What Did GM Really Earn In 1997? (2 of 3)
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Let's look at how GM handled some of these write-offs in 1997 to
get a more concrete idea of their scope, and hopefully, their
cash consequences.
I am not formally trained in accounting, but will nonetheless
attempt a layman's analysis of the special charges reported in
GM's 1997 10-K. There will be errors, probably even gaffes.
Feedback from better informed readers is welcome (the more
gentle, the more welcome).
In 1997, GM took a $4.0 billion charge (after including tax
benefits) for "Competitive Studies". What follows is how GM
describes this interesting item on pages 25 and 70 of its 10-K
for that year. (See:
sec.gov
.txt) [700k text file]. Translations of accountancy jargon are
included that, hopefully, are approximately accurate:
[10-K, page 25:]
NOTE 2. COMPETITIVENESS STUDIES
"The global automotive industry, including the automotive
components and systems market, has become increasingly
competitive and is presently undergoing significant restructuring
and consolidation activities. All of the major industry
participants are continuing to increase their focus on efficiency
and cost improvements, while announced capacity increases for the
North American market and excess capacity in the European market
have led to continuing price pressures. As a result, GM-North
American Operations (GM-NAO), Delphi Automotive Systems (Delphi),
Delco Electronics Corporation (Delco), and GM-International
Operations (GMIO) initiated studies in 1997 concerning the
long-term competitiveness of all facets of their businesses
(Competitiveness Studies). These studies were performed in
conjunction with GM's current business planning cycle and were
substantially completed in December 1997."
[Approximate translation: Business sure is getting tough out
there. Because of continued supply overhang, along with more
capacity coming online, and the consequent price cutting, GM
won't make as much cash as previously estimated expense
and revenue accruals implied. But, instead of treating
this as a normal business event, and restating the accruals in
the prior periods, it is being treated as a special event under
the rubric of "Competitiveness Studies". However, GM describes
this exercise as part of its "current business planning cycle",
implying that such charges may recur, rather than being an
non-recurring or a one-time event. As the related passage on
page 70 of the 10-K states: "...further competitiveness studies
will be undertaken when and as market conditions warrant."]
[10-K, page 26:]
"Based on the results of these Competitiveness Studies, GM
recorded pre-tax charges against income totaling $6.4 billion[*]
($4.0 billion after-tax, or $5.59 per share of $1-2/3 par value
common stock).
Following are the components of the charges:
Pre-tax After-tax
Underperforming assets,
including both vehicle and
component-manufacturing
assets $3.7 billion $2.4 billion
Capacity reductions $1.4 billion $0.8 billion
Assets held for disposal $0.5 billion $0.3 billion
Other $0.8 billion $0.5 billion"
*{The similar paragraph on page 70 of the 10-K indicates that the
total loss is $6.3 billion, instead of $6.4 billion. Note that
the pre-tax figures in the table add up to $6.4 billion. See
comments, further below.}
[Approximate translation: GM has calculated $6.4 billion in
losses, from periods past and future, and is declaring this
amount to have accrued in 1997, since this is the time
when these losses have been first identified. This avoids having
to declare the earnings in prior periods to be lower than
previously reported, and having to declare earnings in future
periods to be lower than they will be reported. Yet, as
mentioned above, such charges now seems to be an outcome of GM's
normal "business planning cycle". Note: This newly calculated
loss will reduce tax liabilities by $2.4 billion ($6.4 billion -
$4.0 billion).]
"The charges were comprised of $3.8 billion ($2.4 billion
after-tax) for GM-NAO, $1.4 billion ($870 million after-tax) for
Delphi and Delco, $1 billion ($658 million after-tax) for GMIO,
and $205 million ($128 million after-tax) for GM's other sector."
[Approximate translation: Having first broken down this $6.4
billion loss by operational categories (underperforming assets,
capacity reductions, etc.), the loss is now broken down by
business segment (GM-NAO, Delphi, etc.), in accordance with a
newly adopted accounting rule (see below). This will aid
analysts in indentifying changes in the Intrinsic Value of GM's
separate components. Since Delphi is destined to be spun off,
this information will help in the calculation of the
post-spin-off Value of GM, as well as that of the new Delphi
entity.
Unsurprisingly, most of the special charge arose in the North
American auto and truck operation (GM-NAO), with lesser amounts
in GM's international and overseas operations (GMIO), and its
parts making subsidiaries, Delphi and Delco. "GM's other
sector", presumably, is the pro rated portion of GM's investment
in satellite-maker GM Hughes, and, possibly, EDS, because GM
still holds a greater than 20% stake in the latter.
GM will spin off Delco and Delphi, in whole or in part, somewhere
down the road. Since their sales price is likely to be less than
their book value, the calculated difference is being taken off
the books now. This will squeeze out further tax advantages of
$342 million ($1 billion - $658 million).]
"Overall, these charges had the effect of reducing net sales and
revenues by $548 million[**] and increasing cost of sales,
depreciation and amortization, and other deductions by $1.7
billion, $4.1 billion and $72 million, respectively."
**{The similar paragraph on page 70 of the 10-K states this
figure to be $459 million. See comments, further below.}
[Approximate translation: The $6.4 billion loss is broken down
according to a third perspective: financial categories.
Revenues were lower than had been estimated, and selling costs
were higher, as were depreciation and amortization (the estimated
rate at which GM's capital equipment was wearing out and/or
becoming obsolete).
In calculating cash earnings, depreciation and
amortization are added to accrued earnings. In their
stead, the current cost of capital spending is deducted to
account for equipment consumed in the production process. So,
this sudden upsurge in depreciation and amortization inflates the
amount being added back into accrued earnings for 1997, and thus
makes 1997 cash earnings appear higher than otherwise.]
"The amount included for underperforming assets represents
charges recorded pursuant to GM's policy for the valuation of
long-lived assets. GM re-evaluated the carrying values of its
long-lived assets as events and circumstances of the industry
changed. This re-evaluation was performed using product specific
cash flow information, which was developed by GMIO during 1997
and refined for GM-NAO, Delphi, and Delco in connection with the
separation of Delphi from GM-NAO and the transfer of Delco from
former Hughes to Delphi. As a result, the carrying values of
certain long-lived assets were determined to be impaired as the
separately identifiable, anticipated, undiscounted future cash
flows from such assets were less than their respective carrying
values. The resulting pre-tax impairment charges represented the
amount by which the carrying values of such assets exceeded their
respective fair market values."
[Approximate translation: Certain assets heretofore have been
carried on the books at a value of X. But, based upon revised
forecasts of product pricing, it is estimated that the cash flows
these assets will generate going forward are only Y, an amount
less than X. Therefore, the book value of these assets is being
reduced by (X-Y).
Note that Y is "undiscounted". No attempt is made to reflect the
fact that the present value of the future cash flow, Y,
should be reduced to account for subsequent compounding of
implied interest. So, by implication, (X-Y) should actually be
larger.
As calculated by GM, (X-Y) comes to $3.7 billion before tax, and
$2.4 billion after tax. GM thereby takes an added tax benefit of
$1.3 billion ($3.7 billion - $2.4 billion).
Of course, even underperforming assets destined for sale or
disposal still require ongoing infusions of investment capital.
Will this future added investment require that these assets be
"written up", having already been written down? Apparently not.
The related passage on page 70 of the 10-K states: "Future
investments relating to underperforming product lines will be
expensed." That is, rather than booking the future investments
in this equipment as an asset, and depreciating their cost over
the improved equipment's useful life, the full expense of the
capital infusions will be immediately charged to the income
statement and the balance sheet. Needless to say, this will
further confuse the issue of what is the actual value of GM's
assets and how much money is being earned on them.]
"The amount included for capacity reductions represents
post-employment benefits payable to employees, pursuant to
contractual agreements, and costs associated with the disposal of
assets at facilities subject to capacity reductions. This
includes the previously announced actions concerning GM-NAO's
Buick City Assembly and V-6 Powertrain plants in Flint, Michigan;
Detroit Truck Assembly in Detroit, Michigan; Delphi's leaf-spring
plant in Livonia, Michigan; and certain GMIO facilities in
Europe."
[Approximate translation: The costs of certain plant closings
and labor force reductions are likewise being taken off the books
in a single stroke, since plant closings and the consequent work
force reductions are considered one-time events (but see Graham's
caustic comments, below). As a result, these costs will not be
reflected in future earnings reports, when the cash is actually
expended.]
"Assets held for disposal primarily related to Delphi's seating,
lighting, and coil spring operations, which were announced for
sale during 1997. The related pre-tax charges represented the
amount by which the carrying values of such assets exceeded the
estimated sales value, net of related costs to sell."
[Approximate translation: GM estimates that the portions of
Delphi that will be sold will garner a price less than their
remaining book value. So, this difference is also being treated
as a special charge: $0.5 billion ($0.3 billion after taxes).]
"The amount included as other primarily represents losses on
contracts associated with pricing pressures on used vehicles and
the related effect on GM's retail-lease commitments. These
pricing pressures are primarily a result of increased industry
sales incentives on new vehicles."
[Approximate translation: When cars are leased, the amount
booked as "revenues" is, in part, based upon an estimate of their
resale value in the used car market when they "go off lease", and
are returned to the auto maker to be resold.
Because of sales incentives on new cars, used cars prices have
dropped correspondingly. Since GM had overestimated what the
strength of the used car market has turned out to be, the
difference between the erroneous estimates and the prices now
expected is being deducted from what had previously been reported
as "revenues", when the lease agreements were entered into. This
reduction in amounts previously recorded as revenues is described
in the table above as "other" and comes to $0.8 billion ($0.5
billion after tax). (To add to the confusion, GM has used the term
"other" to describe 3 completely different items in this section.)]
"In connection with the Competitiveness Studies, GM reviewed the
remaining previously recorded reserve for plant closings. The
amounts remaining in the plant closings reserve at December 31,
1997, which primarily related to accrued expenses for
postemployment benefits (mainly pursuant to union or other
contractual arrangements), other liabilities and asset
writedowns, were reclassified to the consolidated balance sheet
accounts that reflect the nature of the specific reserve
components."
[Approximate translation: Certain estimated costs of closing
plants previously had been placed in a catch-all category on the
balance sheet called reserves. These costs have already
been deducted from earnings and book value. However, at some
point, to satisfy GAAP and to justify to the IRS the tax benefits
taken, these costs must be specifically identified, as actual
events warrant. A portion of this reserve has now been matched
with actual expenses related to specific plant closings. The
reserve has been reduced by this amount, and the same amount has
been correspondingly added to specific expense categories, with
no apparent net change to earnings or book value.
Thus, with respect to 1997 cash earnings, the change seems merely
nomenclatural, rather than financially substantive. But, there
may be favorable tax consequences. For example, there may be a
differing tax rate available from shifting a portion of the loss
between "operations" (termination packages) and "investment
activities" (closing a plant), or between U.S. activities and foreign
activities.]
"In addition, favorable 1996 adjustments to the plant closings
reserve totaling $789 million were reclassified to cost of sales.
Of this amount, $409 million reflected GM's decision to utilize
its Wilmington, Delaware facility for the assembly of a new
generation Saturn vehicle, and $380 million was primarily due to
revised estimates of postemployment benefit costs to be incurred
in connection with plant closings.
[Approximate translation: In 1996, it was decided that a plant
in Wilmington that had been earmarked for closing would not be
closed after all. Instead, the plant and its workers have been
converted to a Saturn plant and Saturn workers. Thus, book value
and income were first written down ("plant closings reserve"),
then written back up ("favorable 1996 adjustments"), and are now
being written back down ("reclassified to cost of sales").
Instead of declaring the amount saved by not closing the
Wilmington plant a "special gain" and adding it back into net
income and the balance sheet, it is being declared a cost of
selling the Saturns that the converted plant will be producing in
the future.
As things stand, the estimated cost of closing a plant that was
never closed is now being deducted from the future cost of
running this plant -- in a single stroke -- with attendant
inflation of the earnings that will be reported when the sales
actually occur.
But note, GM's treatment of this item preserves the tax
deductions already taken.]
"Separately, GM recorded pre-tax plant closings charges of
$80 million in 1997 and $62 million in 1996. The components of
these charges were recorded in accounts that reflect the nature
of the charges, including postemployment benefits, other
liabilities, and asset writedowns."
[Approximate translation: More reshuffling of nomenclature,
rather than substance, with possibly favorable tax consequences.]
A similar passage appears on page 70 of the 10-K:
"COMPETITIVENESS STUDIES
"The global automotive industry, including the automotive
components and systems market, has become increasingly
competitive and is presently undergoing significant restructuring
and consolidation activities. All of the major industry
participants are continuing to increase their focus on efficiency
and cost improvements, while announced capacity increases for the
North American market and excess capacity in the European market
have led to continuing price pressures. As a result, GM-NAO,
Delphi, Delco, and GMIO initiated studies in 1997 concerning the
long-term competitiveness of all facets of their businesses
(Competitiveness Studies). These studies were performed in
conjunction with GM's current business planning cycle and were
substantially completed in December 1997. Additional information
regarding the Competitiveness Studies is contained in Note 2 to
the GM consolidated financial statements.
"Based on the results of these Competitiveness Studies, GM
recorded pre-tax charges against income totaling $6.3 billion
($4.0 billion after-tax, or $5.59 per share of $1-2/3 par value
common stock). The charges were comprised of $3.7 billion ($2.4
billion after-tax) for GM-NAO, $1.4 billion ($870 million
after-tax) for Delphi and Delco, $1 billion ($658 million
after-tax) for GMIO, and $205 million ($128 million after-tax)
for GM's other sector. Overall, these charges had the effect of
reducing net sales and revenues by $459 million and increasing
cost of sales, depreciation and amortization, and other
deductions by $1.7 billion, $4.1 billion, and $72 million,
respectively. Going forward, GM's future cash requirements
relating to these charges are expected to total approximately
$2.1 billion over the next five years.
"The Competitiveness Studies charges included amounts for
underperforming assets, including both vehicle and component
manufacturing assets, pursuant to GM's policy for the valuation
of long-lived assets. Future investments relating to
underperforming product lines will be expensed. GM will continue
to monitor the competitiveness of all aspects of its businesses
and further competitiveness studies will be undertaken when and
as market conditions warrant. Future charges may result from
Delphi's fix/close/sell strategy and cost reduction programs in
Europe."
Comparing And Contrasting The Presentations On Pages 25 and 70:
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The passages on pages 25 and 70 are basically similar. Perhaps
the most important information added by the description on page
70 is the sentence: "Going forward, GM's future cash
requirements relating to these charges are expected to total
approximately $2.1 billion over the next five years." It is
amazing that an item of this significance appears only in the
last sentence of the second-to-last paragraph of the entire
presentation.
In addition, there are these already referenced anomalies:
page 26: "Based on the results of these Competitiveness Studies,
GM recorded pre-tax charges against income totaling $6.4
billion..."
page 70: "Based on the results of these Competitiveness Studies,
GM recorded pre-tax charges against income totaling $6.3
billion..."
More specifically, the discrepancy seems to have arisen in the
reporting of the GM-NAO charges:
page 26: "The charges were comprised of $3.8 billion ($2.4
billion after-tax) for GM-NAO...[overall] reducing net sales and
revenues by $548 million..."
page 70: "The charges were comprised of $3.7 billion ($2.4
billion after-tax) for GM-NAO... [overall] reducing net sales and
revenues by $459 million ..."
In my opinion, the correct figures are likely to be $6.4 billion
and $3.7 billion, since these figures are consistent with the
other sums.
Note that the discrepancy between the net sales reductions
reported on pages 26 and 70 is $89 million ($548 million - $459
million). Both $548 million and $459 million round off to $0.5
billion. Yet, the difference in the two amounts, $89 million,
itself rounds off to $0.1 billion. The difference in the
calculations of net sales reductions probably arose between the
time the first draft was composed and the final version was filed
with the SEC. In revising the earlier draft, some figures may
have been arrived at by adding the figures in millions and some
by adding up the figures to the nearest 1/10 billion.
Whatever the explanation, there is no doubt that the discrepancy
was unintentional. No company intentionally presents conflicting
data in an SEC filing. Nonetheless, this example should be kept
in mind when deciding how solid any published data is,
much less extrapolations drawn therefrom. One way or another,
all of it is based upon estimates.
And, believe it or not, companies are allowed to present one set
of estimated figures to satisfy GAAP, and another to satisfy the
IRS -- as long as they are internally consistent from reporting
period to reporting period.
Summary of GM's Special Charges Resulting From Competitive Studies
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The gist of the two competitive studies passages is that the
special charges fall into 3 basic categories:
1. writing down the value of certain assets;
2. anticipated future costs of labor force reductions; and
3. anticipated future costs of plant closings.
The total writedown of assets and other "special charges" against
earnings is $6.4 billion before taxes and $4.0 billion after
taxes.
The reason this $6.4 billion charge is being deducted from
earnings and book value all at once, instead of the usual
matching of expenses to the time periods in which they accrue, is
that they are impliedly of a one-time nature. One-time events
are charged to earnings and book value at their time of
discovery, though the actual cash outlays may extend both into the
past and the future.
This seems reasonable in the case of, for example, the plant
closings and attendant work force reductions (though Graham is
not as forgiving, see below). However, it does not seem as
justified in the case of writing down the value of leases or
plant equipment due to changes in the pricing environment. These
seem more like normal business events that call for restatement
of past earnings.
Redescribing a portion of the plant closing reserve as the future
costs of sales of cars produced by a plant that was converted
instead of closed seems even more dubious. The more proper
treatment would be to book conversion costs, if any, as assets;
and then to amortize these costs over future periods, by matching
them with the sales revenues the conversion expenses generate, in
the periods in which the sales occur. Those expenses that are
actual ongoing costs of sales (marketing, etc.) should be
deducted from revenues as they occur, instead of being
"pre-deducted", thereby inflating future earnings.
Of course, the $789 million of future sales costs that have been
"recognized" in 1997 must be recorded, in some fashion, at the
time these costs are actually expended. It is likely that as
these monies are paid out, they will be described on the cash
flow statement on a line with a description like "Adjustments
to reconcile income from continuing operations before cumulative
effect of accounting change to net cash provided by operating
activities."
But, they will not appear on the income statement,
because they have already been deducted from the income
statetent in 1997. Therefore, these future accounting
adjustments will cause no change in reported earnings or book
value, since these reductions were already recognized as
"accrued" in 1997.
Leaning On Uncle Sam
-------------------------------
The distinction between the before-tax figure of $6.4 billion and
the after-tax figure of $4.0 billion is, perhaps, the most
concrete of all these numbers, in terms of the effect of
these charges on GM's Intrinsic Value. Contingent upon the need
for subsequent adjustment based upon how events actually play
out (and possible challanges from the IRS), GM intends to save
its shareholders $2.4 billion in taxes now, through this
exercise in accountancy.
The table on page 29 of the 10-K indicates that in 1996 GM was owed a
tax refund of $357 million, but in 1997 had accumulated a tax
liability of $1,307 million (apparently from the Hughes defense
segment sale to Raytheon). Yet, this $2.7 billion increase in
tax liability was almost entirely offset by the change in
deferred taxes from an amount owed of $315 million to a
credit due of $2.2 billion.
Of course, some of the $2.4 billion tax savings identified in the
competitiveness studies should have been taken in the past, had
depreciation and amortization schedules, and pricing forecasts,
not been overly optimistic in the first place. But some, like
future cost of sales, would normally not be taken as tax
deductions until the periods when the sales are actually made.
In effect, this portion of the charges is producing a tax savings
for losses that haven't yet occurred. The amount of this portion
can be estimated from GM's projection that the actual cash
expenses from these charges will come to $2.1 billion over a 5
year period.
Based upon the before-tax and after-tax figures GM has presented,
the implied tax rate appears to be about 38%. Dividing $2.1
billion by (100% - 38%) = 2.1/.62 = $3.4 billion in before-tax
future cash expense. Therefore, about $1.3 billion ($3.4 billion
- $2.1 billion) of current tax savings is coming from money that
hasn't yet been "lost".
Very roughly, the $2.1 billion in additional after-tax cash
expense over the next 5 years has a present value of around $1.5
billion at a discount rate of 7%. (In other words, the principal
and interest, at 7%, on a loan of about $1.5 billion could be
paid off in 5 years of payments totaling $2.1 billion.)
Thus, the taxes that are being saved now by these special charges
fall short of the present value of the cash that will be spent by
$0.2 billion ($1.5 billion - $1.3 billion = $0.2 billion). At
the end of the day, it appears that these special charges have
decreased GM's future cash earnings by only about $200 million.
So while book value has decreased by the total after-tax charge
of $4.0 billion (roughly 10% of total book value), and therefore
the debt-to-equity ratio has increased by a proportionate amount,
the cash available for servicing the debt appears to have
decreased by only $200 million.
[continued at: Message 5489207 |
