Devil's Advocate: New economy, new profitability - yeah, right

In the second part of his look at the internet and telecoms bubble years, Martin Brampton assesses some of the rule bending - and breaking - that was going on...

Last week, we looked at the hard evidence showing that we need to abandon any notion of the last decade auguring a spectacular productivity increase based on new technology. Moreover, we left the story at the point where companies faced falling profits and a need to keep their share prices high. How did they cope?

Generally, it is not possible to detach share prices from the stream of profits generated by a company. A basic principle of finance says that the value of the shares of a company is the same as the discounted value of its entire future stream of profits. While there are all kinds of short-term aberrations, they are generally based on sentiment about future profits. There is a limit to the extent to which investors can maintain confidence if actual profits are falling.

So the boom was kept going by the creation of paper profits. For example, Global Crossing and Qwest developed a system of exchanging business. Each would lease capacity from the other. The payments received were counted as current revenue but the costs of the capacity were counted as depreciation and spread over many years. The companies were not able to do much with the capacity they were leasing, because we can now see that the glut of investment created massive over provision. US networks are now running at utilisation levels below 3 per cent and even undersea cables achieve only 13 per cent.

Those two companies were able to increase their apparent earnings by over $1bn in 2001. But that is trifling compared with the figures achieved by WorldCom. It is now believed WorldCom managed to overstate its earnings by at least $9bn between 1999 and 2001. Rather than rely merely on revenue swaps, WorldCom employed the simple expedient of treating current costs such as wages as capital expenditure. It was thus able to spread costs years into the future, while reporting revenues immediately.

Optimistic financial reporting was particularly encouraged by the US system of dual reporting. Profits are first given on a 'pro forma' basis quarterly to stockholders. The rules governing pro forma earnings are evidently extremely flexible. Only later are companies obliged to produce figures according to the much stricter Generally Accepted Accounting Principles or GAAP.

The Nasdaq index used to be regarded as the home of technology high fliers. An example of the discrepancy between pro forma and GAAP earnings can be found in the first three quarters of 2001, where the top 100 companies on the Nasdaq market reported pro forma profits of $19bn. For exactly the same period, the GAAP reporting by the same companies showed total losses of $82bn. Cisco, Dell, Intel, Microsoft and Oracle taken together reported three times as much profit pro forma as under GAAP.

As recently as last July an analyst told Fortune magazine that WorldCom "seemed to have some kind of secret formula for producing decent margins where rivals couldn't". When the secret formula was understood, it was evident that the margins were simply not there. In fact, WorldCom probably made no profits in any of the years from 1998 to 2001.

Dramatic company news in the telecoms sector was, of course, driven by internet fever. Taken collectively, new internet companies made profits up to 2000 but then made losses that wiped out all the profitable years in one fell swoop. We now face a world where many large corporations have significant over capacity. New purchases of capital assets will not happen any time soon, leaving little cause for any economic optimism. Next week, we will ask what happened to your investments.

** Martin Brampton is a director and founder of Black Sheep Research (www.black-sheep-research.co.uk ), an independent consultancy providing research, writing and speaking services on a wide range of business and technology subjects. Martin was previously a director at Bloor Research, and has worked with IT as a user and analyst for over 20 years. He can be contacted at silicon@black-sheep-research.co.uk.

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