What Did GM Really Earn In 1997? (3 of 3)
"Dear Shareholder"
---------------------------
If there seems something roguish about declaring a $6.4 billion
before-tax "loss" while actually losing only $200 million in cash
going forward, perhaps it's because there is something
roguish about it.
The bulk of the charges comes from writing down the value of
assets GM already owns. Their argument runs something like: The
ROE on these assets is less than a private business buyer would
accept, so the stated value of the equity will be reduced to
raise ROE up to an acceptable level. Then a tax benefit will be
taken for the amount of this reduction. Consider the following
hypothetical letter to shareholders:
Dear Shareholder:
Your company owns certain assets that earn very poor returns (low
ROE).
Every year since these assets were purchased, your company's
management has reduced the book value of these assets by an
amount that was supposed to reflect the estimated reduction in
their remaining economic life, due to wear and tear, and
obsolescence ("depreciation and amortization").
But, sales prices are not rising as much as once hoped. In fact,
after rebates are taken into account, sales prices are falling.
Therefore, the net cash these assets will generate in the future
is less than their remaining book value. Rather than restate
past amortization and depreciation at higher amounts, which would
reveal that earnings were less than previously reported, your
company's management has treated this shortfall as a "one-time
event".
Your company's management is likewise treating this reduction in
book value a non-recurring loss of earnings, and of course,
availing itself of the tax deductions to which this earnings
"loss" entitles it.
Ditto for the declining value of leases.
And, certain costs associated with plant conversion will also be
declared a "special charge", since plant conversions are a rare
event. So, these costs will not thereby reduce earnings reported
in the future.
This recognition entitles your company to the full tax benefits
now. But, these expenses won't show up as they occur in
future earnings reports -- since they have already been
taken in a lump sum in 1997.
Thus, these "losses" entitle your company to an involuntary,
interest-free loan of $1.3 billion from federal, state, and local
taxing authorities. At the bottom line, your company's cash
position is only the worse by $200 million, while making future
cash flow appear $2.1 billion greater than it will actually be.
And, ROE has even improved (by deflating present equity and
inflating future earnings).
Of course, there is no "free lunch" in economics. On the
downside, besides making it appear that the more money your
company earns, the more it shrinks in value, these balance sheet
maneuvers will increase both your company's apparent
price-to-book ratio and its apparent debt-to-equity ratio.
But, nowadays, because these practices are so common, little
attention is paid to the former. As to the latter, no one
believes that a Treasury that is being so beneficent in bailing
out bad investments by far-away banks will not be at least as
magnanimous about financial imprudence closer to home.
Nevertheless, your company faces a challenging environment on the
road ahead. Powerful forces at the Financial Accounting
Standards Board and the IRS are working to thwart your company's
efforts to increase apparent shareholder value by these means.
But, due to your company's creativity in accounting practices,
and its lobbying of friends in Congress and at the Fed,
management is confident of its ability to meet these future
challenges.
Happy Motoring,
Your Company's Management
Graham's View
---------------------
Needless to say, Benjamin Graham would not have been amused. In
The Intelligent Investor (4th Ed., pp. 165 - 174), Graham
devotes a chapter primarily to dissecting a similar balance sheet
maneuver made by Dow component ALCOA in 1970. Because Graham's
writing is so much better than mine, I will quote from it
liberally [with comments applying to GM in brackets]:
"....It is easy to say that [special charges] are not part of the
'regular operating results' of 1970 -- but if so, where do they
belong? Are they so 'extraordinary and nonrecurring' as to
belong nowhere? A widespread enterprise such as ALCOA, doing a
$1.5 billion business annually [a great sum at the time], must
have a lot of divisions, departments, affiliates and the like.
Would it not be normal rather than extraordinary for one or more
to prove unprofitable, and to require closing down? Similarly
for such things as a contract to build a wall [or a lease
contract]. Suppose that any time a company had a loss on any
part of its business it had the bright idea of charging it off as
a 'special item,' and thus reporting its 'primary earnings'
[operating earnings] per share so as to include only its
profitable contracts and operations?....
"The reader should note [an] ingenious aspect of the ALCOA
procedure we have been discussing....by anticipating future
losses the company escapes the necessity of allocating the
losses themselves to an identifiable year. They don't belong in
1970, because they were not actually taken in that year. And
they won't be shown in the year they are actually taken,
because they have already been provided for. Neat work, but
might it not be just a bit misleading?.....
"Years ago the strong companies used to set up "contingency
reserves" out of the profits of good years to absorb some
of the bad effects of depression years to come. The underlying
idea was to equalize the reported earnings, more or less, and to
improve the stability factor in the company's record. A worthy
motive it would seem; but, the accountants quite rightly objected
to the practice as misstating the true earnings. They insisted
that each year's results be presented as they were, good and bad,
and the stockholders and analysts be allowed to do the averaging
or equalizing for themselves. [A few years ago, Daimler, in
order for its ADR's to be listed on the NYSE, was required to
discontinue its practice of "smoothing earnings".] We now seem
to be witnessing the opposite phenomenon, with everyone charging
off as much as possible against forgotten 1970, so as to start
1971 with a clean slate but specially prepared to show pleasing
per-share figures in the coming years....based paradoxically
enough on their past disgraces. [The last phrase comes from an
earlier paragraph.]
"It is time to return to our first question. What then were the
true earnings of ALCOA in 1970 [or GM in 1997]? The answer would
be : The $5.01 per share [in GM's case, $7.89], after "dilution"
[then, as now, related to off-income-statement executive
compensation via stock obtainable at below-market prices -- in
GM's case minuscule], less the part of the 82 cents of
'special charges' [in GM's case, a net increase of 81 cents,
because the defense segment spin-off to Raytheon created a
"special gain"] that may be properly attributed to occurrences in
1970. But, we do not know what that portion is, and hence we
cannot properly state the true earnings for the year. The
management and the auditors should have given us their best
judgment on this point, but they did not do so. And furthermore,
the management and the auditors should have provided for
deduction of the balance of these charges from the ordinary
earnings of a suitable number of future years -- say, not
more than five. This evidently will not do either, since they
have already disposed of the entire sum as a 1970 special
charge." [In the case of GM's competitiveness studies, there was
at least an attempt to estimate the cash outlay over the next 5
years -- $2.1 billion -- though one has to read to page 70 of
the 10-K to find it. But, there was not even a pro forma
presentation of the reduction of past reported earnings implied
by the retroactive portion, apparently about 1/2, of the $4
billion after-tax charge.]
Graham then summarizes accounting techniques common in that era
"that may impair the true comparability of the numbers":
1. "[S]pecial charges which may never be reflected in the
per-share earnings";
2. Failing to present "after-tax" figures for the charges -- and
then using the tax credits as stealth earnings in future periods;
3. "The dilution factor implicit in the existence of
substantial amounts of convertible securities or warrants";
4. Switching from "accelerated depreciation" to "straight-line
depreciation" to increase apparent net income (yet, continuing to
use accelerated depreciation in tax filings);
5. Switching between FIFO and LIFO inventory accounting
according to how conditions of inflation or disinflation favor
one method or the other.
6. The choice between booking research and development as an
asset to be amortized over a period of years (thereby lowering
future reported earnings), or a current expense with immediate
tax benefits and no drag on future reported earnings.
In the current era, taking the above list in order:
1. Special charges are not merely bundled into recession years.
They take place every year. Therefore, there is not as much
distortion in year-to-year comparisons -- at least for years in
the 1990's.
2. After-tax consequences are reported up front.
3. Earnings "dilution", it seems, is nothing new. In the era
about which Graham was then writing (the early 1970's), the
instruments were chiefly convertible securities and warrants,
rather than the options products of today. The effect was
similar though, both in quality and magnitude.
In those days, the high flyers were often conglomerates. On page
227 of TII, Graham provides a list of such conglomerates
whose earnings dilution factor in a number of cases exceeded 50%.
(In the Bear Market that followed less than a year after Graham
published this list, many of these stocks were severely punished.
In some cases, the underlying companies did not survive.)
4 & 5. Today, questionable changes in the accounting practices of large
companies are immediately identified in the financial press, and
severely criticized by analysts. The "shorts" provide publicity
about dubious accounting practices at smaller companies.
Investors are free to ignore it -- but, it's not as if the
information is unavailable.
Nonetheless, it should be noted that on page 28 of GM's 1997 10-K
it states: "The cost of substantially all U.S. inventories other
than the inventories of Saturn Corporation (Saturn), Delco, and
Hughes is determined by the last-in, first-out (LIFO) method.
The cost of non-U.S., Saturn, Delco, and Hughes inventories is
determined generally by either the first-in, first-out (FIFO) or
average cost methods."
Thus, Graham's basic point is confirmed: The answer to the
question: How much was really earned by ALCOA in 1970? (or GM in
1997?) depends upon how one views certain choices made by their
accountants.
And on page 50 of the 10-K, it states:
"GM adopted SFAS No. 131, Disclosures about Segments of an
Enterprise and Related Information, during the fourth quarter of
1997. SFAS No. 131 established standards for reporting
information about operating segments in annual financial
statements and requires selected information about operating
segments in interim financial reports issued to stockholders. It
also established standards for related disclosures about products
and services, and geographic areas. Operating segments are
defined as components of an enterprise about which separate
financial information is available that is evaluated regularly by
the chief operating decision maker, or decision making group, in
deciding how to allocate resources and in assessing performance."
So far, so good. The purpose of SFAS No. 131 is to provide a
more detailed picture of how corporate decision makers themselves
gauge the profitability of various segments. This allows
investors and analysts to get a better fix on what things are
going well and what needs improvement.
But, further down the page it states:
"The accounting policies of the operating segments are the same
as those described in the summary of significant accounting
policies except that the disaggregated financial results for GM's
automotive operating segments (GM-NAO, Delphi and GMIO) [i.e.,
virtually the whole auto and truck making operation] have been
prepared using a management approach, which is consistent with
the basis and manner in which GM management internally
disaggregates financial information for the purposes of assisting
in making internal operating decisions. GM evaluates performance
based on stand alone operating segment net income and generally
accounts for intersegment sales and transfers as if the sales or
transfers were to third parties, that is, at current market
prices. Revenues are attributed to geographic areas based on the
location of the assets producing the revenues."
The above paragraph is not a model of clarity. But, in terms of
the question of how much GM earned in 1997, GM first states that
segment totals are arrived at using the same accounting policies
as used elsewhere in the 10-K. But, when the segment totals are
broken down into their respective components, management uses
different standards in evaluating how these segments are doing.
To this extent, it reveals that management is viewing GM's
financial performance differently than the way they are
presenting it to the rest of us.
6. To my knowledge, nowadays companies consistently record R&D
as an immediate expense.
Is The Value Of R&D Consumed In The Year It is Expensed?
-----------------------------------------------------------------
The last item, R&D, has had quite an effect, in my opinion, on
distorting book values downward, and therefore, ROE and
debt-to-equity ratios upward. I disagree with the view,
implicit in certain accounting rules, that R&D is necessarily a
depreciating asset.
I learned reading, writing, and 'rithmetic, at no small expense
to the public burse, long ago. Yet, when I went to college, I
didn't have to learn these educational basics over again.
And, I still employ this R&D in human capital, to whatever
effect. Academic R&D isn't something that requires complete
replacement (like food, clothing, and sleep), though supplements
may be required from time to time.
I originally learned to use a PC that was running DOS 3.3. Since
I am something of a computer klutz, this took a good deal of
time. And, as they say, time is money. But, at least I did not
have to learn to read again. This saved considerable time in
reading computer manuals, which in turn saved time in realizing
how little useful information the manuals provided.
I now run WinNT 4.0. The underlying principles of much of what I
do now in Windows was originally learned on a machine running
DOS. What I learned in DOS isn't as useful as it was then -- but
it isn't entirely gone either. It took much less time to get up
to speed in WinNT because of what I had already learned in DOS,
than it would if I were just starting out. So, this R&D time
expended on learning DOS hasn't been entirely consumed -- a large
portion of it is now accreted into such knowledge as I possess,
and the time saved learning it, in WinNT.
I believe this is also the case with much industrial R&D.
Though, for example, the rotor and distributor ignition system
has long since been replaced with a computer chip for shunting
electrical power to spark plugs, I don't believe the intellectual
capital developed in designing older ignition systems has
completely evaporated. Rather, it continues to adhere in the
overall technological know-how of auto manufacturers,
particularly in the time saved in not having to first "reinvent
the rotor".
Much R&D leads to a dead-end. Some leads to breakthroughs of
enormous economic consequence. In many cases, it's hard to
separate out which is which. But, as it stands now, all
of it gets taken off the books in the period it is first
expended.
And, if the company is purchased, it is likely to be taken off
the books a second time, as "in-process research and
development". The whole issue will not be rehearsed here. But,
in effect, it's an admission that R&D is really a long-lived
asset, rather than an immediately consumed cost like a ball point
pen or a sales call on the telephone. (For details, see:
Message 4079448, with a
followup at:
www4.techstocks.com
Part of what drives the rules on R&D accounting is a public
policy favoring tax incentives for companies to spend money on
R&D. The net economic effect, in my view, of the current
treatment of in-process research and development R&D is for the
taxpayers to subsidize the expense twice.
For the record, GM Spent $8.2 billion on R&D in 1997. Were at
least a portion of this amount booked as an asset, reported
earnings would have been higher, as would book value.
correspondingly, the debt-to-equity ratio would have been lower.
Ever Hear Of Cadillac?
--------------------------------
Finally, there is another factor, not often discussed in this
vein: Advertising. No one that I know of proposes that
advertising be booked as a long-lived asset. But, how could
Coke, Gillette, or Joe Camel enjoy their current brand
recognition, unless advertising expenses are, are at least to
some degree, an accretive asset?
At some point in the past year, Barron's quoted an analyst who
had added up Coke's advertising spending over the years. If I
recall correctly, this sum would potentially add $78
billion to Coke's assets, and hence equity. Coke's
advertising of 100 years ago probably adds little to its current
level of brand recognition. But surely, much of the advertising
of the past few years still impacts Coke's fame and fortune. If
at least some reasonable portion of this past advertising
expenditure were carried on Coke's books as an asset, it would
reduce Coke's astronomical reported ROE of over 50% to a more
down-to-earth level. (The same could be said for much of the S&P
500).
When it comes to advertising, Coke is barely a blip on the screen
compared to GM. As the U.S.'s largest advertiser, GM spends over
$20 billion on "branding" every year. As a result, GM
brands enjoy very high consumer recognition. Before dismissing
the value of this brand recognition too quickly, consider that GM
enjoys the highest brand loyalty of any auto company
operating in the U.S. (See:
siliconinvestor.com
Why Chose Book Value Over Tax Savings?
----------------------------------------------------------
Because of the economic irrationality (though it is politically
unavoidable) of our tax code, taxes are levied on the creation of
wealth from labor and capital, instead of the destruction of
wealth from final consumption. Hence, companies have no economic
incentive to book R&D, much less advertising expenditures that
boost brand recognition, as assets. By immediately deducting
these expenses from revenues, companies pay lower taxes now,
rather than having the value of these tax savings tied up as
assets on the balance sheet for an extended period. In fact,
much of the ongoing writedowns of asset values can be seen as a
strategy for moving value from the assets column into the tax
credit column on the balance sheet.
I don't believe that GM really earned over 35% on equity in 1997
-- and I certainly don't believe that Coke earned over 50%. For
more details on the accounting maneuvers by which Coke came to
achieve this miraculous ROE, see:
Message 5410513
Therefore, I don't believe that GM's debt burden in relation to
equity is as onerous as it appears under current accounting
procedures.
So What?
-------------
As tedious as it is to read about (and write about) arcane
details of accounting practices, the matter is of import in
valuing not merely GM, but the Market as a whole.
The core of the Value Bears' case is that today's Market levels
can only be justified if current ROE's are sustainable. And, the
S&P 500's ROE has never been this high for very long, if at all.
(See, for example:
pathfinder.com
The Value Bears' fall back position is that if ROE's are actually
lower than reported, then it will be an even longer time before
cash earnings generation provides an adequate return on the
current price of equity.
But, if as the Haydn and Givoly research demonstrates, ROE's are
really in the low double digits, rather than the mid-20's as
reported, then the long term cash payout from equities is still
better than that from bonds or other asset classes. And,
consistent with GADR's 3rd Era thesis, ROE's in the low double
digits are sustainable for a long time, especially if inflation
remains under control.
The current restructuring in emerging markets and Western Europe,
if anything, forestalls the day when excesses will build to the
point that brings the current U.S. business upswing to a close.
Further, events in Asia make it difficult to understand where
inflationary pressure would come from.
But, perhaps the Euro will attract investment into Eurobonds and
away from the Treasuries that finance the U.S. trade deficit,
causing the dollar to plummet and, therefore, U.S. inflation to
rise. Personally, I feel that's a pretty big "perhaps", given
the respective economic efficiency and political stability of
Europe and the U.S..
Today's Earnings Are Not Of The Same Quality As Yesteryear's
-----------------------------------------------------------------
Neither is the quality of today's automobiles -- they are both
better. Haydn and Givoly are explicit on this point. As
Graham's passage on per share earnings makes clear, there was no
"golden era" of financial candor and transparency in Wall
Street's storied past. Whatever the deficiencies in today's
reporting practices, they were even worse in the past. This
again suggests that today's reported price-to-earnings ratios
are less, not more, inflated than in the past.
So What Did GM Really Earn In 1997?
-----------------------------------------------------
Based upon the Value Line presentation of 6/12/98, GM's per share
operating earnings were $7.89. The special charges described
above were more than offset by the special gains generated by the
Hughes defense segment sale to Raytheon. The net gain from
"one-time" items was $.81 per share. To the extent the special
charges were not really of a one-time nature, neither were the
gains. GM still has plenty of assets to spin-off in the coming
years.
GM's options dilution was negligible. In the end, the "no-tears"
answer to the question of what GM earned in 1997 is $8.70 -- its
plain-old vanilla net income per share.
A Final Comment By Graham
----------------------------------------
Summarizing his chapter on analyzing financial statements, Graham
writes (TII, pp. 171 to 172): "All this may be confusing
and wearisome to our readers, but it belongs in our story.
Corporate accounting is often tricky; security analysis can be
complicated; stock valuations are really dependable only in
exceptional cases. For most investors it would probably be best
to assure themselves they are getting good value for the prices
they pay, and let it go at that."
Any answers to these questions would be greatly
appreciated.
Thanks.
No problem.
*********
Graham and Doddsville Revisited
Editor: Reynolds Russell, Registered Investment Advisor
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In addition to editing GADR, Reynolds Russell offers investment
advisory services. His goal is to provide clients with total
returns in excess of those produced by the S&P 500.
His investment strategy applies the principles of Value Investing
established by Benjamin Graham to the circumstances of today's
economy and securities markets.
For further information, reply via e-mail to: gadr@nyct.net
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*********
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(C) Reynolds Russell 1998.
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