The US corporate sector has slashed costs over the past year, eliminating over 7 million jobs and trimming the workweek to a record low. However, the painful rise in unemployment (to an official rate of 10.2% in October) has been accompanied by a record surge in productivity and falling unit labour costs, bolstering equity values and padding corporate profits. This trend suggests that the rebound may be more robust than widely expected.

Workforce cuts. During the past 18 months, the US economy has lost one-third more jobs than would have been predicted by econometric models on the basis of the decline in real GDP. The result of such savage workforce cuts was productivity growth of 4.3% during the past year, including a 9.5% annualised third quarter surge — the fastest quarterly rise since the data series began in 1948. Productivity usually rises during recessions, but at a much slower pace. In the mild recession of 2000-01 there was an up-tick in productivity, but the economy continued to shed jobs for two years after the recession formally ended. Although many commentators predict another ‘jobless recovery’, present conditions are very different, and point towards a more positive scenario.

Wage restraint. There has been no growth in wage and salary compensation since the downturn began and unit labour costs fell 5.8% during the second quarter. During the severe downturns of 1974-75 and 1981-82, compensation grew steadily despite plunging output. Inflation was much higher in those periods, so firms found it more difficult to restrain costs. As a result of the current round of successful cost restraint, non-financial corporate profits have fallen only 7% from their peak in the third quarter of 2008 and rallied nearly 8% during the second quarter of this year. If the US economy can achieve 2-3% output growth next year, profits will probably increase by at least 30%.

Sustained productivity growth? The important long-term question for the economy is whether the corporate sector can sustain high productivity growth once the recovery is underway. In the past, productivity typically soared during the first year after a recession:

• Past pattern. In the year after the 1973-74 slump, productivity grew 6.2%; following the 1981-82 downturn, it grew 4.5%. In the year after the 2000-01 recession, it grew by 4.8% as firms continued to trim their labour forces.

• Crucial to growth. Many economists believe that the sustainable growth rate of the US economy is slowing to 2.0-2.5% from over 3.0% five years ago because of declining labour force growth and faltering productivity. However, if the corporate sector can deliver productivity gains of 3.0% or higher after 2009, the economy’s trend growth rate will also remain close to 3.0%.

• Cure for many ills. The productivity question will be critical to the Obama economic policies. Both the White House and the non-partisan Congressional Budget Office assume that output growth will exceed 4% in 2011-12. Such a healthy rebound would produce a resurgence of tax receipts and help to reduce the federal government’s fiscal deficit. High productivity would also lessen inflation risks and reduce the need for the Federal Reserve to tighten monetary policy aggressively.

The resilience of profits during the past year increases the odds that the economy will enjoy a sustained recovery in 2010.

It has already boosted wealth and confidence by encouraging a major equity market rally. However, after severe cost-cutting during the acute phase of the financial crisis, it is now essential that firms cease laying off employees in order to stabilise personal income.

Technorati Tags: economic-forecast, GDP, productivity, unemployment, US-economy

The paper’s authors note that “This result is striking considering such deals involve larger acquirers, public targets, and are more likely to be diversifying acquisitions, three factors shown by earlier research to affect acquirer returns negatively.”

Other findings:

• Acquirers pay significantly lower takeover premiums in connected transactions, consistent with the view that board connections help acquirers avoid overpaying for target firms.
• Financial advisory fees paid to investment banks are lower in connected acquisitions.
• Board connections are also positively related to the operating performance of the new firm and negatively related to the probability of forced CEO turnover, suggesting that connected transactions generate better performance in the long run.
• The existence of a board connection between two firms has a positive impact on the probability of a subsequent M&A transaction between them.

Overall, our results are consistent with the hypotheses that board connections are related to higher quality M&A transactions and that they reduce the degree of asymmetric information between the acquirer and the target about the other’s value.

Board Connections and M&A Transactions

by Ye Cai and Merih Sevilir  Kenan-Flagler Business School, University of North Carolina

(h/t footnoted.org)

Technorati Tags: board of directors, corporate-governance, M&A, mergers and acquisitions

Together, the 10 states account for more than one-third of America’s population and economic output. And actions taken by state governments to balance their budgets–such as tax increases and drastic spending cuts—can slow down the country’s recovery.

“A challenging mix of economic, political and money-management factors have pushed California to the brink of insolvency. But while California often takes the spotlight, other states are facing hardships just as daunting,” said Susan Urahn, managing director of the Pew Center on the States. “Decisions these states make as they try to navigate the recession will play a role in how quickly the entire nation recovers.”

In the report, Pew’s researchers identified factors that have contributed significantly to California’s difficulties, then determined the degree to which other states are experiencing the same challenges. These factors are: (1) loss of state revenues; (2) the relative size of budget gaps; (3) increasing joblessness; (4) high foreclosure rates; (5) legal obstacles to balanced budgets—specifically, a supermajority requirement for tax increases or budget bills and (6) poor money-management practices.

Pew scored all 50 states using the best available data as of July 31, 2009. The snapshot captures an important juncture: the first and second quarters of 2009, the pressure point for governors and legislatures in the throes of crafting their budgets for fiscal year 2010 (which began on July 1 in all but four states).

While the rest of the states share important characteristics with California, they may not be destined to follow in the Golden State’s footsteps. Some of these states already have responded aggressively to their budget crisis, although it is too soon to tell whether their actions will put them on solid fiscal footing.

Technorati Tags: Arizona, Florida, Illinois, Michigan, municipal-bonds, Nevada, New Jersey, Oregon, Rhode Island, state-and-local-government, states, Wisconsin

“A well-executed retail strategy can turn a profit, grow the business, and increase market share. Our upgrade of Carter’s (CRI) rating in September partly reflected the company’s sustained same-store sales growth and margin expansion in its retail business, even in the recession.” [ Analysts at BMO Capital Markets initiated coverage of Carter on Oct 28 with an "outperform" rating. Analysts at Sterne Agee upgraded the company from "neutral" to "buy" on Oct 4.]

Now Moody’s has placed the company on review for possible downgrade.

Carter’s Inc. on Nov 10 announced a delay in its 10-Q filing and restatements of its prior period financial statements, an ongoing review of the company’s treatment of margin support payments, and the nondisclosure of such margin payments to the company’s finance team.

Standard & Poor’s placed Carter’s ‘BB+’ long-term corporate credit rating and ‘BBB’ senior secured debt ratings on CreditWatch with negative implications.

We are concerned about Carter’s ability to remain in compliance with its bank loan covenants and uncertainty surrounding the materiality of any findings in the investigations. – S&P

However, Margaret Whitfield, senior analyst at Sterne Agee & Leach, supports Moody’s underlying view.”The restatement and the filing of the 10 Q may be weeks away, hopefully in December, but it could possibly drag into the New Year,” she said. adding that Carter’s “underlying business is quite healthy and that the issues related to the mark down accommodations which may involve restatements detract from what is going on with the company overall.”

For latest analyst comment see Alacra Pulse.

Technorati Tags: (CRI), apparel, Carter's

Nearly 16 million new US broadband subscribers will emerge over the next five years, but more than half of those will come in the next two years, according to Forrester Reseearch.

Due to slowing organic growth, the Internet access market will be characterized by shifts across platforms.

• Over the next five years, xDSL subscriptions will fall as subscriptions to fiber-to-the-home (FTTH) broadband rise from 4% to 10% of US online households.
• Cable modem subscribership will remain steady, with only very modest overall broadband market share loss compared with telco broadband (fiber and xDSL combined).
• Consumers will continue to migrate away from dial-up, for which steady losses will continue over the next two years.
• Shifts will also occur relative to the speed tiers to which consumers subscribe, with both supply and demand factors encouraging more consumers to buy higher-speed service.

Technorati Tags: broadband, cable-industry, DSL, FIOS, internet, telcos

As outlined in our criteria, we do not consider contingent capital securities to be a form of common equity. We can include them as hybrid equity depending on their exact features.

“We see contingent capital securities as introducing another potential tool to manage the capital base in times of stress. However, they are not being designed by banks to address the need to repair existing weak balance sheets,”  S&Ps notes in Contingent Capital Is Not A Panacea For Banks.”They are one potential answer to one capital management question, but many banks will still need to address their capital positions through traditional forms of tangible equity.”

“One of the attractions of this contingent form of capital is that it adds a different strand to bank capital management strategy. The situations in which contingent capital securities convert into equity would also be transparent for investors from the start. There are certain practical difficulties, however.”

“The first is whether contingent capital securities will convert into capital early enough to help the bank. For contingent capital securities to prove effective as a buffer for senior bondholders, the conversion triggers need to be set at appropriate levels. However, this is difficult to determine before a crisis hits.”

“The second is that contingent capital securities may not be sufficiently attractive to investors at a price that is also attractive to the issuing banks. The level of investor demand for contingent capital securities is unclear, given the difficulty that investors may face in pricing the potential conversion risks. Therefore, it is too early to gauge how this market will develop.”

“While we expect to see material interest in (and debate around) this concept, we note that contingent capital securities are not designed to repair current weak capital positions and are not meant to act as a main plank of capital strategy. The ongoing debate about banks’ capital positions will need to cover other topics as contingent capital is not–and is not designed to be–the whole answer.”

Technorati Tags: (lloy), banks, contingent capital, Lloyds Banking Group, tangible common equity

“Alternative Public Market Segment: A public market solution that provides an economic model to support the “value components” (research, sales and capital commitment) in the marketplace. This solution would establish a new market segment that benefits from a fixed spread and commission structure. It would be subject to traditional SEC registration and reporting oversight (e.g., annual and quarterly reporting, Sarbanes-Oxley compliance).”

“Enhancements to the Private Market: A private market solution that enables the creation of a qualified investor marketplace consisting of both institutional investors and large accredited investors that allows issuers to defer many of the costs associated with becoming a public company before they are ready for an IPO.”

Might be instructive to see a chart of Grant Thornton’s tax compliance advisory business income over the same time frame.

Other findings from the study:

• The U.S. listed markets — unlike other developed markets — have been in steady decline, with no rebound, since 1997.
• The U.S. should have twice the number of listed companies it currently has.
• The U.S. markets’ last growth phase was before the Dot-Com Bubble.
• The U.S. lags far behind other global markets. Asian markets are growing even faster than GDP.

The full Grant Thornton paper is available here and a helpful summary from Venture Capital Dispatch is here. Elsewhere, Paul Kedrosky takes issue with the paper’s recommendations, arguing that turning back the clock is not the answer:

Technology has changed the way growth companies are produced, funded, and sold in this country. Some people might not like it, but not liking disruptive change is the response of most industries that have been disintermediated.

Technorati Tags: electronic trading, public companies, Sarbanes-Oxley, SOX, stock exchanges, stock market

Barron’s Magazine recently ran a feature entitled “Watch Their Language,’ which focused on some “dirty words” used in 10-K and 10-Q filings.  Key words, such as “related party transaction,” “change in revenue recognition,” “change in the depreciation period,” “sale leaseback,” and others are listed in the article.

I concur with the article’s findings.  It turns out that “dirty words” are frequently associated with management’s discretion to massage a company’s reported numbers in a manner that doesn’t fairly reflect the underlying facts.  Euphemism, or “spin,” is the process of substituting inoffensive words for words that are considered offensive or unacceptable — a common practice in company reporting.

Walter Smiechewicz, our Chief Consultant of Governance and Risk, recently prepared a list of the Audit Integrity risk metrics that appear consistently as identifiers of problematic companies.  He dubbed this list the “Risky Business Catalogue” because, while these events do occur from time to time even in trustworthy companies, the aggregation of multiple flagged risk metrics occurring together indicates a potentially dirty company.

The more “dirty words” we identify for a given company, the lower the company’s AGR® ranking.  I estimate that of more than 8,000 public companies we follow in North America, approximately 500 have a financial vocabulary full of “dirty words.”  It is this relatively small population that is polluting the investment industry.

Of course, the opposite is also true.  The absence of “dirty words” in 10-K and 10-Q filings indicates a clean company with transparent financial reporting and responsible governance.

Let’s look at some of Audit Integrity’s proprietary metrics.  With tongue firmly in cheek, I take the liberty of de-coding 20 common euphemisms.

1. The company has entered into multiple mergers within the last 12 months. Translation:  Management is unable to grow the company organically.

2. The CEO’s and CFO’s compensation is more highly weighted toward incentive compensation than base compensation. Translation:  Management is ignoring long-term sustainability in favor of short-term gain.

3.The Board Chairman is also the CEO. Translation:  The CEO controls the Board.

4.The company has undergone a restructuring in the last 12 months. Translation:  Serious fundamental problems.

5.The company has encountered a public regulatory action in the last 12 months. Translation:   Risk issues and/or control issues were actually documented by regulators.  Possibly the tip of an iceberg.

6. The amount of Goodwill carried on the balance sheet, when compared to Total Assets, is high. Translation:  The company overpaid for acquisitions.

7. The ratio of the CEO’s total compensation to that of the CFO is high. Translation:  Too much power is centered in one position (see No. 3 above).

8. Operating Revenue is high when compared to Operating Expenses. Translation:  The company is relying on financial engineering to mask a weak condition.

9. A Divestiture has occurred in the last 12 months. Translation:  Management had to rectify a mistake.

10. The Debt to Equity ratio is high. Translation:  The company is taking on excessive risk.

11. A repurchase of company stock has taken place in the last 12 months. Translation:  Management boosted the share price via a buy-back rather than improving operations.

12. Inventory Valuation to Total Revenue is increasing. Translation:  The company is understating future expenses.

13. The ratio of Accounts Receivables to Sales is increasing. Translation:  The company is over-stating revenues.

14. Asset turnover has slowed when compared to industry peers. Translation:  Organic growth slowed, or merger is not accretive.

15. Assets driven by financial models make up a larger portion of the balance sheet. Translation:  Financial engineering is being used to obfuscate the company’s actual fundamentals.

16. Prepaid Expenses are high. Translation:  The company is putting off current expenses to pretty-up earnings.

17. Deferred Tax Assets are high. Translation:  Current expenses are understated.

18. The Pension Plan Expected Return and Discount Rate are high. Translation:  Current and future pension expenses are understated.

19. The ratio of Work in Process over Inventory is high. Translation:  The company is getting ready to write down inventory and whack Cost of Goods Sold.

20. Intangible Assets are high. Translation:  Subjectively-valued assets are waiting to be written off.

Every company that uses a plethora of “dirty words” to describe its financial condition will, of course, also offer a euphemistic explanation for red-flagged metrics.  I hear “business strategy” invoked most of the time!  But by definition, “dirty companies” are good with euphemisms.

Again, please bear in mind that none of these events is necessarily indicative of malfeasance.  In combination, however, there is a statistical likelihood of increased risk.

It is our job at Audit Integrity to penetrate opacity in financial statements and shed light on a company’s actual financial condition.  By highlighting potential manipulation, we direct stakeholders’ attention to problems that should be investigated.  I strongly suggest that stakeholders not be lulled into a level of trust that is not earned.

Remember those no-documentation Mortgage-Backed Securities?  Despite their AAA ratings, anyone who failed to recognize that no-documentation was a euphemism for “no assets” and “no income” was blind-sided when the securities collapsed.

Technorati Tags: corporate-governance, SEC filings

Kraft’s

With Cadbury’s swift and firm rejection of the formal offer from Kraft we appear set for a period of  standoff before learning whether a deal will ultimately be consummated.

Of course, now that Kraft has placed its cards on the table, other bidders could still emerge or Cadbury could find a white knight partner. Kraft has 28 days to post the offer documents. It then has a few more weeks to revise the price, taking us into next year.

Analysts expect the most obvious candidate Hershey (HSN)  to remain on the sidelines. Several analysts expect Kraft to eventually improve the bid, mainly by  increasing the cash component, but not by much, absent any competing bidders. And as we have pointed out before, it is not a foregone conclusion that the two companies will reach agreement.

DealJournal has a roundup of analyst comments, as does Reuters,  and Dealbook has a roundup of the story so far.

Previous ResearchRecap posts on this topic are here.

For the latest analyst comments see Alacra Street Pulse.

Technorati Tags: (CFT), (HSY), (NESN), Cadbury, CBRY, confectionery, food industry, Hershey, Kraft Foods, M&A, Mars, mergers and acquisitions, Nestle

The Bank of England’s Monetary Policy Committee (MPC) on November 5 decided to continue its unorthodox programme of asset purchases, known as quantitative easing (QE). This is the United Kingdom’s one remaining policy instrument for promoting recovery from the recession, which has reduced GDP by about 5%. Conventional interest rate policy is exhausted, with an interest rate of 0.5%. Further expansion of fiscal policy is virtually precluded by the size of the budget deficit, now 12% of GDP, and the sharp increase of the debt/GDP ratio.

Prior to the crisis, the MPC failed to take account of asset prices and took no action to curb the upsurge in real estate prices. However, such action was not within its present remit, which limited to achieving a predetermined target rate for inflation, with some concern for growth and stability. If asset price bubbles are to be addressed by the MPC, its terms of reference must be redefined:

• Financial crisis. The MPC’s minutes reveal that it was mainly concerned with the risk of inflation until well into the crisis. It concluded that there was a risk, because of the strong increase in oil and commodity prices, as late as September 2008. It feared that these increases would create expectations of inflation with knock-on effects on wages. This was the view of the MPC, with the exception of independent committee member David Blanchflower, who disputed this reasoning. He was concerned that the United Kingdom would follow the United States into a severe recession; fears about inflation were misplaced, as rising excess capacity would curb price increases. This view was not adopted by the MPC before end-2008.

• Economic stability. The MPC’s discussions of the crisis do not reveal much insight into the problems affecting the financial system. This was partly the fault of the separation of the FSA from the Bank and the FSA’s own failings. However, the MPC also failed to appreciate the banking system’s difficulties. Moreover, there has been a failure to take account of the Bank’s report on economic stability, giving warnings at an early stage of a possible crisis.

Once the MPC grasped the seriousness of the crisis, it reduced the bank rate dramatically by 300 basis points, from 5% in September 2008 to 2% in December. This was followed by further reductions to an unprecedented low of 0.5% in April 2009. These reductions were justified within the inflation-targeting framework; without them the target would have been undershot.

After interest rates were reduced to a minimum, further relaxation required the central bank to buy assets through expansionary open market operations. This purchase programme has now reached its limit of 175 billion pounds (289 billion dollars) and a decision had to be taken whether to expand quantitative easing (QE) by up to 50 billion pounds. Given the views on inflation of some MPC members, it is not surprising that it has now opted for an expansion of only 25 billion pounds.

Outlook. The scheme has had some success in keeping down bond yields at a time of heavy government borrowing to finance its budget deficit. It has been less successful in stimulating the growth of broad money, measured as adjusted M4. Asset purchases should have been directed more towards corporate than government bonds.

The MPC has done little to bring pressure on the banks to make credit more available to smaller companies and has not discouraged the hoarding of reserves.

However, the policy response of the MPC has been valuable in maintaining the pound at a highly competitive level. When recovery comes, the MPC will have to consider how best to reverse QE and resolve the fears of some of its members about the medium-term prospect for inflation.

Technorati Tags: bank lending, monetary-policy, quantitative easing, small business, UK