Can The Recovery Survive This Dive?

By the official reckoning, the recession may have come to an end in the second quarter. But the decline in corporate profits was so sharp that some economists say it could pose a threat to the recovery. Although the anemic 0.4% gain in second-quarter gross national product reported by the Commerce Dept. was below expectations, it wasn't such a surprise as the drop in earnings. According to Standard & Poor's Compustat Services Inc., profits for the 900 companies in BUSINESS WEEK's Corporate Scoreboard fell 23% compared with last year's second quarter. That's much worse than the 10% decline that some analysts had been projecting as recently as two weeks ago.

What went wrong? Some companies in the hard-hit technology sector unexpectedly took massive charges to cover the costs of restructuring their operations. If the office equipment and computer group had been excluded from the Scoreboard, the decrease in earnings would have been only 16%.

Losses at the Big Three auto makers also dragged profits down. If the automotive companies had been left out, the decline also would have been just 16%. Without autos or computers, earnings would have been off 8%--about what many analysts had been predicting.

FEWER SURPRISES. But when all the numbers are factored in, the 23% drop in profits was the largest since corporate earnings began their slide in the third quarter of 1989. Sales were extraordinarily weak, too. They inched ahead just 2% in the quarter, also the poorest performance since the downturn in profits began. For the first half of 1991, profits fell 17%, and sales grew 3%.

If economists were caught off guard by the weakness in corporate profits as a whole, most industry analysts were apparently braced for the lackluster results. The second quarter brought fewer individual earnings "surprises"--results significantly higher or lower than analysts' projections--than usual. In the previous three quarters, 14% of corporate earnings were surprisingly higher than industry analysts were expecting, while 45% were lower, says Thomas Doerflinger, an economist with PaineWebber Inc. In the latest quarter, he says that 16% of the earnings reports were considered good surprises while 33% qualified as bad surprises. "The reason second-quarter earnings did not seem disastrous is that expectations have been driven through the floor," says Doerflinger.

And if profits fail to bounce back as fast as companies and Wall Street are expecting them to, there is the danger that the recovery could be short-lived. That's because businesses have little incentive to expand production and hire more workers unless they are getting an adequate return on their investment. "If we don't get the big profit gains that everyone has been anticipating, it could derail the economy," says Paul Getman, managing director of Regional Financial Associates Inc., an economic forecasting firm in West Chester, Pa.

Still, most analysts are looking for a rebound in earnings during the second half of the year. "Compared to a year ago, we're still in a slump," says Kurt Karl, senior economist with WEFA Group Inc. in Philadelphia. "But the economy is improving, and costs are quite low. It looks like it's up from here."

Even a strong second half may not be enough to overcome the shortfall in the first two quarters, however. A few weeks ago, economists were projecting that 1991 earnings for the companies in the Standard & Poor's 500-stock index would be about even with 1990 results. Now, Doerflinger and others are forecasting a slight decline. Getman expects this rebound to be about half as strong as normal. In the typical recovery, earnings bounce back about 43%. This time, they'll increase just 22%, he says.

NO CUSHION. If the rebound is weak, some blame will go to the strengthening dollar and slower growth overseas. The greenback will be up on a year-over-year basis in the second half of 1991, says Doerflinger, making foreign profits smaller when they're converted into dollars. And while overseas earnings provided a cushion during the latest downturn, foreign economies are starting to stall. That's already hurting the results of computer makers, which until recently had enjoyed strong European growth.

At home, most economists don't see any end to the intense price pressure that began well before the recession started. In the face of restrained inflation and tough competition from foreign producers, it will be difficult for U. S. companies to increase earnings by raising prices. Nowhere is that more apparent than in autos, computers, and steel, where excess capacity has made it hard to earn a buck. All three sectors reported losses during the second quarter.

Without much in the way of sales growth, companies must boost productivity and reduce overhead in order to improve profit margins. That's what's behind the special charges taken in the second quarter by Unisys Corp. and Digital Equipment Corp. Unisys took pretax charges totaling $1.2 billion, including $925 million to reduce its work force by 10,000, while Digital took a $1.1 billion charge to cover the cost of eliminating 10,000 positions. Du Pont, Arco, and Wang Laboratories also took write-offs in the quarter to cut thousands of jobs.

Although car- and truckmakers reported a $1.34 billion loss, Goodyear Tire & Rubber Co. edged back into the black, helping the tire and rubber companies post the largest gain, 140%, of any group. Goodyear benefited from the lack of a restructuring charge taken in the year-ago quarter, lower selling expenses, and better results abroad. Other sectors that turned in sharp earnings increases included health care services, up 63%; aerospace, up 58%; tobacco, ahead 42%; and Midwest banks, up 38%.

Philip Morris Cos. earned the most in the second quarter, with $1.15 billion in profits, ahead 22%. The food-and-tobacco giant was followed by General Electric, which earned $1.13 billion, up 4%; Exxon, with $1.125 billion in profits, up 2%; and American Telephone & Telegraph, which earned $828 million, up 26%. Attesting to the strength of the health care industry was Merck & Co., where earnings rose 18%, to $556 million.

Because of its restructuring, Unisys recorded the biggest loss of any company, $1.3 billion. It was followed by Digital, whose special charges led to an $871 million loss. General Motors was next on the list, with a $785 million loss, followed by Burlington Northern, which lost $420 million, and Midlantic, down $415 million. Those results are pretty grim, to be sure. But they'll be grimmer still if the weak second quarter undermines the budding recovery.

                        Percent change from
                       1990's second quarter
      TIRE & RUBBER              140%
      HEALTH CARE SERVICES        63
      AEROSPACE                   58
      TOBACCO                     42
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