Risk over Reward

Thinking about Investing – www.riskoverreward.com

How to Read Financial

Statements – Evaluating Value
Drivers and Searching in
Footnotes (Part 3)

by Alpha and Vega, an Investor and a Trader

July 20th, 2010

In this issue:
1) Finding the Value Drivers that Make a Business
2) The Credit Card Industry – American Express and Capital One
3) The Airline Industry – Southwest and JetBlue
4) The Cable and Satellite TV Industry – Comcast and DirectTV
5) Footnotes are like Snowflakes: No Two are the Same
Appendix: Ben Graham’s Satire on Accounting, or How to Abuse a Footnote

The first letter in the “How to Read Financial Statements” series went over basics on finding them and
how to approach them. The second letter got into the guts of a 10-K, into the first level of analysis. This
third letter shows how to finesse the footnotes and creatively assess the value drivers behind a
business.

One final note: We publish information on the website and over Twitter that we do not include in the
newsletter. If you want to follow those, visit the website, set up an RSS feed, and follow us on Twitter.

Risk over Reward: A conversation about intelligent investing – we discuss the nature of risk and uncertainty,
macroeconomics, security valuation, and how to think about markets and invest profitably -
http://www.riskoverreward.com/

Read our online posts at: http://www.riskoverreward.com/

Follow our tweets at: http://twitter.com/riskoverreward

Subscribe to the newsletter at: http://blogspot.us1.list-

manage.com/subscribe?u=8568d749127b61697bffe2b17&id=40b55d58d8

See Alpha’s reading recommendations here: Investment Classics

1
1) Finding the Value Drivers that Make a Business
The million-dollar skill in reading financial statements is simplifying complexity. I’ve seen valuation
analyses that fit on 25 Excel tabs, more than a hundred printed pages (murder by model). Other
analyses could fit on one double-sided page. Shorter is harder and often better. KISS – Keep it
simple, stupid. That is, an analyst must know how to read and understand dozens of tables of
numbers, such as revenues, costs, margins, earnings, cash flows, assets, debt maturity walls, etc., to
find the value drivers of a business. She must condense.

A value driver is a fundamental, causative business variable that effects accounting data (revenues,
margins, earnings, cash flows, etc.). Accounting data are then used to calculate ratios to show the
strength of a business and the intrinsic value (or estimated value range) of its securities. Value drivers
make up the economic ghost inside the financial machine. They are the economic forces that drive
financial outputs and metrics. Value drivers tend to be specific to industries or sub-industries,
sometimes even specific to an individual business. Good management teams focus on value drivers;
the bad teams don’t even know what they are.

Here are some examples of value drivers in different industries:

 Retail banking: At its core, retail depository banks make their profits/earnings from borrowing
cheaply and lending at a higher rate. The core value driver is the “net interest margin” (NIM), a
measure of the difference between a bank’s interest income and the amount of interest paid out
to their lenders (for example, deposits), relative to the amount of their (interest-earning) assets.
NIM is usually expressed as a percentage of what the financial institution earns on loans in a
time period and other assets minus the interest paid on borrowed funds divided by the average
amount of the assets on which it earned income in that time period (the average earning
assets). NIM takes both rates and dollar amounts into account, whereas the “net interest
spread” just looks at the rate differential or “spread.”
 Apparel Clothing: Niche business like Polo Ralph Lauren Corp. (RL) may have many products
and lines of business (basic, middle-market, premium, etc.). However, the vast majority of
earnings are generated by a handful of product staples, and for RL the basic items are polo and
cotton shirts, khaki pants, sweaters, and so on. While RL has many outlets, by far the most
profitable are its wholesale and internet outlets. Hence a business with hundreds of products
and many outlets can be simplified into: How many units of staple goods are being sold, and in
what channel? Also, are the total costs of marketing worth it, and are the dud goods not eating
up all the profits?
 Property-Casualty (P-C) Insurance: The basic model for insurance is to take in premiums (up
front protection payments) and pay out expenses (claims for losses plus operating expenses).
An insurer’s “combined ratio” is basically claims plus operating expenses divided by net
premiums (this can be broken into a loss ratio and an expense ratio). However, the net
premiums that insurers collect, the “float”, can be profitably invested while the company holds it.
So if an insurer has positive investment returns greater than the loss from the combined ratio, it
can still be profitable. To wit, an insurance company can be poor at underwriting and make up
losses through good investing. A low combined ratio along with high investment returns (good
use of float) is what makes a great insurer. Warren Buffett explains float well in his 2005
Chairman’s Letter in the Berkshire Hathaway annual report:

“Float” is money that doesn’t belong to us but that we temporarily hold. Most of our float
arises because (1) premiums are paid upfront though the service we provide – insurance
protection – is delivered over a period that usually covers a year and; (2) loss events that
occur today do not always result in our immediately paying claims, because it sometimes
takes many years for losses to be reported (asbestos losses would be an example),
negotiated and settled.

Float is wonderful – if it doesn’t come at a high price. Its cost is determined by underwriting
2
 results, meaning how the expenses and losses we will ultimately pay compare with the
premiums we have received. When an insurer earns an underwriting profit – as has been
the case at Berkshire in about half of the 39 years we have been in the insurance business
– float is better than free. In such years, we are actually paid for holding other people’s
money. For most insurers, however, life has been far more difficult: In aggregate, the
property-casualty industry almost invariably operates at an underwriting loss. When that loss
is large, float becomes expensive, sometimes devastatingly so.
http://www.berkshirehathaway.com/letters/2005ltr.pdf

Other insurance industry value drivers are: renewal rates for policy holders; the costs to acquire a
new policy; and the composition/attribution of investment returns.

The second most valuable skill in reading financial statement footnotes is being able to
verify/validate/examine basic accounting figures, and to catch fraud and shenanigans. This is detective
work.

Some examples of why footnotes are important:

 All revenues are not equal. Some revenues are generated through cash payments, others
through IOU slips call receivables which may never be paid. Footnotes discuss revenue
recognition policies. Also, a company may get most of its revenues from 2-3 buyers, and this is
a dangerous and unhealthy relationship (I know because one of my early, bad investments, in
2000, was in a company which derived 80% of its revenues from 4 customers, who then faced
their own difficulties and stopped buying – there’s no learning that sticks better than losing
money).
 Earnings may be manipulated. A company may report high earnings but a negative operating
cash flow, suggesting earnings are being gamed. Enron (formerly ENE) did that for a few years,
and then came up with a complicated scheme to create fake operating cash flows. Footnotes
explain why reported positive earnings differ from reported negative cash flows.
 A healthy company could go bankrupt due to debt. The debt maturity wall of a healthy,
levered business may signal an impending default, severely hurting unsuspecting equity holders
(a healthy business may be poorly financed). In the 2008-2009 credit crunch, General Growth
Properties (GGP) was a healthy mall company that had a bad financial structure, leading it into
technical default. Footnotes explain the cost and timeframe for maturing debt.

This letter will look at pairs of companies in three industries: credit cards, airlines, and cable/satellite TV
to further delve into the importance of value drivers and footnotes. The point isn’t to illuminate any
industry in particular, but more generally to suggest how one should think about a company’s value
drivers and footnotes within the context of its industry.

2) The Credit Card Industry – American Express and Capital One

American Express (AXP) and Capital One Financial Corp. (COF) are two of the largest stand-alone
credit card companies in the US (if not the world). Their market caps as of early June 2010 are $46
billion and $17 billion, respectively. Credit card companies make money by borrowing money from
capital markets to: i) make loans to cardholders at higher rates, and ii) hold an investment portfolio
earning high returns.

The value drivers behind a stand-alone credit card business such as AMX aren’t horribly complicated:
 Spread Revenues: The company lends to cardholders and then charges them a high interest
rate (in the 10% to 30% range) and also fees galore. Multiplying the spread by the size of the
loan book generates most revenues. In the footnotes to AMX’s 2010 10-K on p. 51, it had
interest-bearing liabilities of $79 billion, at an average rate cost of 2.8%. Roughly $24 billion
was invested in investment securities (mostly state and muni debt, agencies, and USTs),

3
 yielding 4.3% on average (p. 53). Roughly $33 billion was loaned to cardholders, earning 11-
17% (p. 49).
 Write-off Costs: The biggest loss is through written-off loans (and the probability that
nonperforming loans will have to be written off). The operating expense of running and
marketing a large card network is also high. A card company with good underwriting standards
has write-offs that are less than its allowance for losses (its planning account set up to estimate
write-offs). To see how much AMX is losing to writeoffs, compared writeoffs to its entire
cardholder loans outstanding. The table on p. 60 shows this is a high (and unsustainable)
8.5%, much higher than previous experience of 3.5%. If AMX can only charge 11% for loans,
and has to pay 2% for funding liabilities (see below), it has 9% left for write-offs and all operating
expenses. So 8.5% just for writeoffs is too high (operating and marketing expenses are much
more than 0.5%).
 Liability/Debt Funding Costs: Most credit card companies allow cardholders to keep a
balance. The card companies therefore need to borrow money through bonds and the
wholesale funding market, and they relend that out to cardholders who have a balance. In the
footnotes to AMX’s 2010 10-K on p. 66, its short term borrowing fell from $17.7 billion in 2007 to
$2.4 billion in 2009, as the funding markets shut down (AMX almost went bust trying to hustle
and obtain longer-term funding, but TARP money from the US government helped ease the
transition). Note that the cost of the short-term funding fell from 4%-5.15% in 2007 to 0.7%-
1.50% in 2009. So AMX is getting cheaper money to borrow, but also much less of it. More
importantly, AMX has $52 billion in long-term debt, with an average rate of 4.11%, plus
customer deposits of $26 billion (cost not stated). The maturity wall of when debt comes due is
put on a table in p. 96 in the portions of the annual report:

Securitization and other fee income make the AMX credit card business model more complex, but I
won’t go into that now.

The value drivers behind Capital One (COF) are slightly more complicated, as it has three businesses:
credit cards ($23 billion in reported loans), commercial banking ($30 billion in loans to real estate and
middle market firms), and consumer/retail banking ($38 billion in loans). However, COF’s core credit
card business is similar to AMX, as shown below:

 Spread Revenues: COF states metrics in the “Selected Financial Data” table, showing that the
NIM is 5.3%, the net charge-off (writeoff) rate is 4.58%, and the return on overage assets is
0.58%. In the footnotes to COF’s 2010 10-K on p. 48, it had total deposits of $116bn and other
borrowings of $12 billion. COF’s average revenue margin on its domestic credit card book
(about $65 billion in loans) is about 15.5%, of which 12.8% comes from yield (the rest,
presumably, being fees). The table on p. 82 lists the domestic yield as 10.3%, which is
inexplicably lower. COF also holds about $39 billion is securities, from which its yield is 3.6% to
5.0% (pp. 118-119).
 Write-off Costs: COF’s net domestic charge-off (writeoff) rate of 9.7% is higher than AMX’s
8.5%. If you add the 30+ day performing delinquency rate of 5.9%, COF will have to writeoff
nearly 16% of its total credit card loan book!

4
  Liability/Debt Funding Costs: The vast majority of COF’s liabilities are interest-bearing
deposits, at nearly $116 billion. It also borrows another $12 billion from other sources (which
COF admirably gives a full listing of the notes, with their coupon, par values, and maturity date
(p. 133). The interest-bearing deposits have a very low cost of 2.0% (see footnote one to the
footnote on page 133). This is the killer competitive advantage for COF, buried very deeply in
its footnotes.

COF’s Low Funding Costs: The Footnote to a Footnote with a Major Data Point

One can see that the credit card industry reduces to a few value drivers: the size of the loan book; the
average interest rate yield and the average cost of funds; the net writeoff rate. Of course, the SG&A
expense structure matters too. Next I turn to airlines.

3) The Airline Industry – Southwest and JetBlue

Southwest Airlines (LUV) and Jet Blue Airways (JBLU) are two of the largest discount airplane
companies in the US, both known for their great service, innovative business models, and profitability
(unlike most airlines, which are unprofitable and poorly run). The largest value drivers are:
 revenue passenger miles (the total number of revenue-paying passengers multiplied by the
number of miles they flew);
 passenger revenue yield per revenue passenger mile (how much was made on each passenger
for each mile they flew);
 fuel costs (average cost per gallon), which is the largest single cost for an airline;
 the load factor (how many revenue passenger miles were booked for the available seat miles
that an airplane could fill, a higher number showing that an airline is operating efficiently and
closer to “capacity”);
 and average fleet age (as older fleets need to be replaced sooner, at high cost, and are more
expensive to operate).

Southwest, because it is so efficient, is the largest air carrier in the US (measured by the number of
originating passengers boarded). It runs a point-to-point service instead of a typical hub-and-spoke
service, and keeps costs down by having only one type of plane, a Boeing 737.
Southwest, being a very well-run company, prominently lists the value drivers on page 23 of its 2009
10-K:

5
 Operating Metrics in Southwest Airlines 2009 10-K

JetBlue is also a very well run company, emphasizing high quality service (ranked the best in the US by
JD Power for the last 5 years) and focus of running planes out of the New York metro market. JetBlue
even states openly the nature of the industry on pages 4-5 of its 2009 10-K: “Airline profits are
sensitive to even slight changes in fuel costs, average fare levels and passenger demand. Passenger
demand and fare levels historically have been influenced by, among other things, the general state of
the economy, international events, industry capacity and pricing actions taken by other airlines. The
principal competitive factors in the airline industry are fares, customer service, routes served, flight
schedules, types of aircraft, safety record and reputation, code-sharing relationships, capacity, in-flight
entertainment systems and frequent flyer programs.” JetBlue has given both the value drivers and the
competitive factors behind the value driver metrics. It offers the actual metrics on page 26:

6
 Operating Metrics in JetBlue Airways 2009 10-K

JetBlue conveniently explains the metrics in detail:

 “Revenue passengers” represents the total number of paying passengers flown on all flight
segments.
 “Revenue passenger miles” represents the number of miles flown by revenue passengers.
 “Available seat miles” represents the number of seats available for passengers multiplied by the
number of miles the seats are flown.
 “Load factor” represents the percentage of aircraft seating capacity that is actually utilized
(revenue passenger miles divided by available seat miles).
 “Aircraft utilization” represents the average number of block hours operated per day per aircraft
for the total fleet of aircraft.
 “Average fare” represents the average one-way fare paid per flight segment by a revenue
passenger.
 “Yield per passenger mile” represents the average amount one passenger pays to fly one mile.
 “Passenger revenue per available seat mile” represents passenger revenue divided by available
seat miles.
 “Operating revenue per available seat mile” represents operating revenues divided by available
seat miles.
 “Operating expense per available seat mile” represents operating expenses divided by available
seat miles.
7
  “Operating expense per available seat mile, excluding fuel” represents operating expenses, less
aircraft fuel, divided by available seat miles.
 “Average stage length” represents the average number of miles flown per flight.
 “Average fuel cost per gallon” represents total aircraft fuel costs, including fuel taxes and
effective portion of fuel hedging, divided by the total number of fuel gallons consumed.

One final footnote about airlines is worth examining: their debt levels and fuel hedge books. First,
airlines are highly levered businesses, in that their financial leverage is high, and their operating
leverage (their ability to bring down their operating cost structure) is moderate to high. It’s a bad
combination for the equity investor, as unexpected events could push companies into bankruptcy (the
9-11 terrorist attacks pushed the entire industry to the edge, and even with monies from Congress
some companies filed for Chapter 11). Second, fuel hedges are important because they can save a
company much money, or destroy much capital, based on prudent hedging or reckless speculating (the
line between the two is thin) in the derivatives markets.
 Southwest, in a footnote buried on pages 38 and 54 lists its “Contractual Obligations” (more
than $14 billion, split three ways between long-term debt, flight equipment obligations, and
financing obligations). One great thing about Southwest is that most of its debt is long-term,
with maturities from 2014 to 2039 (far better than many indebted companies).
 Southwest discusses its hedging strategy in the footnotes on pages 70-73. Their strategy: “Our
current approach is to enter into hedges solely on a discretionary basis without a targeted
hedge percentage of expected fuel needs in order to mitigate liquidity issues and cap fuel
prices, when possible.” (p. 71) Economically, Southwest hedged between 23%-59% of its fuel
needs from 2007-2009, making $77 million and $17 million in 2007 and 2009, but losing $104
million in 2008 (in comprehensive income).
 JetBlue lists on total contractual obligations of $11 billion, of which $5 billion is long-term debt or
interest commitments, and $5.8 billion is in operating lease or aircraft purchase commitments.
(p. 36)
 JetBlue claims it has a broad management/governance oversight structure for its fuel hedging
program. It does not forswear trading, like Southwest, but rather states: “The Company utilizes
financial derivative instruments, on both a short-term and a long-term basis, as a form of
insurance against the potential for significant increases in fuel prices.” (p. 45) As JetBlue has
done a poor job in hedging, it shows a negative position of $480 million in fuel derivatives and
has given or pledged $510 million in cash and assets to its counterparties.

As you can see, the value drivers behind airlines are very different than those behind credit cards.
Even analyzing liabilities is a different exercise, as credit card companies rely on short-term, ultra-
cheap debt, whereas airline companies have mostly long term-debt, and commitments to purchase
aircraft or rent large facilities that are expensive.

4) The Cable and Satellite TV Industry – Comcast and DirectTV

The cable and satellite industries sell a monthly subscription service. Cable companies can provide
TV, internet, and telephony, whereas satellite companies usually just provide TV and internet. Comcast
(CMCSK) is the largest cable company in the US, and DirecTV (DTV) is the largest satellite TV
company (and arguably the biggest competitor to Comcast, at least in line with Time-Warner Cable,
DISH, Cablevision, etc.). The value drivers behind these businesses are simple, and these include:
 What’s the total market size that a company can physically serve (due to load and infrastructure
constraints)? What percentage is actually being served (the penetration rate)?
 What is the average monthly subscription fee or cash flow from each subscriber? What
percentage of customers are subject to rate regulation (how easy is it to raise prices)?
 How much pricing power do the distribution companies have over the content/programming
companies, who charge them top dollar for access to their product?
 How sticky is the business? Basically, what is the customer retention rate?
8
  What is the cost of acquiring a new customer, and is this less than lifetime total estimated value
of a customer?

Instead of focusing on the many value drivers in the cable/satellite business, I shall focus on the debt,
property and equipment, and legal footnotes. These are asset-heavy companies with mounds of debt –
they also get sued often. Being debt-heavy is tax efficient, as the businesses have a steady,
monopoly-like cash flow stream, so large of amounts of debt can be serviced, while the companies pay
reduced taxes due to depreciation and the debt/interest payment tax shield.

Below are some key debt footnotes to look at:

 Comcast Debt Profile: Comcast has $28 billion of debt (almost as large as its tangible plant,
below), with most maturing after 6 years ($22 billion) or 10 years ($12 billion). It has various
sources of financing: a commercial paper program ($2.25 billion), a bank loan facility ($6.8
billion), lines/letters of credit ($6.4 billion), and subordinated debt. Comcast also has
commitments to content creators in the form of programming license agreements that it must
honor, and these add up to another $9 billion.
 DirecTV debt profile: With over $20.2 billion in total obligations, $9.1 billion is in long-term debt,
$9.7 billion is in purchase obligations (for content), and the rest is mostly for capital and
operating leases. Much of the long-term debt comes due from 2014-2016.
 Security ratings on the debt: DirecTV gets a stable, investment-grade rating of BBB-, Baa2, and
BBB from S&P, Moody’s, and Fitch, for its sizable $8 billion of debt.
 Collar loan: DirecTV has a complicated equity collar and collar loan it set up in relation to a
Liberty transaction (as presumably John Malone likes to protect his transaction values with
collars).
Comcast’s Debt Profile in its 2009 10-K

9
 Comcast’s Other Big Liability in its 2009 10-K

DirecTV’s Debt Profile in its 2009 10-K

Below are some key plant and equipment (P&E) footnotes:

 Comcast has a gross plant and equipment of $52 billion, charged $28 billion in depreciation (a
stunning number!), and has a net P&E of $24 billion. The two biggest pieces are cable
transmission equipment ($16 billion) and customer premises equipment ($20 billion).
 DirecTV’s biggest asset is their satellites, with a gross value of $3.2 billion and a net value of
$2.4 billion.

Legal proceedings against or by a company are a final item that is required in all 10-Ks, something that
most investors just don’t want to consider. Yet it is a legitimate risk:
 DirecTV is engaged in numerous lawsuits regarding intellectual property, early cancellation
fees, and an inherited lawsuit against Liberty Media. None so far looks to be significant.
 Comcast is embroiled in antitrust cases, ERISA pension litigation, and so on. None so far looks
to be significant.

The bottom line is that an analyst should examine the footnotes relevant to each industry and sub-
industry. Debt levels don’t matter in the software industry (where most companies take little debt). It
matters a lot in the cable/satellite industry, as large asset and debt loads are the norm.

5) Footnotes are Idiosyncratic

No footnote is the same. Despite clear, stringent rules from the SEC and FASB on how a 10-K should
be organized and how detailed footnotes should be, accountants have creative control to jigger
financial statements and bury key information in footnotes. The only way to get better at reading
10
footnotes is to know the economics behind an industry and to read many footnotes. Thousands and
thousands of them. Each year. Below are some further reading recommendations.

Three great books I suggest on reading between the lines and dissecting footnotes:
 H. Schilit, Financial Shenanigans
 K. Staley, The Art of Short Selling
 C. Mulford, Sustainable Free Cash Flow

Two books on understanding business models and industries:

 M. Porter, Competitive Strategy
 R. Suutari, Business Strategy and Security Analysis: The Key to Long Term Investment Profits

One great resource to consult regarding footnotes:

http://www.footnoted.com/

I also recommend Ciesielski’s “Accounting Observer,” but you need to subscribe to the (costly) service:
http://www.accountingobserver.com/

Finally, I end with a great unpublished satire that Ben Graham wrote about accounting shenanigans
and have to his best student, Warren Buffett. It shows the importance of understanding the meaning
behind the numbers (where the meaning or accounting policy is often delineated in the footnotes).

Your footnote loving analyst,

Alpha
alpha@riskoverreward.com

Copyright 2010 Risk Over Reward. All Rights Reserved

You have permission to publish this article electronically or in print as long as the following is included:

Risk over Reward: A conversation about intelligent investing – we discuss the nature of risk and uncertainty,
macroeconomics, security valuation, and how to think about markets and invest profitably -
http://www.riskoverreward.com/

Read our online posts at: http://www.riskoverreward.com/

Follow our tweets at: http://twitter.com/riskoverreward

Subscribe to the newsletter at: http://blogspot.us1.list-

manage.com/subscribe?u=8568d749127b61697bffe2b17&id=40b55d58d8

See Alpha’s reading recommendations here: Investment Classics

11
Appendix: Ben Graham’s Satire on Accounting Policies and How to Abuse Footnotes

U. S. STEEL ANNOUNCES SWEEPING MODERNIZATION SCHEME

* An unpublished satire by Ben Graham, written in 1936 and given by the author to Warren Buffett in
1954. This is published in Buffett’s Chairman’s Letter to the Berkshire Hathaway annual report in 1990.
http://www.berkshirehathaway.com/letters/1990.html (Appendix A)

Myron C. Taylor, Chairman of U. S. Steel Corporation, today announced the long awaited plan
for completely modernizing the world's largest industrial enterprise. Contrary to expectations, no
changes will be made in the company's manufacturing or selling policies. Instead, the bookkeeping
system is to be entirely revamped. By adopting and further improving a number of modern accounting
and financial devices the corporation's earning power will be amazingly transformed. Even under the
subnormal conditions of 1935, it is estimated that the new bookkeeping methods would have yielded a
reported profit of close to $50 per share on the common stock. The scheme of improvement is the
result of a comprehensive survey made by Messrs. Price, Bacon, Guthrie & Colpitts; it includes the
following six points:

1. Writing down of Plant Account to Minus $1,000,000,000.

2. Par value of common stock to be reduced to 1¢.

3. Payment of all wages and salaries in option warrants.

4. Inventories to be carried at $1.

5. Preferred Stock to be replaced by non-interest bearing bonds redeemable at 50% discount.

6. A $1,000,000,000 Contingency Reserve to be established.

The official statement of this extraordinary Modernization Plan follows in full:

The Board of Directors of U. S. Steel Corporation is pleased to announce that after intensive study
of the problems arising from changed conditions in the industry, it has approved a comprehensive plan
for remodeling the Corporation's accounting methods. A survey by a Special Committee, aided and
abetted by Messrs. Price, Bacon, Guthrie & Colpitts, revealed that our company has lagged somewhat
behind other American business enterprises in utilizing certain advanced bookkeeping methods, by
means of which the earning power may be phenomenally enhanced without requiring any cash outlay
or any changes in operating or sales conditions. It has been decided not only to adopt these newer
methods, but to develop them to a still higher stage of perfection. The changes adopted by the Board
may be summarized under six heads, as follows:

1. Fixed Assets to be written down to Minus $1,000,000,000.

Many representative companies have relieved their income accounts of all charges for depreciation
by writing down their plant account to $1. The Special Committee points out that if their plants are worth
only $1, the fixed assets of U. S. Steel Corporation are worth a good deal less than that sum. It is now a
well-recognized fact that many plants are in reality a liability rather than an asset, entailing not only
depreciation charges, but taxes, maintenance, and other expenditures. Accordingly, the Board has
decided to extend the write-down policy initiated in the 1935 report, and to mark down the Fixed Assets
from $1,338,522,858.96 to a round Minus $1,000,000,000.

12
 The advantages of this move should be evident. As the plant wears out, the liability becomes
correspondingly reduced. Hence, instead of the present depreciation charge of some $47,000,000
yearly there will be an annual appreciation credit of 5%, or $50,000,000. This will increase earnings by
no less than $97,000,000 per annum.

2. Reduction of Par Value of Common Stock to 1¢, and

3. Payment of Salaries and Wages in Option Warrants.

Many corporations have been able to reduce their overhead expenses substantially by paying a
large part of their executive salaries in the form of options to buy stock, which carry no charge against
earnings. The full possibilities of this modern device have apparently not been adequately realized. The
Board of Directors has adopted the following advanced form of this idea:

The entire personnel of the Corporation are to receive their compensation in the form of rights to
buy common stock at $50 per share, at the rate of one purchase right for each $50 of salary and/or
wages in their present amounts. The par value of the common stock is to be reduced to 1¢.

The almost incredible advantages of this new plan are evident from the following:

A. The payroll of the Corporation will be entirely eliminated, a saving of $250,000,000 per annum,
based on 1935 operations.

B. At the same time, the effective compensation of all our employees will be increased severalfold.
Because of the large earnings per share to be shown on our common stock under the new methods, it
is certain that the shares will command a price in the market far above the option level of $50 per
share, making the readily realizable value of these option warrants greatly in excess of the present
cash wages that they will replace.

C. The Corporation will realize an additional large annual profit through the exercise of these
warrants. Since the par value of the common stock will be fixed at 1¢, there will be a gain of $49.99 on
each share subscribed for. In the interest of conservative accounting, however, this profit will not be
included in the income account, but will be shown separately as a credit to Capital Surplus.

D. The Corporation's cash position will be enormously strengthened. In place of the present annual
cash outgo of $250,000,000 for wages (1935 basis), there will be annual cash inflow of $250,000,000
through exercise of the subscription warrants for 5,000,000 shares of common stock. The Company's
large earnings and strong cash position will permit the payment of a liberal dividend which, in turn, will
result in the exercise of these option warrants immediately after issuance which, in turn, will further
improve the cash position which, in turn, will permit a higher dividend rate -- and so on, indefinitely.

4. Inventories to be carried at $1.

Serious losses have been taken during the depression due to the necessity of adjusting inventory
value to market. Various enterprises -- notably in the metal and cotton-textile fields -- have successfully
dealt with this problem by carrying all or part of their inventories at extremely low unit prices. The U. S.
Steel Corporation has decided to adopt a still more progressive policy, and to carry its entire inventory
at $1. This will be effected by an appropriate write-down at the end of each year, the amount of said
write-down to be charged to the Contingency Reserve hereinafter referred to.

The benefits to be derived from this new method are very great. Not only will it obviate all possibility
of inventory depreciation, but it will substantially enhance the annual earnings of the Corporation. The
inventory on hand at the beginning of the year, valued at $1, will be sold during the year at an excellent
13
profit. It is estimated that our income will be increased by means of this method to the extent of at least
$150,000,000 per annum which, by a coincidence, will about equal the amount of the write-down to be
made each year against Contingency Reserve.

A minority report of the Special Committee recommends that Accounts Receivable and Cash also
be written down to $1, in the interest of consistency and to gain additional advantages similar to those
just discussed. This proposal has been rejected for the time being because our auditors still require that
any recoveries of receivables and cash so charged off be credited to surplus instead of to the year's
income. It is expected, however, that this auditing rule -- which is rather reminiscent of the horse-and-
buggy days -- will soon be changed in line with modern tendencies. Should this occur, the minority
report will be given further and favorable consideration.

5. Replacement of Preferred Stock by Non-Interest-Bearing Bonds Redeemable at 50% Discount.

During the recent depression many companies have been able to offset their operating losses by
including in income profits arising from repurchases of their own bonds at a substantial discount from
par. Unfortunately the credit of U. S. Steel Corporation has always stood so high that this lucrative
source of revenue has not hitherto been available to it. The Modernization Scheme will remedy this
condition.

It is proposed that each share of preferred stock be exchanged for $300 face value of non-interest-
bearing sinking-fund notes, redeemable by lot at 50% of face value in 10 equal annual installments.
This will require the issuance of $1,080,000,000 of new notes, of which $108,000,000 will be retired
each year at a cost to the Corporation of only $54,000,000, thus creating an annual profit of the same
amount.

Like the wage-and/or-salary plan described under 3. above, this arrangement will benefit both the
Corporation and its preferred stockholders. The latter are assured payment for their present shares at
150% of par value over an average period of five years. Since short-term securities yield practically no
return at present, the non-interest-bearing feature is of no real importance. The Corporation will convert
its present annual charge of $25,000,000 for preferred dividends into an annual bond-retirement profit
of $54,000,000 -- an aggregate yearly gain of $79,000,000.

6. Establishment of a Contingency Reserve of $1,000,000,000.

The Directors are confident that the improvements hereinbefore described will assure the
Corporation of a satisfactory earning power under all conditions in the future. Under modern accounting
methods, however, it is unnecessary to incur the slightest risk of loss through adverse business
developments of any sort, since all these may be provided for in advance by means of a Contingency
Reserve.

The Special Committee has recommended that the Corporation create such a Contingency
Reserve in the fairly substantial amount of $1,000,000,000. As previously set forth, the annual write-
down of inventory to $1 will be absorbed by this reserve. To prevent eventual exhaustion of the
Contingency Reserve, it has been further decided that it be replenished each year by transfer of an
appropriate sum from Capital Surplus. Since the latter is expected to increase each year by not less
than $250,000,000 through the exercise of the Stock Option Warrants (see 3. above), it will readily
make good any drains on the Contingency Reserve.

In setting up this arrangement, the Board of Directors must confess regretfully that they have been
unable to improve upon the devices already employed by important corporations in transferring large
sums between Capital, Capital Surplus, Contingency Reserves and other Balance Sheet Accounts. In
fact, it must be admitted that our entries will be somewhat too simple, and will lack that element of
14
extreme mystification that characterizes the most advanced procedure in this field. The Board of
Directors, however, have insisted upon clarity and simplicity in framing their Modernization Plan, even
at the sacrifice of possible advantage to the Corporation's earning power.

In order to show the combined effect of the new proposals upon the Corporation's earning power,
we submit herewith a condensed Income Account for 1935 on two bases, viz:

In accordance with a somewhat antiquated custom there is appended herewith a condensed pro-
forma Balance Sheet of the U. S. Steel Corporation as of December 31, 1935, after giving effect to
proposed changes in asset and liability accounts.

15
*Given a Stated Value differing from Par Value, in accordance with the laws of the State of Virginia,
where the company will be re-incorporated.

It is perhaps unnecessary to point out to our stockholders that modern accounting methods give
rise to balance sheets differing somewhat in appearance from those of a less advanced period. In view
of the very large earning power that will result from these changes in the Corporation's Balance Sheet,
it is not expected that undue attention will be paid to the details of assets and liabilities.

In conclusion, the Board desires to point out that the combined procedure, whereby plant will be
carried at a minus figure, our wage bill will be eliminated, and inventory will stand on our books at
virtually nothing, will give U. S. Steel Corporation an enormous competitive advantage in the industry.
We shall be able to sell our products at exceedingly low prices and still show a handsome margin of
profit. It is the considered view of the Board of Directors that under the Modernization Scheme we shall
be able to undersell all competitors to such a point that the anti-trust laws will constitute the only barrier
to 100% domination of the industry.

In making this statement, the Board is not unmindful of the possibility that some of our competitors
may seek to offset our new advantages by adopting similar accounting improvements. We are
confident, however, that U. S. Steel will be able to retain the loyalty of its customers, old and new,
through the unique prestige that will accrue to it as the originator and pioneer in these new fields of
service to the user of steel. Should necessity arise, moreover, we believe we shall be able to maintain
our deserved superiority by introducing still more advanced bookkeeping methods, which are even now
under development in our Experimental Accounting Laboratory.

16