First came Coca-Cola Co. On Aug. 8, it warned that third-quarter earnings would only "slightly exceed" last year's results, not jump 13%, as some analysts had been predicting. A week later, personal-care giant Gillette Co. advised analysts to cut estimates for the third and fourth quarters because sales of Braun appliances in Japan and Germany were soft. And September brought a seeming flood of warnings from some of America's best-known companies--Corning, Kodak, Manpower, and Motorola--that earnings would come in short of earlier, lofty expectations. And, with each report, Wall Street reacted with a swift sell-off.
"The list is getting pretty long," worries Benjamin L. Zacks, executive vice-president of Zacks Investment Research, which tracks earnings estimates issued by some 2,500 analysts. The firm has already trimmed its estimate of third-quarter earnings growth for the Standard & Poor's 500-stock index from 12.5% to 11.5% and expects the estimate to drop further. "When it's finally reported, we'll have a quarter that did not meet expectations," says Zacks.
Certainly, a 10% gain in net profits is nothing to sneeze at. But investors and analysts are on the lookout for signs that earnings momentum is slowing--that the seemingly unending double-digit gains in profits that justify generous stock valuations is over. "Earnings will still be growing," says Michelle Clayman, CEO of Money Manager New Amsterdam Partners. "It's just that earnings will not increase at the extraordinary rate that we've seen in the last few years." Investors' chief worries: It's getting harder to generate top-line growth, the strong dollar and weak economies in Asia and elsewhere could hamper export expansion, and, after years of squeezing out costs, companies will find it harder to boost earnings through efficiency gains.
So, is an earnings slowdown, in fact, beginning? Given the problems in Asia and some other foreign economies, warns Melissa R. Brown, director of quantitative research for Prudential Securities, sales growth could be "shaky" next year. And, she says, "many companies are getting to the end of their rope in terms of how much they can improve margins." Brown's bottom line: "We're vulnerable to more negative surprises."
BULLS REMAIN. How negative depends on whom you ask. First Call, which tracks analysts predictions, figures year-over-year earnings growth could dip to 6% next summer (chart). At Standard & Poor's DRI forecasting unit, senior economist Mark J. Lasky expects a more severe slowdown. He says aftertax corporate profits will jump 8% this year--to grow just 5.5% in the first quarter of 1998, drop to 3.5% growth in the second quarter, and then be nearly flat in the second half.
Wall Street bulls beg to differ. When a report of low consumer price inflation hit on Sept. 16 and pushed interest rates down in a near-record bond rally, equity investors sent the Dow Jones industrials soaring 175 points. Figuring that lower rates will mean stronger earnings ahead, the market restored some of the value it had lopped off companies such as Coke and Gillette, which had warned of weaker earnings.
Indeed, some bulls, such as Jeffrey Applegate, Lehman Brothers Inc.'s chief investment strategist, shrug off the earnings warnings almost entirely. "If the problems were as severe as some believe, you would have seen a lot more," he argues. Charles L. Hill, director of research for First Call, says that the number of companies issuing warnings is, in fact, not alarming. As of Sept. 16, about 100 of the 5,000 companies tracked by First Call had made early announcements regarding third-quarter earnings.
Moreover, even as Eastman Kodak, Tupperware, and Polaroid have stumbled, other bellwether companies are booming. General Electric Co., one of the world's most profitable companies, is on track to another record-breaking quarter. Thanks to a surge in summer sales, Detroit's Big Three should earn a combined $2.3 billion in the third quarter, up 15% from last year's $2.0 billion, figures Nicholas Lobaccaro, a Merrill Lynch & Co. analyst. He predicts a whopping 38% jump in profits for the fourth quarter. Even AT&T--which has been a perennial earnings laggard of late--is now signalling it may beat the 64 cents per share analysts have been predicting for the third quarter, thanks to cost-cutting and fewer lost customers.
Even so, doubts about the sustainability of earnings momentum are growing. "It's extraordinarily puzzling to see the market rallying in the face of significant earnings disappointments," says John W. Rogers Jr., chief executive of Ariel Capital Management Inc., a Chicago-based growth fund. The Dow's jump on Sept. 16, he says, was "a temporary blowoff, before reality sets in."
One sure sign of investor anxiety is how savagely investors have punished icons who have barely faltered. Consider Gillette. It warned on Aug. 15 that 1997 earnings would probably not hit the high range of estimates--$2.60 per share--and guided analysts to expect $2.55 at best. No biggie: Third-quarter earnings would still be up 13%. But Gillette shares got clobbered, plunging 24% to $79. The stock has bounced back to $83, but it's still more than 20% below its mid-summer peak. Coca-Cola, Motorola, and other former highfliers were similarly hammered in response to warnings of earnings that will come in below earlier estimates. "We're in an unforgiving market," says Hill. When stocks are selling at such high earnings multiples--at its peak, Gillette was selling at over 40 times expected earnings--"you better deliver every penny that's expected."
RIVAL IMPORTS. In many cases, the earnings snafus are self-induced. But there are some trends. The strong U.S. dollar, which makes exports more expensive and erodes the value of repatriated earnings, is having a widespread effect among multinationals. Coke, for instance, derives some 80% of its sales and 70% of earnings from markets outside the U.S. Japan and Germany account for about 35% of its profits. So, factoring in dollar gains against those currencies, analysts have trimmed third-quarter earnings by some 5% to 42 cents per share. Kodak, Motorola, and Polaroid have been similarly affected. And the dollar "will be more of a concern going forward," worries Zacks. He figures multinationals will face growing competition from imports in the U.S. and slowing growth in many export markets.
At home and abroad, finding new growth opportunities is getting harder. Already, says Ned Riley, chief investment officer at BankBoston, "volume growth is disappointing at some multinationals." Gillette managed to boost sales just 3% in the first half, due partly to anemic sales of Braun electric razors--which sell for up to $200 apiece--in Germany and Japan. At Procter & Gamble Co., sales rose only 1%, to $35.8 billion, in the fiscal year ended June 30. That's nowhere near the level needed to reach Chairman John E. Pepper's goal of doubling P&G's sales over the coming decade.
SQUEEZED. In the U.S., where inflation is all but extinguished, companies have little leeway to boost top-line growth through price increases. "It's very difficult to pass on cost increases," complains Mitchell S. Fromstein, chairman of Manpower Inc., the temporary-help firm. With the dollar hurting overseas earnings and prices stuck at home, Manpower is squeezed. On Sept. 12 it advised analysts to cut third-quarter estimates by some 10%. Similarly, Owens Corning has found it must go slow on upping the prices it charges for composites it sells to fiberglass manufacturers, says Chief Financial Officer David W. Devonshire. That and weak sales of roofing material led the company to warn analysts on Sept. 17 to expect earnings to come in 25% below previous estimates this quarter.
And despite a strong second half, Motown also faces a "treacherous" road in 1998, warns Lobaccaro. He expects overall sales to remain static at 15 million vehicles next year. Meanwhile, with gains from cost-cutting slowing, Lobaccaro expects General Motors, Ford, and Chrysler to boost margins just 1% after inflation. The net result: Combined Big Three earnings will slump to $14.5 billion next year, from $15 billion this year.
No one expects overall earnings growth to stall out. Indeed, lower interest rates and a weaker dollar could improve many companies' prospects. But for now, the warning signs about profit growth are all too clear. "We're in a position where stocks are going up, even as earnings estimates are going down," says Prudential's Brown. Sooner or later, that seems certain to spell trouble.