When will American Business Get REAL?

I am so tired of companies today, not being straight with America, or with our Government. I don't think the country has an issue with bailing out companies--as long as there is an honest assessment of the facts, the projections, and a viable case that the money will be paid back. I am not sure I would have even conceded that point a year ago, but these are unprecedented times, so I am willing to be honest about where we are these days.

I am still waiting for companies to be honest about their true financial strength. The sooner these companies come clean--even to themselves--about what kind of risk they truly face, the sooner we can start to fix the problems of the day. Without that kind of catharsis, we will continue to erode into a Japan-like 20 year malaise, slowly eroding any hope that America's best days lie ahead.

What is my idea of honesty? It's complicated, but surprisingly simple. I want to see companies stress test their balance sheets using UN-fair scenario testing. Not Monte-Carlo rules. Not using a weighted average. I don't want to know what happens to a company's financial strength if the stock market goes down another 10% from here. I want to understand what happens if it drops another 50%, or even another 70%! Why? Because let's face it--Dow 3300, or S&P 350 isn't much more than about 3-4 more weeks of the current trend we are on. Companies painting rosy projections have not taken into account the snowballing effect that negative returns create--sapping further strength in assets once held as unassailable. Credit and market risk downgrades beget further erosion, payrolls decrease, robbing these companies of their greatest strengths--human capital--and brand goodwill disappears.

It doesn't have to be this way. But companies have to take a TRUE stock in what assets and value they have. THEY HAVE TO BE HONEST! Here's two examples of companies NOT being honest about their true values, and how they, and the American Tax payer is suffering as a result.

Case 1--General Motors--
I read GM's plan, published in December of 2008, which laid out its plans to regain solvency, profitability, and a long-term sustainable business proposition. It was thoughtful on a number of levels, and sobering in its willingness to make cuts to people's salaries.

However, it was completely misleading to the members of Congress, and in the end, will cost taxpayers AND workers dearly. What did GM get wrong, that everyone seems to have missed?

Honesty on one simple fact: Expected Market demand

GM used what they assessed to be a "reasonable estimate of market demand for the US auto market of 12 million cars being sold in the US in 2009, moving up to 15 million by 2012. The downside scenario was 10.5 moving to 12.8 million cars sold by 2012.

But the estimates were completely rosy, and couldn't conceive of an economy that could possibly shrink 6.2% in a quarter. Demand did fall significantly during 2008 from 2007, and went down to somewhere in the neighborhood of 13-14 million cars sold in 2008, from closer to 16 million in the years leading up to 2008. The fact that GM would consider the "WORST CASE" scenario to be only a drop of car sales from 13 million cars to 10.5 million cars is completely ignoring reality. Based on that scenario, it asked the Federal Government for $17 Billion in loans and guarantees. But sales have fallen off a cliff. Tightening credit and a scary economic picture has meant people have avoided buying new cars by a far larger margin than simply the 25-30% that GM felt was the worst case situation. And anyone watching this could see that being a real problem with the argument. I even wrote a blog about this the DAY I read the plan.

The results have been entirely predictable. GM sales dropped over 50%, not just 25-30%. It is in trouble, and is likely going into Chapter 11. Millions will lose their jobs over this. The Government's $17 Billion loan package may get recouped, if we're lucky. Hopefully Chapter 11 can help GM reorganize into something that can save some of those millions of jobs lost, but it won't look like it did. Chrysler's been dead man walking for years, so they aren't even worth addressing in this scenario.

All of this carnage could have been dealt with if a GM stress test scenario was more dire. This would have been much more informative for the Congress, and the American people. The decisions of what to do could have been debated in December, when a plan to either save GM, or put it out of its misery, could have been made using realistic sales projections. But no one was willing to do it then, opting for the best case, lowest cost, least resistance option. It led to more trouble, a harder decision, more jobs lost, more money spent.

Case #2--General Electric--
I have to disclose that I own 136 shares of this company. At $7/share, it isn't enough to bias my position on this matter. I am basically going to make the point here that GM is already gone. But GE can save itself by doing a REAL stress test, and figuring out what it will take to survive the current market conditions. Here's the background:

GE is a company that is still making money--it made $17B in profit last year. It has a diverse portfolio of businesses, ranging from NBC/Universal Studios, to Jet Engine builders, to plastics providers, to appliance makers, to a financing business--GE Capital. Sounds like a business in good shape, right? So why is the stock tanking?

Well, let's look at the balance sheet. $50 Billion in Retained Earnings is nice, but with $450 Billion of Liabilities, there are a lot of debts to be paid for this business. In years past, this wouldn't be a huge issue. However, if the assets, or investments, underlying the $500B balance sheet are really only worth, say, $350B, then there is a $100 Billion shortfall of assets to pay liabilities.

This is scary, but not devastating. The company is still making a profit (for now, at least), and can use those profits to help eliminate those debts over the upcoming years. But what I'd like to see GE do is stress test those assets with the assumption that 60% of the assets are impaired. Now the asset base is only worth $200B. Can GE survive with a $250 Billion shortfall in its assets that are capable of paying off future debts? Does it have a plan to be able to survive such a scenario (refinance loans, seek government assistance, sell of parts of the business)?

I want to give GE some credit. They have a management team and employee base that is second to NONE. I used to work there, and of my four different employers, GE was hands down the most impressive, smartest group. But being smart doesn't make up for hubris. And if GE thinks they are smarter than everyone else, and that doing a scenario such as I have laid out is silly and stupid, they will regret it.

If they use their heads, they will stress test their asset base, assuming a 60% impairment, and make a determination if they can survive a $300 Billion write down. If they can, they should publicly explain that they are that solid, and could withstand even that doomsday scenario. The markets would LOVE this.

GE is only an example, though. Companies are going to need to be able to prove this strength to shareholders over the next year, or risk being driven to zero by the investors demanding such assurances. At that point, we could start to take stock in what kind of strength we really have in this economy, and start to build around the winners.

Nasim Taleb talks about the "Black Swan" effect in the market place. This idea that simply because people had never seen a black swan before, that one couldn't exist. Until someone saw one, and then suddenly, it was a probability. In investments, scenario testing is no good if companies don't stress test their balance sheets for doomsday scenarios, simply because "it's never happened before". It's time to start having companies stress test for doomsday scenarios. I don't necessarily need to know the results immediately, but I do need to know that the strong companies out there are doing this, and actively taking steps to support their financial positions with more cash and less debt.

In my opinion, without such honesty from companies, Obama's stimulus plans won't be effective, and Larry Kudlow's tax policies won't help much either. People need to believe in their enterprises again. Time to start being soberingly honest about where these companies stand, and where they are going.

It's going to suck for a while. I can't say it any other way. But earning back trust has to be top priority. Just ask the Japanese. After 20 years, their stock market has gone from close to 40,000 to around 7,500. I don't think that's a track record anyone in America wants to copy.