It Is More Apparent Than Real

THE PROFIT SQUEEZE

A PRESSING question for every U.S. businessman, to say nothing of his stockholders, is: how will profits be in the near future? Very often the answer is gloomy. Executives mutter about the "profit squeeze" and "profitless prosperity," point ominously to figures showing that while sales increased more than 100% in ten years, net profits declined from 5.2% of sales in 1947 to only 3.5% last year. But the figures are misleading. The so-called profit squeeze is more apparent than real, simply because companies are spending so much money on replacement and expansion programs that have cost $264 billion since World War II.

The standard method of gauging a company's health is to inspect its net profit--its earnings after all costs, taxes, depreciation and interest charges are deducted. In turn, net profit is split into dividends and cash retained for investment. Before World War II, when expansion was comparatively small, such a breakdown gave an accurate idea of profits. But today, because of expansion, many economists, including those at the Federal Reserve Bank of Chicago, think that it gives a misleading impression.

The Chicago Fed argues that profit reports should not be limited to cash available for dividends and retained earnings, but should also include such things as depreciation, i.e., funds set aside to help pay for new plants and replacement--in effect, profits plowed back into the business. To get a better idea of profits, the Chicago Fed uses "gross returns to capital," counts the total profit after taxes, including all depreciation, interest, retained earnings and dividends. On that basis, there is no profit squeeze. Gross profit margins have actually gone up, will total 7.6% on sales in 1955-57 v. 7.4% in 1946-48. The fact that so much of this profit is poured back into expansion has caused the profit squeeze.

Many an investor does not realize how expensive industry's expansion has become. International Business Machines Corp., for example, had gross returns after taxes of $35.10 per share last year, paid out only $3.80 per share as cash dividends; of the remaining $31.30 per share, $20 was charged off as depreciation, $9.30 was retained as cash, and another $2 per share went to pay interest on IBM's debt. In years past, U.S. manufacturing corporations were able to finance most of their expansion by retained earnings, had a relatively small debt to worry about. But today so many companies are expanding that even though industry retained earnings of $6.8 billion last year, it had to borrow another $9 billion. Result: long-term corporate debt reached $97.3 billion last year v. only $46.1 billion in 1947. Ten years ago, interest charges amounted to only $2.5 billion, or 10% of gross returns to capital. This year the charges will hit $10 billion and 20% of gross returns. Since 1947, U.S. Steel has tripled its interest to $7.6 million, while Union Carbide has gone from a mere $400,000 annually to $14.4 million.

An even bigger profit reservoir is depreciation, the money that companies set aside to pay for their plants over a period of years. In 1947, money set aside for depreciation amounted to only $5.2 billion, said the Chicago Fed. Last year the total was $16.7 billion; this year it may hit $18.2 billion, and grow almost half as big as total U.S. corporate profits before taxes. In a decade, General Electric boosted its depreciation fund from $23.8 million to $108.7 million annually.

One place where industry's billions for expansion show up is in the book value of each company's common stock. Thus, while the ratio of net reported profits to sales has slipped 1.7 percentage points, the value of most U.S. companies has doubled or better. Du Font's current book value is $44.74 per share even though it has split its stock four times since 1947, when the value was $55.69 per share. General Motors, Jersey Standard, U.S. Steel, all of which have split five for one in ten years, have at least doubled the book value of their shares.

The Chicago Fed warns that all will not automatically be rosy once U.S. industry's expansion program slows down. Companies will always have to set aside big chunks of their profit for newer, more efficient plants. Moreover, higher costs and tougher competition will keep businessmen on their toes. Nevertheless, the new plants will act as a double protection for stockholders by producing goods more efficiently, so that even in periods of lower sales, well-managed companies can keep up profits. The steel industry expects to operate at less than 80% capacity next year, yet some steelmen think they will make enough money to increase dividends in 1958 and again in 1959. Said one steelman: "When you expand capacity, it naturally reduces net profits in a given year. But the costs won't lower your earnings in the long run. In fact, they should increase earnings."

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