The De-Leveraging Of America

From an e-mail sent to the now defunct web company

“You are all a bunch of spoiled, arrogant,

conceited thieves who robbed your investors blind.

So how much missing equipment IS in your

apartments? Go to hell all of you.” “They don’t give us enough information,” said Brian at last week’s meeting in Baltimore.

“I checked the package they sent out…” he continued, “and then went to the documents filed with the SEC…but it is impossible to figure out how much the business is worth.”

We were sitting around a conference table trying to figure out how much to offer for a publishing business that was up for sale. The company had put together a thick package of documents and asked for a bid. But a careful study of the figures revealed missing items…and confusing details…that might have made millions of dollars worth of difference. Even in the Information Age, we labored in ignorance.

“Well, Brian,” I challenged, “surely the disclosures to the SEC will tell the tale. Otherwise, why would so many people, including underwriters and large institutional investors, have paid so much money for the stock?”

“They didn’t know what they were getting,” was his reply.

The company was a public company. On the basis of the published information – less extensive and less detailed then what we had in front of us – investors had spent millions to buy the shares. And yet, 4 people with about 80 years combined experience in the publishing business were unable to figure out if the company were worth $10 million – or perhaps nothing. One thing was clear – whatever the company may have been worth – it was a lot less than the public shareholders were paying.

Nietzsche’s distinction may be useful – if not for understanding this paradox, at least for elevating the intellection pretensions of today’s letter.

“Wissen” describes the kind of abstract, collective knowledge of public shareholders and voters. “Erfahrung” is another type of knowledge – the kind you get from direct personal experience.

“Wissen” is what makes overpriced stocks in dubious businesses “must own” investments. “Erfahrung” is what you get after you buy them and watch them get killed.

The latest list of “must own” investments includes a company Daily Reckoning readers will recognize – Cisco. As the Promethean light of the New Era spread its warmth across the entire continental U.S. nowhere did it shine more brightly than San Jose, California…and nowhere more intensely than the headquarters of the Cisco Kids.

A lot of people have gotten rich on Cisco stock. Many more hope to do so. After B2C, B2B, content plays, and other Internet disasters – Cisco is thought to hold the key to Internet success. The company is an infrastructure play – manufacturing the switches and routers that make it possible to send this message to you.

I don’t know what happened to the companies who made electrical switches during the electricity boom of the 20s, but I doubt that millions of people got rich from them.

And I doubt that many people will get rich from Cisco.

One can imagine how a small accounting department could produce numbers that don’t make sense. But you would think that one of the biggest companies on the face of the earth could get its numbers right – if it wanted to. But Cisco’s numbers are almost as confusing as Maria’s geometry homework or Edward’s sentence structure.

The Grant’s team went to work on Cisco’s latest 10-k report:

“What might be a simple matter is anything but. To the forthright question, By how much did earnings per share increase in the latest fiscal year? There are at least three answers.”

The increase of earnings per share is not a trivial matter. Upon it rests a market value of $384 billion, which comes to 151 times earnings. A multiple that great only makes sense – if it does at all – if the company is growing so fast that its future earnings may soon be 10 to 20 times greater than present ones.

But on that point, James Grant is less than sanguine:

“[W]e believe,” he writes, addressing the issue of EPS growth in the latest fiscal year, “the correct answer…is zero. Nil is exactly the rate by which net income per share would have increased if the company had given effect to the cost of employee stock options.”

If earnings are not really growing, a more reasonable price for the firm might be gotten by multiplying earnings by an ordinary number – say 10 – rather than by an extraordinary one like 151. Instead of being worth $384 billion, Cisco might only be worth, say $23 billion.

But even that may be generous. Because once the Cisco Kids realized that they could print their own money – that is, use shares in CSCO to pay employees, it seems also to have dawned on them that they could use the currency for other things. Pockets bulging, they have been on a buying binge for the past several years… buying up technology companies all over the country – and paying with the CSCO paper.

As if to prove that the habit of inflation is not limited to central bankers, Cisco stock multiplied like Wiemar- era deutchsmarks. “In August 1994,” reports Grant’s, “a split-adjusted 4.6 billion Cisco shares were outstanding; today, the fully diluted share count tops seven billion.”

In addition to buying companies of uncertain worth, Cisco raised huge amounts of cash, which was used to buy T- Bonds of much more certain worth. This produced the rather curious situation of a company that now earns about 15% of its total earnings annually from its bond portfolio. But buying a share of Cisco is not a very efficient way to own T-bonds. In fact, it transforms a bond yield of about 6% into an earnings yield of 3/10ths of 1%. But at least that portion of Cisco’s earnings is relatively straightforward and reliable. The rest is not.

For example:

“Word for word,” writes Grant, “the most mysterious passage in the Cisco 10-K is one concerning unfilled orders: ‘The company’s backlog at Sept. 25, 2000 was approximately $3.83 billion, compared with a backlog of approximately $922 million at Sept. 20, 1999,’ it says on page 10. Yet, in the fourth quarter, inventories climbed to the equivalent of 52.85 selling days, up from 45.21 days in the April period.”

Inventories rising at the same time as backlogged orders? It doesn’t quite add up. But Grant’s reports that “our Cisco contact had no ready answer.”

In the popular imagination, in analysts’ reports, and in the wissen of the financial media Cisco is a buy – maybe even a ‘must buy.’ But the erfahrung of bubble veterans…and those who look long enough and hard enough at Cisco’s actual business…leads them to a different conclusion: Sell Cisco.

Until tomorrow…

Bill Bonner October 18, 2000 Paris, France

P.S. The de-leveraging of America will not be a smooth and easy process. People who jump on bandwagons feel the right to hold the driver responsible for where they end up. As the details of Cisco’s reporting emerge – and people lose money – look for lawsuits and recriminations.

*** “Homicide,” answered one Wall Street broker to a reporter’s familiar question yesterday, “we’re getting killed.” Another referred to the “devastating blow to the market.”

*** Both were exaggerating the damage in yesterday’s trading – in which the Dow fell 1.46%, equal to 149 points…and the Nasdaq lost 76 points. Both averages seem to be heading for decisive, psychological breaking points – with the Dow soon to fall below 10,000 and the Nasdaq perhaps dropping below 3,000.

*** And they are not likely to stop there. The big surprise to today’s investors will be that stocks can go down as much as they go up. In his commentary yesterday, Richard Russell reminded us that the Dow tends to go down in real bear markets until stocks yield 6%. That would put the Dow at about 3,000. In 1932, though, the Dow fell to a 10% yield.

*** Also, the bear market psychology can take a long time to take hold and work itself out. The Tokyo stock market, for example, fell below 15,000 this morning – nearly 11 years after than market hit a high of almost 40,000.

*** And John Myers sent me these number on the unemployment picture following the ’29 crash:

1929 3.2%

1930 8.7%

1931 15.9%

1932 23.6%

1933 24.9%

1934 21.7%

1935 20.1%

1936 16.9%

1937 14.3%

1938 19.0%

1939 17.2%

1940 14.6%

Is it possible that we will once again see 24% unemployment? I don’t know. But unemployment today is at its lowest level in 30 years. The unemployment picture – like the stock market picture – could darken considerably before it brightens again.

*** AOL lost 17 dollars to close at $43.60. Yahoo dropped $6 – closing at $49.

*** And TIME’s Man of the Year, Jeff Bezos, lost another 9% of his wealth. dropped more than $2 to close at $21. It’s down about 80% from its high of last December. But even here, the stock still has a capital value of $7.8 billion – a lot of money for a company that has earnings per share of negative $3.37.

*** 807 stocks advanced on the NYSE yesterday. 2134 declined. 35 hit new highs. 239 hit new lows.

*** “The next 24 hours are critical,” wrote Bill Fleckenstein, after the market closed. “If Intel, IBM, and MSFT can save the day, maybe we can have a rally for a little while….But if they are unable to do so…then things are liable to get very ugly…”

*** Alas, instead of saving the day, IBM announced yesterday evening that while earnings were up 18%…sales had risen only 3% in the latest period. Investors were disappointed. In after-hours trading, Big Blue got knocked down $14 – to below $100.

*** “One of the things that I’ve been doing for about a year,” writes Porter Stansberry this morning, “is attacking AT&T, Kodak and IBM. AT&T and Kodak have capitulated. IBM looks to be doing the same. I shorted Kodak at $85 after Barron’s predicted the stock was going to $100 in 1998. Today it’s at $36. I shorted AT&T…and the put options …have gone up 400%. I warned in July that IBM was in serious trouble…”

*** The euro rose slightly yesterday. Gold fell 50 cents.

*** Oil rose a trifling 7 cents a barrel in yesterday’s trading, but then the API came out and said U.S. crude inventories had slipped another 3.11 million barrels last week, after having dropped 3.9 million barrels the week before. In overnight trading oil rose 67 cents.

*** Magazines are great sell signals. Worth Magazine, the same publication that once said I was a “genius” – really, I’m not making this up – this week lists the “5 Tech Blue Chips You Must Own.” The list: CSCO, EMC, AOL, MSFT, INTC. Daily Reckoning readers know that when something becomes such a popular sensation that the financial media describes it as a ‘must own’ investment – it is time to sell. More below.

*** Also, watch for the November issue of MONEY, which is said to mention the Daily Reckoning – favorably, I hope.

*** “It was even worse than I had thought,” writes Ray Devoe. He recently updated a list of dot.coms he has been following since March. “The median decline from their highs for the 65 stocks was 90.5%, and the arithmetic mean showed a slightly smaller loss of 87.8%. If you took out the five stocks that were down “only” 57.8% to 69.8% (some only marginally Internet related), the mean and median loss would be almost identical.”

*** Finally, the debates are over. Not that I saw any of them on TV – but I read about them. And the candidates seemed to have defined each other in the traditional terms – pandering to envy, avarice, fear and collective mumbo-jumbo as the opportunities presented themselves. Gore accused Bush of being a brainless pimp for Big Business. Bush accused Gore of being a soulless shill for Big Government. Both are probably right…

*** But the worst part of the whole campaign is the nags who urge you participate in the fantasy of democracy by voting. “It’s time to get serious about the U.S. elections,” writes International Herald Tribune columnist and Gore supporter, Ellen Goodman. “I venture this thought,” writes the woman who rarely has one, “because the world has begun to intrude.” Goodman worries about the mideast, Slobodan Milosovic, and other remote news items, and comes to the silly conclusion that what matters most is who is in the White House.

*** Meanwhile, an addled Internet entrepreneur has set up a web-auction site where you can sell your vote. The going rate is said to be $19.61 in California and $12.38 in Illinois – perhaps reflecting the difference in available loot between the Silicon Valley and the Chicago suburbs.

*** No matter what its creators may think, the site is a spoof – because there is no way for the buyer to take delivery of his votes. And yet, the very idea of buying votes is so disturbing that election officials are threatening legal action with “felony charges and prison terms.” Buying votes, said one democrat, threatens to “undermine democracy.” What it really threatens is the illusion of democracy – that a majority, bribed with money or just promises, have the right to tell other people what to do.

*** The dreaded “digital divide” is widening. In August, 32.6 percent of blacks and 33.7 percent of Hispanic households owned computers, compared with 51 percent of households nationally.

*** Today is my son Will’s 22nd birthday. Happy birthday, Will.

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