U.S.: Profits: All That Body-Building Is Starting to Pay Off
After months of wringing their hands over how the war in Iraq would play out, investors are putting their war worries behind them and focusing on what matters most to their portfolios: profits. Given all that they have been through in the past three years, shareholders will need plenty of convincing that the outlook for corporate earnings is truly turning around. But from here on out, they may like what they see.
Profits are already improving. At the end of 2002, operating earnings of the companies in the Standard & Poor's 500-stock index rose 19% from year-ago levels. The Commerce Dept.'s gauge of operating profits for nonfinancial corporations is more than 23% above its low point in the first quarter of 2001.
Earnings in the first quarter of 2003 are also looking surprisingly good. With about 200 of the S&P 500 firms now having reported, overall profits are up more than 9% from a year ago, and the final tally could well exceed that showing. Wall Street has welcomed the news: The Dow Jones industrial average is up 3.9% since early April, when the first-quarter earnings season began in earnest.
The results are impressive in light of the economy's tepid growth rate in the fourth and first quarters, and they reflect more than just companies laying off workers. For three years now, businesses have made wrenching adjustments in order to be profitable in a more sober and realistic economic climate. They have eliminated excess capacity, slashed inventories, increased productivity, and replaced high-cost short-term debt with cheaper long-term debt (chart).
The bottom line will also benefit from the depreciation in the dollar and nascent signs of firmer pricing power. All this means that even a moderate acceleration in the economy could yield powerful results on the bottom lines of Corporate America.
THIS POSITIVE VIEW IS A SWITCH from the commonly held notion that the excesses of the 1990s will continue to limit economic growth and profits in coming quarters, even after war uncertainty lifts. To be sure, problems remain. Telecom companies are still awash in capacity. Factory utilization rates remain low. Many companies have to address deficits in their pension funds. And problems at HealthSouth Corp. suggest accounting scandals still lurk in the shadows.
But consider the progress companies have made. In 1998, production capacity in manufacturing was growing 8% per year. Now it's growing 1%. Capacity growth among tech equipment makers has slowed from 50% to 8%. Eliminating spare capacity has allowed companies to cut their fixed costs enormously, a key factor in the rise in profit margins over the past year. Without huge overhead costs, each extra dollar of revenue sees more profit fall to the bottom line. Unit profits of nonfinancial corporations, while still below their highs of the late 1990s, rose at the end of last year to the highest level in 2 1/2 years.
ANOTHER IMPORTANT REASON for the improvement in margins is the strong gain in productivity, which appears to have posted another solid advance in the 2%-to-3% range in the first quarter after output per hour rose by a stellar 4.1% over the course of 2002.
The downside, of course, is that as long as businesses rely on efficiency, and not on extra workers, to increase output, the labor markets will remain weak. Slow job growth is one of the biggest risks to this year's outlook. But when looking at profits, productivity gains are pure nectar because they hold down the labor cost of making each unit of a product. Unit costs are growing more slowly than prices, so more of the price of each item goes into profits.
The weaker dollar is another plus. First, the earnings of U.S. multinationals get a real lift when, for example, a company is able to swap the same amount of euros for a greater number of dollars. Already, despite sluggish global economies, U.S. receipts from the rest of the world rose 20% in 2002 (chart). Second, the weaker currency will give U.S. exporters a price advantage in foreign markets. That will boost revenues, especially when growth abroad recovers.
Better still, different exchange-rate trends mean the dollar's movements will benefit American exports more than they hurt the U.S. inflation rate. The dollar has declined faster against the currencies of our 10 major export markets than it has against the currencies of our 10 most important import sources. On an export-weighted basis, the dollar has fallen 6.4% over the past year; based on imports, it's down only 5%.
As a result, the prices of nonpetroleum imports have risen a bit over the past year. That has given retailers some leeway to lift prices or at least do less discounting. Pricing power is also turning up because of the cuts in capacity and the increased costs that tighter security is placing on supply channels. This time last year, the inflation rate for raw materials, excluding energy and food, was -4.9%. In March, it had accelerated to 15.1%. Further down the production line, the rate for partially processed intermediate goods has picked up from -1.7% to 2.6% (chart).
None of these trends means the era of low inflation is about to evaporate. But given that future gains in capital spending will depend on a better profits outlook, even the inflation-vigilant Federal Reserve may tolerate some firmer pricing power among companies this year in order to boost economic growth.
CORPORATIONS HAVE ALSO MADE great strides in shoring up their balance sheets. As a percent of total assets of nonfinancial companies, financial assets at the end of last year were at a record high. At the same time, equipment and software, which had hit a record low in late 2000, remain well below their levels of the 1990s. Inventories are still at an all-time low. Businesses have a heavy debt load, but in the final two quarters of last year, nonfinancial corporate debt grew at the slowest pace in a decade.
That slowdown, plus exceptionally low borrowing costs, has cut corporate interest expenses sharply, helping to boost cash flow. The cash flow of nonfinancial companies has risen by $134 billion from its low of $601 billion in the first quarter of 2001, and it now stands some $70 billion higher than the average level in the late 1990s.
Any company can make money in a boom. But Corporate America has spent three difficult years repositioning itself to generate profits in a new world of reduced expectations and higher risk. The recent good news on earnings suggests those adjustments are almost complete. For two quarters now, companies made money even while the economy just crawled along. With recent data offering more reasons to feel optimistic on future economic growth, corporate profits could post some surprisingly solid gains for the rest of the year.
By James C. Cooper & Kathleen Madigan