Serious Money: Taking a quick glance at corporate America's balance sheet, it is hard reach but one conclusion - American business is in great financial shape.
Outstanding debt remains low relative to both the book and market value of equity while cash as a percentage of total assets is at the highest level in 45 years. This is in sharp contrast to a few short years ago when daunting challenges, including the most extended industrial downturn since the 1930s and the loss of trust that accompanied a number of high-profile corporate frauds, shifted managerial attention to balance sheet repair.
Yet despite the 180-degree turn in the business sector's fortunes, the number of dollars investors are willing to pay for a dollar of earnings has dropped to the lowest level in more than a decade while stock prices have gained little in eight years. Is now a great time to buy American stocks or do first impressions flatter to deceive?
Valuation multiples are low for good reason. Corporate profits are significantly above trend. Return on equity is currently more than five percentage points above an historical average of 12 per cent. Unlike the 1990s, investors are not willing to pay ever higher multiples for ever higher earnings knowing full well that profitability will ultimately revert to trend.
Nevertheless, US stocks are still trading on an expensive 20 times trend earnings. Additionally, the volatility of cashflows is running at the highest level in the post-second World War era, which calls for lower valuation multiples. Furthermore, current accounting rules enable corporate America to depict a distorted picture of its true financial health. A significant number of liabilities, such as the large pension and retiree health benefit obligations, are not recorded on balance sheets.
The first of the 76-million strong "baby boomer" generation turned 60 earlier this year and US president George Bush himself recently crossed this age barrier. Four million Americans are set to reach this milestone each year for the next 18 years but the defined-benefit (DB) pension plans upon which a growing number of retirees depend have been hit by a perfect storm of low asset returns and interest rates.
The savage bear market in stocks that began in 2000 devastated pension plan assets, which lost more than one-quarter of their value in less than three years. Simultaneously, lower long-term interest rates led to an increase in the expected value of liabilities. Many hoped that financial markets would resolve the problem but asset returns have been mediocre while long-term interest rates have remained stubbornly low.
The bottom line is that the net position of the DB plans offered by constituents of the S&P 500 has deteriorated from a record surplus of $280 billion (€216 billion) in 1999 to a deficit of $140 billion today. Yet the accounting rules enabled S&P 500 companies to post a combined surplus of more than $90 billion on their balance sheets.
DB plans are placing an increasing strain on corporate cash flows. S&P 500 companies have contributed almost $250 billion to their plans over the past five years and a further $140 billion is expected over the next two years. Several companies have diverted more than one-third of their operating cashflow in recent years while some have contributed more than half. This clearly puts American business at a competitive disadvantage to foreign companies that do not have such legacy costs.
To ease the burden an increasing number of companies are seeking to freeze or terminate their DB plans. Freezing is an incomplete solution as it fails to address other issues such as market and mortality risks. To terminate a plan, companies have two options - a standard or distressed termination. Companies must have a fully-funded plan to secure a standard termination, which typically involves the purchase of annuity contracts from insurance companies. However, it tends to be very expensive because of the conservative assumptions that insurance companies use to price termination annuities.
An increasing number of companies have resorted to distressed terminations, where companies file for bankruptcy protection and turn their plan over to the Pensions Benefit Guaranty Corporation (PBGC), a federal agency that provides a safety net for private pension plans. More than one-third of all the claims that the PBGC has incurred in the past 30 years has occurred since 2000.
If the funding status of pensions gives cause for concern, then the status of retiree health benefits can only be described as truly alarming. The combined deficit of the 295 companies in the S&P 500 that offer retiree health benefits is $320 billion.
Changes are afoot that will remind investors that the pensions issue has not gone away. Mr Bush recently signed pension reform into law, which gives most businesses seven years from 2008 to fully fund their plans. Additionally, new accounting rules look set to be introduced later this year, which will require companies to record the net funding position of their pension and retiree health plans on their balance sheets at fair market values.
The new rules should see the debt-to-equity ratio of non-financial companies rise from 62 to more than 75 per cent. Some firms such as Eastman Kodak, Ford, General Motors and Goodyear will see shareholders' equity eliminated entirely. Others such as Boeing, Caterpillar and DuPont will record a more than 40 per cent drop in their equity base.
Record cash balances will not ease the burden as they are concentrated in "new economy" sectors and not the at-risk sectors of old industrial America. Investors are well advised to remember that appearances can be deceptive.
Charlie Fell is an independent consultant and lectures in finance and investment at UCD and the Institute of Bankers in Ireland
