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Computer Associates' Twin Challenges

CEO Sanjay Kumar Has Labored To Reassure Customers And Satisfy Ongoing Federal Accounting Probes. Can He Also Find A Way To Lift Sales?

Nov 22, 2002 | Businessweek.com Charles B. Wang has retired after 25 years as the head honcho at Computer Associates (CA ), and he leaves a troubled legacy. While the Long Island (N.Y.) software company's stock is up about to $15 from the low of $7 it reached in July, the outfit probably remains an investment only for those with nerves of steel.

The big damper on the stock is a dual investigation into CA's accounting by the Securities & Exchange Commission and the Justice Dept., a probe that started early in 2002. But it also faces challenges from a slow-growth economy and tough competition in its markets for enterprise systems-management software.

Wang's successor, Sanjay Kumar, who has been CEO for two years and now picks up the chairman's title, has been working hard to make the federal probes go away. In addition to cooperating with investigators, Kumar in September handed the feds a detailed analysis by PricewaterhouseCoopers of the company's accounting during the third and fourth quarters of 1998. He says the analysis vindicates CA. The SEC and Justice do not comment on pending investigations.

SHARP DIVISION. Meanwhile, the probes are dragging on. "I believe that what we have done over the long haul is right," insists Kumar, who adds, "there's no indication that [investigators] are coming to a conclusion." CA's stock was trading at about $30 before news of the federal probe in February, and several analysts cite the investigations as a reason for recommending against the stock.

As for CA's prospects, analysts are sharply divided. Six have buy recommendations, seven have holds, and three have sells, according to Bloomberg. They range from the gushingly positive , Drew Brosseau of SG Cowen Securities believes the inquiry will be resolved in CA's favor to resoundingly negative. Richard Zandi of Deutsche Bank Securities worries that CA's cash flow won't meet the $1.3 billion in debt payments due in the next seven months.

"Kumar has the challenge of living with the sins of the past in an environment where it's hard for even the best of companies to navigate," says Zandi. "I don't know if he can do it." Neither Deutsche Bank nor SG Cowen has an investment banking relationship with CA.

WELCOME MOVES. CA reported revenues of $772 million last quarter, up 5% over the year-ago period. Its net loss was $52 million (9 cents per share), vs. $291 million (50 cents per share) a year earlier. It expects revenues for the fiscal year, ending Mar. 31, to be between $3.1 billion and $3.2 billion, with operating earnings forecast to come in between $80.2 million and $91.7 million (14 cents to 16 cents per share).

Over the past two years, Kumar has made a series of changes aimed at improving CA's performance and spiffing up its tarnished image after CA had been criticized for murky accounting, poor relations with customers, a passive board of directors, mediocre products, and volatile earnings. Kumar generally gets high marks for improvements in corporate governance, having refreshed the board with seven new outside members including respected accounting and governance experts.

Some critics call the governance moves "window dressing," but Patrick McGurn, a vice-president at shareholder advocate Institutional Shareholder Services, who had criticized Kumar earlier, now gives him kudos. "They have made great strides," he says. "I'll give Kumar credit."

NEW MODEL. In other areas, Kumar has made progress but he has yet to prove he has the right formula for long-term success. Kumar adopted a new business model that recognizes revenues over the lifetime of contracts. While that switch has smoothed out earnings, it initially caused confusion among analysts trying to compare current and past performance. Meanwhile, a new focus on customer relationships is only gradually improving satisfaction ratings.

If CA is to grow once again at a healthy rate, the likely catalyst will be internal innovation, since it has sworn off expensive acquisitions. Although Kumar spends 21% of revenues on research and development, no megahits have emerged in the past few years. He says having made progress on governance and the new business model that his focus now is on product development.

One example: CA is rapidly adapting many of its best-selling products to the Linux operating system, which Kumar notes "has tremendous momentum." He expects to have about 25% of his mainstream offerings running on Linux within two years. He's also investing in computer-security products, because demand has increased since the September 11 terrorist attacks. The security-software market is expected to grow from $6 billion in 2001 to $14.6 billion in 2006, according to market researcher IDC.

TOP-DOWN PAIN. There isn't much evidence of progress for CA yet, however. Last quarter, security-product sales dipped $2 million, to $52 million, vs. the previous quarter. A distribution partnership with Ernst & Young Consulting has yet to yield substantial sales.

Long-term holders of CA stock can take some comfort in the fact that the top executives share their pain. For Wang, Kumar, and executive vice-president Russell M. Artzt, the value of the $1.1 billion incentive stock package they were awarded in 1998 has been whittled down to far less than $100 million after a court-ordered reduction, taxes, and the share-price drop. These guys are still rich, but they're not nearly as rich as they were and they face a tough road getting CA's stock back up to where it once was.

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