard for corporate governance," he told The Deal in November 2002.

Still, in August 2003, CA agreed to settle some lawsuits filed by shareholders who had accused the company of accounting misdeeds. CA issued 5.7 million shares, worth more than $150 million.

Fast forward to 2005. Today, seven former executives have been indicted or pleaded guilty, and the company has acknowledged it improperly booked $2.2 billion in revenue after some executives schemed to backdate sales contracts. The board fired most of CA's top brass, eventually demoting Kumar to chief software architect until he stepped down in June 2004.

"Sam has turned out to be more right than he knew," says William Brewer III, Wyly's lawyer and a co-founder of Dallas law firm Bickel & Brewer.

A few months after Kumar's departure, CA agreed to reimburse shareholders again — this time $225 million — as part of a deferred prosecution agreement it signed with federal officials. This agreement granted CA immunity from prosecution, as long as the company agreed to take numerous steps to clean house and have a court-appointed examiner appoint it for 18 months. The U.S. Department of Justice and the Securities and Exchange Commission, meanwhile, assumed responsibility for pursuing CA's rights to retrieve any compensation and bonuses — i.e., ill-gotten gains — that the former executives received based on fraudulent financial results. CA also agreed to provide information to aid the government's effort.

Gary Lutin, an investment banker at Lutin & Co. and manager of an investor-sponsored, online public stockholder forum, has criticized both shareholder settlements. Had the company not settled, he says, remaining company officials, including the board, would have been exposed to liability.

"The directors essentially used shareholder funds to buy themselves a 'Get Out of Jail Free' card," he says.

In April, the company revamped its executive compensation program, which is no longer tied to CA's stock performance but instead is based on billings growth, adjusted cash flow from operations growth, adjusted net income growth and customer satisfaction.

Wyly, though, remains miffed about the shareholder agreements and says the roughly $400 million allotted to shareholders is not enough, according to Brewer. He and his investor group claim to have lost more than $100 million in the scandal, and he's fed up that CA's board didn't go to bat for shareholders by attempting to recoup settlement, legal costs and ill-gotten gains from the lawbreakers, but instead signed an agreement to let the feds handle the problem.

Brewer says the $400 million reflects only 3 cents on every dollar that shareholders lost in the scandal. "That ought to be given back by [co-founder Charles] Wang and Kumar and people who benefited to the tune of all that money. And who, by the way, have caused the company to spend tens and tens of millions of dollars in lawyers defending themselves." Wang retired as chairman in 2002 and has not been indicted.

In December, Wyly also filed a motion in New York asking the district court to allow him or other shareholders to pursue compensation pocketed by former executives, such as Wang, following the backdating periods. A spokesman says Wyly simply wants to return the money to the company coffers. And last September, Wyly filed suit against CA in Texas state court, alleging he was fraudulently persuaded to terminate his 2002 proxy fight to replace five seats on the company's board, and for breach of CA's promise to adopt improved standards of accounting and corporate governance.

Wyly won a significant victory in June when a judge granted his attorneys the right to view documents central to the 2003 class-action litigations. In April, Wyly had filed suit in New York State Court against Milberg Weiss Bershad & Shulman LLP and two other law firms that represented him and other shareholders in those litigations, alleging they refused to provide him with certain documents, including 23 boxes of files that had gone missing during the government's investigation of the company.

Wyly isn't the only barb in CA's side. Lutin, who runs his shareholder forum for stockholders of CA and other companies, has been an advocate for reform at Computer Associates, even writing a letter to the company April 5 asking the board to step down. Such "clean sweeps" are common following internal strife; Enron Corp.'s board, for example, bowed out after its scandal surfaced.

Lutin says that as long as CA directors who served before 2004 remain in place and continue to control the company's employees, including the CEO, CA will have a "credibility handicap" as it attempts to build relationships internally and outside.

"Investors have to consider the old CA board members' interests in defending their past conduct as a possible bias in every decision they make, including the pricing or strategy of an acquisition that might serve as a diversion to distract attention from unresolved problems," Lutin says. Stephen Davis, president of corporate governance consultancy Davis Global Advisors Inc., agrees board members need to go. "Every step of the way the board failed to take sufficient action to restore trust in the company," he says, calling the group "asleep at the switch."

In reality, it's up to shareholders or the board itself to remove board members, and that may take a while. CA does not have a staggered board and an alternate slate has not been proposed for the company's upcoming board meeting in August. CA press officer Shannon Lapierre says the company expects all board members to stand for re-election this year.

New CA chief operating officer Jeff Clarke defends the board, saying it has added three independent directors in the past six months and has worked to help the government as it continues its probe. A majority of the board members did serve before 2004, but only long-termers Russell Artz, CA's co-founder and manager of the company's product business units, and former U.S. Sen. Alfonse D'Amato, were at CA during the years when backdating occurred.

"It's important that we recognize that many members of the board were not at CA at the time of the scandal, and have been pivotal in cooperation," he says. "They worked incredibly hard."

But one of CA's new independent directors, Laura Unger, a former acting chairwoman of the U.S. Securities and Exchange Commission and past counsel to the U.S. Senate Committee on Banking, Housing and Urban Affairs, a committee D'Amato chaired, has already withdrawn from the board's special litigation committee in April, after Wyly's attorneys criticized her ties to D'Amato. The committee was recently formed to contend with lawsuits from Wyly and others.

These snafus aside, CA is doing many things right. Since early 2004 the company has overhauled its management, bringing in experienced faces from big companies. IBM's Swainson stepped in as CEO earlier this year, and Clarke, one of the chief architects behind the Compaq Corp.-Hewlett-Packard Co. merger in 2001, has been aboard since April 2004. Other executives — from Dell Inc., Citigroup Global Markets Holdings Inc., Novell Inc. and Sun Microsystems Inc. — have also joined CA.

Swainson is known as a good salesman and technologist, and as the creator of WebSphere, IBM's middleware technology. "He really strikes me as a standup guy and a straight-shooter, and I give him credit because I think he's at least quick to admit that CA is far from perfect," says Gregg Moskowitz, an analyst at Susquehanna Financial Group.

But some pundits wonder if Swainson is up to the Herculean task of steering a troubled software giant out of its various difficulties.

"My biggest problem with Swainson is that he is now in charge of all aspects of the business," says Kim Caughey, senior equity analyst at Fort Pitt Capital Group Inc., a money management firm in Pittsburgh and CA shareholder. "While it could be argued that he had a great deal of responsibility at IBM, he was not running the company. Nor was he even at the level of the top management. The additional responsibility of setting a strategy for the whole business and reporting to the board of directors are areas that he has not been exposed to prior to his position."

"John Swainson has to prove himself," echoes Trip Chowdhry, senior software analyst at FTN Midwest Securities Corp. "I still believe Jeff Clarke is running the show."

CA also added a corporate controller and chief accounting officer, both with easy access to the board and audit committee.

Last year, in a move to save $70 million, the company terminated 800 workers, or 5% of its work force. And this year, CA reorganized itself around five core business groups, including security management and enterprise systems management, so it could better respond to customer needs and the changing dynamics in the software sector. The company also plans to bolster its international expansion, particularly to Asia, the Middle East and Eastern Europe, and broaden its channel partner relationships. And in April, in a show of self-confidence, CA announced it would double its annual cash dividend and buy back up to $400 million worth of shares in fiscal 2006.

But it has drawn most attention from deals, which CA and analysts see as critical to its growth. CA's most recent acquisition came June 9, when it grabbed Niku Corp., a provider of IT governance software, for about $350 million. In April, it acquired Concord Communications Inc., a provider of business service management software, also for $350 million.

And last year the company bought security software maker Netegrity Inc. for $430 million and anti-spyware company PestPatrol for an undisclosed sum. Experts overall have praised the acquisitions, which came after a major lull in dealmaking.

Ken Bender, managing director at San Diego M&A advisory firm Software Equity Group LLC, says the Concord deal in particular "was a highly strategic and necessary transaction to fill the gap" in CA's network monitoring and reporting for its Unicenter product line.

Unicenter, its enterprise systems management offering, brought in $1.7 billion in revenue in fiscal year 2005, CA reports, but is losing market share because the company lacked a robust network management tool, Bender says.

Clarke says the company plans to do more deals, particularly small to midsized purchases in the areas of security, identity and access management and networking management. CA will scout companies that offer substantial product overlap, new customers, opportunities for cost synergies or innovative technology. It may also eye targets in different markets, he says.

With about $3 billion in cash (and with about $2.6 billion in total debt outstanding) as of March 31, CA may also look to do larger financed deals once the dust settles from its current problems, sources say. NetIQ Corp., a systems and security management vendor, tops most analyst lists.

Other potential buys include Micromuse Inc., Internet Security Systems Inc., Quest Software Inc., McAfee Inc., Mercury Interactive Corp. or even rival BMC Software Inc. BMC's current senior vice president and chief financial officer, George Harrington, spent 23 years at IBM alongside Swainson, and observers say together the companies would have product synergies.

Caughey says it's imperative for CA to bolster its security technology offerings and its abilities to integrate various products. "Right now there's an opportunity in that not a lot of security solutions work together," she says.

But in a recent report, Moskowitz warns "there is risk that CA could overpay in its zeal for acquiring growth or stumble through integration issues during a period of considerable operational change." CA paid a 27% premium over Niku's closing stock price, and many observers accused CA of overpaying for Concord. Clarke downplays such thinking.

CA has another hurdle to jump: trying to boost its customer satisfaction rates, something that Kumar stressed and improved during his tenure but that sources say is still a company weakness.

"The customers are kind of shaken up," Caughey says. "They really liked Sanjay."

Gregory Corgan, CA's head of sales and another IBM veteran, says three years ago CA began putting 650 customer advocates in place to help mend fences, and it assigned account directors to "cover" customers and be responsive. The company, traditionally known as aggressive and inflexible with its clients, also built a customer advisory board and has worked with customers to individualize contracts. For example, he says, CA bills a wireless customer based on the number of subscribers and an insurance client based on the number of policies in force.

"The point is we're willing to look at different ways" to work with customers, he says.

Clarke admits there's more progress to be made, but says he and other executives have been pounding the pavement, meeting with customers face to face.

"We have gone out contract by contract and often ripped them up and allowed the customer to start over again," he said at a Deutsche Bank Securities Inc. conference in March.

Likewise, observers say revamping CA's image, corporate culture and business won't happen overnight, particularly in light of its latest profit and litigation woes and the reality that the accounting scandal is still a nagging thorn.

"This is a huge company to change and it will take a very long time," Hargil says.

 

İCopyright 2005, The Deal, LLC.

 

 

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