Cautionary Observations From A Chronological Analysis Of The S&P 500 Balance Sheet
There was a time when investment decisions had more to do with fundamentals than whether Bernanke would wake up tomorrow and decide it is time to stop the liquidity spigot (arguably, the only thing that matters these days). Indeed, if in the odd chance Bernanke is not reconfirmed by the Senate, the huge drop the market experienced last year when Congress refused to get Paulson's first TARP version to be shoved down its throat, will seem like a Sunday morning picnic.
In those long gone days when there was more to valuation than persistent bubble liquidity, investors used to look at arcana such as cash flow statement and balance sheets (and income statements as well, before the FASB decided to make a total mockery out of the joke that are "reported earnings").
One recent topic that Zero Hedge has discussed has been the increase in cash and cash equivalents on the balance sheet. We have highlighted how this increase in cash has been primarily a function of increasing debt and decreasing capital expenditures (both maintenance and growth), as companies have bunkered down while the recessionary storm rages.
Today, we analyze a broader set of metrics of the combined balance sheet of the 500 companies in the S&P 500 index. We have compiled key data on a quarterly basis for both the asset and liabilities side of the broadest cumulative balance sheet in the world.
The table below highlights all the data compiled via CapIQ:
Total assets have grown by 30% over the past 4 years, from $19 trillion to $24.6 trillion as of September 30, 2009. And while cash has exploded by 74% from $872 billion at the end of 2005 to $1.5 trillion most recently, as a percentage of total assets it has been relatively flat, rising from 4.6% to just 6.2%.
Ironically, goodwill growth has been substantial, accounting for nearly $400 billion of total asset expansion, from $1.2 trillion to $1.6 trillion. How to believe this "growth" in the face of one the roughest revaluation periods for corporate acquisitions is a different story. It is likely that many companies are far overdue for major goodwill writedowns, which lax accounting standards keep permitting to be indefinitely put off into the future.
On the liabilities side, there are no major surprises: debt has grown by nearly triple the amount that cash increased during the observed period. Debt grew by $1.8 trillion from $5 trillion to $6.8 trillion in the past four years. This is nearly 2.7x greater than the comparable increase in cash. This should be a major concern to all who claim that corporate deleveraging is ongoing, and that the corporate cash increase is sufficient to offset the debt increase.
Yet what likely is the most relevant observation is the disproportionate need to constantly lever up to extract ever declining cash out the asset base, as well as the broadly declining quality of S&P assets as measured by their actual cash generation capacity.
The graph below shows the material increase in both total and net leverage in the S&P as calculated by Total and Net Debt to EBITDA - the one metric that still has some credibility even as Earnings and EPS have been rendered practically meaningless courtesy of ever more toothless GAAP rules. Total leverage has increase from 4.6x to 5.8x in the last two years, and even factoring for the cash increase does not present a rosier picture: Net Leverage is up 20%, from 3.8x to 4.5x. In essence the entire S&P is one big High Yield credit, and would likely be rated in the B2/B area by the rating agencies (assuming these had any credibility). As such, the cost of debt of the combined S&P if it were a standalone company would be around 7.5-8.5%. That it is currently much lower due to the Fed's intervention in the interest rate market is an aberration: look for cost of debt (and, by implication, overall capital) to spike broadly over the next several years, as normalcy (hopefully) returns.
Lastly, an unpleasasnt picture emerges when analyzing the (adjusted) return on assets and equity (however with EBITDA instead of earnings in the numerator). Both the return on assets (EBITDA/total assets) and return on equity (EBITDA/Shareholders' Equity) has plunged, with the first dropping to 4.7% from a four year average of 5.8%, an 18.3% reduction, while ROE has dropped from a 4 year average of 29.2% to 24.1%: a comparable 17.4% plunge.
The preliminary conclusion is that companies are scrambling to beef up the asset side of their balance sheets even as debt continues to be a major threat. The problem, however, as this brief exercise has shown, is that incremental assets are of lesser and lesser quality (even assuming no major goodwill impairments in the future), and the actual cash they generate continues eroding. Absent a major secular breakthrough in economic efficiency, look for cash flow reduction trends to continue even as the S&P labors under ever increasing debt loads. And with the shadow banking and asset system still solidly dead, it appears that creating asset returns out of thin air will not be an option for the corporate world for a long time.