The Recovery's Soft Underbelly
By Robert J. Samuelson
The Washington Post
Wednesday, May 1, 2002; Page A25
When it comes to profits, we've had a social revolution in the past 15 years. Before that, only corporate and Wall Street types discussed anything so crass as profits. The Great Bull Market changed us. Profits have joined sports, celebrities, sex and politics as water-cooler and Internet chitchat. People watch stock prices and wait for earnings (profits) reports. We've democratized talk about profits and, in the process, have learned two lessons: First, a strong economy requires healthy profits; and, second, profit reports seem more mystifying and less trustworthy.
We can't ignore those lessons now, because if the economic recovery has a soft underbelly, profits would seem to be it. In the first quarter, U.S. gross domestic product (GDP) -- the output of goods and services -- rose at an impressive annual rate of 5.8 percent. But if profits don't revive, the recovery may be weak or stillborn. Without higher profits, companies won't have the funds to finance new investment in factories, software or machinery. Profits also underpin stock prices. Poor profits may mean a poor market, dragging down consumer confidence and spending.
Given the ramifications, the present profits picture seems grim. Both sources of profits figures -- the government and companies -- show big declines. The Commerce Department reports that after-tax profits of U.S. companies dropped 16 percent last year to $482.5 billion from $573.9 billion in 2000. The decline began in the last quarter of 2000. Measured from there to the end of 2001 -- and using quarterly statistics -- the decline is 27 percent. But that's still not as large as the drop in company-reported profits, expressed as earnings per share. In 2000 the reported earnings of firms in the Standard & Poor's index of 500 companies were $50 a share for the entire index. In 2001 earnings tumbled 51 percent to $24.69.
Consider the implications for the stock market. Since 1950 the average price/earnings ratio (P/E) of the S&P 500 has been 16, says S&P's Howard Silverblatt. A dollar of earnings results, on average, in a stock price of $16. The S&P index is now about 1100. Divide that by earnings of $24.69, and the result is a P/E of almost 45. Gulp. The market is counting on a rapid rebound of profits. Investors aren't buying on the basis of today's earnings but on the much higher earnings expected for 2002 and 2003.
This is, of course, a gamble now compounded by growing mistrust of corporate profit reports. If Enron taught us anything it is that a company's financial statements don't always reflect -- as they should -- its financial condition. In theory, profits are simple: Revenues (generally, sales) minus costs (labor, material, overhead) equals profits. In practice, complexities arise.
Let's compare the Commerce Department's profits and company-reported profits (the S&P numbers cited above). The differences partly reflect coverage. The government numbers include all corporations, 4.8 million in 1998. By contrast, the S&P has only 500 big companies, which change regularly as a result of mergers and shifting business conditions. In 2000 there were 58 changes.
Profit concepts also differ slightly. The Commerce Department aims to measure profits "from current production." It doesn't count one-time gains or losses. If a company sells a building at a profit, Commerce won't include that profit. Nor will Commerce count one-time losses resulting from, say, the closing of a factory. These costs are typically called "restructuring charges."
By contrast, companies do report one-time gains and losses because corporate financial reports aim to show -- in theory at least -- all changes that might affect the value of shares. One reason for last year's big drop in reported S&P profits was an explosion of "restructuring" and other one-time losses. These have continued into 2002. Last week AOL Time Warner took a $54 billion one-time write-off. Commerce won't pick that up. (Indeed, the loss occurred mostly on paper and related to the AOL Time Warner merger, whose value was reduced by the drop in the company's stock price.)
The trouble with company profit reports -- as Enron reminded -- is that they tend to be self-serving and sometimes dishonest. Corporate discomfort with financial reporting is longstanding. In 1923 only 242 of the 957 firms listed on the New York Stock Exchange provided both annual and quarterly financial reports, says Joel Seligman's authoritative book, "The Transformation of Wall Street."
Legitimate ambiguities exist about how and when some costs and revenues should be recorded. But the ambiguities have tempted companies, especially during the Great Bull Market, to become ever more obscure. One dubious practice has been "pro forma" earnings, which report profits without some costs. Companies with big debts, for instance, omit interest costs. There's a fairy tale quality to this, because (of course) companies have to pay interest. The flimsy justification has been that investors should see how the "underlying" business is performing. (To be fair, companies also have to report all costs according to "generally accepted accounting principles." But companies play down the fuller reports.)
Poor profits signal an economy crippled by some mix of surplus capacity (too many factories, office buildings or companies), weak demand and high costs. The question now is whether the recovery improves profits -- or whether poor profits doom the recovery.
Economist Richard Rippe of Prudential Securities is betting on recovery. Profits will benefit from higher sales, slightly higher prices and stable costs, he thinks. Like most economists, Rippe prefers the government's profit figures. The corporate numbers seem too fickle, depressed by one-time write-offs and inflated by self-serving adjustments. Using the Commerce numbers, Rippe figures that after-tax profits in the fourth quarter of 2002 will be up about 17 percent from the fourth quarter of 2001. Even that would leave profits well below their previous peaks.
© 2002 The Washington Post Company
washingtonpost.com |
