You can tell far more about a company's prospects by the language in its earnings announcement than you'll ever learn from the numbers. The numbers are easily manipulated... confused... and, eventually, restated.
Compare these two brief passages from recent annual reports, filed with the SEC by two very different large American corporations.
No. 1: "Let's look at a summary balance sheet and earnings statement for the entire group. This motley group, which sells products ranging from lollipops to motor homes, earned a pleasing 25% on average tangible net worth last year. It's noteworthy also that these operations used only minor financial leverage in achieving that return. Clearly we own some terrific businesses."
No. 2: "Net income for 2006, excluding special items, of $2.2 billion, or $3.88 per share fully diluted, compared with a net loss of $3.2 billion, or $5.67 per share, in 2005, marking a $5.4 billion improvement. Including special items, [the company] had a net loss of $2.0 billion, or $3.50 per share for 2006, compared with a net loss of $10.4 billion, or $18.42 per share in the year-ago period."
I make my living as a financial analyst. I've read thousands of earnings releases and looked at thousands of financial statements. Try to read that second example and explain to anyone else what it means. You can't.
The second example comes from General Motors' annual results press release. The report is utter gibberish. The summary press release alone is 32 pages long – and there's not a single sentence in the whole thing that makes any sense.
GM's inscrutable reporting tells me far more about the business and its management than any of the company's numbers. Either the people in charge of GM don't want you to know how the business is doing, or they themselves don't know. Regardless, the result is a disaster in the making.
Quote No. 1 comes from Berkshire Hathaway's annual report, written eloquently by Warren Buffett, the largest shareholder and the chairman of the board. Berkshire is a far more complicated business than GM, involving dozens of different industries and huge insurance holdings, which are some of the most complicated businesses in the world. Nevertheless, Buffett is able to describe the history of the businesses, the current operations, and all of the key financial metrics in less than 20 pages – all of which are a pleasure to read.
After studying the GM report for several hours, here is what I would have written to my shareholders, were I the chairman of General Motors:
Dear Shareholders:
We own one of America's proudest companies, whose heritage and reputation far exceeds its operational capabilities today. We have infrastructure and employee obligations that outpace what we can afford given our greatly reduced profit margins and debt load. Our ongoing results reflect these important structural problems, which may be beyond our best efforts to fix.
Last year, we did our best to cut costs, terminate extraneous employees, and retire our debt load. A key to this process was selling a controlling stake in our finance company, GMAC, to a Wall Street hedge fund, Cerberus Capital Management.
However, these Wall Street guys are no dummies. First, they only offered us about five times net income for our most profitable division. And they forced us to guarantee GMAC's estimated $14.4 billion book value. Thus, every single bad subprime loan we made over the years will have to be paid for out of your equity. So far, in the last few months of 2006, that bill came to around $1 billion. Our CFO tells me GMAC is "leaning away" from subprime loans now, but we have no ability to quantify what that means.
The good news about the deal, though, is it removes a lot of debt from our balance sheet. Investors (you guys) won't be able to easily measure the extent of our GMAC risk, which, as a result, means our share price probably won't tank in line with the other subprime lenders.
So, here's where things stand now – officially.
Like the crew on a sinking ship, we've shoved overboard as many hard assets and employees as we possibly could over the last year. We sold our investment in Suzuki ($2 billion). We sold our desert proving grounds in Arizona. We sold our investment in Fuji Heavy Industry. We liquidated a joint venture with Fiat. And we've spent $5 billion-$7 billion (we don't know the real number) paying off union employees to retire, so we can close down money-losing production lines. We even cut our dividend in half – and, honestly, we can't afford even that diminished amount.
We've done a great job cutting costs. Our total operating expenses declined last year by 17%. Even so, our ongoing operations (leaving out all of the special charges) in the fourth quarter lost $132 million. All of our fourth-quarter "profit" came from nonoperating income (asset sales) and tax benefits, which will not recur. For the whole year, things look a lot worse because most of our cost cutting didn't benefit the company until the end of the year. Our operating loss for all of 2006 was $7.6 billion. I don't have to tell you that losses like that, if they continue, will surely bankrupt us.
Now, let's talk about the balance sheet.
There has been a lot of talk in the press about the size of our cash balances. Unfortunately, that's a lot of smoke and mirrors designed to fool the credit-rating agencies. The truth is pretty ugly. We've got about $64 billion in cash and cash-like holdings. But we also have $67 billion (that's $3 billion more) in current debts. You can imagine our cash position as being a lot like what your checkbook probably looked like in college: You weren't bouncing checks, but only because they took three days to clear.
I've saved the really bad news for last. The truth of the matter is we've been operating at a capital loss for a long, long time. Simply put, it's been a while since we made enough money to pay interest, invest in our business, and pay dividends. As a result, we've racked up a stupendous amount of debt. Even after selling our finance operations, we still have $33 billion of long-term debt, $50 billion of post-retirement benefits other than pension benefits, and $15 billion of deferred income taxes. (Take another look at our post-retirement obligations. Any wonder why Detroit has more pharmacies per-capita than anywhere else in the world?)
Even if you assume that our post-retirement benefit obligations don't grow faster than interest rates (and that's not a safe bet) and even if you assume future losses will offset all of our tax obligations, we're still staring down the barrel of more debt than we can afford to service. You can probably do the math in your head: $83 billion of long-term obligations multiplied by steadily rising interest rates, thanks to our deteriorating credit ratings.
If you estimate a 7% rate for 2007, you'll see that we need to make at least $5.81 billion from operations just to pay interest. There's also a very good chance that interest on our debt will increase more than I expect. In the last year alone, the average interest we pay, globally, on our entire debt portfolio increased from 5.25% to 6.01%. In the last two years, we've gone from being one of the best credit risks in the world to being a junk-bond debtor. This fact, more than any other, makes it very unlikely that we'll escape bankruptcy.
The simple fact is, we can't afford our debts. We haven't made more than $5 billion from our car operations in a long time. Probably not since 1992. It's very, very unlikely that we'll ever make that kind of money again because we're facing never-ending declines in our global market share.
Back in 1992, we controlled about 30% of the world's car business. Last year, despite the progress we made in launching some great new trucks, our global market share fell to 13.5%. And that's down from 14.1% in 2005.
As I hope you can understand, unless something radical happens to free us from our employee obligations, there is no way I can honestly tell you that GM will not go bankrupt.
Please invest accordingly.
Your Chairman.
If you'd like to read the annual report by Warren Buffett I just mentioned, you can read it for free on Berkshire's website. If you want a sure cure for insomnia, read GM's annual results press release.
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Good investing,
Porter Stansberry
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