Wall Street now realizes that during 2001 we are likely to see four successive quarters of declining earnings for the companies that make up the Standard and Poors 500 Index, but the Street is still putting the blame primarily on New Economy and tech companies, whose downturn in both earnings and stock prices have been well documented.

They have not yet focused on the Old Economy where, as in the New Economy, accounting shenanigans have raised earnings artificially in 1996-2000. A particular, and now problematic, example of this has been the tendency of Old Economy companies to stop paying pension contributions, as their pension funds grew artificially in the stock market bubble of 1996-2000. By not paying pension contributions for their workers, they were able to inflate artificially their reported earnings, thus benefiting their stock price in the short term, thus boosting top management’s stock options. Naturally, now that the stock market has turned, these chickens too are coming home to roost.

Unless (which is ,of course, possible) there is a sharp stock market recovery in the next four months, 2001 will see Old Economy companies’ pension funds in general showing losses not gains for the year. Hence these companies will once again have to fund their pension schemes, as they have not had to do in the past few years, thus depressing their earnings.

This week, I look at the effect of this on five representative Old Economy companies: three “Generals” — General Mills, General Motors and General Electric — and two other elderly companies with New Economy aspirations, IBM and AT&T.

I have not looked at the real New Economy companies, because until 2000 they tended to pay people primarily in stock options, and to be run by 28-year-old billionaire who thought they would live for ever. Such people don’t have pension schemes, and therefore don’t have the problem (they do, however, have the problem, at least equally bad, of what to do with stock-option remunerated employees when the stock price goes down, but that is another story.)

General Mills, first, reported net income from its pension and post-retirement benefit plans of $66.1 million in the year to May 2001 — this recognition is particularly spurious since it ignores $105.6 million of “actuarial loss,” which was unrecognized. The value of General Mills’ pension plans above the actuarial value of pension and post-retirement benefits, $657.7 million, was recognized in the company’s balance sheet as an asset. In a normal year, if General Mills’ investment portfolio broke even, $126 million (as of 2001) in accrued pension rights would have to be deducted from earnings. Of course, to some extent, this too could be taken as an “unrecognized actuarial loss,” but at some stage General Mills would have to write its pension assets down to fair value.

Assuming, therefore, that $126 million in accrued pension rights were deducted from earnings, instead of 2001’s $66.1 million added to them, there would be a net adverse effect of $192.1 million pre-tax. This would translate into the same amount post-tax, since the company accrued $73.1 million in deferred tax from their employee benefit operations, indicating that in the tax books, pension liabilities are fully accrued. This amount is $0.47 per share, or 22 per cent of General Mills’ net income in the year to May 2001 of $2.20 per share.

General Motors, next, reported a net cost of pension plans in 2000 of $605 million, and in return had an increase in unrecognized actuarial loss of $6,701 million. The value of the pension plans, $18,386 million, is recognized in GM’s balance sheet as an asset. In 2000, GM had accrual of pension rights of $7,132 million. Hence, if the plans break even in 2001, and it is felt by the auditors that the “unrecognized actuarial loss” could not be ballooned further, GM would have an additional cost of $6,096 million pre-tax (again, apparently the same post-tax) as a charge against earnings, or $10.31 per share, 154 percent of 2000’s Net Income. Even assuming some of the portfolio is profitable, and/or some of the cost can be offset against GM’s tax liability, the effect on earnings is devastating, probably wiping them out.

In GE, as discussed in a previous article, the company reported $1,266 million in income in 2000 from its pension plan, but actually had a net actuarial loss of $970 million. However, the company also had a net actuarial gain accrued in its balance sheet of $12,594 million, which would cushion or even eliminate the effect of a poor year. If GE were to have a zero return on its pension plan in 2001, the pension cost it would have to bear would be $2,746 million, a swing of $4,012 million from the prior year, or $0.41 per share, 32 per cent of 2000’s earnings per share. However, the accrued pension fund actuarial gain in GE’s balance sheet is so large that at least two more poor years would be required in practice before GE was forced to make actual pension contributions. Look for GE to have a problem in 2004 or 2005, unless the stock market really craters.

AT&T, of course, has far lower pension plan obligations than would have the old “Ma Bell,” having lost both the seven regional companies and Lucent. In 2000, the company accrued a pension and post-retirement benefit plan gain of $620 million net. Like GE, however, it also had an unrecognized net actuarial gain, in this case of $7,489 million. If AT&T were to have a zero return on its pension plan, it would have to bear a pension and post-retirement benefit cost of $1,626 million, a swing of $2,246 million from 2000, or $0.60 per share, 68 percent of 2000’s net income. However, as in the case of GE, the net actuarial gain is sufficient to cover any such cost for two to three years.

IBM, finally, being an old established company with limited growth in the ’90s, can be expected to have a similar pensions profile to the “Generals” in spite of its business sector. In 2000, it recognized $728 million in income from its pension plan, while the plan’s actual loss was $1,728 million, more than halving its unrecognized actuarial gains, which in 2000 were $4,628 million. Net pension plan assets on IBM’s balance sheet were $6,624 million. In the event that the plan broke even in 2001 on its investments, IBM’s pension cost would be $4,795 million, although of course it could absorb almost all of this by running unrecognized actuarial gains down to zero. Thus its net adverse “swing” would be $728 million or $0.40 per share if it just ceased accruing gains, or $5,523 million ($3.04 per share) if IBM accrued the full cost of its pension contributions; these figures represent 9 percent and 68 percent, respectively, of IBM’s net income for 2000.

In summary, therefore, if the stock market remains relatively weak until the end of 2001, General Motors, in particular, will suffer a huge hit to earnings from its required pension contributions. In all probability, net income would be wiped out. At the other extreme (for these Old Economy companies) GE and IBM could suffer two to three years of flat stock markets before earnings were substantially adversely affected, because of their unrecognized actuarial gains. In between are General Mills, where the adverse effect of pension contributions would be modest in the context of the company’s overall operations, and IBM, where they would be more substantial, but would only become a real problem in a second year of flat pension fund asset values.

Pension fund calculations are extremely abstruse, and rest on assumptions that are almost impossible to make accurately. Nevertheless, three conclusions can be drawn from this analysis: First, if the stock market doldrums are prolonged (let alone if the market drops further) the majority of companies will fund their earnings hit hard by renewed pension contributions, kicking in for the first time since the middle 1990’s.

Second, the effect differs wildly from company to company, so any investor had better do this type of analysis before investing.

Third, in this way as in so many other ways, earnings on U.S. corporations became wildly over-inflated in the late 1990s, hence the U.S. stock markets have a great deal further to fall before valuations reach even the high end of their historical norm.

-0-

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

This article originally appeared on United Press International.