Profits: No Pain, No Gain

If the U.S. economy is to start growing again at its full potential, companies will need to restore profits to pay for capital investment and research and development. Despite recent layoffs, chief executives will have to do more to deliver those profits. The tech bubble, the recession, and unprecedented accounting and business scandals have forced CEOs into a defensive crouch. But the brutal truth is that without taking some painful actions, companies won't have the money to expand and compete on the global scene. In the long run, the entire country will suffer.

What will it take? Big reductions in compensation costs--for top management as well as the rank and file. BusinessWeek estimates that with sluggish revenues over the next year, companies in the Standard & Poor's 500-stock index may have to cut as many as 900,000 jobs, or 4% of the labor force, to boost profits by 12%. Significant cuts in outsized executive pay will have to be made as well.

This level of pain may be needed because overcapacity, deflation, globalization, and even technological innovation are all cutting the pricing power of Corporate America. Companies can't raise prices and in many cases are being forced to cut them. More significantly, it turns out that we never truly understood the relationship between productivity and profits. We assumed that a surge in productivity growth would automatically translate into profits. It hasn't. From 1993 to 1997, as productivity began to increase, earnings per share at the S&P 500 companies did jump from $22 to nearly $40. But after 1997, productivity kept rising--but profits didn't. Profits, according to government figures, actually fell 6% from 1997 to 2000, and dropped 10% further in the 2001 recession.

Where did the money go? To a large extent, compensation. BusinessWeek reckons that managers and employees of the nonfinancial S&P 500 companies took home more than $100 billion in net proceeds from exercising stock options in 2000 alone, enough to wipe out most of the rise in reported operating earnings from 1997 to 2000. This doesn't count regular salaries or other forms of compensation. In effect, a huge transfer of wealth from shareholders to managers and workers occurred.

Shareholders are unlikely to allow a repeat performance. They're already pressing CEOs to run their companies to maximize profitability, not their own compensation or that of their employees. Investors are already demanding that Corporate America move away from a pro forma/EBITDA world of anything-goes accounting and focus on quality earnings. All this will make the generation of solid profits much more difficult in the future.

The government can help some. Extending federal unemployment insurance could help ease the layoff pain, and, for companies, tax credits for investments could help shore up earnings. In the end, though, CEOs are going to have to make hard choices. Rebuilding profits, especially quality profits, will take pain. But profits are the lifeblood of a market economy and the key to sustained growth. There's no alternative.

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