A Reality Check for Corporate America
It seems as though we hear about it everyday – another corporation that has "cooked the books." Addison Wiggin looks at this disturbing trend, and explains what we can learn from these corporate dilemmas…
"History shows," wrote Jim Rogers in the foreword to our first book, Financial Reckoning Day (John Wiley & Sons, 2003),"that people who save and invest grow and prosper, and the others deteriorate and collapse."
Business investment creates economic recoveries. Without that investment, we have no right to expect a recovery. The Fed and other monetary gurus claim that the low level of business investment is to be blamed on excess inventories and low demand overseas. But realistically, corporate America has gone through a trend in the past two decades in which dwindling profits have led to increased levels of mergers and acquisitions, but little change in the lagging profit picture. The belief, or the hope, that merging and internal cost cutting would solve profitability problems has been dashed. It hasn’t worked.
Corporate America is coming to the point of having to face its own set of realities. First of all, merging does not improve profits if the market itself is weak. Lacking real investment in plant and equipment, long-term growth is less likely today than before the merger mania and the growing trade deficit. Coupled with this is an expanding obligation for pension liabilities among large corporations.
Inflated Earnings: Inflated Earnings reports
The problem of deceptive reporting isn’t limited to the government. Corporations do the same thing.
Consider the following: many corporations have notoriously inflated their earnings reports – and not just Enron. Quite legitimately, and with the blessings of the accounting industry, companies exclude many big expense items from their operating statements and may include revenues that should be left out. Exclusions like employee stock option expenses can be huge. At the same time, including estimated earnings from future investments of pension plan assets is only an estimate, and cannot be called reliable. Standard & Poor’s has devised a method for making adjustments to arrive at a company’s core earnings.
Those are the earnings from the primary business of the company, and anything reported should be recurring. The adjustments aren’t small. For example, in 2002, E.I. du Pont de Nemours (DuPont) reported earnings of more than $5 billion based on an audited statement and in compliance with all of the rules. But when adjustments were made to arrive at core earnings, the $5 billion profit was reduced to a $347 million loss. Core earnings adjustments that year of nearly $5.5 billion had to be made.
That is a big change. Other big negative adjustments had to be made that year for IBM ($5.7 billion reported profits versus $287 million in core earnings) and General Motors ($1.8 billion reported profits versus $2.4 billion core loss).That year, the two largest core earnings adjustments were made by Citicorp ($13.7 billion in adjustments) and General Electric ($11.2 billion in adjustments).
Here’s where the question of realistic net worth comes into play: In accounting, any adjustment made in earnings has to have an offset somewhere. So when Citicorp overreports its earnings by $13.7 billion, that means it has also understated its liabilities by the same amount – a fact that should be very troubling to stockholders. One of the largest of the core earnings adjustments is unfunded pension plan liabilities. United Airlines, for example, announced in 2004 that it was going to stop funding pension contributions. After filing Chapter 11 bankruptcy in 2002, the United Airlines unfunded liability is an estimated $6.4 billion.
We’re just scratching the surface. When we hear that a corporation has not recorded employee stock option expenses of $1 billion, that also means the company’s net worth is exaggerated by the same amount – and the book value of the company is exaggerated. So all of the numbers investors depend on are simply wrong.
The escalating pension woes have been building up for years. A booming stock market a few years back added to corporate profits. But once the market retreated, those profits disappeared. In this situation, stock prices fall while ongoing pension liabilities rise. As employees retire, obligatory payments have to be made out of operating profits and – while few corporate types want to talk about this – those very pension obligations and depressed returns on invested assets may be a leading factor in the high number of corporate bankruptcies.
Filing for bankruptcy often becomes the only way out when the corporations cannot afford to meet their pension obligations. We can learn a lot from the corporate dilemma. And we can apply what we observe to the way the Fed is running monetary policies.
In explaining the complexities of calculating value and explaining how or why dollars fall (thus losing purchasing power), the Fed has become very much like a corporate chief financial officer (CFO) trying to explain why things have gone south.
Inflated Earnings: The Problem Isn’t Going Away
Corporate management may be reined in, to some extent, by changes in federal law. The Sarbanes-Oxley Act changed the culture in some important ways. But until the accounting industry goes through some changes of its own, the corporate problem won’t disappear.
It appears so far that the disaster of Arthur Andersen has been viewed in the accounting industry as a public relations problem rather than what it really is: a deep, cultural failure within the business to protect the stockholders.
The parallels between corporate failures and government policy are alarming, if only because the Fed is not accountable to the Securities and Exchange Commission (SEC) or to stockholders in the same way that a corporate CEO and CFO are – and civil fines or imprisonment are out of the question. So as far as accountability is concerned, it looks like the borrowing and spending should continue – with yet more wild abandon.
The halfhearted debate over the twin deficits in trade and budget involve some big numbers, but the Fed is not concerned. In his penchant for understatement, Greenspan reported last year to the House Financial Services Committee on these matters. Noting that many Asian central banks have thus far purchased large amounts of Treasury securities, Mr. Greenspan cautioned that they "may become less willing" to continue that trend indefinitely.
On the subject of high-paying jobs disappearing, leaving many Americans able to find only low wages, Greenspan observed that the situation "is very distressful to people." Continuing on the jobs theme, he said:
"We obviously look with great favor on the efficiencies that are occurring, because at the end of the day that will elevate standards of living of the American people. . . . It’s only a slowdown in productivity or an incredible and unexpected rise in economic growth from an already high level that will create jobs."
This high productivity and economic growth the chairman refers to is nowhere to be seen today, and it wasn’t visible in 2004, either, when he made this statement. About one year later, Greenspan was back. In February 2005, he talked about the trend in consumer spending and savings:
"The sizable gains in consumer spending of recent years have been accompanied by a drop in the personal savings rate to an average of only 1 percent over 2004 – a very low figure relative to the nearly 7 percent rate averaged over the previous three decades."
But is this bad news? It is a negative trend, but Mr. Greenspan explains: "The rapid rise in home prices over the past several years has provided households with considerable capital gains. . . Such capital gains, largely realized through an increase in mortgage debt on the home, do not increase the pool of national savings available to finance new capital investment. But from the perspective of an individual household, cash realized from capital gains has the same spending power as cash from any other source.
Exactly! That is the Fed policy. Translated to its most obvious form, Greenspan is admitting the cultural attitude in America: a penny borrowed is a penny earned.
Something related to this that Greenspan did not address was the relationship between consumer borrowing and GDP. He likes to make comments about productivity like the one he offered in this same testimony: "Productivity is notoriously difficult to predict." But productivity itself is not the issue related to the spending problem. As borrowing increases as a percentage of GDP – up to more than 70 percent during the 1980s – savings rates fall and continue falling. By the end of the 1990s, borrowing had reached 90 percent of GDP. That’s where the real damage is being done. And in the middle of the very same trend, nonfinancial business profits have been falling as well.
The so-called U.S. expansion has been a nonexpansion. Corporate profits fell in the 1980s from 5.1 percent of GDP down to 3.7 percent. By definition, a profitless expansion is not really an expansion at all.The bubble economy of the 1980s was the beginning of a worsening effect in real numbers that built throughout the 1990s and beyond.
The Daily Reckoning
August 11, 2005
Addison Wiggin is the editorial director and publisher of The Daily Reckoning. Mr. Wiggin is also the author, with Bill Bonner, of the international bestseller Financial Reckoning Day and the upcoming thriller Empire of Debt. Mr. Wiggin is frequent guest on national radio and television programs.
"The easy money in commodities has already been made," said our old friend Rick Rule yesterday.
"Now it will be harder. You’ll have to pick the companies that are well run."
Rick was describing the current stage of the bull market in commodities. Just two years ago commodities were so cheap you could hardly make a mistake. All you had to do was to buy. Now, it’s no longer so simple. Now you have to buy the right company.
"What you need to know about commodities is that they are very, very cyclical."
The trouble is, investors are very cyclical too. But their cycles are usually the inverse of the markets themselves. When commodities were extraordinarily cheap two years ago, investors were extraordinarily bearish on them. When they finally become extraordinarily expensive, investors ‘ attitudes will change; they will become extraordinarily bullish – at the worst possible moment.
We would have more to say about this…
But it is already late at night in Vancouver…so we will wait until tomorrow…
In the meantime, more news, from our team at The Rude Awakening:
Eric Fry, reporting from Manhattan…
"I’ll happily accept a lower return in exchange for much lower volatility," a seasoned stockbroker declared yesterday. "That’s why I’ve been selling call options against most of the Valero Energy stock that my clients hold."
Bill Bonner, with more views:
*** It’s official – our favorite Editor-in-Chief has knocked the glasses right off the boy wizard’s nose…
No, Addison didn’t get in a street fight with a nerdy kid (although that would be quite the spectacle)…as of noon today, his new book, The Demise of the Dollar (and why it’s great for your investments) moved Harry Potter aside, and took the number one slot on Amazon’s bestseller list!
(For a sneak peek into the bestseller, see today’s essay.)
*** Oil woes spill out into the airline industry…
The AP reports that airports in California, Arizona, Florida and Nevada recently came within a few days – and sometimes a few hours – of running out of jet fuel.
Despite the close calls, these airlines have not canceled flights or made extra stops to tank up, nor have planes flown with less than the minimum fuel required by the Federal Aviation Administration, executives said.
"But the near shortages underscore the added strain on refineries, pipelines and the airlines’ own fuel procurement efforts as the industry recovers from its worst-ever downturn. June passenger traffic was up 4 percent from 2001 levels, according to industry data…and energy demand is on the rise throughout the economy," continues the article.
"It’s really starting to surface as an issue," said James Holland, vice president of logistics at Kinder Morgan Energy Partners L.P., a Houston-based pipeline operator.
*** "Is airline fuel rationing a harbinger of what’s next?" wonders one of our energy specialists, Justice Litle.
"America is in serious denial regarding the scope and seriousness of what looks to be a slow-building energy crisis. Optimists point to rosy economic data in the face of $65 crude, but they ignore the heavy-duty erosion that is taking place below the surface.
"Consumers have absorbed higher energy costs with the help of a credit cushion that is wearing thin, while government inflation data is painted as positive only by excluding food and energy. Airline troubles and fuel rationing could be the early warning sign for serious storms ahead. The longer we pretend that everything is ‘business as usual’ in regards to energy availability and consumption, the more vulnerable we will be when reality sets in."