NABE Presidential Address

Corporate Profits: Critical for business analysis

by Richard Berner, Chief US Economist, Morgan Stanley Dean Witter and NABE President

As business analysts, many of us produce macroeconomic forecasts that, for all their shortcomings, are key ingredients in business planning, and in analyzing the direction of financial markets and monetary and fiscal policy. Analysts and the business press rightly focus on GDP and its components as the cornerstones of both macroanalysis and measurement. Getting that analysis mostly right is critical for our companies and our careers.

But in my view, analysts spend too little time analyzing the behavior of corporate profits and the returns on investment. It's hardly their fault. The average undergraduate textbook on macroeconomics mentions profits at most twice -- you guessed it -- once in outlining the National Income Accounts, and once briefly in discussing investment. Small wonder that some analysts think a focus on profits is only important for those of us who work on Wall Street, given our obsession with the stock market. In contrast, I think analyzing profits is also critical for those of us who work on Main Street.

There are three key reasons to focus on corporate profits and profit margins. First, and most obvious, the link between Wall St and Main St through profitability, stock prices and their influence on the economy has never been more apparent. Second, analyzing profit margins helps identify what I call critical tension points which may or may not be reflected in market prices. Let's face it: Our efficient capital markets may not misprice assets for long, but there's no denying the bubble we've just experienced. Analyzing these stress indicators often shows what might have to change, in the economy, markets or in our companies. Last, and most important, current and expected profitability both reflect and are key drivers of investment, hiring and pricing decisions. Thus, far from just being a byproduct of your forecasts, profits and margins should be an integral determinant of the outcome.

Many of you will protest. After all, profit maximization is a central tenet of modern macro theory, yielding important insights about how companies behave. Since Modigliani and Miller, for example, analysts have recognized that a firm's valuation and its investment policy are inseparable. But conclusions from that neoclassical paradigm often miss the mark for the real world in which we operate. I believe looking directly at profitability and rates of return can help crosscheck those conclusions. Likewise, returns on investment are key determinants of the strategic recommendations that you make to your Senior Management. But too often our microanalysis lacks a macro profits context to frame the discussion.

To others of you, schooled in the business cycle analysis of Mitchell, Burns and Moore, a focus on profits is second nature. Corporate profits at one time were thought to be a leading economic indicator. According to Mitchell, that is with good reason; his theory of the business cycle put profits at center stage. A period of economic expansion would boost profits and thus business investment. But as operating rates rose, costs would accelerate faster than output. The resulting squeeze on profit margins would curb investment, triggering recession. Cost cutting in the slump would restore margins and lay the groundwork for recovery. No doubt, many managers would accept this as a reasonable description of today's business cycle.

For many analysts, however, the proof of the pudding is whether profits and returns matter. I offer two pieces of evidence that show profitability as a key driver of investment outlays. First, as Exhibit 1 graphically shows, the business cycle has always driven both profit margins and changes in investment outlays. That covariation masked the separate influence of profitability on investment -- until recently. In my view, the simultaneous boom in profits and capital spending in the 1990s -- and the more recent bust --revealed that profit margins do influence investment. But is it mere correlation? Tentative econometric evidence from Macroeconomic Advisers suggests that profitability, in addition to other factors, drives investment, although the jury is still out on whether it improves forecasts.

I'm not suggesting that the causation from profits to investment is one-way. Far from it. The interplay is works in both directions. But to ignore the profits-investment connection in my view breaks a key link in the analytical chain.

Tools of Profit Analysis

How, then, accurately to forecast profits? Most of us look to both revenues and costs, figuring that profits are the residual. But the past year's sharp downdraft in profits hints that the relationship between profits and the economy has changed over the past decade. Profits have become more sensitive, or leveraged, to growth. In my view, profit margins are a helpful metric for gauging that changing relationship and its connection to returns on investment.

I think two factors explain those changes. First, Corporate America significantly increased both financial and operating leverage over much of the 1990s. Second, U.S. profits are increasingly dependent on overseas economic activity.

Let's examine both kinds of leverage in today's setting. You're all familiar with the benefits and costs of financial leverage. Levering up boosts returns in expansions, especially if companies buy back stock. But bond investors look askance at financial leverage. That's because highly levered businesses suffer in downturns as debt service eats into margins, and increases the risk of default. Eroding credit quality, especially in telecommunications, has obviously been a hallmark of this slowdown. And debt service for some companies lingers at high levels in relation to cash flow and investors still demand premiums to take on higher credit risks. Both squeeze profit margins. As Exhibit 2 shows, however, the rise in debt service in the current episode pales by comparison with the LBO boom of the 1980s. So financial leverage isn't the only culprit behind the recent collapse in margins.

Instead, the real story lies in operating leverage. Finance 101 teaches us that the change in operating leverage is the product of invested capital and the change in returns on equity (ROE) that results from that investment. Both increased in the 1990s, as Corporate America scaled back break-even points and boosted ROE by investing heavily in laborsaving equipment. Courtesy of lower marginal but higher fixed costs, many companies are left with increased operating leverage as the overlooked legacy of this capital spending boom.

In my view, this increased leverage has crushed earnings by more than in past slowdowns. Companies must pay the fixed costs regardless, and the boom's most obvious legacy -- extra capacity -- translates into increased competitive pressures via plunging operating rates.

Exhibits 3 and 4 show how operating leverage works. In Exhibit 3, cutting variable costs scales back the break-even point from B0 to B1. As evidence of increased leverage, at volumes to the right of B0, profit per unit is higher than before. Exhibit 4 shows what happens if that reduction in variable costs was achieved through investment that raised fixed costs. The break-even point is back to B0. But profits are much more sensitive to volumes.

Depreciation in relation to sales is one metric for gauging the fixed costs associated with increased operating leverage. As Exhibit 5 shows, depreciation as a share of sales at S&P 500 companies rose by about 10% over the 1982-1999 period, and it is safe to say that they've risen further recently. Indeed, as seen in Exhibit 6, private depreciation relative to GDP measured in the National Income and Product Accounts (NIPAs) has escalated steadily in the 1990s.

Capacity/Leverage interplay

What's more, the interplay between capacity and operating leverage magnifies the impact of leverage on margins as growth slows, as Exhibit 7 illustrates. That's because low and falling utilization rates also hurt profit margins, not just once, but twice. First, industries with extra capacity can rarely raise prices and are often forced to lower them. Second, low utilization rates can be associated with cyclically inefficient operations and, thus, rising marginal costs as volumes shrink.

Even in the past, when operating and financial leverage were not significant issues, sinking utilization rates were bad news for profit margins. This time around, the slide in operating rates has been nothing short of stunning. Courtesy of the investment boom, the capacity buildup in some industries - many in technology-producing segments and in communications, but also in the purchasers of high-tech gear - went to excess. And in other industries, such as primary metals and chemicals, demand has weakened by enough to expose significant pockets of excess capacity. The result: The lowest operating rates in manufacturing since 1983, and at technology producers, since 1975.

This interplay between capacity and leverage has broader implications for macroanalysis, for investors, and for corporate managers. Companies or industries that are disciplined in their use of capital will realize superior returns on assets or equity, while those who are profligate builders or who are serial acquirers will see subpar results. Economic and finance theories teach us that companies who consistently earn returns in excess of their capital costs should outperform for investors. So the market should reward the first group with relatively higher share prices and punish the second group with declining market value. The data in Exhibit 8, assembled by my colleague Steve Galbraith, bear that out. Industry relative stock market performance is plotted on the vertical axis, while ROICs relative to the weighted average cost of capital are plotted on the horizontal axis.

What is really informative about this chart isn't the correlation, but which industries fall in which quadrants. Over the two decades ended in 1999, industries that used capital carefully -- like health care, consumer staples and yes, technology -- produced superior returns in both dimensions. Meanwhile, those unable to right size their industries, especially if they were in cyclical, commodity-producing groups, disappointed their managers and investors alike.

That was then. Many technology industries and their customers, perhaps responding to years of blowout returns, became what Steve Galbraith calls capital pigs. As we now know, they overinvested in capacity, ignoring the fundamentals of finance. Had they heeded the first signs of eroding returns last year, as depicted in Exhibit 9, many of them might have managed the downturn more smoothly. In comparison, the folks in the energy business have turned from pig into cash cow, as their approach to adding capacity has remained more disciplined than in the past. As seen in Exhibit 10, there's no doubt that OPEC also hurts or helps their performance. But there's no mistaking the fact that, so far, they haven't responded to higher energy prices with a flood of new capacity, and they've sustained higher returns.

In short, there are two lessons in this for analysts and managers. One is obvious, but overlooked: Returns and margins matter for analysis and decisions, and may even be leading indicators of performance. The second is more surprising: Relative levels of capital spending are good leading indicators of -- and are inversely related to -- sector and company performance.

Global influences

At long last, I come to the second factor that has changed the relationship between profits and the economy: U.S. earnings are increasingly leveraged to global, not just U.S., growth. That comes as no surprise to many of you. Either your companies operate globally or some of your suppliers are located abroad. And most of you know that exports account for 11.2% of GDP today more than double the share three decades ago. But did you know that, over the same time frame, U.S. companies' overseas affiliates have also more than doubled their share of overall corporate profits, to more than 25%? As seen in Exhibit 11, that share is clearly cyclical, rising in recessions as domestic corporate income turns down. But it is also rising on a secular basis, as globalization knits our companies and economies more closely. That's a channel from growth to earnings that my colleague Joe Quinlan has long highlighted with good reason.

Will the real corporate profits please stand up?

Refining our techniques of analysis, and extending the analysis to valuable bodies of information like corporate profits, is critical to success in making forecasts and decisions. But that analysis is obviously no better than the data on which it is based. It is clear that, as good as our statistical infrastructure is in the United States, there is substantial room for improvement. In a landmark address at our Washington Economic Policy Conference this March, Fed Chairman Greenspan said:

"The experience of the last 40 years underscores a fundamental dilemma of business economics. Should we endeavor to continue to refine our techniques of deriving maximum information from an existing body of data? Or should we find ways to augment our data library to gain better insight into how our economy is functioning? Obviously, we should do both, but I suspect greater payoffs will come from more data than from more technique."

And as I noted in congressional testimony as your president in April:

"Since their inception, statisticians have endeavored to improve the quality and accuracy of these statistics. Yet our economy is constantly changing: The industrial economy of the past has given way to a very different, knowledge-based information economy. That constant evolution -- some would say revolution -- requires both new sources of data and the resources for our statistical agencies to collect and analyze them. While U.S. economic statistics remain among the best in the world, lack of investment in our statistical infrastructure has left us with a system that still does a better job of measuring industrial activity than information-based output."

In the arena of corporate profits, this rapid change towards idea-based value added has clouded our sense of today's results and thus limited our ability to reckon the future. There are at least three sets of issues: What are revenues today and what are expenses? What is a capital outlay and what is an intermediate expense? What is compensation, and how do options and other gainsharing practices affect it?

The biggest problems surround expenses, both for capital outlays and compensation. Decisions about what to expense and what to capitalize will obviously affect depreciation and earnings. The problem is fuzziest when dealing with intangible assets, like ideas or information, because their cost may bear little relationship to their value. But even with tangible assets, the concept of useful lives in the IT age bedevils measurement of earnings. How should we capitalize software expenses?

Regarding compensation, many now recognize that the accounting for stock options overstates earnings, essentially because their fair value as compensation is not charged against income. Lacking any independent measurement of the value of stock options exercised, statisticians in Washington are forced to deduce them from reports on wages and salaries. As we saw in the recent dramatic and offsetting revisions to NIPA corporate profits and compensation in July, this lack of information can dramatically distort reality. Partly because they uncovered more option income than previously recognized, statisticians trimmed the level of corporate profits by $79 billion, or 9%.

These revisions had stunning implications for profit margins. The data confirm that companies are enduring the most intense margin squeeze since 1978-80. The old data were bad enough: They showed after tax "economic" profits as a share of corporate GDP -- one proxy for margins -- sagging by more than 200 basis points to just under 10% between the fall of 1997 and early this year. Revised data show that margins have plunged by a staggering total of 400 basis points since 1997 or roughly one-third, to 8.1%, or their lowest level since 1992. And growth in corporate profits is now reckoned at 5.7% last year compared with 10.3% in the old data.

Confusion about accounting for options is only one of several issues that cloud the measurement of earnings in the real world, let alone in the national income accounts. What are recurring and nonrecurring charges against income? You may have seen that S&P figures that second-quarter operating earnings fell by 32.9% from a year ago, while Thompson Financial/First Call puts the decline at just 17%. How could the gap be so wide? A few tech companies took sizable writeoffs in the second quarter, which S&P counts are operating expense and which First Call sees as one-off items.

More ominously, those who ply the accounting trade are turning up several ways that companies may have overstated earnings in the past. My colleague Trevor Harris notes five: They represented one-time sales as ongoing revenue, they recognized revenue before goods were shipped, they assisted customers with vendor financing but did not account for its cost, they used questionable assumptions in accounting for pension costs in operating income, and they overstated restructuring charges following an acquisition.

The current confusion over earnings, and the suspicion that they've been overstated for years, couldn't come at a worse time. Amid the gloom over a slumping economy and a hard landing for corporate profits, investors may now sense that stocks may have been even more overvalued than they previously thought. Trevor Harris' work shows that companies who play games with earnings won't be able to hide results. It should now be clear that they aren't just hurting their shareholders. They are hurting themselves and the broad investing public.

What should be done? I applaud the Administration and Congress for appropriating increased funding for our statistical agencies to improve the quality of economic statistics. Still more is needed to try to solve some of the biggest shortcomings of our statistics. Business can partner with government to help. We at NABE are initiating efforts to enable business to contribute to the solution. Let's also make sure that businesses don't contribute to the problem. We insist on transparency for our policymakers. Let's insist on transparency in corporate reporting as well.

There's little doubt in my mind that the analysis of corporate profits and the appropriate measurement of earnings are issues that don't just affect Wall St. I believe that they are equally important to everyone on Main St.

Annual Meeting Home

Annual Meeting Presentations

Slide Show for this speech (PDF, 60 K)