Balance Sheet Bailout Begins

Not much. The world keeps turning. And the world economy keeps falling apart. Here in Australia, shares of port and rail outfit Asciano (AIO) fell off the table after a Citigroup analyst changed his valuation of the company and moved it from “buy” to “sell.” Asciano is down 93% from its all time high and was down nearly 60% yesterday before going into a trading halt.

Asciano has $4 billion debt on the books (much of it inherited from when the company was spun from Toll in 2007). But yesterday the company assured investors it wouldn’t be beefing up the equity on the balance sheet with another dilutive capital raising. And chairman Tim Poole told investors earnings were in line with forecasts.

The trouble is that with all that debt and, shall we say, challenging business conditions, investors aren’t convinced the equity in the company is worth anything anymore. This explains why the Citigroup analyst suddenly shifted from a discounted cash flow model of valuation (which focuses on the present value of future earnings) to an enterprise value model.

An enterprise value model adds up the market cap and debt a company has, and then subtracts cash and cash equivalents. It’s not quite the liquidation value of a firm. But it IS, generally, what it would cost you to take over the company and its liabilities, minus its cash.

So why switch valuation models in mid stream? Well, one reason is that you’re looking for any reason at all to get out of a stock, and one valuation model suggests a much lower share price than another, so you use it. But let’s assume the switch in valuation models is based on new and different business assumptions. What are those assumptions?

Well, if you’re taking your eye off earnings two and three years down the track, it means you think there are much larger immediate business concerns that affect the value of the firm. One of those might be access to capital. If a firm like Asicano has to rebuild its balance sheet by raising new capital on the equity markets, that dilutes existing shareholders.

But really, using an enterprise value model as the justification for selling a share means, as an analyst, you’re throwing in the towel on the business itself (not just the management or the balance sheet). It means you think being in the ports and rail business during a contraction in global trade is a lousy business, with zero earnings power going forward. The fact that Asciano has so much debt during a credit crunch certainly doesn’t help.

The challenge for resource investors now is to sort out which model to use for valuing over sold shares. For most resource companies (the non producers anyway) discounted cash flow models are pretty useless. The earnings are highly variable and cyclical for resource shares because commodity prices themselves shift.

Changing commodity prices affect the ebb and flow between supply and demand. If you asked us, we’d say low commodity prices are already leading to a tightening in supply. In addition to BHP, Rio, and Fortescue idling expansion and production plans in the Pilbara, Alcoa has shelved its expansion plans for its alumina refinery south of Perth. High-cost producers are already being forced out as well. What does all that mean?

It means the credit crisis and the deleveraging in the commodity markets in 2008 are going to lead to lower supply of key commodities in 2009. That lower supply, so far, looks like it will be enough to meet the lower demand that’s been brought about by the global recession/depression.

But it also leaves the surviving players in the resource patch in an enviable position. They tend to have cash. They tend to have lower debt/equity ratios. They tend to have better projects where ore grades are higher and costs of production are lower. And the really good ones have poly-metallic ore bodies, a sort of geological diversification that allows them to shift production to those metals with the highest current market prices, while leaving the other stuff in the ground for a rainy day.

The one-trick ponies (those without a poly metallic deposit) are in a tougher spot. But if you believe China’s stimulus package announcement marks the long-sought shift in the Chinese economy away from exports and towards domestic consumption, well then it’s not all bad news for the smaller Aussie resource juniors. More on that tomorrow.

Outside the Lucky Country, General Motors (GM) is telling anyone who will listen that if it doesn’t get a bailout before Christmas, it may not survive to see Barrack Obama inaugurated as the 44th President of the United States on January 20th. GM shares closed under $3 for the first time since 1946. At $2.92, it was a 65-year low for America’s big auto-maker.

Some of Australia’s new handout to automakers will probably make it back to GM and Ford’s Detroit coffers. But if the companies are going to survive in their current form, it will take a mighty Federal hand out to make it happen. And hey, everyone is getting one of those these days. So why not?

It is a remarkable thing that the icon of America’s industrial manufacturing might is on the verge of recognising its bankruptcy. In some ways, GM’s downfall reflects the conscious decision of American policy makers and CEOs to pursue financial services over manufacturing, to favour white collar work over blue collar work, selling stocks over making things.

It started with the passage of North American Free Trade Agreement by the Clinton Administration with the help of Republicans in Congress. Before we get into the details, though, let’s be clear about what happened. The U.S. pursued a “strong dollar” policy when Robert Rubin was Treasury Secretary from 1995 to 1999 under Bill Clinton. The U.S. opened its consumer market to the world and began shipping manufacturing jobs overseas. In exchange, the U.S. got two things.

First, American consumers got cheaper goods via dollar pegs from exporters who kept their own currencies relatively cheaper than the dollar and sold into wide open U.S. markets. You saw a great disinflation in manufactured and retail goods and, not coincidentally, epic growth in China’s industrial production. Earnings for American firms who outsourced labour also increased, and were passed onto shareholders via rising stock prices (and more generous P/E multiples based on the rosy new scenario of lower costs, cheaper capital, and higher sales).

This led to a huge explosion in the current account deficit, most notably the trade deficit. America was buying a lot more than it was selling. But while the current account deficit climbed higher as a percentage of GDP under Rubin, America began to rack up a huge surplus in the capital account. And perhaps that was Rubin’s idea all along.

Foreign dollar holders recycled their trade (and later petrol) profits back into U.S. stocks and bonds. This drove share prices up and long-term interest rates (to which mortgage rates are linked) down. Consumers levered up based on rising asset prices (can you smell a housing boom?). And for awhile, everyone appeared to be getting richer, with more stuff available at lower prices, and ever more credit available to borrow against rising houses and shares.

Further, Rubin’s preference for running a surplus in the capital account favoured the boys on Wall Street. IPOs flourished. Investment bankers thrived. Financial product innovation exploded like a thousand brilliant suns.

And in another fortunate side affect, Federal tax coffers swelled as capital gains taxes poured in from Wall Street. Corporate tax revenues poured in as well. When you threw in booming social security payments from the workforce along with the swelling tax take, the Clinton Administration was even able to give the impression that the Federal budget was briefly in surplus in the late 1990s.

But Rubin’s gambit has not paid off so well for the bulk of the American workforce, has it? It sent jobs overseas and by pushing real interest rates down, disincentivized saving. Savings rates accordingly plummeted while consumers took on more debt to make up the difference between their falling real incomes and their expensive (self-chosen) standard of living.

What hath Rubin really wrought?

By preferring to run a capital account surplus, Rubin essentially conceded that the current account deficit-a function of Americans consuming more than producing and spending more than saving-was an a priori fact of global economic life. He assumed the current account deficit as a fact, and engineered a strong dollar to boost the capital account surplus, which also just happened to be a huge boon to the financial services industry from which Rubin came from. He figured we’d become a nation of spenders and consumers, not savers and makers.

By the time a weaker dollar rolled around in the last year of the first Bush term, there weren’t nearly as many American manufacturers left operating that could take advantage of it. They’d all left for a siesta in Mexico or the world’s new workshop in China. America could compete on price, but there was nobody around to do the competing.

And now today we have GM, a car company that exists to pay off its accumulated healthcare and pension liabilities. It cannot make enough money by loaning money to honour the promises it’s made to its unionised work force. What would Rubin do?

Well, we know that generally in the Western world, government policy makers (many of whom come from the financial services industry or benefit from the contributions that industry makes to their campaigns) have favoured a pattern of trade that generates capital account surpluses and current account deficits. This is good for you if you’re in the financial services industry. Not so good if you make cars.

There is not much at this point that Kevin Rudd and Barrack Obama can do about it, assuming they would want to. And the bigger problem, at least for the U.S., is that foreign trading partners and central banks are no longer recycling trade profits back into American financial markets. Perhaps it’s because they believe the risk free rate of return from sovereign U.S. debt is no longer risk free.

And perhaps they’re right. The U.S. bailout plans take on debt via government borrowing in order to shore up the badly damaged and over-leveraged balance sheets of Americas financial companies. No real value is created. And what kind of investment is that? Besides, so far, the bailout has been a continuation of Washington to favour the financial services industry over real manufacturing.

In the next few days, and with Democrats in Congress pushing hard for it, the balance sheet bailout of the real economy will begin. And when it does, we think it will accelerate the movement out of U.S. Treasuries and into cash or even resources. More on how this happens tomorrow.

Dan Denning
for The Daily Reckoning Australia

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