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More Earnings Restatements

Well the emails have been coming in and so far the requests have tilted toward the Ride of the Valkyries scene from Apocalypse Now.

Clearly this video is not for everyone as it is Oliver Stone’s visual commentary on man’s cruelty to man and the overkill of the US Military, but from a cinematic standpoint the use of the classic opera aria and the visuals of the helicopter attack are classic film making. And its a really cool guy movie.

As you read in yesterday’s blog posting, history is on my mind.

Today, Illinois Tool Works announced that it was going to have to take a $22 million hit to earnings this quarter due to the passage of the health care reform bill last week. This comes on top of several others (AT&T, Deere, AK Steele, Caterpillar, Prudential Insurance, and more to come) that have announced almost $1.5 billion in restated/lost corporate earnings.

These announcements have brought about lots of rhetoric from both sides of the health care debate – Rep Waxman is even calling the CEO’s of these companies to Washington to grill them before a Congressional Hearing because the CBO estimates said the legislation would save money.

I wanted to give you the facts so you can decide for yourself:

(1) the losses come from a provision in the legislation that ends a subsidy to corporations that provide retiree prescription drug benefits – this subsidy was enacted by Congress when they passed the Medicare Part D program because it was a cheaper alternative to give money to the corporations than to have them end their programs and those retirees join the Medicare Part D program – significantly cheaper as it cost tax payers $233 per retiree for the subsidy but would cost $1,203 per retiree if they joined Medicare Part D; under the new law, the companies will no longer receive this $233 per retiree;

(2) the Sarbanes-Oxley laws enacted after the Enron scandal requires corporate CEO’s and CFO’s to immediately restate earnings in the current quarter and publicly announce those restatements when changes in financial position become known; the penalty for not publicly restating earnings is jail time and huge personal financial penalties for the CEO’s and CFO’s; since it is known that the loss of the government subsidy is $233 per retiree, they are required to make it public and restate their earnings otherwise they can go to jail and endanger their families financial futures;

(3) the Financial Standard Accounting Board’s 1990 statement No. 106, which requires businesses to immediately restate their earnings in light of their expected future retiree health liabilities governs the financial reporting in this instance; again, since the $233 per retiree impacts future retiree health liabilities, these companies have to restate earnings and publicly announce it. If they don’t, they can’t pass their independent audits and the auditors would restate their earnings and make the announcements in their stead. The information would become public one way or another.

Those are the financial reporting facts, so I don’t think there is some corporate conspiracy to undermine the new health care legislation – the CEO’s are required by law to restate corporate earnings and make it public or suffer penalties that none of us would believe worth the risk.

The less debated issue is that this has been a sort of corporate welfare program (or maybe less harshly a financial windfall) that these companies have enjoyed that has allowed them to supplement their bottom lines while providing benefits to their former employees that they would have likely provided anyway – had Medicare Part D not come along. The subsidy was a way for the Congress to keep a significant portion of the retired population off of Medicare Part D to make the financial projections of its cost more acceptable to the gullible public. Quid pro quo, Clarice.

The problem now is that earnings projections included the subsidy and now it’s gone. Those projections have to be revised and reported. The Congress may not like it, but that’s the way the laws are written and the penalties to the CEO’s and CFO’s are so severe that no one is going to err on the side of under-disclosure.

But what is really scary is now that the subsidy is gone and Medicare Part D exists, there is really no reason to expect these corporations to continue to provide retiree prescription drug benefits. These retirees – at least a significant number of them – can easily be expected to join the Medicare Part D ranks as corporations decide to wind down their own programs.

This, if it happens, will increase the deficit beyond current projections. If the members of Congress had looked back a few years in history to when they approved Medicare Part D and the subsidy, they would have recalled the debate on the $233 cost Vs the $1,203 cost. Now, the forgotten consequences of that debate are being realized. This isn’t a qualitative statement on the health care reform as Rep Waxman is asserting – it is either just accounting and financial reporting according to current law or a quid pro quo come home to roost, depending upon your viewpoint.

Given the other issues we’ve discussed on this blog that are headwinds to further near-term equity gains in this technically overbought market, and this reduction in corporate earnings coming from the lost retiree drug benefit subsidy, I am more confident than ever that the lessening in the level of equity exposure and increase in fixed income exposure that we have been implementing is the correct strategy for the current market environment. Normally we’d substitute cash for equities, but since cash is earning only a hundredth or two of a percent in interest, fixed income is the only real alternative.

I am not expecting a return to last year’s lows in the market, but pullback to a technical level of support where valuations are lower given potentially lower corporate earnings seems a reasonable expectation. Locking up a portion of the hard won gains we’ve seen since last March and reinvesting in the equity markets at a lower level as we move through the range bound market is the proper investment strategy for this time period.

Later on, the range bound market will end and either a new cyclical bear or bull will begin. Eventually the secular bear we are in will end and a secular bull will begin (Maybe 2014? Secular cycles are roughly 14 to 18 years in length – the last one, the Reagan-Bush-Clinton bull of ’82 to ’00 went 18 years) and it will allow us to buy and hold instead of moving between fixed income and equity exposure. We just aren’t there yet.

History matters, for investors and politicians. It’s wise to pay attention.

Mark