Can't Cut All Expenses
Capital markets have gained a newfound interest in companies that have heavy debt loads. Unfortunately, this is a very large list and list is not for writing "Buy" tickets. Non-financial companies ballooned their balance sheets by almost 400% since 1998. Amazingly, companies didn't slow down as the economy slipped into recession. Corporate bond debt increased almost 31% over the past two years. Bond debt increased only 25% from 1990 to 1995. All this debt will put pressure on net margins as the debt still has to be serviced and is generally a fixed cost. With interest rates already low, it is possible that it can only get worse for companies that used variable rate bonds or swapped for a variable rate. International Paper is a perfect example of the problem at hand. Just since the end of 1999, IP has increased its total debt by 61%. IP's increased debt load has added $388 million a year in interest payments compared to 1999. Our good friends at Tyco ballooned their balance sheet by 500% since 1998, and not surprisingly, interest expense has climbed by 436%. Interest expense has grown form 13% of EBIT (earnings before interest and taxes) in 1998 to 20% last year.
Comparing the third quarter (not all companies have reported fourth quarter earnings yet) of last year vs. 1995 for the S & P 500 companies, interest expense has risen from 21.6% of EBIT to 26.6%. In 1995 interest rates were much higher than today, which obviously would result in higher interest payments. If interest rates rise, so will interest expense, putting more pressure on companies' margins and forcing either lower earnings growth or more cost cutting measures. Interest expense is one expense companies cannot lower just by laying off workers or by taking a charge. The easy cost cutting has been done. Now it is time to wait and see if it was enough.
Often, companies issued debt not to invest in capital equipment, but to buy back their own shares. This would reduce the number of shares net income had to be spread over and boosted EPS growth. Of course these gains were one time in nature, but the interest still needs to be paid.
Another unknown in this financial quagmire, is the extent low interest rates combined with easy credit standard have allowed firms to hang on that should fail. Barton Biggs, strategist for Morgan Stanley, thinks Greenspan "provided the high-octane fuel, both intellectual and monetary, that transformed a 'healthy' bull market and a 'normal' expansion into the most gigantic boom and bubble of all time."
Just when companies are filing their quarterly and annual statements, the SEC's chief accountant, Charles Niemeier, said companies "can violate the SEC laws and still comply with" generally accepted accounting principles. It appears the SEC will make sure companies are not only following the letter of the law, but the sprit of the law as well. Niemeier wants companies to undergo two more tests when accounting for a transaction: "Does the overall result violate the accounting principles on which the rule is based; and does the answer or the result mislead investors as to a material issue?" The SEC actually has case law on its side according to John Coffee, law professor at Columbia University. According to Coffee, there is case law going back to at least 1969 that it is not enough just to go by GAAP and that defense attorneys and auditors have "been in denial" about the legal requirement to fairly present financial performance."
The media is pounding investors about aggressive accounting, but how much does aggressive accounting actually inflate earnings? The Centre for Economic and Business Research Ltd. found that U.S. earnings were overstated by $130 billion. The Centre compared statistics from the U.S. Bureau of Economic Analysis, which remove accounting adjustments to earnings reported from companies traded on the NYSE. As accounting standards increase the transparency, these adjustments will become much more visible. This will not only lower corporate earnings, but the realization of accounting gamesmanship (right word? Or just games) will likely cause investors to lower the multiple they are willing to pay for a company. Already money managers are questioning the quality of the standards used in the U.S. Merrill Lynch's latest Fund Manager Survey found that only 37% of managers thought the U.S. accounting standards were the best in the world, down from 57% just a month ago. Additionally, 62% of the managers think the U.S. equity markets are the most expensive regional market, up from 55% in January. This combination does not bode well for the stock market.
It seems natural that the first cracks that would appear in the residential housing market would be vacation and second homes. These houses can be viewed as much more discretionary and more as an investment than a primary residence. The LA Times reported that vacation home sales have started to fall. According to DataQuick Information Systems Inc., sales of second homes in California fell 15% last year, with some tony locations such as Palm Springs plunging 20%. The slowdown is not confined to California. Vacation home sales in Park City, Utah have declined 5% to 8%, according to broker Dennis Hanlon, president of Rocky Mountain Resort Alliance. In Aspen, Colorado buyers of mountain homes and condos spent $3.75 billion in 2001, 20% less than the $4.7 billion spent in 2000. Lower transaction volume was the result of fewer sales and lower sale prices.
Venture capital fund-raising totaled $40.6 billion in 2001, a decline of 61%. The fourth quarter fared much worse as the $4.6 billion raised was 80% below the fourth quarter of 2000.
The more I think about the "V" shaped recovery story, the more I dismiss it. With any hint of a recovery interest rates will rise and choke off the main catalyst for the strength the economy has had - residential housing and consumer borrowing. Raising interest rates will also bury companies that are using low interest rates as life support.