When Boeing, AT&T, Verizon, GE, HP and Apple Fall Like Dominoes
Will hollowed-out US “blue-chip” companies form the core of the next subprime crisis?
- Will hollowed-out US “blue-chip” companies form the core of the next subprime crisis?
- The balance sheets of major US companies have been hollowed out by overpriced acquisitions and share repurchases.
- The Fortune 500’s problem is that the period of easy money and slow growth has lasted so long.
- As with subprime mortgages, once a few major US companies default, the rest will fall like dominoes.
- A stock market paying decent dividends to long-term investors from adequately capitalized companies is the recipe for sustained economic success.
Subprime mortgages caused much of the 2008 financial crisis. The next financial crisis is likely to be caused by a source that will surprise the experts – the Fortune 500 companies.
They have been repurchasing their own shares like maniacs for a decade now. In many cases, they have left themselves with negative net worth. In a major recession, when their business drops off and their cash flow turns negative, they will only need a breath of adverse wind to default.
Citadels of strength no more
Like the subprime mortgages, once a few major companies default, the rest, with fragile credit structures, will fall like dominoes.
There are actually 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.
Playing financial games
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% 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% 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 close to a decade, you will run out of equity.
The Fortune 500 companies that are in this difficulty (and not all of them are) 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 from day one.
Some specific examples:
• McDonald’s (NYSE: MCD). In spite of having been a thoroughly profitable company for decades, McDonald’s has now repurchased so much of its stock ($53 billion in Treasury stock in the latest accounts) that it now has a book negative net worth of $2 billion. Fortunately, this is not a very cyclical business.
• Boeing (NYSE: BA). Again because of stock repurchases of $42 billion, Boeing has a book net worth of around zero (depending on which quarter you pick) and a tangible net worth of minus $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 (NYSE: GE). 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 (albeit less than half its debt) but its tangible net worth is minus $32 billion. Its engineering businesses are mostly highly cyclical; trouble looms in a downturn.
• HP Inc. (NYSE: HPQ). The printers and PC bit of Hewlett-Packard (the services bit is not quite so bad). Net worth of minus $4 billion, or tangible net worth of minus $10 billion. A highly cyclical business, surely toast in a downturn.
• AT&T (NYSE: T). Mostly a problem of overpriced acquisitions, and if the Time Warner deal goes through this problem will become much worse. Net worth positive, but tangible net worth minus $97 billion because of an astounding $222 billion of intangibles and goodwill.
• Verizon Communications (NYSE: VZ). Mostly acquisitions, but $128 billion of goodwill makes its modest net worth (less than 20% of debt) minus $102 billion in tangible net worth. Surely a problem, given its huge leverage.
Not even Apple is immune
Even Apple (Nasdaq: AAPL), with its huge earnings and cash pile 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.
From being an advancer of the technological frontier, like Henry Ford, Apple is becoming the General Motors of the 1950s, whose new Buicks are distinguished from the previous model merely by the baroque quality of the tail fins. Were the current monetary conditions to last another five years, Apple too would be in severe danger.
How the crisis will unfold
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 2007-08, values will disappear that appeared perfectly sound, and panic will make investors do things that in the long run will appear to have been foolish and unnecessary. Nevertheless, 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, the lessons of 2008-16 will have been learned. Imposing ultra-low interest rates won’t work, and will create huge new problems elsewhere.
Regulating everything in sight will kill economic recovery, making things worse, not better. And a stock market that is somewhat below its long-term value, and pays decent dividends to long-term investors from adequately capitalized companies, is much the soundest foundation for sustained economic success.
Editor’s Note: This article was originally published in the author’s “True Blue Will Never Stain” blog.