The Outlook: Profits -- and Pessimism
Don't talk to business executives about last year's mild downturn. Although many economists don't even qualify the slump as a true recession, for corporations the past year has been nothing less than a disaster. After nine straight years of increases, operating profits for the companies of the Standard & Poor's 500-stock index plunged 31% last year, in what has been called the worst corporate slump since the end of World War II.
Now, many economists are arguing that the dark days for corporate profits are about to end, and that the future may, in fact, prove surprisingly bright. Economists are recognizing a powerful set of forces that could generate a stronger-than-expected turn in profits. Surprisingly robust productivity growth is cutting the cost of labor required for each unit of production. So even though businesses have little pricing power, they can still earn more on each sale they make. In other words, with unit costs falling, profit margins are rising.
This pattern is already showing up in the government's latest profits roundup for some 5,000 companies, both public and private. Fourth-quarter productivity surged at a 5.2% annual rate, while unit labor costs dropped 2.7%, fattening margins. Even though prices economywide barely rose, higher margins and demand resulted in a 17.9% surge in profits from the third quarter. That was still 3% below a year ago, but clearly signals a turn in the profit cycle.
The improvement continued in the first quarter. The March employment report suggested that productivity posted another strong advance last quarter, and unit labor costs fell for the second quarter in a row, something that hasn't happened in nearly two decades. For the rest of the year, with compensation already growing more slowly, continued gains in productivity will keep unit labor costs in check. That means a steady pickup in demand will go straight to the bottom line. Wall Street is jumping on the bandwagon. A consensus of Street analysts predicts that profits will rise 9% in the second quarter, with growth soaring into double digits for the remainder of the year, according to a Thomson Financial/First Call survey.
Great news, right? Not for many execs operating on the economy's front lines. Many don't buy the rosy scenario because for them there's little recovery in sight. That's especially true in the hard-hit telecom, technology, and heavy equipment industries. For these executives, demand remains weak and prices even weaker. Add to that soaring energy prices, a business psychology transformed by the Enron scandal, and the ensuing accounting questions that have trimmed executives' willingness to push earnings aggressively, and the prospects for robust growth look far less promising.
Indeed, from high tech to auto parts, the refrain is the same: 2002 won't be anything to write home about. "We can see order boards for anywhere from 90 to 180 days out, and we don't see the kind of recovery you hear being talked about in the media," says Cummins Inc. (CUM ) CEO T. M. Solso, who warns that sales of his company's diesel engines are running at levels not seen since 1993. "There's an awful lot of wishful thinking" in the Street's profit predictions, adds John D. Laupheimer, who manages the nation's oldest mutual fund at MFS Investors Trust.
As the debate heats up, recent developments seem to support the naysayers. On Apr. 8, IBM (IBM ) shocked investors with its first big earnings warning in 11 years, sparking a 10% sell-off in its shares. And plenty of other big names, from Nortel Networks Corp. (NT ) to Bristol-Myers Squibb Co. (BMY ), have issued similarly downbeat guidance in recent days.
But it's not just the obvious candidates that are having a tough time mustering growth. All across the economy, company after company is complaining that the ability to raise prices -- or even hold prices steady -- is all but nonexistent. "It's not easy to pass on prices in this economy," says Terry J. McClain, chief financial officer of Omaha-based Valmont Industries Inc. (VALM ), which sells irrigation systems and equipment to power companies. Nor are all economists and investment strategists certain that improved profits are anywhere near the horizon. "We remain to be convinced that earnings are going to surge forward," says David Blitzer, chief investment strategist for Standard & Poor's Corp.
So what sectors look to have the toughest time rebuilding profit growth? Autos are near the top of the list. True, auto sales remain unexpectedly strong, and could approach last year's second-highest levels in history. But the Big Three continue to lose market share, and rebate wars are still depressing pricing. With the help of major restructurings, Ford Motor Co. (F ) and DaimlerChrysler's Chrysler Group (DCX ) are hoping to break even this year, after huge losses last year. The only bright spot in Detroit: General Motors Corp. (GM ), which has already made big cost cuts and just raised its earnings forecast for the year. Says GM Vice-Chairman Robert A. Lutz: "We are increasingly optimistic about the outlook for both GM and the entire U.S. auto industry."
Even more worry surrounds prospects for the troubled tech and telecom industries. For many, sales are still falling. In its warning, IBM said it expects revenues to dive 12% in the first quarter, causing profits to come in 22% below analyst expectations.
Many saw this as a clear sign that a tech rebound remains a distant dream. "I think you're going to see a big reticence among executives to really turn on the spending for technology," warns Kevin B. Rollins, president and chief operating officer for Dell Computer Co. (DELL ), which expects sales to fall 1.6% and profits to slump 8% in its first quarter. Rollins says it could take as long as six quarters for a recovery to develop. And fierce competition will make it difficult for tech companies such as EMC Corp. (EMC ) to sustain the huge margins they enjoyed during the boom, says Laupheimer.
Similarly, the telecom titans are still drowning in excess, with the average transport network being used at just 6.6% of capacity, according to Merrill Lynch & Co. As a result, Merrill doesn't expect any meaningful pickup until late 2003 or 2004. In the meantime, there could be "another wave of shakeouts," says Merrill analyst Tai Liani.
Even those more upbeat about profits concede they're concerned about the spike in oil prices caused by the fighting in the Middle East. "Surging energy prices are the key risk" to a strong profits recovery, says Richard Berner, chief U.S. economist at Morgan Stanley Dean Witter & Co. Most problematic: the struggling airline industry. In the wake of September 11, airline revenues fell about 25% below year-ago levels in the first quarter, says analyst Susan Donofrio of Deutsche Bank Securities. She predicts that the 10 largest carriers will lose $2.2 billion in the quarter. Now Reno Bianchi, an analyst at Salomon Smith Barney, figures that if it holds, the recent $8-per-barrel jump in crude prices could cost the industry $3 billion to $3.5 billion a year, offsetting the positive effects of a strengthening economy.
The fallout from the Enron and Andersen scandals is also casting a cloud of uncertainty over the profits outlook. For starters, post-Enron, "companies can no longer manage their earnings the way they did in the late '90s," warns Robert Barbera, chief economist at Hoenig & Co. Then there is the more subtle psychological impact. No one wants to be caught pushing the sorts of aggressive earnings games that have roiled the markets in recent months. With corporations taking a more conservative approach, the overall level of earnings may be depressed by 10%, he figures.
The one sector that sailed through the recession, the pharmaceutical industry, is also bracing for tougher times. Because patents are expiring on blockbusters from Prozac to Glucophage, Stephen M. Scala, an analyst at SG Cowen Securities Corp., figures the eight big drug companies he covers will boost sales just 6% this year, down from 9% last year, while profits will rise an anemic 4%, vs. 14% in 2001.
But if many sectors still face tough times, elsewhere the picture has begun to improve. Through Apr. 5, Thomson Financial/First Call tallied 453 negative earnings warnings, down from 782 in the same period a year ago. Meanwhile, the number of companies saying they will beat expectations soared 79%, to 274. Indeed, plenty of sectors could finish 2002 in fine shape. Charles L. Hill, First Call's research director, says such a swing is almost always a reliable harbinger of recovery.
Which sectors look to finish the year out in far better shape than they started? Solid consumer spending is helping discounters like Wal-Mart Stores Inc. (WMT ), while Sears, Roebuck & Co. (S ), thanks to improved credit-card income and cost-cutting, announced on Apr. 10 that its first-quarter profit should come in 52% above expectations. And business is brisk at Activision (ATVI ). The nation's second-largest video-game publisher said it expects sales to hit $845 million in its current fiscal year, up 10%, thanks to demand created by the new game consoles from Nintendo, Sony, and Microsoft. Combined with cost controls, that helped Activision boost earnings per share 64% in just-ended fiscal 2002.
The debate over the strength of the recovery likely won't be settled for several months. But two things are clear. First, some degree of an earnings recovery is under way. And second, even most bulls admit that this year's profits have little hope of reaching their 2000 peak, at the end of the last boom. At best, another year is needed to recover from that bust.
By William Symonds in Boston, with Andrew Park and Wendy Zellner in Dallas, Michael Arndt in Chicago, Joann Muller in Detroit, and bureau reports