A Reality Check for Corporate America

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"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.

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.

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.

August
13, 2005

Addison
Wiggin [send
him mail
] is the editorial director and publisher of The
Daily Reckoning. He is the author, with Bill Bonner, of Financial
Reckoning Day: Surviving The Soft Depression of The 21st
Century
and the upcoming Empire
of Debt
. This
article is taken from his soon-to-be released new book, The
Demise of the Dollar…and Why It’s Great for Your Investments
.

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