The accounting firm Eisner Amper published their third annual survey, Concerns About Risks Confronting Boards. Based on the opinion of 193 corporate directors, the data show that excluding financial risk, 66% believe that reputational risks are the most concerning currently. The top three reputational risks of 2012 were quality (30%), ethics/integrity (24%), and “public perception” (16%). Security was #4 at 12%. These three named risks, along with innovation, safety, and sustainability (8%), comprise the six major sources of reputational risk according to research published by the Society in the 2010 book, Mission: Intangible.

In early 2008, Baxter International (NYSE:BAX) began a series of product recalls involving the drug, Heparin, that was manufactured with ingredients sourced from a supplier in China. Yesterday, the first of the product liability litigation cases arising reached the verdict stage.

According the to the Chicago Tribune (9 June, Japsen), a Cook County Circuit Court jury Thursday awarded $625,000 to the estate of a man who his attorneys say was given a dosage of a blood thinner made by Baxter International Inc. that contained a contaminated ingredient found in the company's supply chain in China.

The verdict is the first from a case against Baxter and its supplier, Wisconsin-based Scientific Protein Laboratories, from hundreds of lawsuits filed against the Deerfield-based medical product giant. A mountain of litigation has been leveled against the companies after U.S. regulators determined in 2008 that Baxter's heparin was contaminated, from fake ingredients sourced in China.

The Wall Street Journal (9 June, Kell) quotes Baxter spokeswoman Deborah Spak as saying the company is taking responsibility for legitimate cases of harm related to the contamination seriously, adding that Baxter will "vigorously defend claims that are not consistent with the definition established by public health authorities." Baxter's therapies treat serious medical problems such as cancer, immune disorders and trauma. The company is coming off a challenging year due to economic weakness, costs pegged to the U.S. health-care overhaul and some product-quality and regulatory challenges.  It's stock price has appreciated around 50% over the trailing twelve months and shares rose an additional 0.3% to $59.05 in after-hours trading -- not the sort of economic performance associated with a company facing new challenges.

Turning to the reputation metrics from Steel City Re, Baxter is wrapping up the trailing twelve months ahead at the 88th percentile from a start at the 72nd. Its reputation metric volatility, exponentially weighted, is down to about 6%, its reputation velocity is on the upswing at 7% and its reputation vector is positive at 1%. All are signs of reputational recovery. Economically, it is outperforming the median of its peer group comprising 172 companies in the Pharmaceutical sector by a comfortable 17.82%



Finally, while the sector as a whole is demonstrating increased level of reputational volatility reaching around 36%, the Company's intangible asset fraction got a small boost and is now around 90%, slightly above that of the median of its peer group.

We conclude that as with Johnson & Johnson's supply chain issue of the early 1980's, Baxter took the hit early on (2008) and has since progressed with the expected long-term costs of this quality/safety issue already deeply embedded in the stock price and in reputation-related expectations.

A few weeks ago, two of the biggest names in technology found themselves grappling with huge and potentially embarrassing debacles. As the Economist newspaper (28 April) summarized in their colorful headline, Online reputations in the dirt, on 26 April, "Amazon’s finance chief, Thomas Szkutak, said the firm was still trying to get to the bottom of a glitch that caused numerous websites it hosts for other businesses to crash or run painfully slowly during the previous week. The same day, Sony of Japan revealed that names, addresses, passwords and possibly credit-card details of 77m accounts were stolen when hackers gained access to the network it runs in 60 countries for its PlayStation online-gaming system, as well as for Qriocity, a service offering music, films and television shows.”

Reputation, of course, is the amalgam of impressions held by stakeholders, and it is shaped by such intangibles as these six (6): the means by which a company fosters ethical conformance, innovates, assures quality; and assures safety, sustainability and security. Business processes, really. And reputation manifests in many ways. Importantly, it sets expectations.

Of these six reputation drivers, Amazon faced a quality issue while Sony faced a security issue. The reputational consequences to these two companies are explained, in part, by stakeholders’ preexisting expectations, the degree to which those expectations were impacted by events, and the nature of expectations set going forward. Related, in that like reputation, it is forward looking, is the equity market’s reaction to these two different reputational experiences.


The Amazon reputational experience following the quality event shows increased volatility these past few weeks that is actually less than historic reputational volatility. In other words, stakeholders as a group seem overall unimpressed over background levels. As such, the equity jump is less surprising than it would be otherwise. It reflects the fact that Amazon suffered a reputational even and was resilient (relative to its baseline).

The experience at Sony is quite different. Sony's baseline reputational volatility is almost an order of magnitude less than Amazon's, and its reputation ranking is near the top of the peer group. Its stakeholders believe they have a good sense of what drives the company, and the degree to which it is a state of control. Equity investors, however, don't appear to understand how such a major security event could occur in the setting of what reputationally would appear to be a company in control. Their response is panic, and in our interpretation, suggests that Sony is now undervalued by the equity markets.

Turning to crude metrics of fractional intangible asset value, Amazon is almost purely intangible and thus the high degree of volatility is not too surprising. There may be much upside, but -- excluding IP -- there is probably no floor to the downside

Sony, in contrast, has a surprisingly small intangible asset fraction that is far lower than the median of its peer group. The large book value fraction of the company's value speaks to the relative stability of its economic metrics, but the huge drop from 40 to 20% intangible, as with the drop in stock price, is unreasonable for a company with such iconic brand and technology prowess.

Perhaps it is the overlay of the background geophysical crises in Japan that is making Sony's equity investors especially jumpy?

The Financial Times is concerned that the nuclear crisis in Japan may adversely impact the reputation of General Electric (NYSE:GE).

According to the FT, GE designed the Mark 1 boiling water reactors (BWR) used at the Japanese plant, and supplied the No 1 and No 2 units that went into service in the early 1970s. It has also had engineers at the site up until last week; a team of 44 had been working on maintenance at the shut-down No 4 reactor when the earthquake hit. GE’s nuclear operations are now part of a joint venture with Hitachi of Japan that has two businesses: Hitachi GE Nuclear Energy, which is owned roughly 80-20 by the Japanese and US groups, and is based in Japan, and GE Hitachi, which has 60-40 US-Japanese ownership and covers the rest of the world.

Although the businesses are formally separate, they are closely linked. As well as the 70 people working on the crisis in North Carolina, they have a centre in Tokyo, near the Japanese government’s main response centre, to provide technical support and advice. You can read the balance of the FT article here.



Looking at the reputation metrics, GE’s ranking has been sliding as of late. The Steel City Re Corporate Reputation Index shows that after a steady rise, GE’s ranking shows a net drop over the trailing twelve months from the 60th percentile to the 50th percentile among its 86 peers of General Diversified companies. Consistent with the FT's concerns, the exponentially weighted moving average of the reputation ranking has been climbing lately and measured this past week at just above 6%.

The ten point slide in the Corporate Reputation Index has been associated with a trailing twelve week reputation velocity of -14% and a trailing twelve week reputation vector of -0.8%. Both, being signs of significant reputation volatility, reflect especially acute changes over the past week and suggest growing concerns about GE's reputation for design quality and safety excellence - key intangible assets in the nuclear reactor construction industry.

Now to bring this all back to finance. While GE has been outperforming its peers recently, as of 17 March, its return on equity over the trailing twelve months is only 2.3% greater than the median of its peer group. And it is trending negative.

The past two years have witnessed a flood of bad news at the world’s largest diversified healthcare company, Johnson & Johnson (NYSE:JNJ). Ethical breaches, quality failures, and safety recalls by the bucketful, a few of which we noted previously. In more recent times, the Company has witnessed the inevitable pile on of regulators, and now--you guessed it--litigators.

On 17 December 2010, a shareholder group filed a lawsuit against the board as well as managers for an unspecified amount alleging failure to uphold their duty of oversight, breaching their duty of loyalty, and allowing adverse events to proceed which inevitably "destroyed the company's hard earned reputation." According to Tony Chapelle who participated in a recent Mission Intangible Monthly Briefing and who reports for the Financial Times' Agenda Week, “Governance experts say that J&J’s board should step in and more closely oversee the company’s business processes in three vital areas: quality, safety and ethics.” 

According to Cathy Reese who chairs the Society’s Governance Committee and who also participated in a recent Mission Intangible Monthly Briefing, lawsuits that claim a breach of the director duty of oversight warrant serious attention. That’s because in the 2006 case of Stone v. Ritter, the Delaware Supreme Court created a new directorial duty — the duty of oversight. In turn, the court said, directors who breach that duty have breached the duty of loyalty, for which they can be held personally liable.

The quantitative metrics point to both a loss of reputation and value. The first chart is based on the Steel City Re Corporate Reputation Index and reports reputation movement over the trailing 30 months. Beginning in mid 2009 (in red), the data disclose the slow decline of Johnson & Johnson’s reputation ranking relative to 78 peers comprising pharmaceutical sector companies valued at greater than $1B as of 6 Jan 2010.


The Company's relative decline is further accentuated by the overall decline of the industry's ranking. Shown in blue is the slow steady decline of the the average ranking of the 78-member pharmaceutical sector relative to approximately 9000 publicly traded companies on the main US and European exchanges.

There may be any number of explanations for the steady decline of the relative reputation of the pharmaceutical industry. One potential factor, according to Public Citizen, a consumer watchdog group that is no friend of the industry, is that the drug industry has now become the biggest defrauder of the federal government, as determined by payments it has made for violations of the False Claims Act (FCA). The drug industry has surpassed the defense industry, which had long been the leader. Public Citizen reports that of the 165 pharmaceutical industry settlements comprising $19.8 billion in penalties during the past 20 years, 73 percent of the settlements (121) and 75 percent of the dollar amount ($14.8 billion) have occurred during the past five years.

The economic consequences of the reputational decline appears to be an erosion in enterprise value. The chart below shows (in red) the slow decline of Johnson & Johnson’s relative return on equity compared to
 the average of 15 peers (in blue) comprising pharmaceutical sector companies valued at greater than $40B as of 6 Jan 2010. Also shown is the period return of the S&P500 Composite Index. During the 30 month window shown below, JNJ’s economic returns progressively decreased relative to its peers from outperforming them prior to mid 2009, to parity until mid 2010, to underperforming since then. The difference between the two sets of 30-month returns as of Jan 2011 is about 7% - coincidentally, the median cost of a headline risk event according to Steel City Re's research. The S&P500 returns over this 30 month period are essentially zero.


The ramifications extend internally. The National Association of Corporate Directors newsletter adds this morning that "Johnson & Johnson won't give eligible employees their full bonuses for 2010," according to the Wall Street Journal (Jan. 19, Rockoff). The Journal's sources explain the reasoning as "hits to the company's reputation and the 'mixed performance' for the year."

Stakeholders expect pharmaceutical products to be safe and effective by design and meet quality standards by process. The complaints lodged against GlaxoSmithKline (NYSE:GSK), which last week agreed to pay the fourth largest fine in FDA’s history in relation to the production and sale of “adulterated” drugs, are therefore notable. From the Financial Times last week:

“… investigations unearthed manufacturing issues that included micro-organisms in Bactroban ointment, a topical antibiotic used to treat skin infections in babies; non-sterile doses of Kytril injection, an anti-nausea drug used by cancer patients; Paxil CR tablets for depression that lacked the active ingredient; and Avandamet tablets for diabetes that were super-potent and sub-potent.”

The issues have been on the table since at least 2003, and the costs were booked in the 2nd quarter financial results. Still, the lack of reputational consequences other than what may be minor recent equity movement is curious.

Over the trailing twelve months, GSK’s reputation ranking as measured by the Steel City Re Corporate Reputation Index rose from the 92nd to the 96th percentile among the 233 companies that comprise the ethical drug manufacturers sector. The exponentially weighted reputation moving average volatility was barely measurable at 0.3%, and the trailing twelve week velocity and vector values were 0. Its intangible asset fraction has been flat at nearly 100% which is greater than the industry mean of about 83%. In fact, the only sign that anyone was trading the stock was the fall in equity value so that the company’s performance this past year is about 7% below the median of this peer group.




Stakeholders may not have reacted to a large extent for one of several reasons. One could be that GSK’s reputation is so strong and resilient that this minor event was viewed as an aberration rather than a core risk. Another could be that, as with the airline industry, stakeholders have become complacent. The latter explanation is consistent with the relatively low ranking of the entire sector (less than 20th percentile) and its decreasing internal volatility.

Ho hum, indeed.

On 18 August, Johnson & Johnson (NYSE:JNJ) said it is creating a new position to oversee companywide quality, manufacturing and compliance issues and appointing chief quality officers for each of its three major business units. Vice President Ajit Shetty will fill the position overseeing the push for quality improvements in its pharmaceutical, consumer products and medical device and diagnostics groups.

The Company has announced eight recalls involving millions of bottles of nonprescription medicines since last September. They involved products made at factories in Pennsylvania and Puerto Rico. Now the Company, which has come under scrutiny for quality problems with its drug units, is starting to experience similar problems with its device divisions. DePuy Orthopaedics, a J&J company, last week announced a recall of some hip-replacement devices that appear to fail excessively. DePuy also received a warning letter citing it for marketing the TruMatch Personalized Solutions System in the U.S. without clearance or approval.

Quality is one of the six key intangible assets that underlie the value of reputation. (The other five are ethics, innovation, safety, sustainability, and security). Increasing, protecting, and restoring the value of these assets, you might say, is a company’s Mission:Intangible.

This is why. The Steel City Re Corporate Reputation Index, which tracks the financial consequences of intangible asset management, shows that over the trailing twelve months, Johnson & Johnson’s ranking dropped from the 93rd to the 88th percentile relative to the 28 companies in the Major Pharmaceuticals sector. As is often the case with a deteriorating reputation profile, the Company has underperformed the median of this sector this past year by nearly 13%.

The numbers show three other trends. The Company is large with a long history and used to hold the number one reputation rank in this sector, and according to some surveys, among all companies. That standing has provided resilience, but has not been able to arrest the slow and steady decline evidenced by the low volatility. That loss comes almost exclusively from an impairment of the Company’s intangible assets. Whereas a year ago, the Company’s intangibles comprised 91% of the firms market value – right in line with the median of the sector – today that fraction has dropped to less than 88%. All this comes amidst challenges for the industry as a whole, whose reputational standing relative to all companies has also declined from the 91st to the 88th percentile.

With all this going on, Mr. Shetty, a vice president, will have his hands full. And his work will have little impact on enterprise value (and potential derivative law suits and D&O claims) unless signals start emanating from even higher levels that the Company’s credo – written by General Johnson himself – has been once again found and will be honored to the letter. Attention Board of Directors! Are you listening?

A big box retailer’s reputation is driven by the price and quality of its products, but not by its propinquity. Such are the data from an analysis prompted by the July 2010 issue of Consumer Reports magazine whose headline reads, “Best stores for practically anything.”

The 2 June press release provides highlights of a survey of 30,000 readers of the consumer-oriented magazine on their big-store shopping preferences. The companies are Costco (NASDAQ:COST), Dillard's Inc. (NYSE:DDS), Kohl's Corporation (NYSE:KSS), JCPenny (NYSE:JCP), Target Corporation (NYSE:TGT), Sam's Club (NYSE:WMT), Sears (NASDAQ:SHLD), Macy's Inc. (NYSE:M), Meijer (private), Walmart Stores (NYSE:WMT), and Kmart (NYSE:SHLD). The results of the survey may surprise you. If you are a follower of this blog, the correlation of the results of the survey with the metrics of the Steel City Re Corporate Reputation Index should not.

According to the magazine, the Consumer Reports ratings are based on the experiences of 30,666 readers who characterized 56,922 trips to 11 retailers between April 2008 to April 2009. The Reader Score represents overall satisfaction. A score of 100 would mean all respondents were completely satisfied; 80 means they were very satisfied on average; 60, fairly well. The results are summarized in the table at left.

In the two charts below, we show the correlation of the consumer survey data with the Corporate Reputation Index metrics. Blog readers are generally familiar with the underpinnings of the rankings. For this analysis, we created a derivative metric, the Reputation Vector. The reputation vector takes three factors into account: the average Corporate Reputation Index ranking over the trailing twelve months; the trend, and the variance. The first graph shows the correlation of the Reader Score for all of the companies with the corresponding Reputation Vector value. The slope is positive, but the explanatory power of the trend line only accounts for about 20% of the variance.

According to the survey, for each of the stores, readers cited their primary reasons for shopping at that venue. The three reasons were low price, high quality products, and location. When the data are analyzed separately, a slightly more interesting pattern emerges. All three trend lines are still positive, but the explanatory powers are radically different. 77% of the variance in Reader Score is explained by variance in the Reputation Vector when shoppers were motivated by price; 100% of the variance is explained by the Reputation Vector when shoppers were motivated by quality (not that meaningful with only two data points); but only 4% of the variance is explained when shoppers were motivated by location.

The data suggest that the overall consumer experience as indicated by the Reader Score correlates well with the financially-relevant derivative metric of Reputation Vector – which captures the behavioral expectations of stakeholders -- when price or quality are the primary drivers of behavior. The moral: “Location, location, location” may still be important, but with so much now accessible through the internet, price and quality are by far more important drivers of reputation and the economic benefits and costs thereon.

This past Monday’s Agenda, a newsletter for board members published by a subsidiary of the Financial Times, carried a story about social media and how boards should be aware that adverse stories can destroy massive value within hours. Senior reporter Amanda Gerut referenced materials discussed in the Society’s book, Mission Intangible, that sharpen the pixels on the value story and identify specific items in the P&L statement that are impacted by reputation. She also cited the Dominos Pizza case (NYSE:DPZ), a story we first looked at last year and to which we now return.

As summarized by Ms. Gerut, “On Easter Sunday last year, two Domino’s Pizza employees uploaded a two-minute prank video to YouTube of the duo abusing food they were preparing. The video was quickly picked up by other websites and within 72 hours had jeopardized Domino’s $490 million in domestic revenues and $1.4 billion spent on brand building during the past five years.” According to a Seeking Alpha earnings call transcript, the company lost between 1% and 2% in domestic same-store sales for the second quarter of 2009. This is to be expected. Both pricing power and market share are impacted by reputation. Moreover, as we previously noted, Dominos suffered a 10% market capitalization drop in the period immediately following the video. Again, no surprise. Net income, earnings multiples, cost of credit, and other drivers of value are also impacted by reputation.

It is now 2010, and Domino’s equity value is higher than it has been in years. Tim McIntyre, vice president of communications at Domino’s, who helped shepherd the company through the viral video incident, is on the lecture circuit advising directors that their duties of oversight include social media. Is there a connection? Might it be the $2 million insurance payment the company received following the event? Or perhaps the stock surge is due to the December 2009 launch of new crust, new sauce and new cheese? After all, quality is a major driver of intangible asset and reputational value in the food sector.


And yet the Steel City Re Corporate Reputation Index shows a decline over the past year in Domino’s ranking (bright red line, above). We expected to see reputation resilience because we felt Dominos' had a good story about all of its quality processes; but Dominos never exploited its latent intangible assets--the business processes that underpin reputation. It never explained how its processes provide better assurances than other pizza franchises that the quality of its product is protected. This is one reason why be believe it has experienced a two-year ongoing decline in reputation ranking relative to the 42 companies in the Restaurants and fast food franchisers sector.


And yet the stock price surged just before the books for 2009 were closed. Part of the discrepancy with the Reputation Index, and the surge in value, may be explained by the company’s pay down of debt with a net reduction in borrowings of about $75.7 million, which we see in our intangibles chart (above) as a reduction in % intangible asset value.



If we look at select elements from the corporate financials, we see debt pay down and an increase in shareholder’s equity (book value) by about $100 million.



The cash to pay down debt, however, was not necessarily from sales of pizza alone. In fact, total revenue in 2009 was down 20 million compared to 2008. Fortunately, Dominos found an extra $57 million in income from other sources.



In our experience, a company whose reputation index value is low and continues to drift downward tends to underperform its peers. We’ll continue to watch, because the increased value could be due to better quality pizza. Or it could be less leverage and more cold hard (tangible) cash.

Steel City Re Corporate Reputation Index Metrics

Top 5 firms in the Restaurants and fast food franchisers sector ranked by their Steel City Re Corporate Reputation Index as of 10 June 2010 and their corresponding rankings 4 weeks, 12 weeks, and one year ago.

Palm, Inc. (NASDAQ:PALM) is on the block. E & Y reported that in 2007, only 30% of the value realized in M&A deals was tangible. While a smart phone is a discrete, countable, physical asset, its value is mainly intangible With the above in mind, what are the prospects for Palm?

Using the 3-element accounting-like framework favored by Society member and Member News Committee chair Mary Adams of Intellectual Capital Advisors, those intangibles are as follows:
1. Human capital – the founders, who left the company in 1998 to start Handspring, maker of the Treo, which Palm then purchased for $240 million in 2003
2. Relationship capital – agreements with cellular carriers (Sprint/Nextel initially) through which most cell phones are sold.
3. Structural capital – the business processes, patents, and methods comprising the innovation activities and marketing activities behind the solution

Using the six-element Roman arch model of reputation value as defined in the Society’s book, Mission: Intangible, the two key intangible asset drivers of reputation value for Palm are innovation and quality. Palm’s reputation is abysmal. According to the Steel City Re Corporate Reputation Index, Palm’s reputation ranking in the Computer Hardware and Peripherals sector has not been above the 33rd percentile for the past 16 months. This ~60-member sector, which includes the monotonously #1 ranked Apple, Inc., recently saw Palm drop to the 4th percentile.



Reputation is important because among other things, it confers pricing power. It is not surprising, therefore, that Palm’s two current carriers, Sprint and Verizon, heavily discount Palm’s phones. And even in the face of these discounts, Palm’s global share of smart phones has declined from a peak of 4% in 2004 to only 1.5% in 2009.

Cutting to the chase, Shaw Wu of the Kaufman Brother’s equity research firm opines, according to the Wall Street Journal, that “the company should be worth at least the $600 million to $700 million it has spent on research and marketing…” Valuing a company based on expenses related to innovation and building a brand? That’s intangible asset finance at its best!

Act on your intellectual curiosity!

If the above discussion piques your interest, here are several things you can do right now:

1. Register free of charge for the next IAFS Mission Intangible Monthly Briefing set for Friday 7 May. The conversation will feature Scott Childers from Walt Disney and Bob Rittereiser from Zhi Verden on “Process-driven reputation risk in supply chains”
2. Purchase the book, Mission: Intangible. Managing risk and reputation to create enterprise value, at the IAFS Store (or any online book retailer) 
3. Become a member of the Intangible Asset Finance Society.
4. Join our community on Linked-In.