[Mb-civic] America ¹ s false profits Economist

Fri Aug 27 18:20:25 PDT 2004

Buttonwood 

America¹s false profits

Aug 27th 2004 
>From The Economist Global Agenda

American firms are not as healthy as you might suppose

THERE are not many Wal-Marts in St James¹s, the swanky part of London that
The Economist calls home. Actually, there aren¹t any. And it is our loss,
for however grand, charming and quirky the shops, cheap they are not.
Wal-Mart, in contrast, is nothing if not cheap, which is why this one chain
alone accounts for 8% of all American retail sales. So it would be no
exaggeration to say that when Wal-Mart says that its sales are sluggish, as
it did on Monday August 23rd, you should take that as strong evidence that
America¹s indebted consumers are tightening their belts and the economy is
having a rough spell. This will not be good news for corporate America if it
continues. Might it be positively bad?

The very thought! American companies, as we all know, are money-making
machines. Having gone through a bit of a rough patch post Enron, their chief
executives are again being lauded as the titans they clearly are. Profits
for those companies lucky enough to be included in the S&P 500 index
increased by 20% or more in the second quarter. They have increased by over
20% for four quarters on the trot‹only the fifth time they have managed this
feat in 50 years. While markets have in general fallen this year, heady
corporate profits have at least provided corporate-bond and equity markets
with support at their current, still elevated, levels. Anyone who thinks
that they will continue to do so might not want to read what follows.

The conventional view of corporate America is that it is in splendidly lean
shape. Low interest rates and giddy profits have enabled firms to pay off
debts and extend the maturity of those loans still outstanding, thus making
them less vulnerable to rising interest rates. Indeed, the repair of their
debt-heavy balance sheets was the main justification for the sharp
contraction in the spreads of corporate bonds over Treasuries last year, and
provided extra oomph to shares. Even though this process really only
involved a transfer of debt from companies to individuals, who have borrowed
mightily to spend and buy houses, even Buttonwood, ever the sceptic, was
prepared to concede that it had taken place.

Too soon, perhaps‹for evidence that corporate debt has fallen in the economy
as a whole is scant. For one thing, you would have thought that companies
paying off their debts at a rate of knots would have attracted a nod of
approval from the credit-rating agencies. But the average rating of American
firms from Moody¹s, which crunched the numbers for The Economist, has
actually fallen over the past three years, from the lowest investment-grade
rating, Baa3, to Ba1, or junk. Small wonder, perhaps: CreditSights, an
independent research firm, calculates that while companies have become a bit
less leveraged recently, total debts for a sample of 175 firms are still
almost 40% higher than they were in 1999. Measured as debt compared with
market value, leverage has fallen. But this is almost entirely due to rising
share prices, not falling debts.

Yet, in contrast, the average rating of financial firms has risen over the
same period. According to the National Income and Product Accounts (NIPA),
calculated by the Commerce Department¹s Bureau of Economic Analysis, the
nadir for financial firms¹ profits came in 1994 (when the Federal Reserve
last raised interest rates aggressively). In the first quarter of that
tumultuous year, the profits of all of America¹s financial firms fell to $82
billion at an annual rate. Since then they have soared, and by the first
quarter of this year had risen to $356 billion at an annual rate‹almost 40%
of all profits and a quarter of total stockmarket capitalisation in America.
(For comparison, they were 6% of stockmarket capitalisation in 1980.) But in
a time of rising interest rates, you can¹t help feeling that the best years
for this sector are behind it. Indeed, the sector's annualised profits fell
by $3.6 billion in the second quarter, according to figures released on
Friday.

A collapse in financial-sector profits would leave something of a hole.
Strip out financials, an unfair though illuminating exercise, and the S&P
500 would have put in a decidedly poor performance in recent years. From its
peak in March 2000, the S&P excluding financials would have dropped by 50%
by October 2002, its low. Since then it has risen, though it is still down
by 30% from its peak.

The surprise, if any, is that it was so high before. According to the NIPA
numbers, only in the first quarter of this year did the profits of
non-financial firms exceed the record of 1997: $605 billion against $595
billion. For all the talk about the miraculous ³new economy² of the late
1990s, the truth is that American firms¹ profitability was dismal,
presumably because any company that did not squander squillions of dollars
on technology and shifting out of businesses that actually made money was
shunned by investors. By the fourth quarter of 2001, annualised profits had
dropped to $324 billion. Big companies, of course, could disguise some of
this with accounting practices that were as surreal as the level of the
stockmarket.

There is, of course, no denying that companies have been raking it in
lately. But if they haven¹t been paying off debt or investing (and
investment has been lacklustre), what has happened to that money? According
to the NIPA figures, an astonishing 90% of it has been paid to shareholders.
In an era of low interest rates, investors presumably want money up front.

But in the absence of investment and with balance sheets still heavy with
debt, jam today does not necessarily mean jam tomorrow. Companies lack
pricing power. The cost of oil and other raw materials has been rising this
year, but consumer-price inflation has remained subdued, suggesting that
companies are finding it very hard to pass on higher costs to consumers. Now
even the mighty Wal-Mart says that sales are slowing. To Buttonwood¹s mind,
this cocktail makes financial markets about as cheap as the goodies on offer
in St James¹s.

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