[A-List] Enron "profits" and the dismal science

["Keaney Michael" <Michael.Keaney@xxxxxx>]

Hamish McRae: Learning to trust the numbers again may
 take a while

 The Independent, 14 February 2002

 Now the markets want truth and that is what the companies
 will learn to offer

 Beware the profitless recovery. The world economy seems to
 be turning up; interest rates look like turning up; but when will
 profits follow suit?

 Profits matter enormously, and not just for the obvious reason
 that stock market values are predicated on a revival of
 profitability. Profits matter at this moment because there is the
 gravest suspicion among investors that the figures - for
 companies on both sides of the Atlantic - cannot be trusted.
 So not only do profits have to recover. They have to be real.

 We are still in the very early stages of a global rethink on how
 profits should be calculated. There is always an element of
 make-believe about what should constitute profits. There has to
 be, because any running tally of a company's performance
 involves making judgements. Some are simple ones such as
 what you should provide for bad debts. Others are more
 philosophical: how, for example, should you treat money spent
 on promotion of brands or staff development - are these
 "investment" because they increase the capital value or are
 they "current spending"?

 But, during the boom years, the make-believe becomes more,
 well, to use the accountants' expression when trying to sell
 their services, "aggressive". And, while nothing on this side of
 the Atlantic is remotely comparable with the abuses at Enron,
 hardly a day passes without some new story about a
 company's profits that are not quite what they seemed when
 they were first reported. Guardian iT and Cable & Wireless are
 two of this week's crop. Expect many more.

 Looked at globally, a clear turning point has been reached in
 company sentiment. You can see that from the top graph,
 which shows business confidence in the three largest
 economies: the US, Japan and Germany. But while it has
 zipped round very fast, the absolute level of confidence is still
 below the 50 per cent balance. Indeed it is much lower than it
 was at any time during the early 1990s recession. Meanwhile,
 the change in global profitability (bottom graph) is pretty dire,
 worse indeed than it was at the pit of the early 1990s.

 You would expect that, because profits are bound to lag
 business sentiment, but if the early 1990s are any guide,
 another couple of years could pass before profits really recover.
 When they did get going in 1994/5 they shot up. But were that
 experience to be repeated, it would mean waiting for another
 couple of years before the good times really start to roll.

 Besides, there are several reasons to suspect that this cycle
 may be tougher. First, company debt is higher, so firms are
 more vulnerable to rises in interest rates. It is clear that we
 have now hit the bottom of this interest rate cycle. In the US
 rates are so low that there is not much point in going any lower
 and the Fed will want to claw back later this year. In the UK,
 upward pressure on inflation is going to ensure that the next
 move is up, not down - though that move may not come for
 several months. And in Europe, unless the recovery that is now
 starting collapses, expect the next move to be up too.

 Second, pricing power has been destroyed. All the evidence
 suggests that consumers around the world have become much
 more sensitive to prices. I don't think we fully understand quite
 why this should be so. It has something to do with
 globalisation, and something to do with the power of the bond
 markets. The first means that there is a world price for anything
 that can be traded; the second that any government that goes
 soft on inflation sees long-term interest rates soar. But it is
 also to do with attitudes: a new aggression by consumers,
 secure in the knowledge that if they hold off, the price is as
 likely to come down as to go up. Such inflation as there is
 around is in non-traded services and in government rather than
 goods.

 Third, the "pullout" from this downturn looks like being much
 slower and more muted than that of the early 1990s. The main
 reason is that the big imbalances in the US, in particular the
 extent to which consumers have relied on borrowing to
 maintain their life-styles, have yet to be worked off. But there
 are others, including the drag on the world economy from the
 second and third largest economies, shrinking Japan and slow
 growing Germany.

 This leads to two questions. The first is: how serious will the
 re-evaluation of profits be? Auditors will be utterly determined to
 cover their backsides. The balance of the debate between a
 company and its auditors will not only become more fraught;
 the balance of power between the two sides will change. At the
 margin, auditors will write down profits.

 The second question is about the extent to which investors will
 make allowance for this. Lower published profits may be
 acceptable, provided investors feel they are real. On the other
 hand this will make traditional value measures such as
 price-earnings ratios look even more adventurous than they are
 now.

 Companies are very good at dressing things up in a way that is
 attractive to the markets. Over the past couple of years the
 markets said they wanted growth, so that is what the
 companies, with the connivance of their auditors, gave them.
 (They also wanted companies like Marconi to sell off their solid
 boring businesses and invest instead in telecom companies in
 the US.)

 Now the markets want truth and that is what the companies
 will learn to offer. Nothing wrong with that; much better than
 lies. But truth about profits will, in the next couple of years, be
 discouraging and the markets will have to be patient. If they
 lose patience waiting and re-rate the markets then consumers,
 particularly in the US, will find their wealth falling and may cut
 back on their spending as a result.

 Here in the UK, the profit outlook may be rather better than in
 the US (possibly), Japan (certainly) and Germany (probably).
 This week's Bank of England Quarterly Bulletin shows that the
 rate of return on capital for UK manufacturing has fallen from 12
 per cent in 1996 to 4 per cent now. But service sector profits
 have held up well and are still above 12 per cent after a peak of
 17 per cent. But it would be unwise to crow. Every time another
 discrepancy is found in a UK company's profits, investors will
 ponder who is next. As they should.

Full article at:
http://news.independent.co.uk/business/news_analysis/story.jsp?story=119
861

Michael Keaney
Mercuria Business School
Martinlaaksontie 36
01620 Vantaa
Finland

michael.keaney@xxxxxx