2/17/2010

The Great Recession?

By Martin Gremm and Harvey Powers

Introduction

Dick’s Sporting Goods, a Pittsburgh based competitor of Academy and Sports Authority, was not immune to the recession. Nobody was. However, despite the dismal reports regarding discretionary consumer spending, Dick’s maintained steady sales during the recession.

At first glance this result seems unusual, but Dick’s was actually a fairly typical example of companies in the consumer discretionary sector. Like many other retail companies during the recession, Dick’s earnings fell sharply but its operating cash flow stayed strong.

We can get a better understanding of this apparent paradox by looking more closely at Dick’s numbers and examining what earnings and operating cash flow really show. Earnings indicate how a company performed by taking into account the proceeds from business operations, investment returns, and various non-cash items such as changing the value assigned to brand names and other assets. During the last year of the bull market (Oct. 2006-Sept. 2007), and the first year of the market declines (Oct. 2007-Sept. 2008), Dick’s earned $150 million and $139 million respectively. For the next 12 months earnings fell off a cliff. Dick’s lost $36 million from October 2008 to September 2009, a sharp reversal from the profit of $139 million in the previous year. In terms of earnings, the recession looks like an unmitigated disaster for Dick’s.

A very different picture of Dick’s emerges when we look at the company’s operating cash flow over the same time frame. A company’s operating cash flow breaks out the component of earnings that can be attributed directly to business operations--in Dick’s case, selling sporting goods. Operating cash flow measures how well a company is able to make money in its core business.

As the recession developed, Dick’s decreased its inventory, providing a cash buffer as credit tightened. This helped boost the company’s operating cash flow to the highest level in several years. Dick’s annual sales increased slightly. In terms of sales and operating cash flows, the recession did not pose serious challenges for Dick’s.

Dick’s Sporting Goods Key Values

	Stock Return	Sales	Operating Cash Flow	Earnings
Recession (10/08-9/09)	-16.9 %	$ 4283	$ 344	$ -36
Pre Recession (10/07-9/08)	-35.4 %	$ 4135	$ 157	$ 139
Bull Market (10/06-9/07)	5.4 %	$ 3702	$ 167	$ 150
			Table 1. Values in Millions of Dollars

We don’t have to look very far to discover why sales figures and the operating cash flow tell one story, and earnings tell a completely different one. The largest contribution to the earnings figure was an accounting loss of $168 million. Dick’s Sporting Goods decided to reduce the value it assigns to its Golf Galaxy subsidiary and several other assets. Revaluing these assets had no effect on how much profit the company generated from selling its goods (the highest in recent years), but it pushed the earnings into negative territory because the paper loss from lowering the value of these assets overwhelmed strong earnings from Dick’s core business.

Given that the Dick’s drastic drop in earnings turned out to be the result of an accounting change, and not an indication that the business was struggling, it is worth looking at a broader picture to what extent the same is true for the consumer discretionary sector and the economy as a whole.

Sectors

Dick’s Sporting Goods survived the recession better than the average company in the consumer discretionary sector, but most companies in this sector followed the same pattern of looking much healthier in terms of operating cash flows and sales than in terms of earnings.

As a group, the members of the Russell 1000 index in the consumer discretionary sector saw an 8% decline of their operating cash flows relative to the last bull market year (Oct. 2006-Sept. 2007). The corresponding earnings declined 61%. While an 8% decline in business activity is certainly a major problem for any business, it is far less severe than the well-publicized 61% drop in earnings would suggest.

The similar pattern holds true for the market as a whole. For the companies in the Russell 1000, the operating cash flow for Oct. 2008 to Sept. 2009 was 10% higher than during the last bull market (Oct. 2006-Sept. 2007). However, the earnings were 43% lower, in many cases due to massive write-downs of asset values.

Sectors posting better operating cash flows include consumer staples, energy, health care, industrials, telecom, and utilities. Sectors with lower operating cash flows were consumer discretionary, financial, and information technology. However, all sectors except health care posted dramatic declines in earnings.

Companies were able to maintain strong cash flows during the recession by resorting to drastic cost cutting measures. For example, they reduced the workforce as much as possible, they made no investments into infrastructure or technology and they did not replenish their inventories. Not replenishing inventory is a short-term measure to improve cash flow because the company receives the proceeds from sales of existing inventory, but does not spend anything to restock.

These measures allowed larger companies to weather the recession fairly well, but it raised the unemployment rate and it drove some of the smaller suppliers to these companies out of business.

Usually recessions are discussed in terms of the Gross Domestic Product (GDP). Let us now take a look at how company cash flows relate to the GDP.

Gross Domestic Product

The recession officially began at the start of 2008. Using annual inflation-adjusted numbers, we find that 2008 had GDP growth of 0.4% and 2009 had a GPD decline of 2.4%. Over the same period of time the unemployment rate jumped from 4.8% to 10.2%.

Were we flirting with another Great Depression? The answer has to be an emphatic No! Compare the 2009 drop in GDP to declines of 8.6%, 6.5%, 13.1% and 1.3% in 1930, 1931, 1932, and 1933. The same picture emerges if we look at it in terms of unemployment: The current rate of 10% is far lower than the 25% that prevailed during the Depression.

The largest contribution to the GDP is Personal Consumption. It declined 0.2% in 2008 and 0.6% in 2009. This hardly amounts to consumers snapping their wallets shut, but because consumer spending is such a large part of the GDP, this decline corresponds to a nearly $8 billion drop in spending from 2007 to 2009.

Private Investments are another large component of the GDP. The main contributions to this GDP component come from companies’ investments into fixed assets, real estate, equipment, software and inventories. Private investments declined 7.3% and 23.5% in 2008 and 2009. These declines reflect companies’ decisions not to replenish inventories and not to invest into new equipment, factories, etc. Even though Private Investments are a much smaller contribution to the GDP than Personal Consumption, they were responsible for a $62.3 billion drop in GDP from 2007 to 2009. In dollar terms, Private Investments declined nearly 8 times as much as Personal Consumption.

As we pointed out above, companies deplete their inventories to improve their cash position. This accounted for about $13 billion of the GDP decline due to Private Investments. This is a great short-term solution in difficult times, but businesses eventually need to buy more inventory in order to be able to make sales. Unlike investments into IT or infrastructure, which can be postponed for a long time, restocking the shelves has to happen before all current inventory is sold.

Restocking inventory is certain to boost GDP numbers for a few quarters. It remains to be seen how long it will take for a more sustainable recovery of long-term business investments to materialize.

The final large contribution to the GDP is Government Spending. If Government Spending had lessened the severity of the recession, we would see it in this GDP contribution. Government Spending did rise in 2008 (3.1%) and again in 2009 (1.9%), which adds up to a $12 billion increase from 2007 to 2009.

However, about $8.3 billion of the increase was due to spending on defense. The various government bailouts and assistance programs did very little to affect the GDP, contributing only a modest amount of the $3.6 billion increase in Federal non-defense spending.

The only material new government contribution to the GDP was from the “American Recovery and Reinvestment Act,” a program that used government funds for health care, infrastructure, education, and direct assistance to individuals. The “Cash for Clunkers” program also contributed a relatively insignificant amount to the GDP.

The lion’s share of the government commitments and spending went to the financial sector and the mortgage industry. The Troubled Assets Relief Program (TARP), among other programs, injected about $1 trillion of government money into the mortgage industry, primarily through Fannie Mae and Freddie Mac.

About the same amount has been used to aid the financial sector through equity purchases, loans, debt purchases, and debt guarantees. The total cost of these bailouts currently stands at about $4 trillion, or 29% of GDP.

A functioning financial system is extremely valuable even if rescuing it drives up the national debt. Programs that prevent bank runs, such as the increase in FDIC insurance and the bailout of money market funds, are relatively inexpensive and go a long way towards keeping the system functional. Bailing out the mortgage giants Fannie Mae and Freddie Mac, AIG, and various others rewards poor management, transfers the cost of mistakes from the shareholders to the tax payer, and balloons the National Debt. All of this will most likely turn out to be seriously detrimental to the long-term health of the US economy.

Conclusion

Much of the media coverage of the recent recession focused on dramatic headlines such as over 50% declines in earnings at many companies, comparisons to the Great Depression, the idea that consumer spending will disappear, and similar stories. This article attempts to provide a more fact-driven analysis.

We took a closer look at the financial health of certain companies, sectors, and the stock market as a whole to discover that many companies weathered the recession fairly well by laying off workforce, reducing inventory, and other cash-conserving measures. We found that the drastic declines in earnings are largely due to writing down the value of assets. As a result of conservative and proactive planning, most of the larger companies in the US continued to make money at their core business throughout the recession. There was never a material risk of widespread bankruptcies or any indication of a catastrophic business slowdown. There is no doubt that there was, and still is, a difficult business environment, but reports that the US economy stepped off a cliff are not supported by the available data.

Next we dissected the Gross Domestic Product to see how it corresponds to the findings above. We discovered that consumer spending actually held up fairly well during the recession, but that investments by businesses and individuals slowed down dramatically. The latter matches our findings that companies reduced inventories and delayed investments to shore up their cash position. The reduction in Private Investments was the largest contribution to the GDP decline of 2.4% in 2009. Although exaggerated media reports would have us believe otherwise, the decrease in consumer spending was a very distant second.

Government bailouts of failing companies such as AIG, Fannie Mae, and Freddie Mac increased the national debt to unsustainable levels. Nevertheless, the net contribution to the GDP from the government’s crisis response was fairly insignificant, because most of the spending went towards bailouts that did nothing to boost the GDP.

The government can be credited with keeping the banking system from locking up, but whatever economic recovery is taking place is not driven by direct government spending. It is the result of companies and individuals, who successfully weathered the storm on their own, or successfully enriched themselves at the taxpayer’s expense by taking advantage of the bailouts, emerging from their hiding places.