Is This The End Of The Glory Days?

Higher wages and declining profit margins lead to a slowdown in net income growth

Economists said it couldn't last. CEOs prayed it would. But in 1997 the inevitable finally happened: Corporate America's breakneck earnings growth began to falter.

Although annual sales rose 9% for the 900 companies on BUSINESS WEEK's Corporate Scoreboard--equal to the gain in 1996--net income for the year was up just 9%. That marked a significant drop from the 14% earnings growth seen in 1996. Moreover, the consensus of economists is that 1998 earnings will grow at about half this year's rate. "We've undoubtedly seen the best in earnings growth for this expansion," concludes Allen L. Sinai, chief global economist for Primark Decision Economics.

The slowdown seemed to hit especially hard in the fourth quarter. Despite a 9% sales hike, net income registered no growth at all. Still, on an operating basis, things weren't quite as dire as they suddenly seemed. Take out special charges, and profits would have been up about 10%, roughly half the gain seen in the fourth quarter of 1996.

Why the disparity between strong sales and operating income and flat net income? For one thing, companies--especially those that are restructuring, or involved in mergers and acquisitions--tend to do more write-offs in the final quarter. Since 1997 saw both a record year for M&A activity and a resurgence of restructuring, the combination depressed net income. Boeing's $1.4 billion charge on its merger with McDonnell Douglas Corp. helped drive aerospace profits down 64% for the quarter, for example, while the $2 billion charge Sara Lee took to restructure its plants dragged profits down a full 2% for the 900 companies. All together, the performance of those two companies, combined with big losses at HCA/Columbia, Unisys, and Dow Jones, knocked 7% off total profits.

PRICE SQUEEZE. Still, charges weren't the only thing dampening spirits in the fourth quarter. An increasingly severe price squeeze also depressed net profits. The ability of business to charge higher prices, as measured by the government's gross domestic product price inflator, weakened in the fourth quarter. Today, it is lower than it has been since 1963. Unable to pass along higher labor costs and hamstrung by the impact of the strong dollar on international sales, Corporate America is increasingly taking a hit on the bottom line. By the fourth quarter, profit margins, which were falling all year, hit 5.5%, their lowest level since December, 1995.

Despite the earnings slowdown, the economy in the fourth quarter measured an impressive 4.3% annual growth rate. In 1997, real GDP grew at the fastest pace in a decade, driven by healthy consumer spending and business investment. But that should slow in 1998, when BUSINESS WEEK's economists expect real GDP to rise a more modest 2.4%, and capital spending, which hit record levels last year, to slow. A 2.4% GDP jump would be the smallest gain in three years.

Even hot performers in 1997, such as Exxon Corp., won't be immune to these pressures for long. The oil giant, which posted the biggest profit of any company on the list in 1997, $8.5 billion, benefited from the time lag between the drop in crude oil costs and a decline in gas prices at the pump. This year, falling pump prices are expected to close the lag and cool Exxon's returns.

Nor will a broad economic drop-off be welcomed by industries that suffered in 1997. After a 116% runup in 1996 profits, phone companies fell fast in 1997. AT&T's new cost-cutting CEO, C. Michael Armstrong, didn't arrive soon enough to halt a 20% earnings drop. Problems in the consumer market hit AT&T and rival MCI Communications Corp., says Anna-Maria Kovacs, an analyst with Janney Montgomery Scott Inc. MCI lost $391 million in the fourth quarter and eked out a $2 million profit for 1997.

INSURANCE COUP. The winning industries of 1997 included insurance, which saw the lowest catastrophic loss rate since 1988, a drop in car accidents, and healthy stock investment returns. Property and casualty giants like Allstate Corp. grew profits 50% and more, while Hartford Financial Services Group, which posted a $99 million loss in 1996, turned in a $1.3 billion profit in 1997. The upturn was due to stronger business lines and a windfall from the IPO of its Hartford Life business. The 1998 outlook isn't as rosy. "Among the few ways to increase earnings in '98 is to have even fewer catastrophes than in '97," says Harris R. Chorney, national director for insurance at KPMG Peat Marwick. Few would bet on that.

Detroit also had a big year. Slicing a huge $3 billion in costs, Ford Motor Co. bested General Motors Corp. to post an industry-record $6.9 billion profit. A long strike and a dearth of new products clipped Chrysler Corp., and the coming year is expected to challenge all three. Merrill Lynch analyst Nicholas Lobaccaro predicts that lower demand for vehicles worldwide and pricing pressure from Asian imports will push earnings for the Big Three down 13%.

Semiconductor makers also rebounded smartly from a poor 1996, with profits up an impressive 48%. Memory-chip prices continued to drop for the second year running, but that was offset by sizzling microprocessor sales and volume growth. No surprise, Intel led the way back, posting 35% growth on the strength of its Pentium microprocessors. Strong demand from U.S. corporate buyers and a surge of orders from Europe helped PC manufacturers like Compaq Computer Corp. and Dell Computer Corp. do well in 1997. But pressure could rise this year, as corporations start to clamor for the sub-$1,000 models so popular now with consumers.

For many in the financial services industry, however, downtimes remain a distant fear. Fueled by low interest rates, the soaring stock market and the record year in M&A, financial companies continue to rake it in. Giant Morgan Stanley, Dean Witter, Discover & Co. saw earnings for the year rise 32%, to $2.6 billion, while Merrill Lynch & Co. earnings gained 18%, to $1.9 billion. So far, 1998 is shaping up to be another big year for Wall Street. But back on Main Street, many face tougher going. "The process of growing earnings got harder in 1997," says economist Sinai, "and will get harder again in 1998." Finally, the predictions are playing out.

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