The End Of The Slide?Monica Roman
The global economy can be a blessing, it can be a curse, and sometimes it can be both at once. Just look at corporate profits. Even though the recession didn't officially begin until the third quarter of 1990, earnings had been falling for more than a year before (chart), partly because of tough price competition from foreign companies. But after the U. S. economy slipped into recession, earnings of American companies held up fairly well because they got a boost from overseas.
Now, by most accounts, the U. S. economy is on the mend. But the rebound in corporate profits may be restrained. What's holding them back? You guessed it: Many overseas economies are slowing down, putting a drag on revenue gains. And tough foreign rivals aren't going to allow any leeway on pricing.
The mixed news from overseas complicates an already problematic second-quarter profit picture. The biggest uncertainty, of course, is the state of the economy. The recovery may have arrived, but you wouldn't know it from looking at second-quarter earnings reports. When the numbers are all in, they are expected to show a 9% decline from the second quarter of 1990. But the good news is that the latest results should mark the end of the slide in corporate earnings that started in the third quarter of 1989.
One caveat: It's possible that earnings for the third quarter may be flat or down slightly. But that's something of a statistical illusion. Last year's third quarter showed a surprising 10% gain over the third quarter of 1989. That certainly wasn't typical of the year as a whole.
Moreover, the rising tide in the third quarter of 1991 won't lift every boat: Hard-hit sectors such as steel and computers will continue to report down earnings through the end of the year. But most economists figure that after the second quarter, the trend for corporate profits is up.
NO `BIG PARTY'. It's not likely, though, that full-year earnings per share for the Standard & Poor's 500-stock index will rise much above their 1990 level. That's because the economy may not bounce back as high as it usually does after a recession. In the average postwar business cycle, earnings for the S&P 500 have increased 23.9% in the year following a trough in real GNP, according to Rupert Thompson, an economist with UBS Phillips & Drew, a London-based securities firm. Thompson is projecting only a 17% increase in S&P 500 earnings during the first year of the latest recovery.
Ironically, the rebound may be hampered because Corporate America is getting smarter about the way it does business. John McDevitt, a corporate economist at 3M Co., thinks the trend toward just-in-time inventory has kept companies from placing big orders that would pump up the economy. "We're seeing lots of hand-to-mouth buying," he says. The result, says Susan Lakatos, a Kidder Peabody & Co. vice-president: "We won't get the big party that we normally have at the end of a recession." She expects S&P 500 earnings to rise only 11.6% next year.
Those numbers will be rising from a relatively low base. Even though the recession didn't officially begin until the third quarter of 1990, the sluggish growth that persisted for the year or so before that took its toll on profits. Weak demand and intense competition from foreign corporations made it tough for U. S. companies to raise prices at the same time that wages, benefits, and interest costs were on the rise. The result: Profit margins got squeezed.
Foreign competition may have kept a lid on price increases, but the global economy also helped cushion the earnings of U. S. companies during the latest recession. In the typical postwar business cycle, earnings for the S&P 500 declined 19.6%, says Thompson of UBS Phillips & Drew. If this recession is indeed over, it will have been one of the milder ones since World War II, and Thompson estimates the drop in S&P earnings will be 14.5% from the peak of GNP growth to the trough.
Earnings didn't drop more because U. S. companies got plenty of support from their foreign subsidiaries. During the first two quarters of a downturn, the overseas component of U. S. corporate earnings usually grows about 5%, says Stephen Roach, senior economist with Morgan Stanley & Co. In the latest recession, the increase has been about 20%. "While some of this can be attributed to positive earnings translations of an undervalued currency," says Roach, "there can be no mistaking the role played by an improvement in the nation's competitive position."
U. S. pharmaceuticals companies, in particular, are thriving in the global marketplace. Traditionally a recession-resistant industry, drugmakers came out with a host of high-margin new products that allowed them to fare even better than usual in the latest downturn. Companies in the S&P drug group posted a 16.9% gain in earnings, compared with a 9.6% increase in the 1974 down cycle. Baxter International, Bristol-Myers Squibb, and Merck all reported double-digit profit increases in the second quarter (table).
While some companies had new products, others hauled out the pruning shears. Even before the recession was officially under way, companies were laying off workers and consolidating operations in anticipation of weaker demand. Roach says this strategy allowed companies to avoid the margin squeeze that usually occurs in a downturn. Indeed, Lakatos of Kidder Peabody says that aftertax operating profit margins rose from 6.3% in the fourth quarter of 1990 to 6.7% in the first quarter of 1991, when GNP fell at an annual rate of 2.8%. "The fact that profit margins began to stabilize despite a sharp downturn in GNP is persuasive evidence that recent cost-cutting and long-term restructuring are starting to pay off," says Lakatos.
FIGHTING TRIM. The chemical industry, for one, weathered this recession better than previous down cycles. Earnings per share of the companies in the S&P chemicals industry index declined 2.7% during the latest downturn (through the first quarter), compared with a 37% drop in the 1982 recession and a 38% decrease in the 1980 down cycle. The difference this time, says T. Kevin Swift, senior economist with the Chemical Manufacturers Assn. in Washington, is that by eliminating much of its excess capacity during the 1980s, the chemical industry minimized the impact of the recession. At Du Pont Co., for instance, U. S. employment--excluding its Conoco Inc. and Consolidation Coal Co. units--fell to 79,523 in 1991, from 105,171 in 1981. Now that it is in fighting trim, the company is poised for a spike in profits. Says a Du Pont spokesman: "With a turnup in the economy, we should see margins improve."
Moreover, says Swift, chemical production tends to be a leading indicator for the whole economy. So the upturn in chemical production in the past four months suggests that other areas of the economy will soon get moving again.
Not all sectors that purportedly got lean and mean during the 1980s had an easier time in the latest recession. Though the big integrated steel producers such as USX and Bethlehem Steel Corp. have spent about $14 billion over the past decade to modernize their factories, they have been unable to recoup their investment. Thanks to aggressive bargaining by powerful steel buyers in the auto and appliance industries, steel sells, on average, for the same price it did in the early 1980s. As a result, earnings per share for the S&P steel group plummeted 556.7% in the latest down cycle. By contrast, the group, whose composition has changed over time, had an 237.8% drop in reported earnings during the 1982 recession and a 74.4% decline in the 1980 downturn.
Still, steel's restructuring has made the U. S. industry competitive with most foreign producers. And benefits from ongoing modernization should start to pay dividends when the economy works up a full head of steam. Because steel trails economic turns by about six months, analysts don't think there will be a solid steel profit recovery until 1993.
STRONGER GREENBACK. Most corporate earnings should get a lift from faster sales growth sooner than that, but they will lose some of the benefits of overseas earnings. A stronger dollar and slowing growth in foreign economies means that profits from overseas operations will flatten out and decline from their recent quarterly highs, says Richard D. Rippe, chief economist of Dean Witter Reynolds Inc. This trend is already apparent among technology companies such as Compaq Computer Corp., which reported an 81% decline in second-quarter profits. Ron Canion, Compaq's CEO, warns that weaker demand in Europe, severe price competition in the personal computer market, and a strengthening greenback will hurt third-quarter earnings.
The overseas problems of the U. S. computer companies are further evidence that the world is a different place since the last recession. Tough competition from scrappy foreign players means that an expanding economy at home is no guarantee of rising profits. Conversely, strong demand at home is not enough to boost the earnings of many U. S. companies, which are more dependent than ever on foreign sales for growth. Whatever the drawbacks, though, more and more U. S. companies have little choice but to regard the whole world as their playing field.
An Early Look at Second-Quarter Profits The pluses, at last, are proliferating. Executives in the computer and capital-goods industries wouldn't say profits are recovering. But brokers and retailers have cause for hope. % chg. % chg. Sales vs. Profits vs. Margins $ mil. 1990 $ mil. 1990 1991 1990 ABBOTT $1,683.0 +12 % $268.3 +12 % 15.9 % 16.0 % LABORATORIES ALCOA 2,569.3 -5 81.2 -50 3.2 6.0 ADVANCED MICRO 296.8 +11 17.3 NM 5.8 NM DEVICES AMERICAN CYANAMID 1,420.4 +16 131.8 +22 9.3 8.8 AMERICAN EXPRESS 6,363.0 +5 256.3 -20 4.0 5.3 AMERICAN HOME 1,619.5 +1 265.2 -2 16.4 16.8 PRODUCTS AMERITECH 2,742.1 +2 303.9 -14 11.1 13.1 ANHEUSER-BUSCH 3,260.8 +9 286.7 +11 8.8 8.6 BAXTER 2,197.0 +10 141.0 +28 6.4 5.5 INTERNATIONAL BELL ATLANTIC 3,081.4 0 355.1 -2 11.5 11.8 BLOCKBUSTER 210.1 +41 21.4 +44 10.2 10.0 ENTERTAINMENT BRISTOL-MYERS 2,730.4 +10 489.5 +17 17.9 16.8 SQUIBB CAPITAL CITIES/ 1,357.8 0 127.8 -10 9.4 10.5 ABC CBS 709.4 14 50.7 -63 7.1 16.7 COCA-COLA 3,039.5 +11 482.4 +18 15.9 15.0 COMPAQ COMPUTER 717.8 17 20.3 -81 2.8 12.1 CONNER 405.4 +33 26.8 0 6.6 8.8 PERIPHERALS CORNING 778.2 +15 73.9 +10 9.5 9.9 CSX 2,125.0 +4 115.0 +6 5.4 5.3 CUMMINS ENGINE 877.6 +1 -17.2 NM NM 0.7 DU PONT 10,031.0 +3 549.0 -21 5.5 7.1 EXXON 27,267.0 +5 1,125.0 +2 4.1 4.2 GENENTECH 117.6 +9 11.4 +114 9.7 4.9 GENERAL DYNAMICS 2,416.0 8 211.0 NM 8.7 NM GENERAL ELECTRIC 14,800.0 +3 1,131.0 +4 7.6 7.6 GEORGIA-PACIFIC 2,981.0 15 33.0 -69 1.1 3.0 GTE 5,367.0 +1 403.0 0 7.5 7.6 HONEYWELL 1,520.2 2 77.6 -16 5.1 6.0 IBM 14,732.0 11 114.0 -92 0.8 8.5 INTEL 1,252.7 +29 230.8 +35 18.4 17.6 INTERNATIONAL 3,100.0 4 104.0 -44 3.4 5.7 PAPER JOHNSON & JOHNSON 3,031.0 +8 406.0 +15 13.4 12.6 KROGER 5,086.4 +7 32.2 +28 0.6 0.5 LIZ CLAIBORNE 416.0 +22 39.5 +13 9.5 10.3 MARRIOTT 1,940.0 +10 27.0 -41 1.4 2.6 MAYTAG 777.6 1 18.8 -38 2.4 3.9 McDONALD'S 1,670.8 +1 232.0 +8 13.9 13.0 MCI 2,098.0 +12 137.0 -23 6.5 9.5 COMMUNICATIONS MERCK 2,122.4 +12 556.0 +18 26.2 24.8 MERRILL LYNCH 3,063.9 +7 184.3 +149 6.0 2.6 MOBIL 14,449.0 +5 445.0 -11 3.1 3.6 MORGAN STANLEY 1,627.5 +13 100.9 +74 6.2 4.0 MOTOROLA 2,814.0 +4 119.0 -26 4.2 5.9 NCR 1,556.0 3 99.0 -14 6.4 7.2 PEPSICO 4,679.8 +11 318.3 +9 6.8 7.0 PHILIP MORRIS 14,770.0 +16 1,153.0 +22 7.8 7.4 RAYTHEON 2,357.0 0 151.8 +5 6.4 6.2 REEBOK 688.3 +31 60.4 +39 8.8 8.2 INTERNATIONAL REYNOLDS METALS 1,523.5 1 61.4 -40 4.0 6.7 RJR NABISCO 3,780.0 +9 79.0 NM 2.1 NM SAFEWAY 3,519.8 +2 35.6 +51 1.0 0.7 SCHLUMBERGER 1,552.7 +20 180.8 +25 11.6 11.2 SEARS, ROEBUCK 14,090.0 +2 239.3 +1 1.7 1.7 TEXACO 9,031.0 +4 269.0 -24 3.0 4.0 TRW 1,980.0 6 24.0 -62 1.2 3.0 UNISYS 2,202.8 11 -1,299.8 NM NM 0.5 UNITED 5,376.9 6 43.4 -79 0.8 3.6 TECHNOLOGIES WASTE MANAGEMENT 1,880.8 +34 206.9 +16 11.0 12.8 WESTINGHOUSE 3,174.0 0 127.0 -50 4.0 7.9 ELECTRIC WEYERHAEUSER 2,296.6 4 69.6 -39 3.0 4.8 NM = not meaningful DATA: STANDARD & POOR'S COMPUSTAT SERVICES INC.