So Much For The Earnings Slump

Fourth-quarter earnings put the forecasters to shame

Barely a month ago, Wall Street was bracing for what analysts agreed would be a flood of bad fourth-quarter earnings reports. Maybe, just maybe, earnings would come in a little better than in the wretched third quarter, when results dropped 4% from 1997.

Surprise! Day after day during the first weeks of January, companies have been blowing past Wall Street expectations. From Microsoft to 3M to Boeing, dozens of outfits have posted stronger-than-expected earnings. Some did it through huge sales gains--a 38% jump at Microsoft, for instance. Others, such as Sara Lee Corp., didn't top forecasts but still showed outsize gains over losses a year earlier when they were making big cuts to boost efficiency.

Whatever the reason, the results are impressive. BUSINESS WEEK's flash earnings report, based on announced financial results of 80 companies, shows net incomes are up an average 8%. BW's flash estimates in the previous three quarters showed earnings shrinking.

The bottom line on the bottom line? Rather than slowing in the fourth quarter, as many had predicted, the U.S. economic expansion may actually have accelerated. With low interest rates, relative calm in the global economy, and strong consumer spending, economists were upping estimates of fourth-quarter gross domestic product on the eve of the government's official release on Jan. 29.

Now, economists are boosting estimates for 1999. Merrill Lynch & Co. has raised its downbeat 1.5% forecast over the next four quarters to 2%, with even rosier revisions coming. Goldman, Sachs & Co. has boosted its 1999 forecast from 1.5% to 2.1%, largely because its economists figure that Year 2000 computer-malfunction worries will spur output toward yearend. "People are going to add inventories to guard against supply disruptions," says economist William Dudley.

The world's troubles haven't gone away and are still plaguing U.S. exporters. But there's little reason to fear a major slowdown in the U.S. in the near term. The Conference Board's consumer confidence index for January was up for a third straight month. Negligible inflation, low interest rates, rising incomes, strong housing starts, and robust consumer demand all point to continuing growth. "People were just too pessimistic about the fourth quarter," says Lawrence Kudlow, chief economist for American Skandia Life Assurance Corp. "We have indications that a good fourth quarter will spill over into 1999." Kudlow expects operating earnings to stay in the 5% to 6% range for this year.

How strong will the fourth quarter come in? The final numbers for the quarter could be below the flash estimate. But First Call Corp., which had projected operating earnings for the Standard & Poor's 500-stock index would rise 3%, has boosted the forecast to 4.5%. And when every major company has reported, says Research Director Charles L. Hill, "I wouldn't be surprised if we hit 5%." Plus, comparing the vibrant earnings with the flat sales growth in the BW sample suggests some companies managed substantial productivity gains.

AWESOME SHOWING. Behind the averages, though, are widely varying stories. Many of the most pleasing surprises have come from tech companies such as Microsoft and Intel Corp. Analysts expected Microsoft to report 59 cents per share and Intel $1.04; instead, they turned in 73 cents and $1.19. Overall, the industry's showing was awesome, with a 60% average increase in net income. Part of the surge came from strong home-PC sales at Christmas.

But there are signs--hazy ones to be sure--that the high-tech growth engine could slow. One reason sales soared in the fourth quarter is that companies are loading up on high-tech gear now because later in the year they'll be spending their computer budgets on the Year 2000 bug. Microsoft Chief Financial Officer Gregory B. Maffei warned analysts that in coming quarters they may not see the kind of growth the company had last quarter. "A lot of revenues may have been pulled from '99 back into the last quarter of '98," he warned.

If Maffei is right, computer and software makers could see far slower year-over-year gains in coming quarters. Partly because of Y2K uncertainties, "the second half of 1999 may not be as strong," Unisys CEO Larry Weinbach told Wall Street after his company reported a surprise rebound in fourth-quarter earnings after a $1 billion write-off a year ago.

Unexpected earnings gains also extended to some of the biggest victims of the third quarter: financial services companies. The undeniable winner in that crowd was Charles Schwab & Co., whose earnings rose 69% to $106 million. Reason: The discount broker focuses on domestic stockholders and eschews the fancy underwriting and proprietary trading businesses that bedeviled its white-shoe brethren. Morgan Stanley Dean Witter, which saw earnings dip in the third quarter, posted a $1.2 billion profit in the fourth, partly because of a rebound in underwriting. Merrill Lynch & Co., by contrast, was still becalmed in the fourth quarter because of bond-trading losses.

The quarter's sad sacks were the companies with the most exposure to global markets. Heavy-equipment manufacturers in particular: Caterpillar Inc. saw its net skid 33% amid a sales slowdown in Asia. Commodity companies are also suffering. "The home runs were all hit at home, in America," says Edward E. Yardeni, chief economist at Deutsche Morgan Grenfell. Exxon Corp., the largest U.S. oil producer, saw earnings tumble 39%, to $1.5 billion, as oil finished the year at $11 a barrel. The low oil price was harder on smaller companies. Texaco Corp., with one-fourth of Exxon's revenues, recorded a loss of $213 million. And copper producer Phelps Dodge Corp. dismayed Wall Street with a loss of $42 million as copper prices finished 1998 at half the level of a year earlier. When might a turn come? "That's unknowable," sighs Treasurer Thomas Foster.

Sure, the world beyond the U.S. borders could finally harm the domestic economy, making more companies feel the pain of the oil titans. Or the economy's exuberance could spur inflation, pushing up interest rates and putting a brake on growth. Economists, for example, are carefully monitoring wage costs, which Standard & Poor's DRI projects will rise 3.9% this year, up from 3.6% in 1998. Then again, they had the same worries last fall. "Not long ago," says Gruntal & Co.'s Joseph V. Battipaglia, "we heard talk of a recession in 1999. Not now." And that's in large part due to 1998's final sweet surprise.

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