[10/30/19] Baxter Needs a Remedy

Baxter International is a successful pharmaceutical company. It consistently reports sales and earnings growth, and its stock price beat easily the indexes in recent years, commanding a $40 billion market capitalization. What could go wrong?

On October 24, 2019, Baxter announced its third quarter 2019 results: 5% sales growth (on constant currency basis), and operating income of half a billion dollars. Management guidance for the fourth quarter 2019 was also optimistic. And yet, Baxter’s stock price fell 12% during October 24-25, and didn’t recover over the next few days. An almost $5 billion shareholder loss. What gives?

Amidst all the good news in the October 24 quarterly announcement, Baxter informed investors of an internal investigation which was recently opened “into certain intra-Company transactions undertaken for the purpose of generating foreign exchange gains or losses.” This is an archaic accounting issue, generally ignored by investors. Companies with international activities have to translate foreign currencies (e.g., sales in Euros) to U.S. dollars for the quarterly consolidated reports. These translations create gains or losses, depending on the relative movements of exchange rates, which generally average out over time. Hence investors’ general disregard of these gains/losses.

Apparently, something happened at Baxter regarding this issue. The company said that these transactions were “undertaken for the purpose of generating foreign exchange gains or losses.” Strange. A pharmaceutical company doesn’t usually trade, or try to generate gains from foreign exchange. So, why did Baxter undertake transactions for the purpose of “generating foreign exchange gains or losses”? (Who undertakes transactions for the purpose of generating losses?)

Perhaps a clue was given by Baxter when it said: “These intra-Company transactions resulted in certain misstatements in the Company’s previously reported non-operating income related to net foreign exchange gains.” So, perhaps Baxter inflated those gains? But overall, the previously reported gains from foreign exchange were relatively small for a company of Baxter’s size: $8M, $113M, $28M, $50M and $73M for 2014-2018. So, what explains investors’ harsh response, leading to a 12% price drop?

Perhaps investors know more than I do? But I think I know the reason for the sharp price drop.

For many years, while in Berkeley, I was a partner in a consulting firm, and I often served as an expert witness in securities litigations. Lawyers I worked with used to call this phenomenon the “disgust factor.” When investors hear about the existence of accounting issues and wide-spread investigations, they get disgusted and assume the worst. Hence the often overreaction to the news of accounting issues.

The opacity of Baxter’s announcement surely added to investors’ concerns. The Company said: “The investigation is in its early stages and the Company cannot predict its duration or outcome.” This reminds me of an old joke from the days of the telegram (anybody remembers?). Someone received a telegram saying: “Start worrying, letter follows.”

In a research I did several years ago on earnings restatements I found that opaque company announcements of accounting issues, without revealing the amounts affecting sales or earnings, generated the harshest investors’ reaction. This, I believe, explains the 12% price drop.

All this presents an interesting dilemma for stock speculators. If you believe that investors overreacted to Baxter’s investigation announcement—buy the stock. Problem is that price overreactions can be determined only after the fact. If you (like me) are uncertain at this early stage about the investigation’s outcome and impact on Baxter’s earnings, sit tight.

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