Network Associates (McAfee): a case of “channel stuffing”

Network Associates (hereafter, NA, later renamed McAfee) designed computer hardware and software to combat viruses, improve network security, and manage network operations.

Like many other high-tech companies of that era, NA rode a wave of high stock market valuation in the late 1990s. The company achieved high revenue growth through 1998, some of it organic, some via acquisitions.

However, in early 1999 the stock price took a big hit. After peaking at a split-adjusted $335.39 per share in December 1998, the first four months of 1999 saw significant declines: −21% in January; −10% in February; −35% in March; and −57% in April. The closing price at the end of April was $67.08, or an 80% drop in just four months.

In its prerelease of 1998 earnings (made in January 1999 for the purpose of providing guidance to the analyst community), management gave no indication of sales declines on the horizon. On the contrary, they stated that they were on track to meet analysts’ expectations for the year. Yet three months later they reversed their previous announcement. In April 1999 several shareholder lawsuits against the company and its senior management were filed.

Management’s explanation for the reduced forecasts of future sales blamed a shift in customer preferences, as explained in this 7 April 1999 article from Dow Jones Business Service:

“Our sales cycle is more complex,” said Network Associates’ Chairman and Chief Executive Officer William Larson. Only a year or so ago, corporations would buy security software by picking a so-called firewall, encryption software and then cobbling their purchases together as a security umbrella. Today, companies are seeking integrated suites of security products, taking longer periods of time to evaluate the product and paying more attention to price.

Network Associates has begun integrating offerings from its many acquisitions into a suite. But the move toward a broader, enterprise-wide sales posture has meant longer evaluation cycles. “Be careful what you ask for, you just might get it,” Larson said of its enterprise focus.

Yet at the time management was making these claims to the investing community, they were actually dealing with the effects of several quarters of channel stuffing. Inventory was backing up at the distributor level, and distributors could not pay off the amounts owed to NA.

On 26 December 2000 the CEO (Larson) resigned without explanation, as did the CFO and President. The company’s share price fell by 68% that month, which followed a loss of 32% in November.

Eventually, the SEC filed a complaint in the US federal court system which sought monetary penalties from the company. Among other charges, the Commission claimed that the company:

created a subsidiary to buy back inventory it had previously sold to distributors, in order to avoid characterizing the transaction as a return of merchandise;
secretly paid distributors significant amounts so that funds could be cycled back to the company and be portrayed as “payments”;
used other unrelated reserve accounts to draw upon (i.e., debit) when transferring cash to the distributors as mentioned above;
timed sales with a significant customer (Ingram Micro) with a fiscal quarter date that often followed McAfee’s by several days – McAfee would pass the inventory along at the end of its quarter as a “sale,” yet Ingram would return it after McAfee’s new quarter started but before Ingram’s current quarter ended;
sold inventory to distributors on consignment, where the distributor only paid for the receivable when the product was passed along to an end customer; and
conducted sham sales of its accounts receivable by transferring them to a financial institution for up-front cash, yet guaranteeing the institution that the receivables would be paid (thus McAfee retained the risk of collection).

NA, now called McAfee, settled these claims, without admitting or denying the allegations, in early 2006, by paying a fine of $50 million.

Before the settlement, the company recorded a series of accounting restatements related to the above issues, most notably in June 2002 and October 2003. Those two restatements focused on the year 1998, and resulted in a reduction in revenues in that year of $562 million as well as a reduction in net income of $356 million. Overall, cumulative restatements during the early 2000s reduced revenue by $622 million and net income by $353 million over the period 1998 to 2000.

Required

(a) Describe in one or two sentences the concept of “channel stuffing.”

(b) Can a company stuff its distribution channels forever? If not, how does the practice come to an end?

(d) What indicators can you find in that might indicate channel stuffing?

(e) Not all of the allegations made by the SEC are easily detected from the analysis of financial statements. Which ones might be more difficult to detect?

(f) What is the pattern of operating cash flows that is likely to occur when a company stuffs its channel? In NA’s (McAfee’s) case, where was it getting the cash that enabled it to carry out the strategy?

(g) What sort of forces do you suppose pressure managers into opting for a strategy of channel stuffing?

Selected financial information and ratios from 1996 to 2001