Stock Scandals: Why Some Companies Survive

Many long-standing companies at one time or another have faced critical, headline-making challenges that have threatened the company's ability to operate and make profits. There are various reasons for the challenges, from external forces - like the Tylenol scares that hit Johnson & Johnson (NYSE:JNJ) in 1982 when seven people died from taking capsules that had been poisoned with cyanide - to internal forces like Merck's (NYSE:MRK) non-acknowledgement/disclosure of the risks associated with Vioxx. Despite product issues such as recalls and lawsuits, some companies weather the storm and emerge faster and stronger, while others are virtually destroyed.

So what characteristics make a company more susceptible to failure through difficult times? Read on as we take a look at some historical corporate disasters.

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Four Companies, Four Different Stock Reactions

1. Tylenol and the Speedy Recovery
In the past 30 years, there have been several examples of negative headlines that have plagued companies and threatened their survival. Some companies have emerged from these scandals stronger than ever, while others have floundered, sometimes for years. Johnson & Johnson, the maker of the well-known over-the-counter pain reliever Tylenol, faced one of its biggest challenges in 1982. After the deaths of several people who took poisoned Tylenol were announced on September 29, 1982, the stock took a split-adjusted nosedive of 17%. However, as it became known that the company was not responsible for the cyanide-laced pills and the poisonings occurred at the store level, the stock was able to recover its pre-headline price of $2.95 within 43 days of the scandal, and was on its way up to $3.20 by January Of 1983 - a return of 31% from the low point after the negative headlines hit. Why is this? In part, it's because J&J handled the scandal well; by issuing press releases and remaining visible during the investigation, the company maintained investor and consumer confidence. (For more on what happens to a stock during a scandal, see Playing The Sleuth In A Scandal Stock.)

Figure 1: JNJ September 1982-February 1983. A) Day before tampering case; B) Low price is hit and volume jumps; C) Price returns to recent highs (43 days)
Source: Yahoo! Finance

2. Merck's Hard-Fought Battle Back
Merck
(NYSE:MRK), another drug maker, faced similar challenges in 2004 when one of its biggest selling drugs, Vioxx, was found to increase the risk of heart attacks. Unlike Johnson & Johnson, Merck allegedly knew about the risks but did not disclose them during the clinical trials or after the drug was on the market. Prior to this, Merck had a good reputation in the market as being one of the strongest research and development drug companies, so investors were shocked by the news. The company's stock fell from $45 to $33 on the day the news broke, a drop of 36%. After further investigations uncovered that the company may have known about the risks and tried to cover them up, the stock continued to drop, finally landing at its low of $26 almost 40 days later.

Figure 2: MRK August 2004 - December 2005; A) Initial fall; B) Second fall
Source: Yahoo! Finance

Although many in the news media speculated that the company would not survive this type of negative publicity or the flood of lawsuits that were filed, the company did survive and the stock finally returned to, and surpassed, its former high price in January of 2007. After many initial missteps, Merck eventually took several actions to allay investors' fears. First the CEO was replaced, second, the company vigorously fought the lawsuits (which are traditionally difficult to prove) and last, the company introduced new products to the market by focusing on research and development and making some key acquisitions. Despite these efforts, it took more than two years for the stock to return to its former highs. (For more on pharmaceutical stocks, see Stocks On Drugs: What It Takes To Get High.)

3. ExxonMobil's Great Escape
ExxonMobil (NYSE:XOM) is one of the world's largest oil exploration and production companies. On March 24, 1989, one of its tankers, the Exxon Valdez, hit a reef in Alaska and spilled millions of gallons of crude oil. This disaster was caused by a variety of factors, including human error and poor judgment, poor maintenance of the ship's radar system and possibly an inadequate number of crew members, according a 1990 report by the National Transportation and Safety Board. As a result of its negligence, ExxonMobil was ordered by a federal court to pay $5 billion in punitive damages (which was reduced to $2.5 billion), and $287 million in actual damages. Interestingly, the stock barely reacted to the news of the spill, or the initial fine, and the disaster resulted in only a 4% loss in stock price after the largest fine in history was announced.

Figure 3: XOM 189 - 1995; A) Dip on announcment of spill; B) $5B fine announced.
Source: Yahoo! Finance

The reason this stock reacted very minimally to the announcement of the spill and the fine may be a result of how oil stocks are priced. Oil stock prices are based on perceived supply and demand. The spill caused a decrease in available supply, while demand remained at steady levels. Therefore, the expected result would have been an increase in the price of a barrel of oil. The $5 billion fine was the highest fine ever levied against a company. However, the market assumed that this fine would be reduced and would be tied up in the court system for many years, so investors did not focus on its immediate impact to profitability. (Learn more in Understanding Oil Industry Terminology.)

4. Toyota's Decceleration
Toyota Motor Corporation (NYSE:TM), a leading car manufacturer, was once known to the market as the maker of reliable, well-made cars. On November 2, 2009, January 21 and January 28, 2010, the company recalled many of its car models due to sticking accelerators, which caused unintended acceleration. At first, the November recall had no effect on Toyota's stock because it was small and thought to be due to a problem with Toyota's floor mats. But as the recall widened and evidence of deaths suggested there were other issues, the January recalls caused Toyota's stock to drop from $90 to $72 over a 15-day period, a loss of 20%.

Figure 4: TM October 2009 - March 2010; A) Initial recall; B) Expanded recall with further investigations
Source: Yahoo! Finance

Six months after the recall, Toyota's stock still had not recovered. The 20% loss and the slow recovery can be attributed to the fact that consumers purchase cars that are affordable and safe. When consumers lose confidence in an automaker, sales typically suffer.

The Traits of a Suvivor
There are many examples of companies that failed to survive a challenge and no longer exist, but most of these are due to fraud or illegal activity (Enron), or excessive risk taking (Bear Stearns and Lehman Brothers). However, there are several characteristics that are common to companies that faced major challenges and survived. First, the larger capitalized the company, the better-prepared it is to weather a financial storm and gain access to external funding should the need arise. Second, companies with long histories and strong reputations tend to have investors' support over the long term, as well as access to external funds. Third, the cause of the challenge determines whether the company recovers quickly or slowly. An external cause typically results in a short-term impact to the stock, while an internal cause can have a long-term impact.

The Bottom Line
When examining a stock scandal, determining whether the cause is internal or external and examining the company's moves to mitigate any effects on its stock price are key. Investors may attempt to sell the stock on the news and then analyze the situation later. However, this type of timing is very difficult to execute because once the news breaks, institutional investors have generally already made a decision to sell and the small investor may end up selling at the bottom. (See Enron's Collapse: The Fall Of A Wall Street Darling, and Case Study: The Collapse of Lehman Brothers.)

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