William Dunk's 2003 Annual Report On Annual Reports
The Shock of Recognition and
the Uncertainty Principle
“Thanks for weathering the economic storms of 2001-2002 with us. We’re grateful for your loyalty. When you need this poncho, remember that stormy weather never lasts forever.”
Herman Miller, the office furniture company, attached a poncho along with this inscription to its 2002 Annual Report. Its cover looks like a very disturbed, computer-generated weather map, just in from a TV meteorologist. Miller sales in 2002 declined 34.3%.
That about sums up the 2002 batch of annual reports—an economy, as Miller says, that was “buffeted by a powerful storm,” and lots of businessmen looking for glimmers of light. A very resolute band of optimists tell us sunshine and recovery are just around the corner, although the rebound keeps getting postponed. Despite this wishfulness, the storms and the rain continue into 2003, with manufacturing still floundering, a host of troublesome earnings reports, and unemployment still rising. “For the past two quarters,” says the Wall Street Journal, “the U.S. economy grew at an annual rate no better than 1.75%, so slowly that unemployment kept rising.” Whether you are watching MSNBC or listening, between the lines, to economists and business leaders, a doleful “uncertainty” fills your ears.
In fact, after some years of drought, we are now getting a record rainfall throughout the Eastern United States, a literary accompaniment (called the pathetic fallacy) to the insecure mood on the human stage. As we began working on this report, Tropical Storm Bill was having a field day in Louisiana, and the weather map showed plenty of green (for rain) up and down the coast. This has made us hope that Herman Miller, with its poncho, is really announcing a move into raingear, since there’s no telling when furniture will stage a real comeback.
The uncertainty of which we speak finds its roots in many factors, not one. Despite the re-inflation of stock prices and the profits of some money center banks since March because of robust rate cuts by the Fed and a little firming of oil prices, the economy is still lousy. Two of the world’s leading economies, Germany and Japan, are caught up in deflation. Stephen Roach, lead economist at Morgan Stanley, thinks the U.S. is probably headed the same way, although the ebullient Jim Smith, the most interesting economist at the University of North Carolina (he’s at the business school), assures us it will never happen. The recession of 2001 is officially come and gone, and a few indicators are strengthening. But nobody is uncorking the champagne bottles yet, and the sideways economy is only perplexing to those who are spending real money and want to know if things are really going up or down. We are caught in a grey, indecisive period of inertia typical of a prolonged stretch of economic stagnation. This is stagpression instead of stagflation, and Uncle Greenspan is still very worried. With the three principal economic powers of the world in a tailspin, it’s hard to know what will drive a global recovery. As Choicepoint says plaintively on its cover, “Remember when the world was a safer place?”
Uncertainty about the economy and the stock market is amply reflected in the Sage of Omaha’s annual report for Berkshire Hathaway, where he announces that “the portion of our assets committed to common stocks has significantly declined. This change, of course, helps our relative performance in down markets such as we had in 2002.” Could it be that Mr. Buffett is even betting we’re in for a few more bad years in the capital markets?
He has, in fact, gotten into the junk bond business. He and several others who have to deploy large amounts of capital have been forced to go to low-end investments in order to find prices that are proportionate to risk, or, as we would say, to hide in safe ports for the duration of the current storm. “Overall,” says the Berkshire CEO, “our commitments in this sector sextupled, reaching $8.3 billion by yearend.” And that ain’t chickenfeed, even for Berkshire. Alternative investments have become the trend du jour (against which the Sage has not been inoculated) because all the main investing arenas present us with certain uncertainty. Aggressive, adventurous investors looking for better returns will focus more in 2003 on selective investments that are not the standard fare where we place our bets in normal times.
Buffetted like the rest of us, Berkshire’s Chairman has also made another big-time change worth noting. He did away with the baseball game at his annual meeting, which was certainly its highlight. “After my fastball was clocked at 5 mph last year, I decided to hang up my spikes.” Probably he was afraid he would get rained out. Maybe, too, this means the sun is setting on baseball in America, now that a few financially powerful teams have taken a lot of the spirit out of the sport.
There’s no end in sight for the downturn. Moreover, those companies that flourish when good times roll again may not be the giants of yesteryear. The recession that began in Clinton’s last years in office is different than those that have come before, which is why monetary and fiscal stimuli are not bringing us out of it. The best of the Wall Street financial newsletter writers—Ray DeVoe of Legg, Mason—says we have created all sorts of excess capacity in the run-up to 2000, and it has to be worked off one way or another. That, combined with a number of asset bubbles that have yet to be pricked, means that much has to be righted before we recover. Excess capacity exists in most of the industries that formed the backbone of America.
In other words, it’s a whole new ball game, and it’s just as well that Mr. Buffett shut his own game down. For instance, it looks like we have hollowed out a lot of our industry and sent it packing to China (the world’s growth dynamo) and other places. Progressively, the American economy is becoming a huge distribution machine, and the companies that have mastered all aspects of getting things from here to there at a reasonable price are becoming the new mandarins. Arguably the nation’s (and maybe the world’s) most important company is Walmart, which barreled its way to record profits of $8 billion in its last fiscal year, largely based on its supreme mastery of supply chain management, troubled only by less than spectacular relationships with some of the communities it serves. Likewise, Southwest Airlines, Dell Computer, and Lowe’s each have had good things to tell shareholders through this downturn. In the New American Economy, we can expect to see distribution companies (broadly defined) that have built a radically different distribution model than their peers (e.g. Dell’s build-to-mail-order, Southwest point-to-point 737 service) turn in good performances even though they depend on a middle class which has an eroding real income. Conservative investors will be focusing on these clever fellows who have built a superior distribution scheme.
What this suggests, and what has gone largely unnoticed, is that business has turned the corner post 2000 and begun to realize it really needs a new idea. What has happened is that everybody really requires a new strategy and, incidentally, every middle manager probably has to figure out a second career. In our 2002 Annual Report on Annual Reports, we said “reports do show most company leaders to be without a ‘great idea.’” Basically, they were still doing the same cost-cutting to survive that they had been doing for 15 years. Now strategy is breaking out all over. It’s the signal development in this year’s crop of reports, though subdued enough that it’s been missed by journalists, businesspeople, etc. A few companies—such as Barrick Gold in Canada and Wolford in Austria—still look to expense control to turn things around, occasionally firing a chief executive who can’t get enough slashing done. And yet, for the first time in years, strategy is back in the saddle.
For example, Jack in the Box, Inc., which has put forward reasonably eye-catching, out-of-the-box reports for several years, calls its current report “Jack’s Illustrated Plan.” Jack plans to broaden its menu, franchise more, and reduce building costs, having found “the old rules … no longer apply,” particularly as it feels the hot breath of casual dining restaurants at its heels. Jack in the Box vividly presents both the changed economics of its industry and its sharp response to the new realities.
Others are also making a decisive shift, even if they declare it less dramatically. In fact, investors may now choose to avoid companies that have not added a totally new business area or vastly changed the way they operate their traditional business. Walmart has been hard at work becoming the nation’s grocer, having added “192 Supercenters” last year. Education, as seen in 2002 reports, has become the key business for two media companies, the Washington Post and Pearson in Great Britain. Altria, dropping its Philip Morris name, is trying very hard to be anything but a domestic tobacco company, reworking itself into an international purveyor of packaged brands. Le Chateau, a clothing chain in Canada, is striving to pry more sales out of less inventory, following the example of Zara in Spain.
Mr. Buffett looks like he is going to pour some money into the natural gas business. He has an 80.2% interest in Mid American Energy Holdings, which now will transport through its pipelines 8% of all gas used in the United States. Mid American also has both feet in the electricity business, another area where we can anticipate shortages. “Berkshire stands ready to inject massive amount of money into MEHC….”
In fact, this generally looks to be a good time for businesses and investments that are based on commodities. In his new book Adventure Capitalist, Jim Rogers opines that “Raw materials supply and demand are out of whack again, and inventories are down. Commodities will do well for years, while stocks, recovering from the bubble, will do little.” Things have sure changed in Mr. Rogers’ neighborhood. In other words, find commodities that are in short supply and bet long on them.
In some instances, the business transformation that is occurring appears to be a little more murky. GE’s President’s letter, always lengthy, promises that the management is doing everything under the sun to keep its magnificent earnings machine cranking out profits. Unapologetically, on the first page of the report, even before the letter, the Annual Report brags about being a conglomerate, crowing that “only one company—just one—delivers on all these things.” And GE certainly deals with a mixed bag of markets.
But one gathers that GE now will accent its manufacturing and services businesses, pulling back a bit from its dependence on GE Capital. Says Chairman Immelt and his three vice chairman, “We are taking the company to a place where few can follow … big, fundamental, high-technology infrastructure industries in which GE can have enormous competitive advantage.” If so, this would be a watershed event for GE, which, at its heart, has been a financial juggernaut for several years, light bulbs notwithstanding. Indeed, in 2002, revenues and earnings at General Electric Capital Services seem to be on hold, and the gains seem to be coming from the rest of the business. It turns out that GE will come up short on earnings for 2003.
Although we find GE’s 2002 report hazy and slightly worrisome as we struggle to divine where it is really laying its bets, the design of the report has improved, and its pictures and layout convey that it is a major force in a number of big scale markets. GE has never shined graphically, and it is ironic that it should now get some pictorial panache, just as other reports are slumping in this regard. At the same time, for instance, Herman Miller’s annual report, usually graphically innovative, looks straitened, perhaps feeling the weight of the company’s several business burdens. We suspect, this year, that GE has conveyed more graphically than it has verbally, and Miller has done quite the reverse.
For graphic smarts, one increasingly looks abroad, as America falls by the wayside. Fiskars celebrates design and its chief designer in its annual report. It’s worth examining Wolford 2002, an Austrian lingerie and legware house. It features a bevy of beauties wearing its wares who outshine those on display in Playboy or American couture reports. As importantly, Wolford uses a host of financial charts throughout to tell its story. On page 11, for instance, you can see Wolford’s average prices per unit dating back to 1950, learning how prices really ratcheted upwards in the 90s, only to slow in the new century. A chart like this tells you the whole financial history of Wolford.
We’ve long thought that a great annual report could feature 10 or 12 such long-term charts that would, at a glance, let the investor understand a company. (We call them “monster charts.”) This is important, as we will see below, because we suspect that reports have become less, not more revealing, in the new litigious regulatory disclosure climate that has emerged in response to the Enron debacle and the other excesses of the 90s.
As we grind through this recession, which seems to have no end, and launch new, unprecedented strategies in company after company, we seem to be caught up in a distracting sideshow called “better corporate governance” that is adding yet more to the confusion. The centerpiece of all the heightened commotion in disclosure is the Sarbanes-Oxley Act (also known to some wags as the Lawyer/Accountant Enrichment Act of 2002). It and the regulators have devised a host of procedures and penalties to make sure, hopefully, that companies don’t cook their books. As a result, officers and directors have become as much or more obsessed with staying out of the hoosegow as with running their companies and getting on with the business of the 21st century. A recent conference on corporate accounting at the Cato Institute suggests that companies are now even foregoing perfectly valid financial policies to avoid being painted with the Enron tar brush. On the Global Province (see www.globalprovince.com/bigideas.htm#122), we have cited Mr. William Baumol’s fear that risk averse behavior, stemming from terrorist attacks and other dire events, would cause economic stagnation. It is arguable that disclosure paranoia is having just that effect.
The unintended consequences of this unfortunate, if well intended, piece of legislation are too numerous and too disturbing to recount. Post-Sarbanes, it has become much more difficult for Wall Street researchers and others to get decent information about companies, as everybody has clammed up in this litigious atmosphere. Worthy businessmen are eschewing service on the boards of public companies. Extraneous, extra audits are being performed that add a mountain of accounting expense. A colleague points out that an increasing number of companies are going private (316 in 2002 according to Mergerstat), a result perhaps of some rather permanent damage to the public capital markets.
Worse yet, current accounting practices, with all their contradictions, are now being baked into the body of accepted regulation, although there is now a lengthy body of academic literature that shows how public accounting has become increasingly divorced from the internal realities of what really occurs inside a business. This cleavage only grows as intellectual capital has become as important as hard assets in both running and valuing an enterprise. Our bean counters don’t quite know how to measure knowledge enterprises. For the same reason, economic statistics are not giving us much of a window on the new dynamics of our economy. It is probably fair to say that our measurement systems have become dysfunctional.
The immediate thrust of the legislation has been to turn directors into cops to prevent fraud rather than into catalysts who can promote the vast strategic change that lies at the heart of corporate survival. Sadly, too, it does not really address the interesting question of the broader relationship corporations have with society. For 25 years, we have thought of the corporation only as an instrument for creating “shareholder value,” and yet it is so central to our society that it needs a richer definition. In reality, the Sarbanes-Oxley Act only dealt with its shareholder obligations.
In 1927 the German physicist Werner Eisenberg enunciated the Uncertainty Principle. In the quantum world, he more or less said, the process of measurement hopelessly distorts the phenomenon being measured. Reports 2002, under the strictures of this new disclosure atmosphere, suffer much the same fate. The reports abound in detail yet do not clearly come to grips with a changed world where companies can sense the ground shifting under them. We are not obtaining transparency, at least on the issues that matter, and so, if anything, find that things are becoming more opaque.
For that reason, you may have missed the broad strategy revolution that is only implicit in most reports, since the discussion is often short, and frequently muddy. There are, however, discourses ad nauseam about corporate governance that shed little light on whether the company is well governed. Warren Buffett offers 5½ pages on governance and accounting, taxing all boards to watch executive compensation, nix bad acquisitions, throw out bad CEOs, achieve genuine independence, etc. He is quite candid about the weak governance at most companies, but he appears to have a narrow view of the duties of board members and of the compact between companies and society. His report also includes, by the way, a long discussion on derivatives, a huge financial timebomb waiting to go off (at least in our opinion and his) and a peril, like options, that is not being addressed.
Walmart has a special letter from its Board Chairman Rob Walton that goes through the mechanics of how well its board governs. It does not mention, incidentally, 3 governance proposals before the shareholders, two of which gained a surprisingly large 22% of the votes cast, hinting perhaps that shareholders other than the Waltons feel that their interests may not be well represented. Other companies have also provided ritualistic sections testifying to their uprightness.
It’s not just that reports dwell too much on governance, too little on strategy. Other things contribute to the opacity. The numbers have gotten more confusing than ever. The Washington Post Company talks happily (and justifiably, by the way) about a great 2002, yet its earnings are down 24% from 2001. As it turns out, the 2001 numbers were inflated by some asset exchanges it made in its cable operations.
Likewise, DuPont also reported a great year but lost $1.1 billion versus its earnings of almost $4.3 billion in the previous year. As it happens, it sold its pharmaceutical business in 2001, which dressed up the numbers. An accounting change also pulled down 2002 results. Loss and all, Chairman Halliday is able to chortle about great cash flow, and a performance that put it at the top of the chemical industry. Audits aside, companies are finding it harder year after year to produce comparable numbers for the last 2 fiscal periods where the investor can be sure he is seeing apples and apples, oranges and oranges. This is not transparency.
Amidst this uncertainty, the smartest, biggest companies have discovered a new way of demonstrating that they are coming clean and that they have confidence throughout the storm. They’re owning up to their bloopers, sporting a “mea culpa” attitude that helps refute critics who rail about corporate arrogance.
For instance, Warren Buffett admits to mismanaging General Re, where he, and apparently his management, did not know what was going on. “Gen Re’s culture and practices has substantially changed and unbeknownst to management—and to me—the company was grossly mispricing its current business.”
Similarly, GE had serious troubles with one of its major insurance units, where over-ambitious growth plans undermined its underwriting standards. “We pride ourselves on having sound strategy and strong operating accountability. A GE business can briefly get out of balance strategically or operationally, but rarely do we get both wrong at the same time. We did both at ERC.” At major companies, it’s not just outside investors, but also top managers, who often cannot tell what’s going on, for their periscopes are not permitting them to see the workings of their company or to understand the re-alignment of large sections of our economy.
Even the Walmart steamroller has had some of the same problems. Its SAM’s division has been substandard for a while, and chief executive Lee Scott has admitted to a few failings. “Speaking of SAM’s Club, it is important for you to know we are not pleased with its performance in 2002. Today we have a new management team in place that is energized and refocused on the basics of the Club business. Satisfying the need of the business member is a renewed priority….” When we ourselves look at the stores, we find there are glitches in both product selection and convenience that would be remedied if the store had better merchandisers. Walmart runs the back of store better than it runs the front.
Towards the end of June, Vorwerk, a wonderful company in Germany that deals in everything from carpets to financial services, finally forwarded its English language version of its annual report to us. It was worth waiting for. Vorwerk is yet another example of a growing trend: Foreign companies are overtaking the U.S. in annual reporting, producing more imaginative and hence more revealing documents for our perusal. This may be the world’s most elegant annual report.
Vorwerk had a good year, both because its direct sales model has worked out so well and because it has become so dramatically global, operating successfully in Europe, North America, and Asia. It’s now in 52 countries with 57% of its revenues coming from international sales.
As interesting to this reader is the terribly relevant theme Vorwerk establishes each year in its annual report. This year it focused on truth and lying. Among the aphorisms in the report is a quote from Karl Heinrich Waggerl: “A half-truth is never half a whole truth.” Certainly the 2002 reports that seek to comply fully with generally outmoded accounting principles built for the last century only confuse matters more, for they portray half truths. More interesting, as we see above, are reports that spell out big problems and, in the best cases, tell us what is to be done about them. That’s especially pertinent in the troubled business environment we are now experiencing.
Further along in the same report is a page that one can barely decipher until one dons the special eyeglasses provided with the report. Then, you read: “Could the truth be that you need glasses?”
That’s what we may best learn from the 2002 reports. To deal with uncertainty—a troubled economy, uncharted strategies, and very muddled disclosure—you need extreme eyesight to tell you what’s going on.
That is, we need psychic glasses that permit us to experience “the shock of recognition.” This term seems to have been first used by Herman Melville in the nineteenth century to describe the awakening he experienced when he first encountered Nathaniel Hawthorne and felt himself in the presence of luminous genius. Melville was aware of meeting something he had never seen or felt before.
Annual reports 2003, if read carefully, indicate we’ve met a rude, new economy that demands strategic responses the like of which we have never imagined before. Yet, most days, we find the great mass of leaders in most segments of society acting as if the same old rules apply. Even though many are shifting strategy, they have not yet revamped their day-to-day operating tactics. They require the “shock of recognition” that will permit them to grasp that their world is suffering from global wrenching, and they must change everything in their small piece of it if they are to render economic value.
Companies Mentioned in the Report
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