A Matter of Perspective

This is a quick update on my recent post on corporate accounting and EPS.

The FT ran a rather bullish story the other day proclaiming that corporate America is spending again, a sign of returning confidence they told us.

Their ebullience seems to have been triggered by the fact that, according to a survey by the Association for Financial Professionals, corporations’ cash balances have been falling. The FT assures us that this is an important turning point in our recovery from the Great Recession.  Accordingly, this is a clear sign that animal spirits are returning to the US economy.

If only it were true. The FT starts the story this way:

US corporations are starting to run down their cash for the first time since the recession- a sign of returning confidence- but they remain reluctant to invest in new equipment.

Let me give you my translation of this line:

US corporations are confident in their ability to boost earnings per share so long as they DON’T invest in their businesses by purchasing new equipment.

The story does note that buybacks and acquisitions are what the cash is being used for, but it neglects one small detail that may be important: Cash is going down despite the fact that businesses, in the US anyway, are borrowing money at a faster rate.

According to the Fed’s Z.1 report:

Annual Business Borrowing

($ billions)

Year             Amount

2011               295

2012               532

2013               516

2014*             700

*  Annualized YTD numbers

Here is what we know, annualized borrowings have jumped nearly 40% this year, companies refuse to reinvest to grow their businesses and corporate profits have flattened out:

After Tax Corporate Profits with Inventory Valuation and Capital Consumption Adjustments

(SAAR, $ Billions)

Period             Amount

Q2 2012           1551

Q3 2012           1600

Q4 2012           1594

Q1 2013           1565

Q2 2013           1644

Q3 2013           1673

Q4 2013           1648

Q1 2014           1380

Q2 2014           1498

Source: Economagic, BEA

BEA defined profits differ from what we see in GAAP accounting. The BEA only wants to show the economic impacts from production in a current period. As such, it eliminates inventory profits and losses, adjusts depreciation expense to reflect current, real, depreciation and it strips out capital gains and losses and things like changes in expenses for bad debt.

As we can see from the above table, real economic profit growth is becoming tough to come by as profits have now fallen for three straight quarters.

So, where does this leave the corporate executive? He can no longer seem to grow his business top line. Over the past year, half of the companies listed in the Dow have seen negative real sales growth. Additionally, the Fed’s abusive interest rate policy has crushed any incentive to reinvest since incremental returns on capital must equal incremental costs. These are now set at zero, thanks to the Fed. Growth at the bottom line seems to have peaked, as well.

This leaves the corporate executive who wants to show EPS growth with share buybacks and acquisitions. Corporate capital allocators have been pushed into the equity markets, just like all other investors, as it appears to be the only place where a return in excess of punitively low interest rates can be generated. As stock prices rise, however, it is costing companies more to reduce their share count by a similar amount. This is what explains the need for more borrowing and lower cash balances. In fact, companies are buying shares at dramatically higher prices today than two years ago despite the fact that economic profits have fallen over this time.

As Austrian Business Cycle Theory teaches, central bank interest rate policies can act in a way that fools most capital allocators by sending signals that push these capital allocators to do the wrong thing at the wrong time. This is true of corporate executives today, in my opinion.  

The FT wants to proclaim that the decline in corporate cash balances is a sign of strength for businesses. I see it very differently. My view is that the corporate world is trapped, and their only option at the moment is to buy overvalued shares in businesses that cannot grow any longer. This will end badly.

I will point out that BEA after tax profits peaked well in advance of the peaking of share prices in 2000 and 2007. Those were also periods of time, not coincidentally, that saw a less accommodative Fed.  Will declining economic profits and a less profligate Fed combine, once again, to crush investors?

Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.