Profits: Reality Pays A Call

Is the fizz finally going out of Corporate America's earnings party? After 13 ebullient quarters, profit gains are returning to earth. Although the economy's surprisingly strong third quarter pushed profits up again, the rate of improvement is clearly slowing. Earnings for the 900 companies on BUSINESS WEEK's Corporate Scoreboard rose 11%, to $72 billion, from $65 billion a year ago. That's well down from last quarter's 19%--and anemic compared with the 45% in 1994's third quarter.

Still, the news isn't as bad as it seems. Much of the quarter's profits erosion stemmed from a few large write-offs: IBM and Computer Associates took merger-related charges, Texas Utilities wrote off assets, and AT&T and MCI swallowed big restructuring charges. Together, those five one-time charges cut $5 billion from total U.S. corporate earnings; add them back, and profits would have grown 21%.

Moreover, many companies chalked up far better earnings than anticipated. Thanks to strong housing starts and auto sales, soaring exports, and a big jump in government spending, real gross domestic product was surprisingly robust. It hit 4.2% for the third quarter, up from 1.7% in the second. Just as important, the increase didn't stem from inventory buildup, which fueled growth early in the year. Instead, inventory accumulation flattened out as final sales to businesses and consumers rose. "The economy got a second wind in the third quarter," says Maureen F. Allyn, chief economist at Scudder, Stevens & Clark Inc. In all, sales for the 900 companies rose 10%, to $1.2 trillion.

But maintaining the momentum will prove increasingly tough. Most economists expect GDP growth to come in around 2.7% this year after barreling ahead at 4.1% in 1994. For 1996, it should fall between 2.5% and 3%.

TIRED CONSUMER. Although the weak dollar continues to fuel strong foreign sales for companies such as Bristol-Myers Squibb Co. and McDonald's Corp., slower U.S. growth will likely mean trimmer profits. Rising real wages could also hurt: Hourly wages were up 0.4% over last year's third quarter, the biggest jump in nine years. Another worry: weak consumer spending. "The real key is the consumer," says A. Gary Shilling, who runs an economic consulting firm in Springfield, N.J. "He is pretty well exhausted because of heavy debt, restructuring, and layoffs." Indeed, with consumers often refusing to buy goods unless they are on sale, many companies cannot raise prices. That's already nicking at profit margins. In the third quarter, margins hit 6.1%, down from 6.5% in 1995's first quarter.

Among the Top 25 earners in this quarter's Scoreboard, General Electric Co. leapfrogged General Motors Corp. to regain the No.1 spot. Earnings for the company were up 11%, to $1.61 billion, from $1.46 billion last year. Sales were up 19%, to $17 billion. The gains came thanks to a big rise in sports advertising at NBC Inc., strong growth, and cost-cutting in GE's plastics and aircraft engines businesses, as well as from surging insurance profits.

Elsewhere, though, performance was mixed. Although strong August sales allowed the auto industry to rack up its biggest volume month in almost a year and a half, heavy rebates dented profitability on those sales. And costly new model launches took a big toll on both Ford Motor Co. and Chrysler Corp. Ford's profits plummeted 68%, to $357 million, because of the expense of introducing the new Taurus and the F-Series pickup truck. Chrysler's earnings fell 46%, to $354 million, as it launched a restyled minivan. Only GM, which benefited from an unusually low 1.2% tax rate, saw earnings rise. GM's profits rose 16%, to $642 million.

On Wall Street, many firms reported higher earnings on the strength of heavy trading volumes and surging investment banking revenues. Leading the parade was Salomon Inc., which reported income of $268 million, up from a loss of $104 million a year ago.

CUTTING COSTS. Computer and software makers also continued their earnings surge. Microsoft Corp. profits soared 58%, to $499 million, on strong sales of Windows 95. And at Digital Equipment Corp., income hit $48 million after last year's loss of $195 million. Strong sales of its Alpha computer network servers and cost-cutting helped.

The big exceptions were IBM and Apple Computer Inc. Big Blue posted a net loss of $538 million, after a $1.8 billion charge for its acquisition of software maker Lotus Development Corp. But despite the loss, growth in services and software continues to fuel IBM's recovery. Apple saw income fall 48%, to $60 million, as it struggled with snafus and was forced to cut prices to keep market share.

In telecommunications, too, the third quarter proved difficult. AT&T reported third-quarter income of just $262 million, a 75% slide from last year. The drop reflected a one-time charge for restructuring at its troubled computer operation. Long-distance rival MCI also took a pretax restructuring charge of $831 million to streamline operations in the face of stiff competition. The charges resulted in a net loss of $240 million.

Retailers also sang the blues, and with them, apparel makers. "Consumers did not respond to fall fashions or back-to-school sales with any vengeance," says retail consultant Alan Millstein. Wary shoppers took a toll on AnnTaylor, VF, and Fruit of the Loom. Finicky consumers also shunned specialty chains and off-price retailers such as Toys `R' Us Inc. and Woolworth Corp., although Wal-Mart Stores Inc., which is still expanding rapidly, chalked up profits of $634 million, a 12% gain. With high levels of debt and the threat of economic slowdown shadowing many households, quite a few companies could use a dose of Wal-Mart's formula--low prices and great operating efficiencies--to propel corporate profits forward next quarter.

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