A REALITY CHECK FOR CORPORATE AMERICA

A REALITY CHECK FOR CORPORATE AMERICA
by Addison Wiggin

"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.

Regards,

Addison Wiggin
The Daily Reckoning