Profits: Don't Get Your Hopes Up--Yet

Earnings are a bit better, but real improvement is down the road

This was supposed to be the season of celebration--a time when buoyant corporate profits would finally prompt pessimists to recognize that recovery was well under way. But even with an 8% jump in second-quarter earnings from the year before, a specter of misery continues to loom over the 900 companies on BusinessWeek's Corporate Scoreboard. That growth comes off a notably weak 2001 period that had been marked by a 52% plunge in profits. Meanwhile, second-quarter sales managed only an anemic 1% increase, year to year.

The soft top-line growth suggests that companies are managing to squeeze out gains mostly by keeping costs low. Margins rose to 4.4%, from 4.1% the year before, and average wage growth slowed significantly in the first half of 2002 to nearly flat levels. Indeed, wage growth may even drop into negative territory if unemployment starts to rise. Meanwhile, a weaker dollar is just starting to give a boost to manufacturers selling goods overseas. That, along with the growth in productivity and gross domestic product, should bode well for sales in the second half, says Richard D. Rippe, chief economist at Prudential Securities Inc. "Even if they only push through minimal price increases, companies should start to see more revenue growth," he says.

That optimism is by no means universal, however. In one earnings call after another, CEOs have tripped over themselves talking about disappointing capital spending, soft demand, underperforming investments, and, of course, the scandals besetting Corporate America. Managers are simply more cautious now. And once new rules kick in requiring CEOs to sign off on financial statements, they will likely be more conservative in reporting results as well.

Charles L. Hill, director of research at Thomson Financial/First Call, now believes 4% profit growth is the best that S&P 500 companies can do for the year, pointing to downgrades in earnings estimates over recent months and a steep 11.5% profit decline in the first quarter. Historically, their profits have risen about 7% annually. What will help determine if profit growth approaches even the lower figure? Says Hill: "The big issue is whether consumers will hang in there."

Consumers have continued to gobble up goods despite the dour state of the stock market. At Wal-Mart Stores Inc. (WMT ), for instance, quarterly earnings rose an impressive 20%, year to year, to $1.65 billion. The auto makers also rebounded, thanks to strong consumer spending and their own deep discounting. Even Ford Motor Co. (F ), after a disastrous 2001, posted second-quarter profits of $570 million, vs. a loss of $752 million. And General Motors Corp.'s (GM ) earnings soared 171%, to $1.29 billion. Chairman John F. Smith Jr. vows to build on those results: "We are determined to maintain our momentum in the second half of the year." That, despite investor worries about the future impact of GM's pension costs.

Another industrial heavyweight, General Electric Co. (GE ), regained its place as the biggest generator of profits. Its quarterly earnings rose 14%, to $4.4 billion. Company execs pointed to the growing strength of GE's economy-sensitive units like plastics as a sign that the economy is truly rebounding. "I can only talk about the world of GE, but I don't see anything that indicates a double-dip activity," says Chief Executive Jeffrey R. Immelt.

Nevertheless, some sectors still remain deeply profit-challenged. It's hard to believe, but after two years of trouble, telecom's problems are actually getting worse. AT&T (T ) reported a $12.7 billion loss because of a $13.1 billion charge to reflect the decline of its cable operations. Lucent Technologies Inc. (LU ) lost $7.8 billion, and analyst Tal Liani of Merrill Lynch & Co. doesn't see Lucent making money until some time in 2004. And SBC Communications Inc.'s (SBC ) quarterly earnings fell 11% to $1.8 billion, thanks to competition from wireless carriers and weaker demand. Says a glum CEO Edward E. Whitacre Jr.: "We do not anticipate a rebound in demand for the rest of the year."

That could also be the refrain of the tech sector, which was marked by a 79% profit plunge at blue-chip IBM (IBM ), to $445 million, because of soft demand and more conservative accounting. There was one bright spot: Microsoft Corp. (MSFT ) saw profits grow to $1.53 billion from $65 million. The software giant is now projecting revenue growth in each of its seven major product categories and plans to significantly boost research and development in fiscal 2003, which started July 1. Chief Financial Officer John Connors almost gloats over the poor showing of rivals such as IBM, Sun Microsystems (SUNW ), and Oracle (ORCL ). Says Connors: "People still ask, `Are you a growth stock?' Compared to these guys in the last 12 months, yes, we are."

In the pharmaceutical sector, double-digit profit increases were once taken for granted. Not any more. Former highflier Merck & Co. (MRK ) saw earnings slump 4%, to $1.8 billion, while Bristol-Myers Squibb's (BMY ) profits fell 60%, to $440 million. Bristol blamed an onslaught of generic drugs and bloated wholesaler inventories for the plunge.

Scoreboard profits also took a hit from weakness at Big Oil. ChevronTexaco Inc.'s (CVX ) earning fell 81% on weak natural gas prices, tight refining margins, and a $531 million write-down of its investment in troubled Dynegy Inc. (DYN )

In the face of difficulties ranging from lower capital spending to the uncertain impact of business scandals, analysts polled by Thomson Financial/First Call have sharply lowered third quarter growth forecasts for S&P 500 companies to 12.8% from 20.7% back in April. Things will get better. It's just not going to happen overnight.

By Diane Brady in New York, with bureau reports

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