Witch Hunt

I’ve written about this before, but since the issue won’t seem to go away I can’t help but expound further on this opportunistic move by some in congress to attack “wild” profits by big oil.

This is the most disingenuous, opportunistic attack on American business by the United States congress in years. This is motivated by politicians looking to curry favor with people who either can’t understand, or have not taken time to understand the implications of what they propose.

In 2005, Exxon Mobil made a profit of $36.130 billion dollars, the “largest” profit in U.S. history. In fact, this profit is so large that it is bigger that according to Fortune it is larger than the profits of the next four companies on the list combined! No one is denying that’s a lot of money, but the argument of many Senators and Congressman only focuses on that single number by itself. Anyone who has attended business school (and paid attention) understands that a net income number by itself is meaningless. Without further information you can’t compare this net income number to any other company’s earnings with any meaning. This makes the description, “the largest profit in U.S. history” totally fallacious. The real question is “how much invested capital did it take to make that $36 billion in profit?” Without answering that question there can be no comparing bit oils profit.

Anyone who has taken a basic accounting class understands that investors and managers have a whole host of different ratios that help them compare one business to another. Return on equity is an investor’s measure that helps you evaluate an investments potential. Return on assets is a measure of management’s ability to create value given all of their available assets, equity and debt. The most common measure of profitability used to compare companies’ profits is profit margin or net income divided by revenue. Profit margin is most useful when comparing companies in the same industry – that is, given similar market circumstances, which company is best using it’s assets to produce profits. In this way, you can compare a very large oil company like Exxon Mobil (339 billion in sales) with a smaller petroleum refining company like Holly (3.2 billion in sales) to see which one is a better operator in its industry (Exxon wins this round with 11% profit margin versus Holly’s 5%).

Measuring profit margin’s across industries has less value when measuring cross industry. However, when looking to measure a purely theoretical question like “who is the most profitable company in the world?” it is a far more pure and better measure than a flat net income number. The flat income number is just a number, profit margin actually conveys real information.

So in that vein, how profitable is Exxon Mobile. For fiscal year 2005 the company posted earnings as we said of $36 billion dollars on over $339 billion dollars in sales, producing a profit margin of 11%. Let’s stop there for a second. This is a fantastic feat. It should take a up a separate post, but Exxon Mobile’s management deserve all of the high compensation retirement packages they earned. Managing such a vast enterprise that produces $339 billion in sales is a monumental task (it’s “harder” to grow a large company than a very small one, especially in a mature industry). Managing it for a double digit profit is something to be applauded. However, as profit margins go, that is “most profitable company as a percentage of their sales,” there are hundreds of companies more profitable than Exxon Mobil.

Flipping through the April 17th issue of Fortune, including the annual Fortune 500 list unearths tons of companies with higher profit margins than Exxon Mobile. An excellent example is banking. Of the thirty companies in the Fortune 500 in category of Commercial banking how many do you suppose are more profitable than Exxon Mobil? The answer is, twenty-eight. Two companies have the same 11% profit margin as Exxon Mobil, all the rest have profit margins ranging from 13% (Commerce Bancorp) all the way up to 27% (North Fork Bancorp). Where’s congress? Shouldn’t we be taxing these “unfair” profits?

Okay, so maybe that’s a bad category. Let’s go to a different category. Computer software. Of the ten companies in the Fortune 500 from this category, how many are more profitable than Exxon Mobil? The answer is seven. Microsoft takes the lead with a 2005 profit margin of 31% (nice work if you can get it).

The list of companies with a higher profit margin than Exxon Mobil goes on and on. McDonald’s 13%. Plum Creek Timber 22% (obscure, I know). Illinois Tool Works 12% (should we protest?) Verisign 24%. FM Global 20%. Google, cute, cuddly Google – 24%!

The bottom line is that Washington D.C. hacks need to immediately stop demonizing business in the United States of America. There are most definitely “bad guys” in big business, ala Enron that need to be watched. Government absolutely should play a role. However, too often in this country legislators choose to make business (and big business in particular) into the bad guys. Large enterprise in this country is the “engine of democracy.” It is the back bone of this country. It employs our citizens, provides investment opportunity for millions (think of your 401k and your dad’s pension), and generates revenue from which all taxes direct or indirect are derived.

The most ironic part of this whole laughable suggestion by congress that big business is gouging the people is that it’s in fact congress that is gouging us. They’re like the “good” Samaritan that tells you someone stole your wallet, wall pick pocketing your car keys. If congress wants to bring down the price of gasoline and stop price gouging, consider cutting gas taxes, which the U.S. gets revenues estimated to be twice the size of the profit that big oil is making from each gallon of gas.

The Smartest Rats in the Room

I finished reading Bethany McLean and Peter Elkind’s account of the collapse of Enron, “The Smartest Guys in the Room – The Amazing Rise and Scandalous Fall of Enron,” last fall. So I was really interested to see the documentary based on the book, “Enron, The Smartest Guys in the Room.” The book is a great read for those that like a business story ala “Barbarians at the Gate,” or “Den of Thieves.” The authors bring you back to the go go 90’s feeling at Enron, and give you a good sense for the various characters involved. The book and documentary together are a great one-two punch, they make this tragic story come alive.

At it’s biggest point, Enron was the United State’s seventh largest company, with a market cap of over seventy billion dollars. Enron’s descent into accounting fraud began in the 1990s when the company won an okay from it’s auditors to use a type of accounting known as “Mark to market.” Essentially, this type of accounting allows for the booking of _potential_ future profits as earnings on a current income statement. That means that when Enron won a large, long term deal it could recognized the future estimated worth of the deal to Enron. While allowable under GAAP for certain types of business, mark to market was a wholly inadequate form of reporting to give shareholders insight into Enron’s business. The company quickly became addicted to this extremely subjective form of revenue recognition, setting the stage for future, much more egregious blurring of the accounting lines.

I think it was useful to read both the book and see the documentary, though I found the two diverging at points. Certainly each takes a “point of view” of either the authors or the director/producers. While they mostly follow the same path, in fact, Bethany McLean the book’s co-author is interviewed throughout the film, the documentary diverges in spots.

One path the documentary goes down that I did not remember so much in the book was the insinuation that the Bush family is in Ken Lay and Enron’s back pocket. While I don’t remember that from the book, the guilt-by-association is blatant in the documentary. It may be true that the Bush’s gave improper favors to Enron or Lay, but the documentary doesn’t come out and say that, and certainly offers no proof of any sort. In merely insinuates. It’s a curious inclusion in what otherwise stacks up as a credible indictment of Enron’s senior executives.

The other topic I found to be somewhat non-genuine was the “rank and yank” example of Enron as a really tough culture to work in. I’m sure Enron was a macho/tough culture, “Guys with Spikes” as they put it, and I’m sure they did in fact use a tough 1 to 5 ranking system where they fired or moved out the bottom 15% of performers. What struck me as funny I guess is that the company best known for “rank and yank” (a pejorative term for philosophy that has very pragmatic and humanistic reasons associated with it) is one of the business world’s most respected, General Electric. Of course, the way the system is applied has a lot to do with the what you get out of it, and it does sound as though its practitioners at Enron were, well…bastards.

One of the best pieces of watching the documentary after having read the book are the actual recordings of various Enron players. On one infamous earnings call, after the deterioration of Enron had begun, an analyst presses CEO Jeff Skilling on Enron’s inability to produce a balance sheet at the same time it published its income statement. Skilling, the CEO of the seventh largest company in the U.S. (though at that time it may have fallen some), is heard clearly on the line calling the guy an “Asshole.” This unprofessional behavior was just one of many new signs that Enron was not what it appeared to be. In other recordings, you hear energy traders at Enron actively (and perhaps illegally) manipulating California’s deregulated electric grid- adding to California’s rolling black outs.

At any rate, I highly recommend both the book and the documentary. The two together give a great overview of what happened at Enron. The book and the film give great insight into the people that were responsible for Enron’s fall (Lay, Skilling, Fastow, and a host of others), as well as the intricacies of some of their misdeeds. The descriptions of how Andy Fastow, Enron’s CFO, used Special Purpose Entities to manage and twist Enron’s earnings, and at the same time get himself rich, is eye opening. After reading these sections alone you can’t help but think that Fastow’s plea bargain, getting himself only ten years in prison, was criminal in of itself.

It will be interesting to see how things play out in the Ken Lay/Jeff Skilling trial. While the news accounts certainly draw out and paints these top level characters as the bad guys, the book unearths not just them but the system of interlaced people, investment banks, corporations, accounting firms, and lawyers that all failed, and all contributed to this catastrophe.

The Fog of War

“Every Military commander who is honest to himself will admit that he has made mistakes with the application of military power that has resulted in needless deaths.”
-Robert S. McNamara

You have to hope that your leaders are the type of people who at times take time to step back and reflect on their policies and their actions. A great Saturday afternoon “time out” activity for George W. Bush and Don Rumsfeld would be to sit down and watch the documentary, “The Fog of War: Eleven Lessons from the life of Robert S. McNamara.”

For seven years in the 1960s Robert Strange McNamara served as the United States Secretary of Defense. Weeks after starting as the first outside-the-family President of Ford Motor company, President Kennedy appointed McNamara as Secretary of Defense, despite McNamara’s uncertainty whether he was qualified for the job. Serving first under Kennedy, and then under Lyndon Johnson, McNamara held the office during a time that, as McNamara puts it, “on three different occasions we came within a hairs breath of nuclear war with the U.S.S.R.”

This film is interesting in that McNamara, eighty-five at the time of the filming, reflects and shares with us what he’s learned from his experience as a war fighter. McNamara lists eleven “lessons” he’s taken away these experiences, and the film fills out the background that has lead him to these insights.

The film leads us from McNamara’s WWII experience, to the Cuban missile crisis, and to the events that led to the United States’ entry and eventual escalation of the Vietnam war. What comes out is sobering parade of human miscalculations and brutality. In WWII, McNamara served in the Air Force’s statistical air corps. From there he analyzed the efficiency of delivered force against Japanese targets, specifically the fire bombing of Japan. He sites the example of 100,000 Japanese civilians killed in a single night as a result of fire bombing and questions the morality of this decision (That was just one night, the segment on 67 Japanese cities and the percentages of them that burned is scary). Is that okay in war? Was it the right thing to do in order to fight the war? McNamara points out that if the United States had lost, General Curtis Lemay who made the firebombing decision and himself would certainly have been tried as war criminals by the Japanese. In the film McNamara ponders, what makes it moral if we win, but immoral if we’d lost.

Near the start of the film McNamara takes us through the Cuban missile crisis and his revelations in the 1990s when he actually met with Castro to discuss the crisis. He asked Castro – did you know the missiles were there? If so, would you have told Kruschev to use them, and if you would, what do you think would have happened? I won’t spoil it, but it we came closer to nuclear war than we even knew. McNamara’s point is that Kennedy, Kruschev, and Castro were all very rational men, but still we came so close to madness.

The film is fascinating. It has many interesting side anecdotes about JFK and LBJ. McNamara was actually the person who walked the ground of Arlington Cemetery, found the most beautiful spot, and proposed it to Jackie Kennedy as the spot to bury JFK.

The piece I think would be most interesting for George W. and Don Rumsfeld to ponder was near the end. McNamara believes that as the lone super power the United States should never apply its force unilaterally, “if we can’t persuade nations with common values of our case, we should re-examine our reasoning.” McNamara was talking about Vietnam, but clearly this question has meaning today (incidentally, the U.S. is not applying force in Iraq unilaterally, but certainly it could (and is) be debated if the degree to which it has multi-lateral support satisfies McNamara’s suggestion.

Where McNamara clearly had the most impact and of course what he is most known for is the U.S. escalation and execution of the Vietnam war. It is his belief that had JFK lived we would have gotten out far sooner, and that Johnson held the responsibility for the escalation – though he paints LBJ in a sympathetic light. The film, and actual recordings illustrate the clear hesitation, and conflict these two men had around escalation the war to include significant ground troops.

In the end we have some very interesting lessons, but even McNamara leaves us without an “answer.” He is not so naïve to think we’ll just end all war. His sum up of the film is where it gets its name. He describes the term “Fog of war” and what it means to him. Essentially that a war is so complex that it is beyond the capability of any person to understand all of the variants, and the result as that we as humans needlessly kill people. “It isn’t that we aren’t rational, we are, but reason has limits.”