About That Earnings Rally You Were Counting On...

An uneven recovery and weak pricing power pummel profits

Three months ago, as the third quarter began, economists were proclaiming the earnings recession over. And since then, personal income and consumer spending have risen as America's jobless rate has declined. Productivity is advancing, too. As a result, after almost coming to a standstill last spring, the economy looks as if it's on solid footing again, on track to grow at 3.5% or better for the quarter. And even though growth is expected to moderate again, to 2.4% in the fourth quarter, many economists and policymakers continue to sound optimistic. "The latest indicators look good," Treasury Secretary Paul H. O'Neill said in a recent speech, specifically noting strong corporate profits, among other measures.

So if things are looking up, how come they still feel so bad for many companies--not to mention investors? Although the ingredients for recovery finally seem to be in place, the much-ballyhooed earnings rebound appears to be melting away as the third quarter closes, battering the market as it goes. True, some companies, such as General Electric Co. (GE ) and Procter & Gamble Co. (PG ), are still hitting their targets. But since mid-September, companies as varied as Dow Jones (DOW ), Duke Energy (DUK ), EDS (EDS ), J.P. Morgan Chase (JPM ), McDonald's (MCD ), Nucor (NUE ), and JDS Uniphase (JDSU ) have all warned that profits would fall below expectations. They'll have lots of company: already, the likes of Lehman Brothers (LEH ) and Morgan Stanley (MWD ) have announced earnings that fell way short of forecasts. Says Duke Energy Corp. Chairman and CEO Richard B. Priory: "We have moved from having the wind at our backs to having the wind and the rain in our faces."

Of course, there's often a rash of companies that flag disappointing results whenever a quarter ends, leading economists and analysts to dial back their initial expectations. But the scale of downward revisions is extraordinary this time. On July 1, analysts expected earnings to climb 16.6% in the third quarter, according to surveys by Thomson First Call. Now, they see profits growing just 7.9%. And they're already slashing fourth-quarter projections way back, from 27.7% to 20.8%, with three months more to go. Though that may still look like a dramatic improvement, the number is up so markedly only because earnings in last year's final quarter were down so low.

What gives? Usually a 3.5% expansion would be enough to spark strong sales and earnings growth for U.S.-based companies. Now, though, the fundamental problem may be that the economy is not as robust as it appears. Strength is concentrated in just a few key sectors, notably defense, health care, housing, and, especially, autos, which alone accounts for about a full percentage point of gross domestic product growth in the third quarter.

Much of the rest of the economy still suffers from a glut of capacity. So, many companies find that the only way to boost sales is to take it away from competitors--usually through price cutting. At best, that means companies have no pricing power; at worst it means many industries face a downward price spiral. "Market share is everything," says Peter Blackmore, head of Hewlett-Packard Co.'s enterprise systems group. "You want to be the big dog."

That's not the only problem. Demand, which had been picking up through midyear in many sectors, is now slumping again. Though the third quarter started strong, companies from high tech to airlines and utilities say sales sagged markedly in September as the stock market tumbled and war worries spread. Business outlays were particularly weak. Even the long-robust housing market slowed.

Now, as companies close the books on another quarter, the lack of pricing power combined with weak demand is sapping the top and bottom lines. Telecom supplier JDS, for example, says it will lose at least $85 million in the quarter, with sales slumping $20 million below its previous forecast, to no more than $200 million. And Weyerhaeuser Co. blames falling lumber prices for trimming profits to no more than $22 million--a third of what the Street forecast.

Still, hope springs eternal. If fourth quarter profits come in as strongly as analysts now expect, economists could declare the long drought over. But remember, it wasn't too long ago when analysts were predicting a strong third quarter, too.

By Michael Arndt in Chicago, with bureau reports

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