10-K Season

“10-K Season” has arrived on Wall Street…and this year’s 10-K season promises to be more exciting than ever! This is the time of year when most of America’s largest public companies release their 10-Ks, also known as annual reports. Lending drama to the 2002 vintage of 10-Ks is the fact that pension plan liabilities are skyrocketing to become a very serious problem for many companies…and the annual 10-K filing is the only public document in which companies must fess up to these ugly truths.

Several well-known corporations, like General Electric and Berkshire Hathaway, have already dispatched their 10-Ks. But many more of these revealing annual filings are yet to emerge. Traditionally, many of the most disturbing K’s arrive on, or immediately prior, to March 31st, the final due date. While there is no automatic connection between corporate shenanigans and a late-arriving 10-K, it’s true that “cooking the books” requires more time and creativity than merely reporting the unvarnished truth.

This year, however, even the varnished truth may be unsightly to investors. That’s because many corporate pension plans are racking up titanic liabilities.

Normally, pension plan health doesn’t change very materially over a 12-month span. But 2002 wasn’t “normal” – the stock market tumbled and health care costs soared, which means that many pensions suffered a wicked double- whammy.

Corporate Pension Plans: The Worst Year in Pension History

Ron Ryan, president of a New York-based pension plan consultancy, calls 2002 “the worst year in pension history”. His firm, Ryan Labs Inc., estimates pension assets dropped 11%, as pension liabilities soared 19%. GE, as a case in point, divulged in its latest 10-K that its pension plan’s surplus declined a whopping $10 billion last year. The industrial giant’s surplus shriveled from $14.5 billion at the end of 2001 to a mere $4.5 billion on Dec. 31, 2002. Thanks to the long-running bull market of the 1990s, GE hasn’t made contributions to its pension plan since 1987. The company optimistically states that no future contributions will be needed, as long as expected rates of return are achieved. But that’s a significant caveat. GE’s management expects its pension plan’s investments to earn about 8.5% per year.

We are skeptical. And so is Warren Buffett, who recently cautioned companies to lower their annual pension income estimates to 6.5%, as he did with his Berkshire Hathaway Inc. Not surprisingly, his cautions have largely been ignored.

Another fly in the ointment is that, even if GE achieves its unrealistic investment-return bogey of 8.5%, health- care costs are soaring out of control. That’s a particularly acute problem for a company like GE, where nearly three quarters of pension plan participants are retired personnel and therefore, more likely to require medical care than current employees.

The bad news for corporate America, and by extension, the stock market, is that GE’s pension plan is fairly typical of established U.S. companies in that the lion’s share of the plan’s participants are retired, which makes any retroactive benefit reduction nearly impossible. In other words, there’s no easy way to get rid of these nasty liabilities! Net-net, GE may find itself functionally working for its pensioners rather than its shareholders.

The good news is that GE’s pension plan remains in surplus…for now. Many other companies are not so fortunate.

Corporate Pension Plans: Pension Liability

Apogee Research (a company from which I draw a paycheck) has been prospecting for short-sale candidates among the companies with large, and growing, pension liabilities. Late last year, for example, Apogee identified a metasticizing liability on the books of Deere Corp. The tractor company’s pension liabilities had soared more than 70%, from $3.2 billion to $5.5 billion. “Put another way,” said Apogee, “$5.5 billion is equivalent to almost 10 times Deere’s estimated earnings for all of 2003.”

More recently, the gang at Apogee has been sniffing around the financial statements of a few other American companies. In fact, Apogee’s latest short-sale recommendation is a well-known American company that’s saddled with a spectacular $76 billion liability – a number four times larger than the company’s market capitalization! In other words, every dollar an investor spends buying the stock also buys about $4 worth of pension liability. Most folks would not knowingly make such an investment, if they thought about it in those terms.

It’s true, of course, that pension plan liabilities are “soft liabilities”: they are based upon unknowable, long- term assumptions, like rates of return on investment, future benefit costs and discount rates. Even so, these “soft liabilities” can create some very hard costs in the here and now – costs that can take a huge bit out of the shareholder’s equity.

Deere, for example, reduced its shareholder equity by $1 billion to account for its pension losses in 2002. That represents a sizeable hit to the company’s $3.26 billion book value. In and of itself, a large pension plan liability does not make a given stock a great short-sale candidate. But since massive pension liabilities can create a substantial headwind to profitability, stocks like these are likely good ones to avoid.

Unfortunately, an investor has to do some serious digging to uncover the facts about a company’s pension liability. GE, for example, buried its pension plan disclosures in the footnotes of its recent 10-K filing.

Furthermore, Financial Accounting Standards Board (FASB) accounting rules help to obscure the truth. The full magnitude of pension fund losses hasn’t shown up on many corporate financial statements, because FASB rules allow companies to allocate estimated pension investment gains to net income, rather than actual investment losses.

Corporate Pension Plans: Real Money

“Companies in the Standard & Poor’s 500 Index lost more than $200 billion in the past two years in pension investments without clearly disclosing those losses in SEC filings,” Bloomberg News reports. “12 companies, including General Motors Corp. and International Business Machines Corp., said they had reduced shareholder equity by $40 billion to account for pension deficits.” This too, is real money!

“IBM, for example, using an estimated rate of 10 percent, reported assumed pension gains totaling $12.2 billion for 2000 and 2001 in its SEC filings, following FASB rules,” Bloomberg continues. “IBM’s annual reports showed in footnotes that the world’s largest computer maker actually lost $2.8 billion in its pension fund for those two years – a disparity of $15 billion. On Dec. 31, IBM said it put $3.95 billion in cash and stock into its U.S. pension fund to make it fully funded.”

Don’t blame IBM; it’s legal!

CFOs become addicted to booking illusory pension “gains” as profits, says Ron Ryan, even when their plans produced losses. “Some [people] get addicted to heroin and cocaine. They got addicted to pension earnings.”

A prediction: De-tox will be a painful experience.


Eric Fry
The Daily Reckoning
March 21, 2003


“Damn Americans, I hate those bastards…”

Osama bin Laden? Saddam Hussein? Jacques Chirac?

No, Carolyn Parrish, a Canadian member of parliament, speaking in front of a microphone she thought had been turned off.

Even America’s closest neighbors and dearest friends are getting a little irritated. Here in Paris, demonstrators filled the Place de la Concorde. The U.S. Embassy closed. A plate-glass window was smashed at a McDonald’s franchise on the rue de Rennes.

“Bush is a terrorist!” “No blood for oil!” said the signs.

“No War!” said the demonstrators.

Hey, wait a minute. These demonstrators were speaking English…they’re Americans! French television showed groups of Americans who were protesting the war.

“I’m embarrassed to be an American,” said one young woman to the TV. “I’m all for getting rid of Saddam,” said an older man, “but this is not the way to do it.”

Isn’t it interesting, dear reader, the way people tend to take up whatever sentiment surrounds them? Americans in America back the war. Those overseas oppose it, along with 87% of the French population and similar majorities in other countries.

People believe they come to their opinions by thinking about things. But what would cause them to think so differently on one side of the Atlantic from the other? Opinions do not seem to be derived from independent thought at all…but from contagious infection…like hoof and mouth disease or genital herpes. Usually, the absurd opinions held by masses of people do them no harm. But occasionally, the infection produces a fever…and they go a little mad.

Here at the Daily Reckoning, we have no opinion on the war. We are neither for it nor against it…we merely try to avoid getting sick…

It is a war for “Iraqi Freedom,” says the administration. Most Americans believe the war has something to do with protecting their own freedom. Of course, people who x-ray their grandmothers’ shoes are ready to believe anything…

We love freedom too, here at the Daily Reckoning. Not from an ideological or theoretical point of view, though; we just don’t like anyone telling us what to do. Which is why we’re a little suspicious of changing a foreign country’s government without being asked. Who knows; it just seems like the kind of good deed that might not get you a sincere ‘thank you’. If you fail, you look like a foolish meddler. And if you succeed, your neighbors begin to get nervous or jealous. Maybe what you’re doing is a good thing…still, when you throw your weight around like that, others are bound to resent it. Even your friends begin to hope you get taken down a peg.

America’s major war aim must be to make the world safer from terrorism. But after it’s over, will the frogs, the krauts and the canooks – to say nothing of the ruskies or pakis – cooperate even more to suppress terrorists? Or mightn’t they turn their backs…and say, “damned yanks had it coming…”

But in the Homeland at least, Americans are sure it’s a heroic war rather than a sordid one…and pretty sure it marks the end of a long, annoying bear market.

Here in Paris, we’re not sure on either point. So, we content ourselves to guess about the latter and make disagreeable reflections on the former.

Our guess is that if Saddam goes down hard and fast, the thud may be enough to bounce U.S. stock prices for weeks…months…who knows…even years. But what really will have changed? Oil may be cheaper…but it would have to fall 50% to get back to January ’02 prices – which was not an especially good time for the U.S. economy. Growth rates are still below 2%, or near what Stephen Roach calls “stall speed”. Jobs are still disappearing. Corporations are reluctant to invest…not because of the war, but because they can’t figure out how to make a profit. Without jobs – and debts at record levels – consumers can’t very well increase spending. They need more money to do so. Where could they get it? From stocks? Nope. From bonds? Nope. From their homes – ah ha! They’re refinancing their homes at record rates in order to uphold a standard of living that they cannot really afford. How will the end of the war for Iraqi Freedom change things?

We will see…

Over to our man in the Homeland…Eric Fry in New York City:


Eric Fry, checking in from the Big Apple…

– Well, George W. launched his big, beefy, Texas-style invasion yesterday, and the nation’s unemployed colonels and generals couldn’t be happier. Suddenly, no TV news anchorman dares to go on the air without a couple of retired military personnel flanking him like a fighter escort. The TV anchors and their decorated guests take turns spewing inane speculations about each and every rat- tat-tat that issues from the night sky over Baghdad. We hope the war ends soon, so that all these retired stiff- jaws can return home to Boca and resume boring their wives and burdening their friends with their tedious opinions.

– Meanwhile, here on Wall Street, we seem to be reaching the point of diminishing returns…the deployment of 100 Tomahawk cruise missiles yielded fewer than 21 Dow points. That’s less than a quarter of a point per missile! But stay tuned; tomorrow’s bombings may produce a more satisfying result. Apparently, investors are having difficulty identifying attractive “targets of opportunity” in the stock market. The Dow finished the day at 8,287, while the Nasdaq added half a percent to 1,403.

– The U.S. military’s apparent initial success in Iraq sucked a little more of the “war premium” out of bonds, gold and oil. The 10-year Treasury note fell about half a point, pushing the yield up to 4.00% from 3.98% in the previous session. Gold also slumped, falling $3.90 to $332.30, while crude oil fell $1.11 to $28.25. Investors’ fleeting fling with caution is yielding to a rekindled passion for risk.

– Are the retreating prices of oil, gold and many other commodities creating targets of opportunity in the resource sector? Selectively, yes, says Greg Weldon, the newly minted editor of Outstanding Investments and Resource Trader Alert. In particular, Weldon suspects that the recent sell-off in the energy sector presents a buying opportunity – or at least a trading opportunity.

– Weldon is no perma-bull on commodities, however. Last month, his Resource Trader Alert (RTA) initiated a well-timed bearish trade on heating oil. As heating oil prices collapsed this week, Weldon urged RTA members to exit the trade with their 300% gains. RTA also deployed a bearish trade on gold a few weeks back. But Weldon now sees opportunity on the long side of several commodity markets and in selected resource stocks. Specifically, Resource Trader has issued a couple of brand new trades to capitalize on rallies in crude oil and natural gas.

– How rugged has the U.S. job market become? Consider the following anecdote from Grant’s Interest Rate Observer: “A four-line ad for an administrative assistant in the March 2 New York Times said the following: ‘Expanding company seeks smart, self-motivated person. Must have excellent computer skills, be good with details and have patient, friendly phone manner. Growth opportunity. Fax resume…'”

– The advertisement, placed by a friend of Grant’s, elicited an overwhelming response. The first fax arrived early Saturday evening, as the Sunday paper hit the streets, and as Grant’s friend explained, “[the fax] basically did not stop through Wednesday, and it slowed down somewhat on Thursday and Friday…I think I fed over 3, 000 pages into the fax machine…and I was just constantly refilling it. And when it would run out, it would build up in memory and then it would go for three hours straight. And I went through two ink cartridges.”

– Despite the stunning volume of responses, Grant’s friend said, “I didn’t get a bad resume, and most of them had a nice cover letter…It just dawned on me after reading these things that, you know, this is the bubble unwinding.”

– The job market is awful, no question about it. But at least the television networks are still hiring unskilled labor.


Back in Paris…

*** What America’s supporters, friends, allies, and enemies all have in common is dollars. Trillions of them. Friends and foe alike may admire America’s military machine…but, after the war, they may still despise its currency. We can hardly wait to see what happens…

*** Argentina…! We try to keep an eye on life south of the Rio Plata…just to get a glimpse of what it might be like in the U.S. when the dollar finally gets marked down to where it belongs. Last year, the Argentine peso fell 70% against the dollar. The economy dropped 10.9% – the “worst performance in a century”, said press reports. Sixty percent of the population now lives in poverty – with former government employees picking through trash bins to try to find something to eat.

Buy gold.

*** “Freedom” is the word that people use to describe what America means to them. Freedom was the reason often given by immigrants. Freedom was what the Bill of Rights and the Constitution were meant to protect…and what elected and appointed officials pledge to honor. It is also the word now used to explain America’s war against Iraq.

More than a year ago, we began wondering about freedom and America. Are today’s freedom fighters in the Bush administration really pursuing the cause of freedom? Or are they more like the Christian crusaders of the Middle Ages – killing Moors in the name of the Prince of Peace? Has freedom itself become a sort of religious relic in America – worshipped, rather than used in daily life?

These cogitations led to a book – The Idea of America – a collection of writings on the subject. Back from the printer this week, the book is sure to be a classic…or a complete dud. Before that happens, however, we will give you a chance to buy a copy. Watch this space.