The Picture Starts To Darken

First-quarter earnings were flat amid signs that the profit cycle is slowing

The air seems finally to be leaking out of the corporate profit balloon. The 900 companies on BUSINESS WEEK's Corporate Scoreboard posted record earnings in '94 and '95. But now it looks like time to start getting used to slower growth: Corporate profits were flat in the first quarter of '96 vs. the same period last year. "Companies are doing their best to put a positive spin on it," says Richard Bernstein, director of quantitative research at Merrill Lynch & Co., "but it's clear that the profit cycle has started to slow."

A major factor affecting earnings was a pair of one-time hits to the bottom line. Chase Manhattan Corp. took a $1.03 billion write-off in the aftermath of its merger with Chemical Banking Corp. A strike at two Ohio parts plants cost General Motors Corp. $900 million in profits in the quarter. Subtract these two nonrecurring events, and profits for the 900 companies would have been up 3%.

So while profits have slowed, there's still some steam left. And not all the numbers were sluggish. Revenues rose 9% in 1996's first quarter vs. the same period last year. Sales growth and thinning margins are consistent with a maturing profit cycle, say economists. As the economy slows, companies are forced to make price concessions to entice customers while costs still remain high. Result: Profits suffer.

THE CULPRIT. Bellwether cyclicals were among the industries whose profits took the hardest hits in the first quarter. Earnings in the steel sector plummeted 58% in that period, compared with last year's first quarter, while forest products were off 56%. Paper and chemical companies also lost ground. "It does point out that the economy is not exactly booming, but it's hardly a sure sign of a recession ahead," says James R. Solloway, director of research at Argus Research Corp.

Foremost among those industries dragging down overall earnings were computer makers. The main culprit was Apple Computer Inc., which reported a stunning $740 million loss for the quarter. This was Apple's second consecutive loss, and analysts expect more red ink to flow. At the heart of its troubles are sinking sales, which were down 18%, prompting price cuts. IBM's profits, too, were off--40% vs. last year--after the computer giant turned in a disappointing performance in computer hardware. Product transition in its mainframe and midrange computer lines slowed sales, as did weak demand for PCs in North America. Notable industry exceptions reporting gains were Digital Equipment Corp. and Hewlett-Packard Co.

Detroit caused some ripples, as well. In the strike's aftermath, GM posted profits of $1.02 billion, down 53%. Ford Motor Co. was still suffering from the cost of launching two mass-volume products, the F-150 full-size pickup truck and the Escort subcompact. Meanwhile, Chrysler Corp. pulled off its best first quarter in history. Its new minivan is a big hit, and truck sales are booming.

The retailing industry continued to flounder, hampered by tightfisted consumers, too many stores, and a lack of exciting new products. Toys `R' Us Inc.'s profits plummeted 77%, to $93 million. The toy retailer was forced to cut prices and boost promotional spending because of competition from discounters. The company also took a $270 million write-off to pare down the number of products offered, close stores, and consolidate operations. Two companies that bucked the trend: Home Depot Inc. and Federated Department Stores Inc., both of which posted gains last quarter.

Several other bright spots shone through the cloudier economic picture. Profits in the financial-services industry soared in the first quarter as the stock market rose to all-time highs. Salomon Inc., parent of Salomon Brothers Inc., led the pack with net income of $276 million, the third-largest quarterly profit in the securities firm's history. Merrill Lynch's earnings rose 80%, to a record $409 million, while Morgan Stanley & Co. posted an all-time high of $273 million. "Everything came together on Wall Street," says Michael Flanagan, president of Philadelphia-based Financial Service Analytics. "Record exchange volume and underwriting and robust asset management" all contributed to the boom.

Another big winner: the nation's airlines. Rising air fares, strong demand, and tighter capacity drove up earnings. Continental Airlines Inc. posted a profit of $93 million in the first quarter, after losing money last year. At AMR Corp., the parent of American Airlines Inc., an influx of business fliers helped raise revenue per passenger seat-mile by 2.9% and sent profits up 324%, to $157 million.

Telephone companies enjoyed a strong first quarter. Why? Simple--more telephone lines. "They've become a status symbol; everybody needs a second and third line at home for their computer and fax," says Linda Meltzer, managing director of UBS Securities Inc. And cellular phones are wildly popular. Riding both these trends was BellSouth Corp., where first-quarter profits rose 77%. BellSouth had a record hike in phone lines, adding 359,000.

Microsoft Corp., the No.1 maker of PC software, was the engine behind stellar gains in software and services in the quarter. Microsoft's applications business, which claims some 90% of the market, also got a boost from its Win95. Now, Corporate America faces the challenge that Microsoft has ably conquered--trying to carve out earnings in the mature phase of a profit cycle.

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