Commentary: Where Did All the Profits Go?

By Michael J. Mandel

One of the marvels of the New Economy in the 1990s was the sustained growth in corporate profits. From 1995 to 2000, earnings per share for the Standard and Poor's 500-stock index rose by almost 50%. The Commerce Dept.'s measure of corporate operating profits told an almost identical story, rising by 41% in the second half of the 1990s.

But the truth about profits is turning out to be far less rosy. On July 27, the government's statisticians lowered their estimates of corporate profits for the past three years; for 2000 alone, they sliced a full $70 billion off their 2000 number. Nonfinancial corporations got a major haircut, with estimated profits in 2000 reduced by $81 billion, or 13%. The new data now show virtually no growth in nonfinancial profits from 1995 to the first quarter of 2001.

Does this mean the productivity miracle of the 1990s turned out to be little more than a mirage? Not at all. The new numbers still show that output per worker at nonfinancial corporations rose at a sprightly 2.9% annually from 1995 to 2000. That's about double the rate of the prior two decades and higher than in the Golden Age of the 1960s.

But the revisions do imply that the economy was fraught with much more risk than anyone assumed during those go-go years. Newly available tax return data for 1998 and 1999, and better estimates for 2000, reveal more small companies losing big bucks than realized, especially in telecom and tech. Add those losses up and they cancel out an awful lot of profits at the S&P's bigger companies. Moreover, the new numbers show a big jump in payments to managers and workers from exercised stock options, which reduces profits as the government calculates them.

As a result, the benefits of higher productivity did not show up in corporate profits. Instead, they seem to have been funneled into high-risk telecom and dot-com investments and into stock option compensation. At the same time, much of the nontech sector saw profits fall in the late 1990s. Profits in nondurable manufacturing, including food and pharmaceuticals, peaked in 1997, for example, while transportation profits topped out 1998.

There are several reasons why the revised data show a worse picture than reported S&P earnings. For one, the S&P 500 index is composed of large public companies, while the government includes all companies. Because there are so many smaller companies and because many are privately held, their losses are difficult to tally until the tax returns come in.

The preliminary results from 1999 are becoming available only now--and the size of the losses are a big surprise. Money-losing companies reported $300 billion in red ink in 1999, 50% more than the 1997 figure. Much of the jump came in communications and business services, a category that includes most of the dot-coms. For example, money-losing communications companies reported $25 billion in losses in 1999--enough to cancel the combined reported profits of General Electric (GE), Ford (F), and General Motors (GM). Such losses didn't stop in 1999. One example: Covad Communications Group (COVD), with sales of $159 million, reported a 2000 loss of $1.4 billion.

As new tax data trickles in, it's also clear that the stock-option boom has hit profits. The government includes the cost of exercised stock options in its revised profits. But S&P earnings typically omit that cost, which boosts reported profit growth.

WORK IN PROGRESS. And what of the recent spate of huge write-offs, which have raised questions about the strong profits reported earlier at many of the companies taking them? The two profit measures handle the timing of write-offs in different ways. Corporations tend to announce big one-time restructuring charges which include reserves for future expenses. By contrast, the government records expenses when they happen--when plants are closed, workers laid off, and worthless inventory disposed of. Still, the difference in timing didn't make much of an impact on the current revision. In the future, though, it's likely to become more important.

The latest numbers aren't the last word. As data comes in, the revisions will continue. But one thing is certain: Investors clearly were paying more for stocks and taking more risk than they realized. Mandel writes about the economy from New York.

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