$100 Billion Goes Poof!

Why companies' shrinking net worth could hurt cash flow and raise borrowing costs

The hits just keep on coming. In the seven months since Enron collapsed, dozens of companies, from General Motors (GM ) to AOL Time Warner (AOL ), have confessed that they're worth far less than their books showed. Sometimes that's because assets are now worth a fraction of what companies paid a few years ago. In other cases, pension liabilities are soaring because of investment losses.

Either way, shareholder equity--a company's assets minus its liabilities--is shrinking dramatically. Some 154 companies in the Standard & Poor's 500-stock index lost $104 billion of net worth in the first quarter alone, according to S&P. Bear, Stearns & Co. says that more than 500 listed companies will have to write down acquisitions. For at least 14, the tab will be $1 billion or more.

The devastating numbers reflect the damage the bear market has wrought to corporate finances. After AOL's January, 2002, disclosure that a $54 billion cut in the value of Time Warner had slashed shareholder equity by a third, the stock fell for four months--though it had already halved before the announcement. Gemstar-TV Guide International Inc. expects to slash its assets by about $5 billion, or two-thirds of its net worth.

Worse may be in store. The Financial Accounting Standards Board plans to issue new draft rules soon to get more off-balance-sheet activities onto company books. That's sure to turn up more debt than assets, increasing the leverage of companies and making equity look even punier. Rating agencies may downgrade companies when debts they didn't know about show up--raising borrowing costs.

Some shareholder-equity cuts will drain cash from companies. Underfunded pension liabilities siphon off investment money and distract management from other tasks. Consider General Motors Corp. Because its U.S. pension-plan investments fell 14%--to $67 billion as of Dec. 31, 2001--it had to slash equity by one-third, or $9.6 billion. GM made a $2 billion makeup payment earlier this year--nearly half the proceeds of new bond issues. And it will have to fork over more cash, unless returns on its fund rise dramatically.

Other companies are in the same pickle. UAL Corp. (UAL ) and Caterpillar Inc. (CAT ) had to subtract 5% and 3%, respectively, from their shareholder equity last year. "If stock market returns don't improve, there are going to be a lot more hits like these," says actuary Adrien R. LaBombarde of pension consultants Milliman USA Inc.

Pension woes could produce some nasty surprises, since most shareholders have paid scant attention to the issue. The accounting involved can be confusing because three different sets of rules apply. For instance, GM didn't have to trim reported earnings even though it paid out cash to bolster the pension fund. The equity cut just showed up as a balance-sheet item.

Asset writedowns like AOL's have little direct impact on a business. They're making headlines because of new rules that make companies account more frequently for changes in goodwill--the premium paid for companies over what they were really worth. But they don't affect cash. "A goodwill charge is [only] a reflection that in the past you overpaid," says Bear Stearns analyst Janet Pegg.

Shrinking shareholder equity does mean that companies' debt-to-equity ratios will get worse. That gives lenders a potential cudgel to beat them with, as most loan agreements have covenants requiring minimum ratios. Still, if goodwill is the only issue, most lenders will change the covenants. Aetna Inc. (AET ) negotiated with J.P. Morgan Chase & Co. to trim its shareholder equity requirement ahead of a $3 billion markdown. "Your lender usually has more interest in your being alive than dead," says Jack Ciesielski, publisher of The Analysts' Accounting Observer.

Already shareholders were feeling low over portfolio losses. The erosion of corporate balance sheets knocks them down again. It's the next verse of the bear market blues.

By David Henry in New York, with David Welch in Detroit

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