Some days, subject matter for articles just doesn't come easily. Others, it pops up on the radar screen like an intruder at Fort Knox. While contemplating the issue of employee stock options and its real effect on corporate earnings for us owners - an issue that many Wall Street pundits and hucksters hope just dies and goes away - I stumbled into news released earlier today from Europe.
Guess what? The International Accounting Standards Board (IASB), a two-year-old board based in London designed to unify corporate accounting standards across 10 nations, issued a draft proposal saying specifically, "all share-based payments should be recognized in the financial statements." Whoa! No ambiguity there. If it costs the company money, it needs to show up on the earnings report and balance sheet. No more trickery, to which I say, "Amen".
But it doesn't end there. Besides, calling for corporate expensing of incentive stock options is yesterday's rally cry and seemingly futile exercise in hand wringing. I was thinking of something much bigger that has barely surfaced in public financial circles, yet has remained in the corporate boardroom under lock and key in the "dirty little secret" file. I'll probably get hate mail from CFO's, CEO's, and COO's telling me that their firms are above board, as all information pertaining to said corporate shell game (oops, err. . .EBITDA [earnings before I trick dumb auditors]) is available in public disclosures filed with the SEC.
Right. And all taxes are fully disclosed in the purchase of a gallon of gasoline, a pack of cigarettes, a bottle of hard alcohol. While we may be able to figure it out, we have to know what we're looking for and where to look. That might explain why very few are aware the next big accounting issue, UNDERFUNDED PENIONS, soon to be the other drag on earnings.
Well, I was going to talk at great length about the general concept of underfunded pensions as the next great drag on earnings and how they will affect stock prices in the future. Unfortunately that ranks right up there on the entertain-o-meter with rearranging my sock drawer. I had already ruled out revisiting the bear call spread on IBM, as we've hit that twice in the last two weeks. Again, about as entertaining as watching paint dry. Still a pretty decent bearish play in my opinion.
Then, in one of the rare moments when I was actually tuned in to CNBC, what to my wondering eyes did appear, but a little segment on. . .ta da. . .IBM and its underfunded pension! Sometimes, it's better to be lucky than smart. This was just such an instance. How much better could it get than dovetailing a bearish trade on IBM with the concept of underfunded pensions? And thus, here we are with the topic of the day.
Let me state it for the record. Despite the bullish cyclical pattern of equities during the last three weeks, this is still a secular bear market. Stocks are going to crest again and likely get hammered to lower lows. How can I be so sure? Many factors, but the one sticking most in my mind is squarely focused on earnings. If you thought earnings and forward statements were weak now, just wait until corporate America starts confessing its underfunded pension sins. We aint seen nothing yet.
Here's the issue in a nutshell. In addition to the 401K or IRA, many Fortune 500 companies fund a pension plan for their employees to be used by the employee (or beneficiary) at some point as a source of income following corporate retirement. Consider it a private enterprise version of social security. We work hard putting in 20 years with the same company and the company mails us a check every month once we've retired. That's simplified, but you get the idea.
Every year, the company is allowed to set aside some of its revenue (and call it an expense) for the benefit of its employee pension fund. Say a company grosses $1 bln in sales, and among other expenses totaling $800 mln (including interest taxes, amortization, and depreciation), it also includes a $100 mln expense that to be set aside for the pension. So far, so good - pensions funded from profits of the business - makes sense.
One of the integral parts of pension funding as it relates to net income is that the CEO, COO, CFO, or the board (pick one or a few) gets to assign a rate of return on the pension fund assets that is allowed to be counted as net income to the corporation. Did you get that?
Assume that over the years, a company's pension fund has grown to $1 bln in assets. The CEO says (under his breath buried deep in a 10K or 10Q where he hopes you won't find it), "I expect to earn 9% on that invested money this year, 2002". Doing the math, he expects to earn $90 mln on the pension fund assets, which he is allowed to count toward net income of the business!
In the same vain, if we impute that we earn 9% on our $500K portfolio of stocks this year (even if we don't), it still counts as income on the loan application when try qualifying for that $1 mln home loan on our $100K income. Wouldn't that be nice?
Yes, despite its appearance as a game of 3-card Monte, imputed pension asset returns are actually legal. So for the company with $200 mln in earnings from operations, it can report $290 mln in its earnings report thanks to the $90 mln imputed in the return on pension assets. So, if the company is a few dollars short in operating earnings, no problem! Just assign a higher imputed rate of return to the pension fund and everything will be OK! You don't actually have to earn it. You just have to SAY you are going to earn it. Neat trick!
Well, not really. See, the pension assets didn't really earn 9% last year. In fact, it actually lost about 15% last year and 25% the year before that thanks to the bear market in stocks. The company not only never earned the 9%, they lost 15% and 25% in value respectively over the last two years. And they are heading for another loser year in 2002, as well.
So for the pension fund with $1 bln in assets above, those assets were worth $750 mln (25% loss) the year before, $638 mln last year, and $510 mln at the end of this year, assuming another 20% loss. Let's see. . .$1 bln in assets to just over $500 mln in assets over three years. That's a $500 mln loss in value. Or as a sharp financial mind would say, "underfunded by $500 mln dollars".
Uh oh! The company is actually going to have to fund that missing $500 mln some day.
But the worst thing is that companies are still, to this day, assuming imputed rates of return of 8.5%-10% on pension fund assets that they hope to count toward net income! Unbelievable! How long can accompany report income it never actually earned? And how long can it hide losses in asset value that need to be replaced without actually replacing them? And when that company does fund the underfunded $500 mln, how will it affect their $200 mln of EBITDA earnings?
Once this shell game is discovered and given the coverage it deserves, don't look for an earnings recovery anywhere even near today's levels. Underfunded pensions are going to cost shareholders a bundle in earnings and stock price.
But where does IBM fit into all this? They happen to be today's stellar example of pension abuse. IBM has pension fund assets of roughly $60 bln. That's a huge number. Trouble is that it is 10%-15% underfunded. That's a minimum of $6 bln to a maximum of $9 bln that IBM will have to fund from somewhere. How will it do that? The only way it can. From earnings, of course!
I can hear it now from the shareholders meeting: "IBM had a stellar year because we imputed $5.4 bln of pension income to our income statement that we didn't really earn and we neglected to fund $7.5 bln to our underfunded pension, which we were able to defer to another year of our choosing. Were it not for those perpetual sources of "one-time" income and hiding of actual pension fund losses, we'd have lost $12.5 bln more this year! Oh, and we're guiding earnings from operations down for the foreseeable future."
Of course, the longer IBM prolongs the pension underfunding, and the application of a bogus imputed 9% return on those assets, the greater the hit to earnings in the future.
Corporate CEO's, CFO's, or COO's, are caught between the devil and the deep blue sea. How much longer do they fraudulently keep imputed pension returns higher than what they know is possible?
The bigger question is how much longer does FASB keep its mouth shut on the subject? [I believe the operative word in their title is, "Standards".] Or do companies take the monster hit now and smaller hits from pension losses year after year as stock prices deflate around smaller earnings and deflating P/E ratios of stocks, which more accurately resemble interests in a going concern rather than speculative pieces of paper? No wonder CEO's pray for the return of irrational exuberance! It's the only thing that will cover up mistakes and accounting quackery.
Alright, enough of that. I don't hate IBM. I just point them out and lump them in along with a majority of other corporate chieftains as a flagrant example of trying to "span the chasm" in hopes of avoiding bad news and ultimate cratering of the stock price. And there are plenty.
But IBM still makes a nice put play or bear call spread in my opinion. Eventually, they are going to have to make real money or confess their sins. It's only a matter of time.
All that said, focus on the bigger picture. Financial imagination is going to be tested and fail against the harsh reality of underfunded pensions and imputed rates of return.
See you next week!