Above It All?

A supremely confident Michael Roth sailed through his earnings session on Friday morning, his first before analysts as Interpublic Group’s CEO.

In his last top job, at MONY, Roth invoked the ire of the financial community after he sold the insurer to AXA in 2004 below book value and pocketed a severance package worth more than $18 million. But in an 8 a.m. conference call Friday, analysts went easy on him as he discussed the company’s five-year earnings restatement, filed on the Sept. 30 deadline to meet federal filing requirements and to comply with bond indentures.

The news was considered better than expected, with IPG’s stock jumping 7 percent to $12 at the start of trading. (Some of that increase can be attributed to short-sellers scrambling to cover their positions.)

IPG said the material restatement totaled $550 million for the period of 2000 through 2004, with roughly half of that reduction in earnings and shareholder equity occurring before 2002.

The company also released what appeared to be good news: Organic growth rose 7.2 percent in the second quarter of this year, compared with a decline of 5.1 percent in the first quarter. For the first half, organic growth climbed 1.3 percent. IPG said it lost $139.4 million, or 33 cents a share, in the first half, compared with a restated loss of $182 million, or 44 cents a share, in the year-earlier period. First-half organic revenue rose 1.5 percent.

For 2004, the No. 3 holding company reported a net loss of $558.2 million, compared with restated loss of $539.1 million for 2003. Revenue grew nearly 4 percent to $6.4 billion last year, but that was offset by skyrocketing professional fees, such as those paid to PricewaterhouseCoopers. PWC pocketed a staggering $92.6 million from IPG in 2004, up from $39 million in 2003.

During the 90-minute call, analysts could not pin Roth down with questions about the robust second-quarter results in the face of recent account losses like General Motors ($50 million in revenue) and Bank of America ($65 million)—the latter is still transitioning out of IPG companies—or on his vague outlook for 2006. He initially suggested that full-year earnings may be up in 2005, with fourth-quarter new-business wins, but when pressed for further details, admitted the year will likely be flat without such gains.

IPG also revealed it won’t be compliant with Sarbanes-Oxley standards until 2007. “Controls over most [control] areas are stronger as a result of our review process, but much of the work is still being done manually,” says IPG CFO Frank Mergenthaler. “Remediation efforts will extend into 2006. We expect to be 404 [Sarbanes-Oxley] compliant with the filing of our 2006 10-K.”

Afterward, some analysts were still scratching their heads. Merrill Lynch’s Lauren Rich Fine, who is maintaining her “sell” recommendation on IPG’s stock, issued a response under the headline, “Preliminary Look at Updated Financials Confusing, But Somehow Positive.” She described the second-quarter gain in organic growth as “hard to imagine” and alluded to an IPG quote about the timing of revenue recognition as a possible reason for it. (A company source confirms that was a significant contributor to gains in the quarter.)

Credit-rating agencies were also skeptical. After the call, both Moody’s Investors Service and Standard & Poor’s lowered their ratings on IPG and said their outlook remains negative.

By all accounts, Roth, who took the top job at IPG in January, did a masterful job in handling the analysts, as did Mergenthaler in his public debut. Roth reiterated the company’s struggles with issues related to its aggressive acquisition strategy in the late 1990s. He explained IPG’s changes in revenue recognition, acquisition accounting and policy about media credits, and the company’s internal investigation into employee misconduct.

Curiously, there were no questions from analysts about the ongoing role of long-term auditors PWC, which is reaping a windfall for second-guessing financial issues it previously approved, or the status of the ongoing Securities and Exchange Commission investigation. Given IPG’s admission in its recent 8-K filing of employees’ “violations of laws,” “inappropriate customer charges and dealings with vendors” and “misappropriation of assets,” an expansion of the SEC’s scrutiny might be expected. In its 2004 10-K filing, IPG does say the SEC issued a subpoena to the company on April 20 of this year, asking for additional documents related to the restatement. But, sources say, at this time there has been no broadening of the inquiry beyond the original focus, which is largely on inter-company transactions within IPG network McCann Worldgroup.

In its SEC filings, IPG said about $441 million, or 80 percent of the restatement, was due to poor accounting for revenue. The next biggest chunk, about $105 million, stemmed from acquisition accounting problems. IPG said adjustments related to internal investigations reduced retained earnings by $55.9 million, although in the 10-K filing, the amounts blamed on misconduct at specific offices totaled some $96 million—McCann Turkey ($31.8 million), FCB Turkey ($14.5 million), McCann Greece ($12.7 million), FCB Spain ($10.5 million), McCann Netherlands ($7.2 million) and McCann Eastern Europe (five countries, $8.6 million). IPG previously characterized the problem as primarily occurring overseas. For the first time, it identified a U.S. entity that also engaged in employee misconduct: Media First in New York ($10.8 million).

Roth said he hoped the restatement, resulting from a rigorous six-month internal financial review, will allow the company to move away from the situation “IPG has found itself in” and toward “the forefront of disclosure and transparency.”

“The high professional fees, the time and effort we put into this [indicate] we wanted to do it right and we wanted to do it for the last time,” Roth said during the call. “We’ve looked under every rock, every nook and cranny of the multinational company. … We’re confident these are the right numbers.”

Lacking a system of controls

While financial observers applauded IPG in cleaning up its financial issues, the task going forward is to build a system of controls that was lacking in the first place.

IPG’s current problems in large part reflect the legacy of former CEO Phil Geier and his partner, former CFO Gene Beard. Flush with cash in the 1990s as media inflation outpaced the growth of the economy, they made IPG an acquisition machine, ringing up constant revenue increases from more than 400 purchases that kept shareholders happy and made the pair favorites on Wall Street. Integrating those companies and their financial systems into IPG would prove a thornier task. “The challenge in this industry is to build controls, infrastructure and standards at the pace of acquisitions and growth,” says one IPG competitor.

To be fair to Geier and Beard, the standards by which IPG’s past practices are being scrutinized today are much more stringent than those which were common practice when the two sat atop IPG. (Also, about half of the restatement deals with events occurring after 2002, after the two executives retired—when John Dooner and David Bell served as CEO and when Roth, prior to his current CEO role, headed IPG’s audit committee.)

Still, IPG, an entity that pioneered the industry holding-company model in 1961, is now emblematic of what can go wrong when a publicly traded company fails to reinvent itself in changing times.

“[With] a roll-up company like IPG, you take on a lot of risk—management is not committed to getting acquisitions sorted out,” says a competitor. “It takes a lot of effort and willpower to make sure things are accounted for on a like-for-like basis. You have to take the view that the Street will reward performance over the long term.”

As competitors like Omnicom Group and WPP Group pulled ahead of IPG in the marketing-services area, IPG began to play catch-up in non-advertising investments at the top of the business cycle. In 1999, IPG invested $32 million in a Swedish new-media company, IconMedialab International, followed by an additional $24 million in 2000, only to lose most of that in the dot-com meltdown. Even worse was IPG’s $240 million investment in Brands Hatch Leisure, which ended up costing IPG even more in write-offs and costs.

As industry rivals began to formulate broader corporate visions guiding their acquisition strategies, IPG’s culture remained disconnected, lacking a cohesive strategic bond among its operating units.

“Compared to the other holding companies, IPG has less of a sense of purpose,” says one exec at an IPG unit. “It goes back to the roll-up of a bunch of companies that make up IPG—there’s no strategic fabric, no common link or foundation. IPG is a roll-up of disconnected companies.”

A dynamic of misbehavior

That disconnect may have introduced a dynamic of misbehavior within a family of operating units pushing back against a corporate parent. Geier never hesitated to step in and deal with a client if problems surfaced at the operating level. But ultimately, the big-hearted executive could be indulgent when it came to lackluster performers at operating units like Lowe. Critics say Geier moved too slowly to break up the interminable politics that undermined the top management at Lowe, factionalized by its series of agency mergers and fronted by Frank Lowe, an outspoken critic of IPG.

Geier declined comment.

“At IPG, the people at the operating units didn’t like the [corporate] center—there was willful disobedience,” says one former top exec at an IPG unit. “IPG does not have a business culture of accountability and consequences.”

Some IPG observers attribute that ingrained corporate resistance to John Dooner’s own reluctance to take strong actions during his two-year stint as CEO after Geier, who stepped down as CEO in 2000. Others dispute that, saying Dooner didn’t shy away from taking action, restructuring IPG with new operations like The Partnership and replacing Frank Lowe as CEO of his namesake agency.

For his part, Dooner is said to feel that he was rocked by a perfect storm of maladies, with the client meltdown in the technology sector in 2000 and subsequent asset writeoffs at IPG, the U.S. economic downturn, the advent of Sarbanes-Oxley and the disclosure of accounting imbalances at McCann.

According to one observer, Dooner was reluctant to interfere with his operating units because he has a long-held reflex against doing so, dating back to when he was running a business, McCann, within IPG and had a hands-on manager in Geier.

Dooner declined comment, as did Bell.

To the extent that IPG has a corporate personality, it is defined by its largest flagship company, McCann Worldgroup, insiders argue. Geier, who became IPG CEO in 1980, and Dooner both spent most of their careers at McCann. Inside and outside the company, McCann is seen as tough and streetwise, often described as an “Irish mafia” whose members don’t shy away from a new-business brawl. That can-do attitude may have led to the aggressive business targets that delivered the performance that helped establish McCann’s ambitious favorite son, Dooner, as Geier’s heir apparent.

“The culture at IPG was a McCann culture, where phrases like ‘Whatever it takes, make it happen’ were part of the culture,” recalls one former McCann exec. “It was like, ‘Don’t talk to me about why you can’t do it. Get it done.’ But it was also about, ‘Don’t do anything stupid.’ There was an ethos there.”

Nearly half of the $550 million restatement stems from media credits, or so-called Agency Volume Bonification, an industry practice in certain overseas markets that is not illegal. Agencies sometimes get cash back from media vendors in exchange for large placements. The $250 million that IPG is paying out to clients and vendors in the next two years relates to media credits and improper service contracts that agency executives established for themselves. With media credits, IPG is not saying it is stopping the practice, which is customary in certain markets in Latin America, the Mediterranean (Italy, Spain, Portugal and Greece) and parts of Asia. Rather, it is reconciling practices to a consistent standard. Primarily, the money will be paid to a few hundred clients, as well as some media vendors, according to a source.

“The media practices that are prevalent in many international markets are both accepted and legal,” Roth says. “They are often known to all parties—agency, client and vendor. However, the contracts that govern our media arrangements are not always consistent with these local practices or with master contacts that exist with some major clients. Our decision to reconcile to a consistent global standard is the right one.”

Under a magnifying glass

IPG’s scrutiny of financial controls began in 2002, when McCann execs first uncovered lapses in billing practices among its offices; they tracked imbalances back to the early 1990s. Not helping matters much was that McCann’s European operations had a revolving door of CFOs in the mid-1990s. “There were invoices between McCann offices that went unreconciled for a long, long time. There were thousands of invoices, down to [as little] as $200,” says one source.

“This is a function of very poorly functioning internal controls over dispute resolution,” says a competitor. “With inter-company billing, costs get disputed. It’s not uncommon, but you have to make sure it’s in balance. It can take a long time to resolve, but it’s improper not to include it as a cost.”

One of the first executives to take the fall after those disclosures was former McCann Worldwide CFO Sal LaGreca, who resigned in October 2002. LaGreca declined comment.

In the ’90s, IPG accounted for acquisitions on a pooling-of-interests basis, whereby the holding company booked multiple quarters of revenue from an acquired entity into one quarter after IPG’s purchase. While that was a common practice in corporate America at the time, it is now frowned upon—a development that underscores the new era of scrutiny IPG is now using on past practices.

With things like pooling of interests in acquisitions, “IPG is trying to apply more stringent GAAP standards of 2005 back to 2000, when they didn’t apply. Different methodology applies today,” says one sympathetic competitor. (GAAP refers to generally accepted accounting principles.)

Admittedly, between the legions of outside auditors and the SEC investigators, IPG is under a magnifying glass unlike any ever focused on an industry holding company.

“You can’t forget the hall of mirrors you step into when the SEC starts an inquiry, although you can argue you shouldn’t be in there in the first place,” says one IPG operating head. “It’s like Clinton—it starts with Whitewater and ends up with Monica Lewinsky.”

But some company execs argue that IPG’s transparency issues will need to be addressed by the industry at large.

“Our financial issues are the chaotic M&A activities in the early ’90s that resulted in the poor integration of business and financials. [IPG] didn’t build the right platforms,” says Stephen Gatfield, evp of global operations and innovation at IPG, who joined the company in 2004. “But other issues, like transparency of revenues, will test all holding companies. IPG is being scrutinized more carefully because it’s the first to be under scrutiny with the new financial standards.”

The difference may lie in how the situation has played out at IPG, with the torturous drip-by-drip flow of bad news over the past three years.

“If this were [WPP CEO Martin] Sorrell or [Omnicom CEO John] Wren, this thing would have come out differently,” says a former IPG operating exec. “This has been handled abysmally.

“This was out of control at the beginning, with neglect, fear, finger-pointing, and it has become more and more out of control,” continues the exec. “They needed stability, confidence, constructive resolution. The opposite occurred, with ‘Save my ass’ and ‘What am I going to look like after all this?’ ”

One CFO after another

Sean Orr joined IPG from Frito-Lay as CFO in May 1999 and was squeezed out in July 2003. Former insiders say he never had a team to support him in a new industry that he struggled to understand. “Sean didn’t have the skills to do this,” says one. “The board wanted someone from outside the industry, but his legs were cut out from under him. He didn’t have the support of the board, Geier, Beard or Dooner.” Orr did not return calls.

Orr was the first of three IPG CFOs, all recruited from outside the industry, who have left since Beard’s retirement in 1999. Christopher Coughlin joined as COO from Pharmacia in June 2003, after a much trumpeted search, and also assumed CFO duties from Orr. Coughlin, who left after just a year, was said to be “shell-shocked” by what he walked into at IPG, according to one financial source. “He was a big pharmaceutical kind of guy—he underestimated what he was getting into at IPG,” says the source. Coughlin did not return calls.

Sources said Coughlin also underestimated the resistance he would encounter when he tried to push through a plan to sell off IPG corporate assets and create a standardized salary system across IPG operating companies.

Says one IPG operating exec about the salary initiative: “I said [to Coughlin]: ‘Think of [these employees] as a sports team with different talent levels and performance track records. I don’t think he got it—he was a hyper-rational person.”

Coughlin brought in Robert Thompson from Pharmacia, who assumed Coughlin’s CFO job last June, only to last a year himself. Adding to the chaos within IPG’s financial corridors, at a time of unprecedented challenges and an SEC inquiry, is the churn of multiple controllers who have come and gone since Orr arrived.

Given that upheaval, as well as the fact that IPG is already on its third CEO since 2001, one of the few constants over this period has been the company’s 10-person board of directors. Three of the seven outside directors are retired: presiding director Frank Borelli, former CFO of Marsh & McLennan Cos.; H. John Greeniaus, former CEO of Nabisco; and Reg Brack, former CEO of Time Inc.

“The constitution of the IPG board is baffling to say the least,” says one IPG source. “They have proven to be a totally complacent, passive group of people who are too far removed from the corporate world and have no understanding of this business.”

IPG board members did not return calls.

Such criticism is a familiar lament among IPG operating heads who fault the board’s selection and oversight of the holding company’s destabilized roster of top managers during the past five years.

One former IPG operating exec recalls a telling anecdote from Geier’s going-away party in an upstairs room at Manhattan’s 21 Club. Among the war stories recalled that night, IPG director Borrelli told how a search firm contacted him about becoming an IPG board member. He went through the interview process and didn’t hear anything until just before IPG’s annual report was going to press. It was then that IPG asked him to join the board, so his name could be included in the shareholder report. Borelli did not return calls.

While IPG insiders expect the company to shake up the board, Roth defends his directors. “The audit committee, [for example], had a great deal of insight and information,” he says. “We are the ones picking up all this stuff. We are the ones instigating all this [scrutiny].”

IPG is expected to spend $200 million this year alone on professional services fees for those leading that investigation. Sharing the windfall with PWC are Deloitte & Touche, which is working on an inside audit at IPG; law firm Cleary Gottlieb Steen & Hamilton, which is handling the SEC inquiry; and law firms Dewey Ballantine and Paul, Weiss, Rifkind, Wharton & Garrison, which are currently engaged in “forensic” work for IPG.

Time to go private?

Given the severity of IPG’s latest revelations, some observers believe the company’s best bet going forward is to take itself private, liquidate debt, sell off assets and reformulate itself around McCann. “The only sensible thing to do now is to contain this mess and go private,” says one industry exec. “They’re announcing all this bad news, and then they’ll lose clients. They should bring in an outside firm to help them go private and sell off assets like FCB, Lowe, Draft, Deutsch.”

Private equity firms like Kohlberg Kravis Roberts are said to have shown interest in the past; an outside rep for KKR declined comment.

Roth has said: “Our company and the board of directors have an obligation to enhance share value any which way we can. But with all the turmoil and speculation in the press, it would be idiotic to do it now. You do this when you have a strong balance sheet. You don’t do this at a point of weakness.”

He shrugs off the proposal put forth by one activist IPG shareholder who wants to sell the company, “He has no clues about our company, our earnings or our sales potential,” Roth says. “I’m not going to take that position on the basis of a guy who owns 300 IPG shares.”

At the market close on Friday, other shareholders seemed to believe that Roth is taking IPG in the right direction. The stock closed at $11.64, up 3.84 percent, after hitting $12.25 during the day, on huge trading volume of 12.6 million shares. But IPG’s problems have been reflected in its stock price. The key now is to get the systems in place so that no more bad news rocks a place worn down by an incessant barrage of it over the past three years.

“I don’t want to just change things for now,” says Roth. “I’m doing this for the future so we don’t have to face another writedown or two. Materiality has changed a lot. There used to be a broader spectrum. There’s greater transparency under Sarbanes-Oxley. What was immaterial then is material now.”