4 Tools of Corporate Profitability & the Economic Consequences

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Recently, I wrote an article discussing the "Truth About Wall Street Analysts" and the inherent conflict between Wall Street and individual investors. There is also another group of individuals who are also just as conflicted - corporate executives. Today, more than ever, corporate executives are compensated by stock options, and other stock based compensation, which are tied to rising stock prices. There are billions at stake in many cases and the game of "beat the Wall Street estimate" is critical in keeping corporate stock prices elevated. Unfortunately, this leads to a wide variety of gimmicks to boost bottom line profitability which is not necessarily in the best interest of long term profitability or shareholders. Today we will discuss four tools that have been at the heart of the surge in profitability since 2009 and why such profitability has failed to boost the economy.

One of the primary debates that is currently raging is whether, or not, the economy is currently experiencing a "soft patch" of activity and is set to begin a longer sustained recovery. Such an economic recovery is critical to support the primary thesis of a new secular bull market beginning in the stock market. At the core of all of these arguments is corporate profitability. With the stock market hitting all-time highs in 2013 market valuations have increased considerably. The chart below shows the forward reported P/E ratio change from January of 2012 to present.

S%26P-500-ForwardPE-060613

The problem is that the price/valuation increases have come at the expense of deteriorating corporate profitability. I discussed this issue earnings at length in my recent report on "Evaluating 3 Bullish Arguments" but importantly was the chart below which showed the deterioration in earnings.

S%26P-500-Earnings-052813

Since 2009 the reported earnings per share of corporations, the bottom line of the income statement, have increased by a total of 175% which is the sharpest, post-recession, increase in reported EPS in history. However, at the same time, reported sales per share, which is what happens at the top line of the income statement, has only increased by a marginal 34% during the same period. This is shown in the chart below.

S%26P-500-Sales-Earnings-PerShare-060613

In order for profitability to surge, despite rather weak revenue growth, corporations have resorted to four primary weapons: wage reduction, productivity increases, labor suppression and stock buybacks. The problem is that each of these tools create a mirage of corporate profitability. Furthermore, as I will discuss below, each have a negative impact on investors and/or the economy.

Stock Buybacks Create An Illusion Of Profitability

One of the primary tools used by businesses to increase profitability has been through the heavy use of stock buy backs. The chart below shows outstanding shares as compared to the difference between operating earnings on a per/share basis before and after buy backs.

S%26P-500-OperEPS-Buybacks-060613

The problem with this, of course, is that stock buy backs create an illusion of profitability. If a company earns $0.90 per share and has one million shares outstanding - reducing those shares to 900,000 will increase earnings per share to $1.00. No additional revenue was created, no more product was sold, it is simply accounting magic. Such activities do not spur economic growth or generate real wealth for shareholders.

Working For Two

Since the end of the financial crisis corporations have been able to markedly boost profitability has been through increases in productivity. In any business the highest single expense is the cost of labor. Therefore, increases in productivity can reduce the need for more employees. The first chart below shows

Productivity-employment-060613

As productivity increases the need for employment is reduced. Automated answering systems have been used to replace receptionists, automated billing systems, outsourced help desks, etc. have allowed for lower headcounts for businesses while increasing output per person. Higher output, and lower costs, have led to the highest profit per employee in history as shown in the chart below.

Profits-Employees-060613

What? You Want A Raise?

While increasing productivity will increase profitability - a large and available labor pool, which creates competition for existing jobs, keeps wages suppressed. Suppressed wage growth, combined with increases in productivity have created massive profitability for businesses. The chart below shows real compensation per hour since 2000.

Compensation-PerHour-060613

The spike in 2012, see inset, is deceiving because the entirety of the increase came in the 4th quarter as corporations panicked prior to the "Fiscal Cliff." That one time effect is now past but higher tax rates are here to stay. Real compensation has now fallen back to levels previously seen at the beginning of 2012 but higher tax rates have reduced the purchasing power of individual workers. With profitability now under pressure it is unlikely that we will see any significant increases to compensation in the near term particularly as real unemployment remains elevated. This does not support the economic recovery story.

Sorry, We Aren't Hiring Full-Time

The reason that I state the real unemployment remains elevated is that despite increases in employment in recent months it has been a function of population growth rather than a improved outlooks by businesses. The issue of population growth is ignored by most analysts and economists when discussing employment. However, when businesses are geared for a certain level of demand, increases in population will incrementally increase demand requiring fractional increases in business productivity and output. However, in order to keep costs minimized businesses have resorted to temporary hires rather than full-time employment which incurs additional costs of benefits and healthcare. The expectation is that temporary workers will eventually become full-time employees, however, with the impending effects of higher healthcare costs due to the Affordable Care Act - temporary hires may be the new normal. The chart below shows full-time employment relative to the population.

Employment-Fulltime-population-060613

With full-time employment still near the recessionary lows it shows that businesses remain focused on the cheapest cost of labor possible. The chart above also shows jobless claims which have been steadily falling since the peak of the crisis. This is due to "labor hoarding" where businesses have literally run out of employees to terminate or fire. However, just because fewer people are being terminated it does not mean that greater levels of full time employment are being created which is what is needed to create sustainable organic economic growth.

Profit Scraping May Have Reached Its Limit

There is no doubt that corporate profitability has surged from the recessionary lows. However, if I am correct in my assessment, then the recent downturn in corporate profitability may be more than just due to an economic "soft patch." The problem with cost cutting, wage suppression, labor hoarding and stock buybacks, along with a myriad of accounting gimmicks, is that there is a finite limit to their effectiveness. While Goldman Sachs expects profits to surge in the coming years ahead - history suggests something different.

S%26P-500-Earnings-052813-3

I say this because of something my friend Cullen Roche recently pointed out:

"We’re in the backstretch of the recovery. We’re now into month 47 of the current economic recovery. The average expansion in the post-war period has lasted 63 months. That means we’re probably in the 6th inning of the current expansion so we’re about to pull our starter and make a call to the bullpen. The odds say we’re closer to the beginning of a recession than the beginning of the expansion. That puts the Fed in a really odd position and not likely one where they’re on the verge of tightening any time soon."

This is a very important point. While the Fed's ongoing interventions since 2009 have provided the necessary support to the current economic cycle it will not "repeal" the business cycle completely. The Fed's actions work to pull forward future consumption to support the current economy. This is turn has boosted corporate profitability as the effectiveness of corporate profitability tools were most effective.

However, such actions leave a void in the future that must be filled by organic economic growth. The problem comes when such growth doesn't appear. With the economy continuing to "struggle" at an anemic rate of growth the effects of businesses profitability tools have become much less effective.

This is not a "bearish" prediction of an impending economic crash but rather just a realization that all economic, and earnings, forecasts, are subject to the overall business cycle. The problem with earnings forecasts, such as Goldman Sachs above, or the CBO's 10 year economic growth forecast, is that they have failed to factor in the probability of normal economic recession. This is a mistake that eventually produces very negative outcomes for investors.

Source: Steet Talk Live

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