News: Analysis & Commentary: THE ECONOMY
Why the Fourth Quarter Looks Like a Stinker
Profits are still historically high, but weak overseas sales, price deflation, and high wages are taking a toll
As 1998 drew to a close, holiday spirit bubbled over on Wall Street. A "Santa Claus" rally took the Standard & Poor's 500-stock index and the NASDAQ to new highs and lifted the Dow Jones industrial average back over 9000. But in Corporate America, Ebenezer Scrooge set the tone. Blue-chip giants from Coca-Cola to Caterpillar and Case somberly warned investors that fourth-quarter earnings would fall below expectations. By Dec. 28, some 400 such warnings had been issued. And by late January, "we will certainly surpass the previous record" of 526 warnings for a quarter, predicts Charles L. Hill, research director at First Call Corp.
These warnings set the stage for what is sure to be a dismal earnings season. Back on July 1, analysts tracked by First Call expected fourth-quarter operating earnings for the S&P 500 to soar 16%. But after the recent warnings, they now expect a rise of just 3%, and even that may prove overly optimistic, warns Hill. In any event, it will be the fourth straight quarter in which operating earnings have risen less than 4%. Given that trend, says Hill, operating earnings for 1998 will likely climb just "a little over 2%," down from 11% in 1997, and 18.5% as recently as 1995.OVERSEAS PAIN. A flood of restructuring charges will make net earnings even bleaker. Through November, corporations had unveiled plans to cut 574,629 jobs, just 7% shy of the decade's record high, set in 1993, according to outplacement specialists Challenger, Gray & Christmas. With Citigroup, Case, and others wielding the axe in December, 1998 may be "the worst year for corporate layoffs in the '90s," predicts Rick Cobb ofChallenger. With many companies figuring "they might as weLl get all the bad news out at once" with huge write-offs, net earnings will fall 5.5% in the fourth quarter, figures David A. Wyss, chief economist at Standard & Poor's DRI.
So why is the market setting records? It may be in part because 1998 profits as a percentage of gross domestic product, while lower, will still be strong. At roughly 8.5% of GDP in 1998, they'll be below 1997's 9.1% but well above anything reached in the 1980s or early 1990s, says Wyss. Also, the market tends to look beyond current problems. Analysts tracked by First Call still expect earnings to surge an eye-popping 18.7% in 1999. While such forecasts often prove optimistic, many strategists do expect accelerating growth in the second half of 1999 (page 88).
Still, many companies will face tough sledding in the first half. Multinationals, buffeted by the Asian crisis for 18 months, will continue to feel the pain. Coca-Cola, which gets 80% of operating earnings overseas, recently warned that fourth-quarter net will come in some 25% below the $817 million earned a year earlier. And weak markets from Asia to Russia will continue to hammer Coke, which analysts say may not hit its goal of increasing unit volume 7% to 8% in 1999. On Dec. 17, Nike Inc. said second-quarter earnings fell 51%, and warned that future orders are down 37% in Asia, versus just 7% in the U.S.
Things won't get any easier for multinationals in 1999. Asia "is still showing no signs of recovery," says James E. Goodwin, president of UAL Corp., which lost $600 million of business there in the 12 months ended Sept. 30. And with the Asian flu spreading to Brazil and Venezuela, "we think 25% of the world will be in recession in 1999," up from 20% in 1998, says Jeffrey M. Applegate, chief investment strategist at Lehman Brothers Inc.
Then there's pricing pressure, which affects companies at home and abroad. With the world awash in capacity, "there are almost no manufacturing industries where you can raise prices," says Jerry Jasinowski, National Association of Manufacturers' president. Makers of dynamic random access memory (DRAM) chips have seen prices plunge up to 97% over the past two years. As a result, chipmakers lost $8 billion to $9 billion in 1998, says Dataquest analyst Jim Handy. "They need to make some money to reinvest for their future," worries Intel CEO Craig R. Barrett.
For all sorts of commodities, prices are plunging--and earnings, too. Texaco Inc. has joined the ranks of those making bigger cutbacks to cope with $10 to $12 a barrel oil (page 44). Steelmakers are also being clobbered by plummeting prices, which they blame partly on dumping.
In Detroit, sales are strong, but pricing power is weak. The average price of a new car or truck will drop by 1%, to $22,750 in 1999, predicts Paul Ballew, chief economist at J.D. Power & Associates Inc. Even airlines feel pricing pressure: The average one-way business fare has fallen slightly, after three years in which they rose 25%. That could help push down industry earnings 8% from this year's record highs, says PaineWebber analyst Samuel Buttrick."CAUTIOUS." Aside from some hot high-tech businesses, the prospects for big revenue gains look dim. Peter J. Canelo, U.S. investment strategist at Morgan Stanley Dean Witter, predicts U.S. companies will manage top-line growth of just 1% to 2% in 1999.
At the same time, labor costs are rising. In 1999, compensation will rise 3.8%, up from 3.6% this year, predicts DRI's Wyss. For many companies, "the only option is to pursue a restructuring strategy," says Ned Riley, BankBoston chief investment officer. And many are doing so with a vengeance. On Dec. 21, Case said it would close two plants and lay off 3,400 workers, or 19% of its total workforce, by the end of 1999, to counter what CEO Jean-Pierre Rosso calls a "precipitous decline in the agricultural equipment market worldwide." Nearly a dozen big banks have announced they will take restructuring charges in the fourth quarter. Among them: Citigroup, which plans to cut 10,400 jobs and take a $900 million charge.
Many companies are also slashing capital spending. DRI expects overall capital spending to rise just 3.2% in 1999, vs. an 8.8% increase in 1998. That's hurting capital-goods suppliers such as Parker-Hannifin Corp., a Cleveland-based maker of motion-control products and aircraft parts. In early December, Parker said fourth-quarter results would fall 10% to 15% below year-earlier levels, "and we've been telling everyone our outlook [for 1999] is cautious," says Parker CEO Duane E. Collins.
At the same time, some companies are thriving. Analysts expect General Motors Corp. to earn a record $1.9 billion in the fourth quarter as it builds 150,000 more vehicles than usual to make up for last summer's strike. On Dec. 17, General Electric Co. hiked its dividend by 17%, after announcing it sees another record year in 1999. Wal-Mart Stores Inc.'s profits are expected to jump 14% in the fourth quarter, and same-store sales increases in the mid-single digits are possible in 1999, says CEO David D. Glass.
Tech companies, especially those riding the Internet boom, are also bucking the earnings trend. Cisco Systems Inc. is expected to boost profits 31% on a 36% revenue gain to $2.7 billion in the quarter ending Jan. 31.
For all the bad news, Corporate America as a whole remains remarkably profitable. And earnings should begin to rise faster in the second half, once restructurings take hold and the global economy recovers. Even so, the rate of growth may look poor compared with the double-digit gains investors have seen in the past few years. "We've been spoiled," says Kevin Parke, chief equity officer of MFS Investment Management. As long as inflation remains at 1% to 2% a year, Parke figures earnings growth of 6% to 8% a year will qualify as a "tremendous performance." Clearly, the market expects at least that much.By William C. Symonds in Boston, with De'Ann Weimer in Chicago, Andy Reinhardt in San Mateo, and bureau reportsReturn to top