Corporate Profits

In his blog, Mish Shedlock quotes from the Wall Street Journal. If you want to read the whole article you can subscribe or google the title, click on the link, and read it for free. This works for all wsj articles. 

Quarterly profits and revenue at big American companies are poised to decline for the first time since the recession, as some industrial firms warn of a pullback in spending.

From railroads to manufacturers to energy producers, businesses say they are facing a protracted slowdown in production, sales and employment that will spill into next year. Some of them say they are already experiencing a downturn. 

“The industrial environment’s in a recession. I don’t care what anybody says,” Daniel Florness, chief financial officer of Fastenal Co. , told investors and analysts earlier this month. A third of the top 100 customers for Fastenal’s nuts, bolts and other factory and construction supplies have cut their spending by more than 10% and nearly a fifth by more than 25%, Mr. Florness said.

Caterpillar Inc. last week reduced its profit forecast, citing weak demand for its heavy equipment, and 3M Co. , whose products range from kitchen sponges to adhesives used in automobiles, said it would lay off 1,500 employees, or 1.7% of its total, as sales growth sagged for a wide range of wares.

The weakness is overshadowing pockets of growth in sectors such as aerospace and technology.

Profit and revenue are falling in tandem for the first time in six years, with a third of S&P 500 companies reporting so far. Analysts expect the index’s companies to book a 2.8% decline in per-share earnings from last year’s third quarter, according to Thomson Reuters.

Sales are on pace to fall 4%—the third straight quarterly decline. The last time sales and profits fell in the same quarter was in the third period of 2009.

Wal-Mart recently warned its sales this year are likely to be flat, down from projection of as much as 2% growth, and cut its earnings forecast for next year as it raises wages. The retailer blamed the strong dollar for the weakening sales growth.

And truckload carriers have warned that they aren’t witnessing the usual uptick in retailer demand as the holiday season approaches, thanks to stubbornly high inventories, said Alex Vecchio, a transportation analyst at Morgan Stanley. “Transportation companies are typically a leading indicator, and our data is not good,”Mr. Vecchio said.

I read Mish regularly and find his views interesting, and he thinks corporate profits are headed down. I think so too, but that is not the focus of this post. Nor is the focus illegal misstating or manipulation of income. Instead I want to focus on legal manipulation of income. Since corporate officers salaries are usually based on making a set profit number, there is high incentive to use both legal and illegal techniques to increase profits. My view is that the last crisis was exaggerated in depth by these practices. 

One way this is done is to borrow money to buy back shares in the company. Since interest rates are low right now this results in a increase in profits. The total profits might remain the same, but those same profits are spread over fewer shares. For example a hypothetical corporation might have a profit of 100 with ten shareholders. Each shareholder gets 10. The corporation borrows enough money to buy one share. Maybe the new profit is 97 after interest, but this profit will now be spread over 9 shares so instead of a 10 profit for the each share, it will 97/9 or a profit of 10.78. A company that does this consistently is one you want in your portfolio. This is an increase of almost 8%. The corporation's health is less, but the share price would go up. A corporation can either go the traditional route and actually increase profits, or load up the corporation with debt, buy back shares and in some cases get a nice salary bump for its officers.  Do you care to guess what many corporations are doing? Have you ever wondered why all the Radio Shacks are closing? While there are other factors involved as well, Radio Shack has been a "poster boy" for this risky practice. 

Can you trust corporate profit numbers? Mostly you can, but you need to understand that there are ways, legal and illegal, to manipulate profit.