Risky Business

When blue chips fall like dominoes

financial crisis looming
Have we learned our lesson? Source: AP

Subprime mortgages caused much of the 2008 financial crisis. The next financial crisis is likely to be caused by a source that will surprise experts: Fortune 500 companies. They have been repurchasing their own shares like maniacs for a decade now and, in many cases, have left themselves with negative net worth. In a major recession, when business drops off and cash flow turns negative, the slightest gust of wind would make them default.

Like the subprime mortgage crisis, once a few major companies default, the rest with fragile credit structures will fall like dominoes. There are two mechanisms by which the balance sheets of major companies have been hollowed out: Overpriced acquisitions and share repurchases. Both are products of a decade of extremely low interest rates. This has greatly skewed the economy’s allocation of financial resources.

In the case of overpriced acquisitions, even companies that make a low return appear attractive purchases — if they can borrow at a negative real cost to finance their acquisition.

Share repurchases, for their part, are more attractive than dividends because they goose the value of management’s stock options. If long-term money can be borrowed at 3 percent on a tax-deductible basis, then it makes sense to go on buying the company’s shares up to 33 times earnings, even if there is no earnings growth to be had.

The Fortune 500’s problem is that the period of easy money and slow growth has lasted so long. For a year or two, if profits look good, you can buy back stock worth 150 percent of earnings and make some overpriced acquisitions, and the hit to the balance sheet will only be moderate. But if you keep on doing it for decade, you will run out of equity.

Values that appeared perfectly sound will disappear, and panic will make investors do things that will appear foolish and unnecessary in the long run.

The Fortune 500 companies in this situation can be divided into two groups. The acquirers have eaten away their stockholders’ equity through overpriced acquisitions; they still have a positive book net worth, but a negative tangible net worth. Their fate during a deep downturn will be determined by how much of that goodwill must be written off through “impairment of value” and whether net worth remains positive after doing so.

The second group, who have destroyed their shareholders’ equity by repurchasing shares, often worth several times their earnings, will have only moderate amounts of goodwill, and negative net worth even including intangible assets. If their business turns down substantially, they are in trouble.

Some specific examples:

  • Boeing: Because of stock repurchases of $42 billion, Boeing has a book net worth of about zero and a tangible net worth of negative $6.8 billion. This is a highly cyclical business, with massive capital investment requirements for each new aircraft; Boeing is surely in trouble in the next downturn.
  • General Electric: GE has repurchased $85 billion of its stock, very foolishly as its stock price has now dropped sharply, but it has also made numerous overpriced acquisitions, with goodwill and intangibles of $108 billion. Its book net worth is still positive, but its tangible net worth is negative $32 billion. Its engineering businesses are mostly highly cyclical; trouble looms in a downturn.
  • HP: The printers and PC part of Hewlett-Packard (the services bit is not quite so bad) as a net worth of negative $4 billion, or tangible net worth of negative $10 billion. It’s a highly cyclical business, surely toast in a downturn.
  • AT&T: This is mostly a problem of overpriced acquisitions, and if the Time Warner deal goes through, this problem will become much worse. Its net worth is positive, but tangible net worth is negative $97 billion because of an astounding $222 billion of intangibles and goodwill.
  • Verizon Communications: Mostly acquisitions are to blame, but $128 billion of goodwill makes its modest net worth (less than 20 percent of debt) negative $102 billion. Surely a problem, given its huge leverage.

Even Apple, with its huge earnings and $900 billion valuation, is not immune. Its debt is rapidly rising towards its net worth as stock repurchases exceed earnings, while the innovations in its product line grow less and less technologically significant. Apple is becoming the General Motors of the 1950s. Were the current monetary conditions to last another five years, Apple too would be in severe danger.

At first, only a few of these companies will get into unexpected difficulties, but those well publicized problems will cause lenders to look askance at all of them. Some will save themselves by large emergency stock issues (collapsing their share price in the process), but this avenue will rapidly become unavailable as the stock market declines. Just as with subprime mortgages in 2007-2008, values that appeared perfectly sound will disappear, and panic will make investors do things that will appear to have been foolish and unnecessary in the long run.

The chances of a Fortune 500 panic, like 2008’s subprime mortgage panic but much worse, appear very high indeed. We can only pray that this time around, we learned the lessons of 2008-2016. Imposing ultra-low interest rates won’t work and will create huge new problems elsewhere. Regulating everything in sight will kill economic recovery. A stock market that is somewhat below its long-term value and pays decent dividends to long-term investors from adequately capitalized companies is the soundest foundation for sustained economic success.

To contact the author: gastautor@handelsblatt.com.

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