At Last, The Payoff

For two years straight, companies across the country have been skinning off layers of debt, slicing fat, and cleaning up their balance sheets. But despite all the pain, the wave of restructuring that swept through Corporate America was slow in producing results. In 1991, profits plummeted quarter after quarter on skimpy sales gains. And while the first half of 1992 showed promising improvements, the economy remained weak. Analysts waited with crossed fingers, wondering if cost cuts and lower interest rates could produce truly impressive results.

Well, the guesswork is over. After all the bloodletting, corporate profits soared in the third quarter. Earnings for the 900 companies in BUSINESS WEEK's Corporate Scoreboard rose by a stunning 31% before extraordinary items. Not only are the results much better than the 20% earnings gain posted in the second quarter, but they also represent the biggest quarterly leap since the prerecession days of 1987, when profits climbed 37% in the third quarter. What's more, if not for IBM's staggering $2.8 billion loss because of massive restructuring charges, profits in the latest period would have risen by an even more impressive 41%.

True, this year's third-quarter figures, prepared by Standard & Poor's Compustat Services Inc., are benchmarked against one of the worst periods on record. Profits drooped 22% in 1991's third quarter, while the economy was still trapped in the recession. But it isn't just soft comparisons that make the last quarter look good: Net profit margins stood at a respectable 4.2% in the third quarter. That's not as good as the 6.2% margin that prevailed in 1988 when the economy was expanding at a robust pace. But it's still better than the 3.4% that marked 1991's third quarter.

`MAGIC.' The profit surge is the strongest evidence yet that the massive restructuring among companies can indeed work wonders on the bottom line. "Finally, low labor costs, interest costs, and energy costs performed their magic," says economist Mark Zandi of Regional Financial Associates, a West Chester (Pa.) consultant.

And with corporate cost reductions working at full force, economists argue that the fine showing in the third quarter will be repeated in the fourth quarter and beyond. "The improvements we're seeing are going to lay the foundation for a strong 1993," says Zandi, who sees a 22.5% earnings gain in the final quarter. For all of 1993, Zandi forecasts a 15.2% profit increase. Already, 1992 is looking much better than last year. Profits were up 19% in the first nine months. By contrast, earnings had fallen 17% in the same period a year ago.

A major reason for the upbeat forecast: Companies continue to hack away at operating expenses. "Firms that downsized two to three years ago are doing it again," says Lacy Hunt, chief economist at HSBC Holdings PLC. Even healthy companies with robust earnings are announcing plans to cut more bodies this quarter. Compaq Computer Corp., with a 50% sales gain in the quarter, just announced a 10% cut in its work force.

The cost-slashing could even help the economy rebound smartly at some point. To reduce carrying costs, companies have pared inventories to the bone: Compared to sales, inventories are now at a record low. That means even a modest improvement in demand would boost overall production.

Unfortunately, surging profits don't necessarily mean that the economy has kicked into high gear--especially since those continuing layoffs make for ongoing consumer jitters. Economist Edward F. McKelvey of Goldman, Sachs & Co. points out that improved productivity, while beneficial to the economy, is no substitute for strong sales. Indeed, sales rose 6%, better than last year's flat results, but much weaker than the 10% to 12% gains that could be expected in a typical recovery. Moreover, in sheer dollar terms, companies still have a long way to go. The companies that are listed in BUSINESS WEEK's Corporate Scoreboard earned $46.9 billion in the third quarter of 1988, the last boom period before the recession. That's roughly $7 billion more than in the latest period.

And then there's a growing concern that companies may take restructuring too far. In their quest for wider margins, cost-conscious CEOs could wind up without the kind of capacity and experienced workers that they'll need when the economy finally snaps back. Layoffs and other cost-cutting measures have become "an addiction," warns Eric Greenberg, a researcher with the American Management Assn. "You get to the point where the cure is worse than the disease."

BRIGHT STARS. Still, no matter how the experts try to slice it, the third quarter brings welcome news across many industry groups. The semiconductor industry, with a phenomenal 1,285% increase in profits, topped the list of industry winners. Strong demand for personal computers didn't hurt. Last year, the sector posted a meager profit of only $25 million. In the latest quarter, stars such as Intel, Analog Devices, and Advanced Micro Devices burned brightly, propelling the industry to profits of $362 million. Analog Devices' 743% increase was a result of higher sales and improved margins.

Railroad companies, which last year were among the big losers, posted a solid 618% gain in profits. Again, much of the increase comes from the comparison with last year's poor showing. But a couple of companies posted strong sales growth as well. Union Pacific Corp.'s earnings benefited from increased railway traffic, as well as efficiency measures. And Kansas City Southern Industries Inc., a bit more diversified than other railroad companies on the list, tallied a 20% hike in sales in the period.

Banks continued to prosper, despite--or perhaps because of--their propensity not to lend these days. The 51 banks listed in the Scoreboard earned $4.3 billion, up 145% from a year ago. Banks have been offering miserly interest rates to depositors, investing their cash in relatively high-yield government securities, and benefiting from the spread. While real estate exposure is still a question for many banks, problem-credit costs related to consumer and other commercial loans are down. Crestar Financial Group, based in Richmond, Va., posted the biggest profit gain, with earnings up more than eightfold, to $21.5 million.

The telecommunications sector also showed a strong profit improvement, up 241%, to $4.3 billion. But this was somewhat exaggerated by the results at American Telephone & Telegraph Co., which earned $963 million after a loss of $1.8 billion a year ago, much of it resulting from charges related to the company's takeover of NCR Corp.

Of course, not every company was celebrating the quarter's results. The biggest losing sector in the three months ended on Sept. 30 was computers and peripherals, where losses hit $2.4 billion, compared with a profit of $592.5 million a year ago. IBM and Digital Equipment Corp., whose profits suffered from poor sales and restructuring costs, dragged down the group. Without Big Blue, the entire office equipment and computer industry would have chalked up a 34% profit increase, or $1.2 billion.

Results in the airline industry also worsened, as increased traffic failed to offset the damage left by the summertime fare war. In total, the industry lost $271.7 million, compared to a loss of $25.7 million last year. Companies with the steepest declines were Delta, AMR, America West, and USAir. The only cheery news in the skies came from Southwest Airlines, whose earnings climbed 71%, to $26.9 million.

Health-care services, one of the strongest sectors in 1991, was another losing industry as revenue growth slowed. Hemant K. Shah of HKS & Co., an investment research firm, notes that health-care companies are under severe pricing pressures. "The buzzword in Washington is to control health-care expenses regardless of who's elected," remarks Shah. The results at HCA-Hospital Corp. of America also helped depress the sector. Loaded down with more than $2 billion in debt, the company took an aftertax charge of $333 million in the third quarter to restructure its flagging psychiatric hospitals.

Drug companies have been facing similar pressures from Washington, not to mention customer resistance. The industry will have trouble relying on steadily rising prices for earnings increases. Industry profits are down 4%, to $2.7 billion. While Bristol-Myers and Merck were among the most profitable companies on the Scoreboard this quarter--with over $1 billion in earnings between them--Eli Lilly's $268 million loss may be a sign of tougher times for the drug group in the future. Lilly wrote off $520 million, before taxes, for restructuring and special charges. "I don't see it getting any better in the fourth quarter," Shah says of the industry.

The auto industry also remained mired in red ink, though the losses were less than in last year's dismal third quarter. Carmakers collectively lost $741.6 million, after a $1.7 billion loss last year. The one bright exception was Chrysler Corp., which earned $202 million, compared to an $82 million loss a year earlier. Chrysler's shining quarter was the result of increased operating efficiencies and higher sales of trucks. The auto maker also had the largest increase in nine-month sales figures of any car company on the Scoreboard. Chrysler sales rose 26%, to $26.7 billion, in the January-September period.

SKITTISH. Looking ahead, many analysts are worried that the improving trend in profits may eventually begin to trail off. While it's true that companies will continue to improve productivity and lower interest rates will help managers reduce corporate debt costs, the benefits of such trends can't last forever.

While a pickup in sales would help avert such a falloff in earnings growth, economists don't see that happening. So far, there is little sign that consumers have overcome their skittishness. Even low interest rates haven't enticed them to spend much. In addition to worrying about their jobs, households are still coping with a staggering debt burden, says economist Gary Shilling. "Eventually, 10 years down the road, the debt will be worked down enough for lower interest rates to be a stimulus," says Shilling. Exports aren't expected to provide much help, either. After growing by 35% during 1988, they're now expanding at only 3%. And it is doubtful that trade volumes will improve soon. Europe is in the grip of its own recession, and Japan is beginning to feel the pinch as well.

The poor sales outlook still worries economists. Despite improvements in profits, industrial companies haven't yet begun to spend more on plant and equipment or to hire new people--typically the two critical engines of a strong recovery. Shilling worries that companies will have to downsize even more. And the prospect of more layoffs may further spook consumers.

Still, thanks to restructuring and lower interest rates, companies are in the best shape they've been in for some time. And if the economy picks up a little speed, a leaner, meaner Corporate America may finally catch the tailwind it has been waiting for.