By Elizabeth Stanton
Dec. 15 (Bloomberg) -- Just when U.S. companies are about to report their biggest writedowns, the losses may be the strongest signal yet that it’s time to buy stocks.
Companies in the Standard & Poor’s 500 Index are marking down assets at the fastest rate in six years, leaving operating profits 46 percent higher than net income in the third quarter, a level last seen in 2003 when the previous bull market began. Starbucks Corp., Johnson Controls Inc. and Washington Post Co. reported profits before restructuring and layoff expenses for the period ended in September that were twice their bottom line.
Earnings at U.S. companies have dropped for five straight quarters, matching the longest streak on record, as the deepest financial crisis since the Great Depression turned 2008 into the worst year for the S&P 500 since 1931, according to data compiled by Bloomberg. The ballooning gap between net income and operating profit suggests companies are getting rid of their weakest businesses, setting the stage for a recovery in stocks next year.
“Trough earnings tend to coincide with a maximum level of writedowns,” said William Knapp, New York-based investment strategist at MainStay Investments, which manages $25 billion. “You will start to see profitability return once the economy turns, which will probably be in the second half of next year. The market is going to recognize that through price and activity six-plus months ahead of time.”
Frozen Credit
Frozen credit markets and concern Detroit-based General Motors Corp., the biggest U.S. automaker, will file for bankruptcy protection sent the S&P 500 down 1.8 percent this month. Shares may plunge another 20 percent before recovering late next year, New York University finance professor Nouriel Roubini, who predicted the global financial crisis, said on Bloomberg Television on Dec. 12.
The U.S. economy may shrink 0.8 percent next year, according to the average estimate of gross domestic product by economists surveyed by Bloomberg.
The S&P 500 tumbled 44 percent since its October 2007 record as almost $1 trillion of losses and writedowns at the biggest financial companies triggered a global recession and raised the possibility of deflation, when falling prices squeeze corporate earnings.
This decline is worse than in 2001 when the bursting of the technology bubble brought on the last recession, said Stephen Wood, New York-based senior portfolio strategist at Russell Investments, which manages $180 billion.
‘Systemic Implications’
U.S. stocks fell today, wiping out last week’s gains, after manufacturing showed a worsening economy that analysts said will hurt earnings at companies from JPMorgan Chase & Co. to Apple Inc. The S&P 500 retreated 1.3 percent to 868.57.
The last bear market “was large, but it didn’t have systemic implications,” Wood said. “We will be led out of this by credit. If credit doesn’t improve materially, then stock isn’t going to matter.”
Companies are paying an average 10.8 percent to borrow, up from 6.53 percent in January, according to Merrill Lynch & Co.’s Corporate & High Yield Master Index on Dec. 12. The premium investors demand for lending to companies instead of the government has risen to 8.85 percentage points, compared with 2.96 at the start of the year, the index shows.
The growing difference between operating income, which measures a company’s surviving businesses and strips out one- time costs, and net income, which includes all expenses, may mean the profit slump will end, says MainStay’s Knapp.
Setting the Stage
A widening gap heralded the end of the dot-com crash. S&P 500 operating earnings exceeded net profit by 67 percent in the final three months of 2002, a period when stocks dropped to the lowest level since 1997. The index then doubled through October of last year.
Texas Instruments Inc. reported operating profit of $67 million and a net loss of $589 million in the fourth quarter of 2002 after the second-largest U.S. chipmaker wrote down an investment in Micron Technology Inc. That set the stage for per- share profit growth from continuing operations of 186 percent in 2003 and a 96 percent rally in the Dallas-based company’s stock that year.
Companies report bigger differences between profit and operating income when profits are falling the fastest, “and that often happens near market lows,” said Robert Arnott, the founder of Pasadena, California-based Research Affiliates LLC, which manages $30 billion.
‘Significant Jump’
The gap will expand in the fourth quarter as companies write down acquisitions and take charges for job cuts and plant closures, said Chris Senyek, head of accounting and tax policy at ISI Group Inc., an economic and market-research firm in New York. The number of Americans filing claims for unemployment benefits has surged to the highest level since 1982, according to a government report last week.
“You’re going to see a significant jump in the fourth quarter and into next year,” Senyek said.
Steeper writedowns may be inevitable because falling stock prices diminish the value of completed takeovers. Thirty-eight companies in the S&P 500 have a lower market capitalization than the value of their goodwill, the balance-sheet asset left when companies pay a premium in an acquisition.
New York-based Time Warner Inc., the world’s largest media company, and Macy’s Inc., the department-store operator, as well as Los Angeles-based Northrop Grumman Corp., the third-biggest defense contractor, may be forced to write down acquisitions to match the decline in their shares after the S&P 500 dropped 40 percent this year, according to data compiled by Bloomberg.
‘Ultimately Improve’
The writedowns “will ultimately improve reported earnings when the economic downturn ends and we come out of it,” Senyek said. A rebound may take longer than it did in 2003 because the current economic contraction is more severe, he added.
Starbucks, Johnson Controls and Washington Post are among S&P 500 companies that are coping with the recession by getting rid of weaker units, which may help them rebound once the economy exits the yearlong recession.
While Starbucks reported operating income of $76.9 million for the quarter that ended in September, the Seattle-based coffee retailer’s net profit was $5.4 million because of charges taken to close 600 U.S. stores and cut 13,000 jobs.
The company this month doubled its forecast for 2009 expense reductions to $400 million. Chief Financial Officer Troy Alstead told analysts during a conference on Dec. 4 the savings will come mostly through firings and lower product costs.
Johnson Controls
Johnson Controls, the largest maker of automotive seats, reported net income for the September quarter of $16 million. Excluding a $495 million charge for job cuts, earnings at the Milwaukee-based company were $439 million.
In October, the company said it would pare production and workers as U.S. auto sales slumped. The retrenchment included the shutdown this month of a plant in Ohio and the mid-2009 closing of a Kentucky plant that makes metal parts for seats.
Washington Post, publisher of the newspaper in the nation’s capital, earned $10.3 million under generally accepted accounting principles. Operating income, excluding writedowns from cutting the value of its community newspapers, was $40.3 million.
Sales rose 10 percent last quarter thanks to gains in its education and cable-television units, helping the company maintain its $2.15-a-share quarterly dividend in November. The New York Times Co., publisher of the namesake newspaper, reduced its payout by 74 percent last month.
For S&P 500 companies, both net income and operating profits are likely to decline through the first half of next year, said Nicholas Sargen, chief investment officer at Fort Washington Investment Advisors, which manages $30 billion in Cincinnati.
At that point, he said, “I’m going to start to pay more attention to the operating profits because I think we’ve seen most of the write-offs and operating is going to be giving me a better gauge as to the true earnings power of these companies going forward, and we’re doing it from very depressed levels.”
To contact the reporter on this story: Elizabeth Stanton in New York at estanton@bloomberg.net.
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