The Economic Drift

Is the economy falling apart or not? The mixed signals include a crisis in home finance, a weak jobs report, strong productivity numbers and an expectation (from analysts) of a 15% gain in corporate profits for 2008. The good news is that collateral damage from the credit market fiasco and concerns about consumer spending have made shares of high-quality companies a lot more affordable. The S & P 500 index is down 6.9% so far this year, which puts it at 17 times estimated 2007 earnings. If earnings growth meets expectations, you're paying 15 times 2008 earnings. That ratio is right in the middle of the historical range.

Is the economy falling apart or not? The mixed signals include a crisis in home finance, a weak jobs report, strong productivity numbers and an expectation (from analysts) of a 15% gain in corporate profits for 2008. The good news is that collateral damage from the credit market fiasco and concerns about consumer spending have made shares of high-quality companies a lot more affordable. The S&P 500 index is down 6.9% so far this year, which puts it at 17 times estimated 2007 earnings. If earnings growth meets expectations, you're paying 15 times 2008 earnings. That ratio is right in the middle of the historical range.

Our Beyond the Balance Sheet department looks at the numbers behind the numbers--ways of analyzing companies that are different from the usual metrics such as book value and earnings. Previous editions covered earnings quality, free cash flow and breakup values, among other topics. This time we take a look at three topics that relate to how companies will weather the recession, if that's what we're in (the truth about this may not be known until it's over). They are: employment, dividend-paying ability and pensions.

If a company is adding employees to its payroll and investing in fixed capital, it expects to grow. That's a big vote of confidence--especially as employment in the U.S. economy heads in the other direction. In the table we display eight companies that added jobs in the December quarter and also increased their capital outlays between 2006 and 2007.



If there's a recession, you wouldn't know it by looking at Google (nasdaq: GOOG - news - people ). Discussing the fourth-quarter addition of 889 jobs--including engineers in the U.S.--on its conference call, Chief Financial Officer George Reyes said the company "will continue to invest in its core business" of distributing ads to Internet surfers. Chief Executive Eric Schmidt followed that up later, responding to an analyst's question about economic weakness: "You're using the term 'potential slowdown,' which is not a term we have used on this call, so again that's your view, not necessarily ours." While holding a leading market share in its core business, the company is also investing in ancillary ones, like office productivity software. Its December quarter of 2007 cap-ex was $678 million, up from $367 million for December quarter 2006.

Another tech titan adding firepower is AT&T. The old landline business isn't what it used to be, but this phone company is expanding its payroll in order to get into the cable television business. It is adding technicians and installers for a service it calls U-verse. UBS analyst John Hodulik gives the thumbs up to this technology, writing in a February report that those covering the cable industry haven't yet factored in the competitive threat AT&T now poses to traditional cable operators like Cablevision (nyse: CVC - news - people ) and Time Warner Cable (nyse: TWC - news - people ). Echoing Hodulik's comments in a conference call with investors, AT&T Chief Financial Officer Richard Lindner said the company had no choice but to spend on new hires and training. In other words, recession or not, here we come.

Corporate prosperity can be reflected in a different kind of jobs number: productivity. In the table we show companies with big changes in sales per employee. Hospital-supplies vendor AmerisourceBergen, benefiting from rising expenditures on health care and automation of the wholesale industry, enjoys sales of $5.8 million per employee. Whole Foods Market (nasdaq: WFMI - news - people ) is going the other way, one reason its stock is sagging. This organic grocer bought competitor Wild Oats; the latter's smaller, older stores seem to have dragged down the average.



Our next table looks at dividends. Stocks with rich dividends are often touted as safe havens during bear markets on the theory that investors disillusioned with capital gains will seek comfort in quarterly payouts. Our take on dividend seeking: Look closely at whether the company can afford the payout. The metric here compares dividends with free cash flow, defined as cash flow from operations minus capital expenditures. In a financial statement you'll find cash flow from ops right after the profit-and-loss summary; it's roughly equal to net income plus depreciation plus declines in inventory and receivables. Clorox yields more than the average stock, has been raising its dividend and could afford to pay more.



Our last set of tables concerns old-fashioned pension plans, the ones that promise a certain monthly benefit. Such pensions are no longer the millstone they once were for American industry, partly because employers are shifting to defined-contribution plans that leave them with no obligations. But lots of older companies still have defined-benefit plans on their books, and the accounting for these plans can give a hint about a company's financial strength.





Take a look at the future return the company assumes in calculating its pension liabilities. The higher the return, the lower the discounted present value of those monthly payouts, and therefore the lower the hole on the balance sheet and the lower the annual pension cost charged to earnings. A return assumption on the high side suggests that the company is straining to meet its earnings targets. That is not a good sign.

The mostly bullish stock market of the past five years has lessened the problem of pension funding, says Mark Ruloff, director of asset allocation at pension consultant Watson Wyatt. Pension fund assets as a percentage of obligations went from an average 81% in 2002 to an estimated 109% at the end of 2007. But if the stock market keeps sinking, funding shortfalls will catch up with employers, and they will have to chip in more cash to their plans than they expect. In the table, our "conservative expectation" for pension fund returns is based on the sponsor's asset allocation and on bond yields, recent hedge fund performance and historical stock market returns.