The need for responsible reporting on profits -- including our own
COMMENTARY | October 26, 2006
Journalists need to stop letting CEOs get away with deceptive descriptions of their profits, writes Morton Mintz. And that’s certainly true in our own industry.
By Morton Mintz
The public would profit if news organizations would take care to describe profits -- including those in their own industry -- clearly and precisely. Consistently, however, they don't. Thus -- unintentionally -- they repeatedly mislead.
A case in point involves the June 18 edition of "Meet the Press." Three top oil-industry executives were among the guests. Listen to Chevron Chairman and CEO David J. O'Reilly:
In fact, we -- our profits are in the mid-range for all of industries, if you look at the statistics, and this is BusinessWeek data....For example, last year we made $14 billion dollars. That sounds like a lot of money. But the return on capital and return on sales were very modest.
This was high-octane deception, which Tim Russert, regrettably, didn't challenge. The fact is that Big Oil's return on capital is anything but "very modest," as data from Chevron -- O'Reilly's own company -- demonstrate.
Last year, Chevron's return on invested capital was 21.9 percent. That's high enough that the company's accumulated earnings would come to equal its equity in less than five years. Yet the company's chairman and CEO assured a television audience of millions that oil industry profits -- as he defined them -- are "very modest."
Ford Motor Co. posted a $5.8 billion loss--the worst since 1992--on Oct. 23. Could anyone conceive of Ford's new CEO, Alan R. Mulally, tut-tutting Chevron-like returns on the capital invested in Ford?
O’Reilly was on firmer ground in saying that his company’s “return on sales” was “very modest.” But does it matter to investors if the return on enormous sales is "very modest" (as is common in many high-volume businesses, including supermarket chains) so long as the return on invested capital approaches 22 percent?
After O'Reilly and two other oil company executives -- Shell's John Hofmeister and ConocoPhillips' James Mulva -- appeared on "Meet the Press," the oil industry bought full-page ads in major newspapers.
The industry's profit margin, 5.9 percent, the ads pointed out, is only slightly higher than the average of 5.6 percent for all U.S. industry. Surely not accidentally, the ads did not make clear that these profit margins are on sales. The result was to conceal enviably high rates of return on invested capital.
The industry's coyness about return on invested capital is also evident at the Web site of the American Petroleum Institute. Click on http://www.api.org/statistics/earnings/index.cfm and you will see this: "Oil and Natural Gas Industry Earnings Compared to All U.S. Industry: Over the past five years, the oil and gas industry's earnings averaged 5.9 cents compared to an average for all U.S. industry of 5.6 cents for every dollar of sales." To find returns on investment on that Web site, you have to download a 17-slide presentation entitled “Making Sense out of Oil and Natural Gas Prices." The fifth slide discloses that in 2004, returns on investment averaged 18.9 percent for "U.S. Oil & Gas" and 17.4 percent for the Standard & Poor Industrials.
Similarly, the abundant reports on the financial health of the Tribune Co., Knight Ridder and other large news organizations have regularly invoked but not explained the terms "profit margin" and "operating margin." How many newspaper readers know what they mean? Know that they are the result of dividing operating income by total revenue? Know that return on invested capital -- should this measure happen to be mentioned -- is the return on what the shareholders "own"?
I was able to clear my own head about these matters thanks to the generous help of newspaper-industry analyst John Morton (who, it may be noted, reports in the current American Journalism Review that “[i]n the first six months of this year, not a particularly good one for the newspaper business, the average operating profit was a robust 18 percent.”)
"Return on invested capital," he told me, "is the most rational way to evaluate companies in the long run." Here are highlights of his responses to my questions, which I hope reporters and editors will, as I did, find enlightening:
Usually in writing for the public I try to express operating profit as "keep in operating profit 18 cents on every dollar received in revenue," or words to that effect, which avoids the problem of 18 percent of what?...
The emphasis on operating profit margin stems from its role as a measure of management efficiency, something Wall Street dotes on and because, generally, increasing operating profits likely is reflected in increasing per-share earnings, which tend to drive stock prices.
While return on invested capital is the most rational way to evaluate companies in the long run (although this measurement is muddied up a bit because of depreciation, which can be hefty for companies like Tribune that have made big acquisitions), Wall Street has become famously short-run oriented in recent years, hence the Street's over-reliance on the next quarter's and the current year's earnings performance.
The reasons for Wall Street's approach are too complex and depressing to go into here, but basically it comes down to portfolio managers being judged on their bonuses according to the stock-price appreciation quarter to quarter on the equities they manage….
All or nearly all the news reports on Tribune Co.'s and Knight Ridder's profits have neither made clear to ordinary readers that the calculations are percentages of revenues, nor mentioned rates of return on invested capital.
Most years, the average after-tax return on invested capital for the publicly owned newspaper companies is "in the mid-teens," Morton told me. In 2005, Tribune's was 5.4 percent, but, he said, "would have been higher but for the Times Mirror depreciation it had taken on." (He added that "the company doesn't make public balance sheets for individual properties, such as the L.A. Times.")
Knight Ridder is a different story. In 2005 its operating profit ($493,521,000) was 16.4 percent of revenues ($3,003,992,000), Morton told me. Its pretax income (the $384,260,000 that remained of operating income after deductions for interest and other nonoperating expense) was 12.8 percent of revenues.
Knight Ridder's return on invested capital ($3,310,011,000) was 14.2 percent, up 3.1 points from 2004. Major oil companies likely would not be impressed. Many major U.S. corporations would probably say, Wow!
Here is an abbreviated glossary derived from experts found by Googling:
- Return on sales: The proportion of revenue remaining after paying for wages, raw materials, and other variable production costs the result of dividing operating income by sales revenue.
- Operating income: Gross profit minus operating expenses; the pre-tax, pre-interest profit from "operations."
- Operating margin, operating profit margin, net profit margin: see return on sales.
- Profit margin: Net profits divided by sales; measures how much of every sales dollar is kept in earnings.
- Return on investment /invested capital: Net after-tax income divided by net worth. The Motley Fool explains why it's key: “Return on invested capital, or ROIC, is one of the most fundamental financial metrics.. It is defined as the cash rate of return on capital that a company has invested. It is the true metric to measure the cash-on-cash yield of a firm and how effectively it allocates capital."
- Invested capital: Can be in buildings, projects, machinery, other companies, etc., and includes long-term debt and common and preferred shares.
- Net profit (bottom line): The result of subtracting total expenses from total revenue.
- Net worth (shareholders' equity or net assets): The result of subtracting total liabilities from total assets.