Blues Brothers: Enron and Cisco

John Mauldin | Thoughts from the Frontline
January 18, 2002

Last week we looked at the continuing evidence of deflation, which is my primary concern when I analyze the future direction of the markets.

This week, we are going to first look at the world economy and then come back home to analyze a mountain of new data that has come our way - the very data that Greenspan and Company will be looking at when they meet next week to decide whether to cut rates yet another time. I have called the rate cuts correctly so far. Last year at this time, I said rate cuts would go much further than analysts predicted, dropping into the low 2% range. We have come that far. Now will we go further? Let's see what the data says.

The Gears of Progress Have a Few Teeth Missing

The world is slowing down, and more and more economies are going into outright recession. Let's review the latest roll-call.

Japanese factory use fell 1.5% in November, to the lowest since the Ministry of Economy, Trade and Industry started keeping records in 1978. Factory use or capacity utilization fell over 10% in the last year, from already low levels. Business spending fell 3.9% in the fourth quarter. Other data also showed Japan's trade picture weakened in November, with the trade surplus falling an unadjusted 16.9% year-on-year.

Elsewhere in Asia, Philippine imports fell 23.6% in November at the fastest pace in almost three years as electronics makers bought fewer parts and machines, suggesting exports will keep sliding in coming months. Korea and China officially complained about Japan's aggressive lowering of the yen with poorly veiled threats in the comments.

Italy experiences its biggest drop in production in 9 years. Germany will soon declare "official" recession, with two back-to-back losing quarters. Total growth last year will be less than 1%. The fourth quarter in France was at an 8 year low in its economy, with essentially no growth. The Canadian dollar falls to an all-time record low as our neighbors to the north continue in a recession. Good for those of us who like to vacation in Canada, but bad for locals.

Britain has been one of the few countries to defy the world-wide recession. But they too are beginning to show some signs of fatigue. British retail sales unexpectedly fell in December. Output in the UK's recession-bound manufacturing sector has sunk to a five-year low. Unemployment has started to rise, although it is still quite low at 3.2%.

Closer to home, Mexico continues in recession, Argentina is in total collapse and Brazil is trying to figure out how not to get drug even further down with Argentina.

We could continue in this vein for a few pages, but you get the picture. The world economy is slowing down. That is not a surprise.

Lamy Ducks, and We Waffle

But as I read scores of comments from various countries, I begin to sense a pattern. Nothing you can clearly point to, just a hint of concern.

The level of rhetoric has increased. Each country expresses more concern about how other countries' decisions affect them. "We will not sit still." "This is a grave concern."

I don't know how many of you are keeping track, but there is a crisis brewing in Europe. The World Trade Organization has made a bizarre ruling against the United States. They have ruled that our tax laws give US companies an unfair advantage against the European counterparts, and that we must either change our laws (fat chance) or have higher tariffs imposed on our goods. WTO arbitrators will decide whether to whittle the penalties down from the EU's request of $4.04 billion. The eventual penalties will reflect "the damage that we are suffering," European Trade Commissioner Pascal Lamy said.

The ruling has drawn sharp criticism from business on both sides of the Atlantic. Lamy said, "I don't agree with this idea that sanctions would be as harmful to the EU as to the U.S. EU policy is made by the EU institutions. and not by EU businesses. It's not a system where I phone businesses before making decisions. For companies that benefit, it's a nice bit of butter on the side."

Trans-Atlantic trade is almost $400 billion, and total investment between the U.S. and EU tops $3 trillion. Business councils on both sides of the Atlantic have denounced the ruling.

Essentially, US multi-nationals, by setting up in tax havens, get to avoid US corporate taxes. But European businesses get to drop VAT taxes on exports, so it cuts both ways. I am not arguing for the correctness of any tax system, but pointing out the issue. They are all too high.

President Bush is weighing whether to impose tariffs on foreign steel, as US manufacturers are getting creamed by a combination of cheaper imports and a strong dollar. Is steel a "critical" resource necessary for the national defense, and so something we must protect? What about European reluctance to take our agricultural products? Where does all this end?

Lamy suggests he is willing to impose a political solution on a problem that could have far reaching effects.

It is one thing for the WTO to try to make trade fair. It is another for them to start to dictate tax policy. The tax policy they obviously prefer is one that makes other countries impose taxes as high as those in Europe. Suggesting that low taxes is an unfair trade practice is simply bizarre economics, and threatens to bring new trade talks to a halt. It is a huge expansion of power by a trade body with no elected representatives.

This could be the beginning of a trade war. It always starts with something small. Hopefully cooler heads will prevail, but Lamy is not a cool head. He is a loose cannon on a pitching deck. It was something like this that started trade wars in 1930. If this was the only problem, and someone besides Lamy was negotiating, I could worry less. But as I mentioned above, all around the world the level of nationalistic rhetoric is rising. This is not a good trend. Lamy's bosses in the EU need to take him to the woodshed.

Back at the US Ranch

U.S. business inventories fell 1% in November. That is good, as eventually inventories fall enough and manufacturing begins to increase. However, sales fell 1.4% in the same month continuing a pattern of sales falling faster than inventories. That is not good.

US office vacancy rose to 12% from 7% one year ago. That is a huge increase, and certainly bodes poorly for new office construction.

The Consumer Price Index fell 0.2% in December, and has fallen or been flat for three straight months. The last time this happened (for three straight months) was in 1986. We are in outright deflation for the last six months.

Last week I reported that the Producer Price Index fell. The year on year change is down 1.8%.

But there are two other figures I did not report, which Greg Weldon brings to my attention. These are what I call "pipeline" indicators, as they tell us what is coming down the pipeline in the future. They are the intermediate and raw producer price indexes. The intermediate PPI measures the prices of materials used to produce final products, and raw PPI measures raw material costs, which are the base costs for future products.

Intermediate PPI dropped 0.9% for the month and 2.9% for the quarter. The yearly drop of -1.6% was the lowest I could find on record.

Raw materials drop 9% (no decimal here!) and is down over 30% from last year at this time, again at the lowest levels of change I could find.

This suggests price deflation is in the pipeline for the next few quarters. It is quite possible we will see a negative 12 month CPI. This does not bode well for corporate profits, and should be good for bond prices, as inflation worries will go away.

Exports prices were down, giving little hope for increased profits in companies which rely upon exports for profits.

For new readers, I look at three factors I call the Three Amigos to indicate for us the economy has bottomed, and that we can safely get back into the stock market. I want junk bonds, capacity utilization and the NAPM index to be rising for two months. These generally turn around at the bottom of a recession and near the bottom of the stock market.

Capacity utilization numbers came out this week, and they are still falling, to 74.2%, which is the lowest level since 1983.

Junk bonds have rebounded some, but they are still 3% or so below where they were September 11. The NAPM Index rose last month. I would expect we should see all these turn up soon, if we are going to see even a weak third quarter recovery.

Greenspan, in a major speech, clearly indicated he thought the US was still in a difficult period. He said, "...we continue to face significant risks in the near term. Profits and investment remain weak and, as I noted, household spending is subject to restraint from the backup in interest rates, possible increases in unemployment, and from the effects of widespread equity asset price deflation over the past two years."

Profits plunge 50% in 2001

"While the S&P 500 companies reported that their earnings were $45 per share in 2001, their reported earning (before bad stuff is excluded) plunged to only $25 per share, 50% below a year ago and the lowest since the fourth quarter of 1994. Write-offs were in excess of $120 billion for the S&P 500 and exceeded 30% of operating profits." (Yardeni.com) This makes the current P/E ratio on a trailing earnings basis a nose-bleed 45!

Analysts are projecting earnings to be in the $55 range this year. I don't want to be too impolite, but they are just simply out to lunch. Of course, these are the same people who told us earnings would be $55 this year last January. They will continue their dismal track record of being wrong, wrong, wrong.

To Cut Or Not To Cut

So, you are the Fed chairman. You have these reports and more. Yes, there are lots of cheerleaders out there telling us the economy is turning. The recession, by historical standards, hasn't been all that bad. Consumer confidence is up. If it wasn't for those pesky Japanese exporting their deflation, we could relax, sit back and watch the economy start to turn up. Declare victory and go home would be the call of the day.

But, in his words, "we continue to face significant risks in the near-term."

It says here that we get another small rate cut. When we read the notes from the minutes, there will be opposition, but my bet is Greenspan will force one more through, and the notes will still favor a loose money policy.

Blues Brothers: Enron and Cisco

I have written about Cisco before, but in light of the Enron debacle I want to go back and visit that company again. Let me first state that as a company, Cisco is not an Enron. They have $19 billion in cash, have dominance in a lot of their markets and will be around for a long time.

But there is one thing Cisco and Enron have in common. Both have highly charismatic chairmen who cheerlead their stocks. The $440 billion in market cap that Cisco has lost for investors is more than the drop in Enron. Where is the outrage for Cisco? I would probably not care so much, but every week I talk to new clients, many of them retired who could not afford to lose the money who have lost large sums of money investing in Cisco and companies who make promises like Cisco.

John Chambers has consistently told us that things would be better, just as Ken Lay did, even while the stock and the companies prospects were dropping like a stone. Is he clueless as sales drop 30%? Where are the realistic warnings?

Now Chambers tells us, with a straight face, that 30% compound revenue growth is in the cards as far as the eye can see into the future.

Two years ago I said that was impossible, last year I said that was impossible and I am telling you that it is impossible now.

Is that because I have some magic pipeline insight into Cisco? No, it is because I know the Law of Huge Numbers. A Robertson Stephens study estimates that even if Cisco grew by 20% a year for the next ten years, to $100 billion in sales and maintained a 15% operating margin, an investor who bought the company today would earn only 3% return per year.

That means Cisco would need to find an additional $80 BILLION dollars in sales annually of routers and other electronic widgets to justify its current price.

The problem is sales are not growing 30% or 20%. They dropped 32% last quarter, and the company lost $268 million.

You simply cannot grow a $20 billion dollar company at 30% over a decade, no matter how many companies you buy in order to try and capture growth. That would mean your company would double and then double again and then almost double again. Growing from $17 billion to $100 billion in sales in ten years is simply impossible, unless you do a lot of mergers, which then dilutes shareholder value. Internal growth of that magnitude cannot happen absent a monopoly.

Now, if you start from $1 million or $10 million or even $100 million it can be done. That happens all the time. We all dream of finding the next Microsoft or Cisco. And some of us will. However, Cisco is no longer the "next Cisco". It is the old Cisco at a very high price.

To make Chambers predictions come to pass, the market for his products has to grow beyond anything predicted by anyone sane today and all his competitors have to die.

I said it last year and I will say it again. Chambers is grossly misleading the public and propping up his stock. The only difference between Lay and Chambers is that Lay was involved in direct fraud. The investors in Cisco will lose money just as surely as those of Enron.

The day will come when his siren song will wear thin. People will tire of hearing promises that cannot be met. When that day comes, this stock will collapse to a realistic P/E ratio. Cisco will be seen for what it is: a company in a maturing market that makes boxes that look like the boxes it competitors make. Chambers will be replaced by a CEO who will shoot straight, and then investors can once again consider buying Cisco because it is a good company in a good business with good products and people, and not because of some pie-in-the-sky dream.

Today, however, it is a hyped-up stock with a 90 P/E ratio. It is a company that plays very aggressive accounting games, which should not be allowed even if they are currently legal. It is a company in a maturing industry with strong competition. It is not unlike automobile companies in the 20's, railroad companies in the 1880's, or Xerox in the 60's. All had spectacular growth and promised to continue that growth forever.

But trees cannot grow to the sky, and multi-billion dollar companies cannot compound at 20% forever.

The Enron Solution

I see two main problems the Enron debacle highlights. One can be dealt with, and the other is endemic to human nature.

The first is the extremely poor performance by the auditors. Arthur Andersen is culpable. Three strikes and you're out: Sunbeam, Waste Management and Enron.

Enron used off the book partnerships to "smooth" out their profits, or create phantom profits. It now appears they used their own stock to prop up the equity in these partnerships, which is a highly dubious practice.

But Enron is the tip of the iceberg. Investments banks like Morgan and Citibank are selling these partnerships and other forms of accounting magic to many more firms than just Enron. Accounting/consulting firms also assist as the fees for putting these deals together are huge.

I remember some ten years ago that the firm I was a partner in did a survey to our clients asking them what types of investments they were interested in. A significant number asked for a particular management style as a way to hedge their portfolios. Investigating the possibilities, it seemed we needed to use a new form of investment partnership that was just being discussed in legal circles. Today that form is old hat, but back then it was cutting edge.

We wanted to get a legal opinion on whether it would work for what our clients wanted to do. We called our chief consultant and asked him which attorney to call. His reply?

"Do you want a positive or a negative opinion?" There were two attorneys who he considered experts in this field. Both were senior partners of famous 900 man law firms. Our consultant's experience made it more likely that one attorney would give a positive opinion. As it turned out, we asked both attorneys and they both gave it the green light.

But his question highlights the problem. It is far too easy to find an accountant or attorney to tell you what you want to hear. I can guarantee you Arthur Andersen will tell us their attorneys told them to proceed with the paper-shredding. Nobody does anything like that without getting an attorney to CYA (Cover Your Ass).

In the days when making your earnings number can make a huge difference in your stock price, the temptation is to do what it takes to make sure you beat the street estimate.

How is it a company like Cisco can consistently beat street estimates by a penny every quarter for 43 quarters? How can anyone's business be so precise? The answer is obvious. They cook the books.

Sometimes it is simply shipping out boxes on the last day of a quarter to make sales numbers (like Cisco has been known to do). Sometimes it is recognizing profits early, or deferring expenses, or calling expenses like painting trucks extraordinary (Waste Management). But it is done every day, and by a significant number of companies.

Not every company does this, of course. But which ones do? Who can we trust? We rely upon auditors to catch these issues and report them. But it appears that either they are not competent enough to find them or they go along in order to get million dollar fees. This makes it very difficult for investors to know the true nature of the companies in which they have placed their faith.

I work in a regulated industry. Those of us in the financial services industry like to consider ourselves professionals. When the SEC or the NFA (National Futures Association) calls me and tells me it is time for an audit, I cannot tell you I jump for joy. Regulatory audits are time consuming and a hassle.

But they are necessary because there are bad guys out there. The audits say nothing about my competency as an investment manager, but they do make sure I keep proper records, handle client money correctly and don't break the rules. There are exacting, detailed standards about how we must go about our business.

I don't always agree with the rules, and have worked to get some changed or some added, but you always play by the rules as they exist, or you subject yourself to fines and/or expulsion.

Maybe the accounting industry needs to develop a self-regulating body like the NFA or the NASD as we have in the investment community. Not for every CPA, but those firms which audit public companies should be held to a very strict standard.

I hate the thought of more regulatory oversight for anyone. It is inconsistent with my free market instincts. But something needs to be done to make sure that investors are provided more transparency into public companies. If we are going to continue with this pro forma earnings charade, there need to be detailed standards as to what is a regular expense and what is truly one time. We need to know about off-balance sheet debts. How many derivatives does a company deal in, and do they potentially hide losses or merely hedge risk?

Free Market Analysis Software

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I am doing a lot of travel this month. This week I am in NY and Philly. Next week I go to Boca Raton for four days (Jan. 26 -30) to speak at an investment conference, and hope to find a golf game somewhere Sunday. I will be glad to meet with clients and potential clients. Please call my office at 800-829-7273 and we will get back to you and schedule a time to meet.

Last month, I finished the new book by David McCullough on John Adams. It deserves to be the best-seller it is. It is a brilliant read. I had thought I was fairly knowledgeable about American history, but McCullough expanded my understanding of the human side of the American Revolution ten-fold. Every American should read this book to learn what it cost our forefathers so that we can sit in comfort and gripe about Cisco, Enron and recessions. It will also make us think through the implications of subjecting ourselves to world alliances like the WTO.

To those who are waiting for my next e-letter written just for accredited investors, it will be coming out next week, after my trip to NY and Philly. I will use the letter to report about several of the offerings I analyze on this trip. If you are an accredited investor (net worth $1,000,000), contact my office and we will send you the form to get the letter. I am sorry, but SEC rules say I cannot discuss certain matters in a public forum, and must limit readers to those with a net worth of $1,000,000 or more. Not my rules, but I follow them religiously.

Your grateful to be the beneficiary of the great labor of John Adams analyst,

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