Profits: "The Fog Is Beginning to Lift"

With the economy's biggest worries behind it, earnings look set to keep heading up

The recovery in corporate profits keeps chugging along. While the second quarter opened inauspiciously with the U.S. at war, that didn't slow the momentum of improving earnings. Profits for the 900 companies on BusinessWeek's Corporate Scoreboard jumped 31%, a second straight quarter of double-digit gains. Almost half of that came from a huge rebound by Lucent Technologies (LU ) Inc. Still, sales grew 6%, vs. the tepid 1% turned in a year ago.

Even better, some of the economy's most nettlesome worries are behind it, which should help keep profits moving northward. There are far fewer of the billion-dollar-plus write-offs that depressed earnings last year. The spring saw the quick end of major combat in Iraq, while the threat of a widespread SARS epidemic abated. Demand for some goods and services improved, giving companies a chance to crank up factories and occasionally raise prices. The result: Profit margins rose to 6.4%, more than a full percentage point higher than the year before. Throw in the declining dollar, which boosted the value of profits generated abroad, and by July 25, two-thirds of companies reporting earnings to Thomson First Call had exceeded Wall Street's expectations. "The fog is beginning to lift," says Richard D. Rippe, chief economist at Prudential Securities Inc.

Could the second phase of the recovery that has eluded the economy two years running be upon us? Economists and investors who doubted it just six months ago are now voicing a full-throated yes. They say improving profits foreshadow a stronger economy, which will, in turn, be even better for profits. Interest rates are low, some companies are boosting capital spending, and productivity is rising. With companies running lean, "even a modest improvement in growth is likely to drop straight through to the bottom line," says Stuart A. Schweitzer, global investment strategist at J.P. Morgan Fleming Asset Management. Moreover, Federal Reserve Chairman Alan Greenspan expects tax cuts to pump $35 billion into the economy in the third quarter. The consensus now is that gross domestic product will grow at a 3.7% annual rate in the second half of 2003, up from a sluggish 1.5% estimate in the first half.

To be sure, not every company will benefit from the good news. Already, 179 of 341 U.S. companies that reported earnings as of July 25, says First Call, warned of earnings misses in the third quarter. Many hotel, airline, and capital-goods companies are likely to remain weak. Unemployment, at a nine-year high of 6.4% in June, could still rise. Fears of terrorist attacks could revive to put a crimp in spending, and energy prices haven't dropped much from their prewar runup. Overall, though, good feelings abound. Since early March, the stock market, a leading indicator, has rallied, with the Dow Jones industrial average surging 22%.

One of the big positives in this quarter's results is the upturn in the technology industry. While no one is quite yet ready to declare a full-blown recovery, demand for computers is slowly rising, and the giants of the industry are getting higher prices for their snazziest new offerings. At IBM, second-quarter earnings shot up 288%, to $1.7 billion. The year before, IBM earned only $445 million, as its bottom line was crushed by write-offs and restructuring charges. Chief Financial Officer John R. Joyce says the uptick is just the beginning: "We can and will do better as the second half evolves." IBM credits gains from its acquisitions of PricewaterhouseCoopers Consulting and Rational Software Corp., which broadened IBM's reach in high-margin businesses.

In the quarter, Intel (INTC ) Corp. shipped 1 million of its new Centrino chips, which link notebook computers to wireless networks. That helped earnings to more than double, to $896 million, Intel's best year-over-year showing since the third quarter of 2000. Microsoft Corp., meanwhile, boosted profits 26%, to $1.9 billion, thanks to strong sales of a new operating system for servers.

Even telecom companies, once the economy's leakiest boats, are finding safe harbor, thanks to continued cost-cutting and big gains in wireless, broadband, and long distance. BellSouth (BLS ) Corp.'s earnings rose 262%, to $951 million, after the company added 540,000 wireless and 856,000 long-distance customers -- far more than anticipated. And both Lucent and Motorola Inc. bounced back from ugly losses the previous year. Lucent trimmed its $8 billion loss to $254 million, while Motorola turned a $2.3 billion loss into earnings of $119 million. "The telecom recession has run its course," says Susan Kalla of Friedman, Billings, Ramsey Group Inc.

With market prospects improving, the financial industry continues to post solid gains. Citigroup's profits rose 12%, to $4.3 billion, the largest total for all companies. Bank of America (BAC ) and Wachovia (WB ) posted 20%-plus growth. Surging trading volume and higher levels of debt issuance helped offset the dearth of underwriting and merger business. "Fixed income has just been roaring for us, and we're starting to see a comeback in equities," says Robert B. Willumstad, Citigroup president. Profits at rival J.P. Morgan Chase & Co. rose 78%, to $1.8 billion, the first time earnings rose in back-to-back quarters since Chase Manhattan and J.P. Morgan merged in 2000.

So where does the optimism about profits stop? In the car business, for one. Sales at General Motors (GM ) Corp. were flat, year to year, while profits fell 30%, to $901 million, and most of that came from lending operations, not car sales. Meanwhile, Ford (F ) Motor Co. suffered a 31% profit decline, to $425 million, as heavy incentives ate into earnings. Drugmakers also got hit hard. Bellwether Pfizer Inc. lost $3.7 billion, largely because of a $5.9 billion aftertax noncash charge related to accounting for the Pharmacia (PFE ) Corp. acquisition, while Johnson & Johnson's earnings fell 27%, to $1.2 billion, also hurt by acquisition costs. Even mighty General Electric Co. saw profits fall 14%; its power-systems unit, for one, suffered in the downturn.

But the economy is likely to gather steam in the months ahead. And as it does, Corporate America should see its profits energized once again.

By Andrew Park in Dallas, with Mara Der Hovanesian in New York and bureau reports

— With assistance by Mara Der Hovanesian

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