FOOL ON THE HILL

We Need More Bankruptcy

Governments tend to try to preserve industries -- to save jobs through price supports, bailouts, and other activities. That's admirable, but, unfortunately, some companies -- in fact, some entire industries -- would be better off dead. Weak companies can destroy the earnings power, not only for their stronger competitors, but for those trying to supply the industry.

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By Bill Mann (TMF Otter)
October 25, 2002

Do you know what would cure the economic malaise in America quicker than anything else? Price supports, you say? Government bailouts? Free Slurpees for all?

Well, get back to me on that last one, 'cause that just might work. But what would really clear up the economic picture in a hurry are bankruptcies. Scads of them. Entire industries, those making no money, should just go away. As a whole, we'd be better off if they did.

Many people, especially those who would lose their jobs as a result, are going to disagree with me. Violently so. "How could you be so callous?!" "Why don't you care about people's ability to make a living?!"

I'm not callous; I'm compassionate, just in an unsentimental kind of way. And, actually, I care deeply about one's ability to make a living. But there's no future in debt-ridden companies offering minimal prospects for economic improvement. The faster we wash them through the system, the quicker the system can be made whole. Price supports, protective tariffs, and government intervention only delay the inevitable, which not only prolongs the agony of atrophied capital, but maims the earnings power of similarly employed healthy capital.

In bankruptcy, economic Darwinism reigns in full glory. The Darwinian theory of evolution states that all species of organisms develop through a natural selection that increases the individual's ability to compete, survive, and reproduce. OK, companies don't tend to reproduce much, but they absolutely, positively compete and try to survive. Natural selection doesn't exist to knock around the weaker guy; it exists as a way to ensure that the entire species grows stronger. When natural selection doesn't occur efficiently, weak, underperforming members drain the overall society and its communal resources.

This happens in business, as well. Take the telecommunications industry as an example. At present, nearly every telecommunications company is in some form of financial stress. Very few lack significant debt. None, it seems, has any control over its pricing. Take out the portion of pricing that's regulated to go to the local carrier, and the amount of a per-minute long-distance call going to the long-distance carrier drops below a penny. Telecom companies sell services below cost simply to generate enough cash to stay in business. Since the weak players have no concerns about profitability, other companies in the sector can't price above their own costs, either. Until the walking dead actually collapse, there will be no pricing discipline in this business, which puts the entire species at risk.

So get 'em out, already! Bankrupt them. Our telecommunications industry, which is vitally important, will be much healthier in the long run if the government does nothing to help it. No price supports; no protection of the big incumbents. If these companies cannot survive on their own merits, the entire industry will be healthier without them.

The continued existence of the walking dead in telecommunications has created a deflationary environment in that market. Any additional time allowed to companies that only destroy capital just deflates that market and all of its components. This is a big, big thing -- between 1996 and 2000, $1.2 trillion were spent on capital development in the telecommunications business worldwide. A fair amount of that investment is obsolete, for technological reasons. A good portion of it has no chance to generate a positive return on capital because the company that owns it couldn't garner enough business to meet its debt obligations. And the fall in pricing feeds upon itself in a way that harms more than just the carriers.

In a deflationary environment, consumers delay purchases, thinking the goods will be cheaper later on. As a result, the suppliers of these goods are deprived from revenues, and so starts the vicious cycle. From a business standpoint, companies aren't allocating more cash to capital projects because none of their old capital expenditures has provided a return, and as long as dying competitors drive prices down, there's no real hope of a positive return in the near future. In telecom, this means equipment suppliers, such as JDS Uniphase (Nasdaq: JDSU), Avanex (Nasdaq: AVNX), and Lucent (NYSE: LU), are withering on the vine.

As a result, what seems benevolent is actually extremely harmful, and maintaining the status quo, while beneficial to those directly protected, generally harms the industry. By extension, it harms those who make a living providing goods and services to those industries, too. Had the Japanese government a decade ago addressed the billions in non-performing loans gracing bank balance sheets by letting the debtor companies fail, there's little doubt Japan's long recession would've long since passed. As it is, Japanese consumers simply don't consume and are content to while away a deflationary environment with their savings generating 0.5% interest. The banks are unable to loan more money, and the government spends billions trying to prop up companies that really should've gone into bankruptcy, and then gone away.

I've talked about telecommunications, but really airlines, the steel industry, and even the manufacturing industry are in the same boat. Nucor (NYSE: NUE) and Southwest (NYSE: LUV) are actually hurt by having to operate in an industry where their competitors can control neither cost nor price. The bailouts and protective tariffs propping up these industries really only hurt all of us.

People constantly ask me when the economy will turn around. Unfortunately, I don't know. No one does. But I do have a theory: The economy will improve as soon as the number of bankruptcies spike -- when companies with no chance of competing finally give up the ghost. When this happens, the companies left standing can make better spending decisions and have more pricing power for the true economic value of goods and services. The more the government meddles in this messy process, the longer it could take.

Foolish best!
Bill Mann, TMFOtter on the Fool Discussion Boards

I'm sorry, but the word of the day is "Frank Tanana." Bill is the managing editor of The Motley Fool Select, where you can find his best Foolish stock ideas you won't find anywhere else. The Motley Fool has a disclosure policy.