Can Earnings Stay on the Recovery Track?

Results are up from third quarter last year, a low ebb. But consumer jitters are spreading

Everything, they say, is relative. And that certainly applies to third-quarter corporate earnings. At first glance, results for the 900 companies on BusinessWeek's Corporate Scoreboard seem to give investors good reason to pile back into the stock market. Profits were an astounding 57% higher than a year ago. But look again: Much of the gain is due to big, one-time charges taken last year, so the sharp earnings rebound has more to do with cost-cutting and financial cleanup than with big improvements in core businesses. True, corporate revenues were up a hefty 6%. Yet that's mostly because sectors like and technology are much stronger than a year ago, when business all but ground to a halt after September 11.

Earnings had only one way to go: up. The third quarter of 2001 saw the second-steepest profit drop in the 25-year history of BusinessWeek's earnings Scoreboard. Terrorist attacks turned what was already a tough quarter into a black hole for much of Corporate America. Many companies in battered sectors such as telecom and technology took the opportunity to do some extra bloodletting. Motorola Inc. (MOT ), for instance, took a $2 billion pretax charge, mostly for bad debt, and lost $1.4 billion. This quarter, it made $111 million.

Still, despite all the special items, the third quarter delivered some of the first good earnings news in a long time. The 6% sales increase is the best since the second quarter of 2001, and compares with an average 2% drop through the previous four quarters. Strip out all the one-time hits, and third-quarter profits still rose 8% above the year-ago level. True, profit margins, at 4.8%, remained below the first quarter 1998 peak of 7.5%. But all in all, it's enough to convince many observers that earnings have bottomed out. The numbers "are getting better each quarter by an expanding margin," says Charles L. Hill, research director at Thomson First Call. "It's just a slowly expanding margin." First Call predicts that, for companies in the Standard & Poor's 500-stock index, operating earnings--before special charges and extraordinary items--will grow 15% in the current period.

The question is whether consumer jitters will cause the economy to sputter in the fourth quarter--and whether corporate profits will be dragged down again. After all, it was largely shoppers buying new cars that helped drive third-quarter growth in gross domestic product to 3.1%, up from 1.3% in the previous period. Now, however, consumer confidence has fallen sharply. Consumer spending fell 0.4% in September, and auto sales slumped 27% in October. Economists, who had been expecting GDP growth of 2.2% in the fourth quarter, reduced estimates following the negative reports.

That has dire implications for some of the sectors that turned in the strongest performances last quarter. As a group, specialty retailers registered an 11% sales increase and a 61% profit gain. Leading the pack were such sector-dominating players as home-improvement twins Lowe's Co. (LOW ) and Home Depot Inc. (HD ), which had profits that were 42% and 28% higher, respectively. Wal-Mart Stores Inc. (WMT ) led multiline retailers with a 26% rise in profits, to $2 billion. The housing boom played a big role in who won: Maytag Corp. (MYG ) reported a 63% profit leap, to $61 million, thanks to sales of high-end products such as super-capacity dishwashers. "Those who have the money buy what they want," says Ralph F. Hake, Maytag chairman and CEO.

The folks buying new appliances probably used credit cards. Those purchases, plus the surge in mortgage lending and refinancing, gave a boost to banks with strong consumer-credit arms, such as Bank of America (BAC ), based in Charlotte, N.C. BofA has benefited by steadily shifting its business from low-margin wholesale loans to high-margin consumer loans. The bank also avoided losses on the corporate side by cutting nearly half its $110 billion loan portfolio, including much of its exposure to telecom and energy. This portfolio-scouring helped BofA post a profit jump of 166%, to $2.2 billion, although the gain is partly due to a $1.7 billion pretax charge that BofA took a year ago, when it exited the subprime lending business.

Much of the earnings improvement was made through corporate cost-cutting, of course. That is bad news for companies trying to sell new industrial and technology gear. Many tech and telecom-equipment companies continue to slash staff. Telecom-gear maker Lucent Technologies Inc. (LU ), which is laying off 10,000 people, recorded the biggest loss of any company in the third quarter--$2.8 billion. It was a big improvement, though, over last year's $7.3 billion loss.

At some point, of course, all the cost-cutting should pave the way for an earnings rebound. Take Verizon Communications (VZ ), the telecom giant that recorded the single highest profit for the quarter--$4.4 billion, more than double its year-ago level. No one believes the telecom turnaround is at hand: Verizon's revenues rose only 1%, to $17.2 billion. But it was able to bolster its bottom line by slashing costs--it cut capital spending by 21%, to $2.6 billion, in the quarter.

Companies also continue to benefit from productivity growth as they rejigger processes and make smarter use of years of IT investments. And eventually, as aging equipment grows creaky, companies will have to replace it. Sometime in 2003, corporate housecleaning should be largely complete. As long as we don't get a double-dip downturn, investors may look back on this quarter as a turning point.

By Faith Keenan in Boston with Dean Foust in Atlanta and Michael Arndt in Chicago

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