The Great Deformation (86 page)

Distributions to shareholders greatly in excess of net income are rarely a formula for long-term financial health, but in this case were especially counterproductive because Hewlett-Packard was also drastically under-funding its fixed-asset base. It recorded $22 billion of depreciation and amortization charges during this five-year period, compared to only $18 billion of capital expenditure, notwithstanding that it was the largest high-tech equipment manufacturer in the world and faced brutal East Asian competitors who did not usually play by capitalist rules.

Investors on the free market would have given a thumbs-down to such self-destructive policies long before its stock price rolled over in the spring of 2010. But that had not happened because liquidity-juiced Wall Street speculators had ramped the stock over and over, initiating a new run-up each time another M&A deal was announced or rumored, and whenever the board renewed or extended its massive stock buyback program.

The promise of huge synergies from acquisitions was a particularly potent catalyst for periodic stock ramps because Wall Street is replete with rumors and inside information about M&A deals. As shown in
chapter 23
, takeover speculation is one of the crucial inner mechanisms of profit capture in the hedge fund–driven casino which now operates on the stock exchanges.

In the fullness of time, however, it became evident that the $37 billion that Hewlett-Packard spent on M&A deals during this five-year period did not have the flattering impact on earnings its deal-making CEOs had so loudly advertised. In fact, this M&A spree brought a vast expansion of its corporate footprint and complete disorder to its business operations and strategy.

Consequently, even as annual sales surged from $100 billion to nearly $130 billion, nothing at all fell to the bottom line, with net income of $7.3 billion in 2007 remaining flat at $7 billion four years later. Needless to say, when the M&A trick finally failed to satisfy the market's Pavlovian expectations for growth, the speculators moved on to more promising targets.

The abysmal failure of Hewlett-Packard's serial M&A deals became starkly evident when it was recently forced to write-off nearly $20 billion of goodwill and assets for just two acquisitions, Electronic Data Systems and a British company called Autonomy. What was also evident is that in massively overpaying for bad deals, the company had wrecked its balance sheet. During this five-year spree of financial engineering, Hewlett Packard had spent $90 billion on shareholder distributions and M&A deals, but had generated only $45 billion in operating cash flow after capital expenses.

In short, the stock market–obsessed CEOs of Hewlett Packard had spent twice as much on financial engineering projects as they had available in cash flow. The company's net debt thus inexorably mushroomed, rising by $25 billion over the period and leaving one of the nation's technology giants hobbled by the excrescences of bubble finance.

Here was powerful testimony against the Fed's “wealth effects” policy and the consequent propping and juicing of the stock averages attendant to it. Owing to these machinations, the stock market was crawling with speculators capable of powerful hit-and-run forays that encouraged CEOs and boards to do their bidding; that is, feed the speculative mob with another stock buyback or M&A deal. Great companies like Hewlett-Packard were now being run not by adult professionals but day-trading punters.

Boards and CEOs who strap on their helmets and resist the pressure to mete out another “fix” face the real risk of getting swept out by the clamoring herd. Certainly the prospect of harvesting capital gains from stock option winnings, if financial engineering works, and keeping share prices rising is the more appealing scenario.

But there is another reason why CEOs capitulate and feed the beast. They are not operating on a level playing field, whether they know it or not, due to the Greenspan-Bernanke Put. It provides the speculative marauders who dominate the stock market cheap downside insurance against a big drop in the broad market averages, such as the S&P 500.

On the free market, of course, there would be no Greenspan-Bernanke Put, meaning that the cost of an honest to goodness put on the S&P 500 index would be far higher than prevails in the Fed-sponsored casino today. Since most speculators—whether big-name hedge funds, trend-following mutual fund managers, or home gamers who are prudent enough to stay solvent—must continuously buy downside protection to remain in the game, the problem is obvious: the cost of market-priced downside insurance would consume much if not all of their winnings from piling on the momentum raids.

At the end of the day, the Greenspan-Bernanke Put is a profound distortion of the free market. In this case, it induced one of the great progenies of American capitalism to essentially commit financial hara-kiri. Still, the looting of Hewlett-Packard was all in a day's work in the Wall Street casino.

BIG BLUE: STOCK BUYBACK CONTRAPTION ON STEROIDS

IBM's huge share buyback program, by contrast, shows that financial engineering does not always produce such immediate untoward results. Yet it is nonetheless a dramatic illustration of how the Fed's bubble finance
régime enables companies to literally “buy” themselves a higher stock price, at least temporarily, by plowing massive amounts of cash into share repurchases, thereby creating the false impression of robust earnings growth.

Big Blue's reported earnings thus surged 16 percent annually from $7 per share in 2007 to $13 in 2011, but those results were not apples to apples by any stretch of the imagination. The company's stock buyback program reduced its net share count by 22 percent, and profits on its massive overseas operations had been artificially boosted by a double-digit decline in the dollar. IBM's reported results also reflected a 12 percent reduction in its tax rate and $16 billion of acquisitions, all highly accretive mainly because they were financed with ultra-cheap long-term debt.

In the absence of these one-timers and financial engineering maneuvers, however, the picture was not so buoyant. Based on organic revenues, constant exchange rates, and no reduction in tax rates and share counts, earnings per share grew by about 5 percent annually, not 16 percent, over the past five years. It is far from evident, therefore, that IBM's true mid-single-digit growth rate justified the doubling of its share price during the period.

Upon closer examination, in fact, IBM was not the born-again growth machine trumpeted by the mob of Wall Street momo traders. It was actually a stock buyback contraption on steroids. During the five years ending in fiscal 2011, the company spent a staggering $67 billion repurchasing its own shares, a figure that was equal to 100 percent of its net income.

This massive and continuous stock-buying program brought approximately 550 million, or 36 percent, of the company's 1.5 billion of outstanding shares into its treasury, but needless to say, they did not all stay there. Nearly two-fifths of these shares reentered the float, mainly to refresh the management stock option kitty.

It goes without saying that in this instance the interests of stock traders and top management were aligned—perversely. The steady, deep shrinkage of the IBM float kept a bid under the stock and thereby delivered a “perfect” price chart, rising almost continuously from $100 to $200 per share over the past five years. It was a carry trader's dream.

Likewise, top executives got big-time pay packages they may or may not have deserved, but in any event they were dispensed in envelopes marked “tax once over lightly.” Former CEO Sam Palmisano, for example, cashed out $110 million worth of stock options a few weeks after his retirement party.

This rinse-and-repeat shuffle of stock buybacks and options grants is undoubtedly a significant source of left-wing jeremiads about executive
pay having gone to three hundred times the average worker's compensation when, once upon a time, allegedly, the ratio was more like 30 to 1. But the issue is not simply whether this kind of financial engineering has contributed to the sharp tilt of income flows to the top 1 percent in recent years. There can be little doubt, on the math alone, that it has.

The more crucial question, in this instance, is whether the massive CEW evident in IBM's numbers is setting up another of the great iconic American companies for a fall sometime down the road, similar to Hewlett-Packard. The data on this score are not encouraging. Total shareholder distributions, including dividends, amounted to $82 billion, or 122 percent, of net income over this five-year period. Likewise, during the last five years IBM spent less on capital investment than its depreciation and amortization charges, and also shrank its constant dollar spending for research and development by nearly 2 percent annually. Neither of these trends is compatible with staying on top in the fiercely competitive global technology industry.

Most especially, however, IBM's earnings—like nearly all the big cap global companies—could not be flattered permanently by the Fed's bubble finance. Already, the plunge of the euro has taken a toll on the company's reported results, causing the artificial translation gains it booked on its huge European businesses during the weak dollar cycle through 2011 to now unwind. Indeed, with nearly two-thirds of its sales outside the United States, the company's sales are now actually falling in dollar terms, and will likely continue to do so for the indefinite future.

THE WORST $225 BILLION DEAL EVER

In many cases, financial engineering did not work out so well for either management insiders or Wall Street speculators. One such example is Time Warner Inc.'s ill-starred merger with AOL, which was announced just in the nick of time to perfectly top-tick the dot-com mania in January 2000.

Needless to say, the path from there had been an extended sojourn on the downside, with the company's post-AOL market cap dropping from a peak of $225 billion to only $20 billion. Soon after the merger, AOL Time Warner set a corporate record that still astounds; namely, the $100 billion net loss it recorded in the single year of 2002.

This financial bone-crusher triggered a continuous corporate exercise in “demerging” the discordant parts and pieces that had been accumulated by the Time Warner acquisition machine during the two decades prior to AOL. These spin-offs included books, music, magazines, cable, the Atlanta Braves, and much else. AOL itself was ultimately cast out of the fold.

By early 2006, the stock price had dropped from a peak of $228 to $65 per share, but Wall Street financial engineers had not yet completed their
work on the corpse. At that point a group of raiders led by Carl Icahn forced the company into a further restructuring plan under which it divested still more of its historic M&A spree, absorbing deep write-downs from the destruction of value it had accomplished during the holding period. Accordingly, Time Warner recorded cumulative net income of just $5 billion on sales of $200 billion during the six-year period through fiscal year 2011. Even as the net income line came up punk, however, the company did undertake $26 billion of stock buybacks pursuant to the financial engineering deal with Icahn.

Having essentially no cumulative earnings during this period, Time Warner therefore funded the buybacks by continuously shrinking. Annual revenues of $46 billion in 2007 fell to $29 billion by 2011, and EBITDA was reduced from $14 billion to $7 billion. This drastic downsizing was a rational antidote to the thirty years of feckless M&A, but despite all of the demerging and $26 billion of stock buybacks, value could not be created were none had really existed. By the end of 2011, Time Warner's stock price was $35 per share—down by 85 percent from the Greenspan Bubble high of January 2000.

THE DECAPITALIZATION OF THE FORTUNE TOP 25

This drastic decline is often cited in condemnation of the AOL merger as the worst M&A deal of all time. Most surely it is that, but the prolonged unwinding of the whole edifice of AOL Time Warner Inc. also exposes the shaky financial engineering foundation which underpinned the faux prosperity of the Greenspan bubble era.

As the bubble reached its final peak in 2007, financial TV reported what sounded like healthy corporate earnings and stock prices at all-time highs. But the underlying data told another story. As shown below, what was being reported as “earnings ex-items” vastly exaggerated true profitability. At the same time, the American economy was being decapitalized by rampant financial engineering. Cash was not flowing toward productive investment and growth—not in the slightest.

This was starkly evident in the manner in which the largest twenty-five companies on the Fortune 500 list disposed of their fulsome earnings. Their net income aggregated to $242 billion during 2007, but only 15 percent ($35 billion) of that hefty total was reinvested in their own businesses; that is, allocated to additional capital expenditures and other working capital after funding depreciation and amortization of existing assets.

By contrast, these same twenty-five companies—which included a medley of giants from Wal-Mart to ExxonMobil, AIG, Home Depot, JPMorgan, Philip Morris, and AT&T—invested nearly $345 billion in financial engineering
and shareholder distributions. This stupendous total represented 140 percent of the aggregate net income of these leading companies.

These sharply contrasting numbers spoke volumes about the financial priorities in corporate America. These giant companies effectively elected to send ten times more cash outside of their corporate walls for acquisitions, stock buybacks, and dividends than they invested in growth of fixed and working capital inside their current operations.