Industrials Also Financials in Drag?

First it was the banks and investment banks.

Then it was the financials in drag - those manufacturers with large captive finance arms.

And now, with the economy clearly slowing, many investors are wondering if industrials are somehow really "financials in disguise."

To me, the answer is unequivocally “yes.” And here’s why:

While each industry group is different, there are 4 principal areas where corporation and financial services firm balance sheets are alike:
 

• Cash and short-term investment portfolios;
• Short- and long-term receivables book;
• Derivatives exposures;
• Pension obligations.

And I can easily think of many examples of where corporations have de-facto become financials because of these asset categories:
 

• Bristol-Myers Squibb (BMY), as it wrote off holdings of its Auction-Rate Preferreds
• Constellation Energy (CEG), with its Lehman Brothers derivatives' exposure
• Disney (DIS), with its Lehman Brothers' “receivable”

And those are just the asset exposures.

On the liability side of the balance sheet, the risks are largely contingent. Will the banks be there to ensure that corporations have access to funding (be it commercial issuance, providing bank loans or long-term debt and equity underwriting)? And as we have already seen, with capital tight, banks and brokerage firms have significantly pulled back on their lending and underwriting activities.

So, as I hope you can see, financial-services firms impact all aspects of non-financial firms’ balance sheets.

So what are the implications?

Slower revenue and earnings growth. Everything I have just described puts a premium on protecting corporate equity and liquidity. In an environment like this, corporations will trade R&D and capital expenditure dollars for certainty. And, even worse, risk-taking and innovation will be sacrificed to meet short-term funding needs.

While not defending the specific actions taken by the Federal Reserve and the Treasury, it’s because of bank turmoil’s implications for the corporate sector that we’ve seen such aggressive action taken. Whether it’s purchasing commercial paper, lowering interest rates or boosting bank capital, each of these actions has been focused on unwinding the countervailing forces of credit stress.

Which leads me to the following question: Can corporate earnings grow without a recovery to the banking system?

Only if you believe that things are getting better with the banks. Banks lead: Just as a mother puts her own oxygen mask on first, then puts it on her child, they get the first gasp of oxygen. Credit is oxygen to commerce. The banks need it first. And only once they have it will commerce flow.

Don’t get me wrong - I truly appreciate all of the global efforts to support the credit market, but I believe we have miles to go before we sleep on this one. What took us 20+ years to create cannot be unwound in 12 months. The credit excesses go much deeper.

And like the investors who were surprised on Thursday by Disney’s $91 million exposure to Lehman Brothers, I expect that there will be many more surprises before we’re done.