When Deutsche Bank co-chief executive John Cryan began to speak, journalists could hardly believe their ears.
“I feel responsible for, basically, a €7 billion loss. Personally responsible for all of it,” the British-born banker deadpanned during a late-January press conference in Frankfurt, where Deutsche Bank divulged its record loss for 2015.
Mr. Cryan, who has led the bank together with Jürgen Fitschen only since July, underscored his deep dismay by taking all the blame for Deutsche Bank’s doom and gloom.
“It’s not someone else’s fault.”
Saddled with a massive €5.8 billion ($6.4 billion) write down on goodwill impairments – assets that are unrealistically overvalued – Germany’s largest bank was forced to slash 9,000 jobs and shutter more than 200 branches.
Balance sheet cosmetics never help companies in a lasting way; just one to two years at best. Thomas Harms, Partner, EY
A large portion of the write down traces back to Deutsche Bank’s purchase of German retail specialist Postbank for €6.4 billion amid the bursting bubbles of the 2008 financial crisis. After years of wishful thinking, Deutsche Bank has cut the value of the subsidiary – which it is desperately seeking to unload – to about €4 billion.
But that’s still much too high, say insiders.
Deutsche Bank is an especially grave case. But it is far from the only corporation to game the book value of its assets for short-term share-price gains – and subsequently slapped with a hefty price tag.
In Germany’s corporate corridors of power today, the books are being cooked as if there’s no tomorrow.
Unwanted burdens are expunged from balance sheets and retirement obligations pushed into the distant future, or simply reinterpreted with a company-friendly data narrative. Costs are buried, special items are hushed up and equity capital is embellished by dubious methods.
While sometimes walking a fine legal line, such practices in most cases serve to prop up share prices. But sometimes such balance sheet cosmetics are used to disguise ugly financial distress.
Air Berlin, Germany’s second-largest airline, is a case in point. After repeatedly posting blood-red financial results and negative equity capital, the cash-strapped carrier has faced insolvency several times. Yet, fueled by giveaway prices, it continues to fly.
Meanwhile, major investor Etihad Airways restocked Air Berlin’s depleted capital resources by buying convertible bonds to the tune of several hundred million euros. The trick: The bonds have no maturity date to convert into stocks. Instead, they count toward equity.
Bigger rival Lufthansa has pulled off its own clever financial maneuver. Thanks to a new method for writing down depreciated assets, its operating earnings jumped by €340 million in 2014 and by another €350 million in 2015. The trick: writing down airplanes after 20 years, instead of 12 years, as it had done previously. The practice – completely legal – artificially boosts its earnings.
For years, German retail group Metro, one of Europe’s largest, and department-store chain Karstadt sold real estate at inflated values only to rent them back at upscale prices. The trick: the special, one-time proceeds masked the retailer’s poor operative business for years.
All of these examples are legal, unlike the criminal betrayals and spectacular accounting scandals of Enron and Worldcom at the turn of the millennium.
To prevent such malfeasance, BaFin, Germany’s financial sector watchdog, has subjected publicly traded companies to additional external supervision since 2005. The external auditor examines their bookkeeping in detail. Bafin probes further when companies do not participate willingly or if they are not in agreement with the audit.
But the many legal tricks and tweaks companies use to scrub their balance sheets clean in the short term may still be dangerous over the long term, and financial watchdogs are sleeping on such issues.
Chief financial officers calibrate and cleanse their balance sheets to the point where professional investors and analysts, let alone private investors, cannot follow their creative accounting.
It all serves one purpose: to light up stock prices. The creativity in pursuit of this purpose knows almost no bounds. The problem, however, is that short-term thinking dominates long-term strategy.
When share prices start to dive, as happened to Deutsche Bank’s stock, number crunchers quickly jump into action and execute an abrupt 180-degree turn in company strategy. They let the past catch up and attempt to make a clean sweep of all inherited liabilities.
But one thing is certain, says Thomas Harms, a partner at financial advisory firm EY: “Balance sheet cosmetics never help companies in a lasting way; just one to two years at best.”
Ever popular are so-called pro-forma earnings exclusions such as write downs, goodwill, taxes, depreciation, amortization, restructuring costs and other items that impact the bottom line. Under the umbrella of arcane analytic indicators – EBIT, EBITDA, EBITDAR and EBITDARM – the creative accounting always follows the same guiding principle: generating more profit.
Economics professors Karlheinz Küting and Claus-Peter Weber proved years ago in an empirical study that the wave of financial data rises when profitability shrinks. But because there is no generally accepted accounting method for such projected earnings indicators – and because they often fail to create clarity for investors – numerous nicknames have emerged. Among them: earnings before bad stuff, or EBBS, and earnings excluding bad stuff, or EEBS.
An EY study, based on a survey of 3,800 chief financial officers and managers in legal departments, including 100 in Germany, indicates just how widespread such creative accounting practices are in corporate boardrooms today.
More than a third of German executives responding to the survey said they believe companies in Germany portray a rosier financial picture than exists in reality. Moreover, while all major companies have created guidelines for good corporate governance, only 23 percent of respondents held the ethical standards of their own companies in high regard.
As the Oracle of Omaha, Warren Buffett, once said, “At too many companies, the boss shoots the arrow of managerial performance and then hastily paints the bulls-eye around the spot where it lands.”
What seems at first like a curious game, however, often lands in a treacherous spiral. The incomprehensible jumble of figures obscures reality and drives up stock prices until eventually companies seek refuge in takeovers to mask their weaknesses – which pushes share prices still higher.
“Companies depend on growth because of the often high share-price valuation,” said Dirk Albersmeier, co-director of mergers and acquisitions in Europe for investment bank JP Morgan. “Whoever cannot fulfill these expectations must increasingly rely on intelligent takeovers.”
Otherwise, companies face the threat of takeover themselves.
Growth can never be the actual goal. The goal must always be higher profits. Anything else is wealth destruction. Thomas Körfgen, Director, Savills Investment Management
It is no wonder rumors thrive in this environment. Sometimes companies themselves, hoping to lift share prices, are behind them.
Last August, Reinhard Ploss, the head of German chipmaker Infineon, told the Financial Times he considered the company “more the consolidator” than the consolidated. “There is one risk,” he added. “We are busy in highly attractive markets. That is a strength but maybe we should be aware that people might be interested in Infineon because of that market position.”
Whether Mr. Ploss intended it or not, Infineon’s share price jumped 40 percent in the wake of the interview, boosting the company’s market valuation by €5 billion.
But poor timing in takeovers – such as in the boom years of 2014 and 2015 – can evaporate capital over time, even if market valuations rise in the short term. The problem is that takeovers last year and the year before cost companies more money than ever.
German pharmaceutical giant Merck, for instance, paid some €15 billion for laboratory equipment Sigma-Aldrich, while Bayer shelled out about €12 billion for Merck’s consumer health unit.
Times of exuberance might call for restraint, so that overly expensive takeovers do not have to be written down.
Engineering powerhouse Siemens offers a cautionary tale. The company acquired Texas-based oil and gas drilling equipment supplier Dresser-Rand in September 2014 – at the height of the U.S. shale boom and peaking global oil prices – for $7.8 billion.
While the price for entering the U.S. shale market at such a late stage of the game already seemed high at the time, the Dresser-Rand price tag appeared almost insane once oil and gas prices crashed over a matter of months.
The danger for investors of such an ill-timed acquisition is that the premium value paid for a company – goodwill – becomes an overvaluation that eventually must be written down. In accordance with accounting standards, companies undergo an annual goodwill impairment test to assure they have not artificially loaded their balance sheets with excessive goodwill valuations.
But goodwill is always an estimate that is subject to a strong temptation to err on the high side.
The most well-known German accounting expert, the late Karlheinz Küting, for years investigated the annual earnings of publicly traded companies for Handelsblatt. Time and again, he criticized companies’ excessive overstatement of goodwill.
He noted that companies, on average, assumed they would make use of an acquired asset for more than 200 years. But in reality, according to Mr. Küting, acquisitions provide use for only around 20 years. In the face of rapid technological change, his assessment still makes sense.
Another cautionary tale is that of Deutsche Telekom, which purchased U.S.-based mobile phone company Voicestream in 2000 – at the height of the dot-com bubble – for more than $50 billion. The mistake quickly caught up with the former German telecommunications monopolist as the bubble burst. Large write downs for the company – renamed T-Mobile – reached into the double-digit billions and torpedoed Deutsche Telekom’s balance sheet for years with large losses.
Ron Sommer, the Deutsche Telekom boss behind the deal, is not the only chief executive to create such headaches for his successors. Indeed, the list is long. There’s former Daimler chief executive Jürgen Schrempp, who overreached for Chrysler; former Deutsche Post head Klaus Zumwinkel, who went after British logistics company Exel and many companies from the U.S.; and former E.ON chief Wulf Bernotat, who went on an €11.5 billion shopping spree in Spain, Italy and France.
Measured in terms of profit, sales, share prices and billions of write downs, these chief executives would have been better off without such acquisitions.
“Growth can never be the actual goal,” cautioned Thomas Körfgen, director of asset management company Savills Investment Management. “The goal must always be higher profits. Anything else is wealth destruction.”
But the possibility of camouflaging overpriced acquisitions as goodwill in balance sheets leads to such excesses. That leaves new chief executives, such as Deutsche Bank’s John Cryan, to clean up the mess.
Silvia Rogler, an accounting professor at the University of Freiburg, reaches a sobering conclusion in an audit of 160 German companies: larger goodwill impairments almost always arise when there’s a change at the helm.
Top executives who refrain from blockbuster deals opt for easier ways to boost share prices.
That’s what Ulf Schnieder, head of German health care company Fresenius, did last year when weaker growth in China hit German businesses hard and shaved 10 percent off the company’s share price in just a few days.
Mr. Schneider reiterated his optimistic targets for the year, adding that he expected dividends to jump “significantly more than 20 percent.” The immediate result: Fresenius’ share price promptly recovered the prior 10-percent loss, halting the slide.
Mr. Schneider understood that in times of low interest, high and rising dividends are becoming more and more important.
“The six-year bull market has been dominated by multiple expansion, with very little progression in corporate earnings over this period,” wrote Fidelity investment director Caroline Pearce in a note last year. According to Ms. Pearce, who does not see a period of strong earnings growth on the horizon, “dividends are therefore set to become an even greater proportion of investors’ total return going forward.”
German companies, which are set to pay out more dividends this year than ever before, are already on the same page. Despite shrinking profits, companies listed on Germany’s blue-chip DAX index are on track to payout €30 billion this spring.
Companies are also driving their share prices and financial performance data increasingly with share repurchases. When companies buy back their own shares, it reduces the total supply of outstanding shares and bolsters earnings per share – one of the most important data points for financial markets.
In Germany, Siemens and Munich Re are repurchasing their own shares in grand fashion and creating a shortage. In doing so, they are increasing their dividends without needing to spend much more in the process.
The big role model, of course, is Wall Street, where the 500 largest U.S. companies last year repurchased $600 billion of their own shares. In doing so, 300 of them managed to raise their earnings per share – satisfying the analyst community. But their total net earnings – to which the world of finance pays less attention – dropped about 5 percent.
Aggressive shareholders demanding higher returns are driving such bold moves. At least for now, such excesses remain foreign to German companies. But there’s hardly ever been a Wall Street trend that Germany hasn’t followed, albeit with some delay.
Ulf Sommer is a Handelsblatt editor based in Düsseldorf, covering blue-chip companies in Germany and Europe. To contact the author: [email protected]