Streaking Past Expectations

Soaring profits surprised even the bulls -- but the party may be winding down

Even before the spring profit parade began, Wall Street was counting on another strong performance. But investors didn't know how much of a blowout it would be. Second-quarter earnings for the 900 companies on BusinessWeek's Corporate Scoreboard gained 41% from the year before. True, the big jump was skewed because a handful of companies were coming off huge losses or acquisition-related write-offs from a year ago. But even after factoring out all one-time items, overall results were still impressive: Profits for the quarter soared 32%, the sixth straight quarter of double-digit growth.

How startling were the numbers? As late as the beginning of the quarter, on Apr. 1, analysts thought profits from continuing operations would rise by 14.9%, according to researcher Thomson First Call. Now, Michael Thompson, director of research, says profit growth for the quarter was more like 26%.

The difference between our numbers and those of First Call is that Scoreboard profits are based on reported income from continuing operations before extraordinary items, as defined by generally accepted accounting principles. That definition includes such things as asset sales and charges for layoffs. First Call's numbers are based on analysts' estimates and exclude certain unusual items.


It turns out that analysts sharply underestimated how much the continued sales growth would help fatten the bottom line. Revenues climbed 13% -- for the third straight quarter of double-digit gains. Of the 60 Scoreboard industries, 58 had higher revenues. Gains were especially notable in energy, where crude oil prices were at or near historic highs; the reinvigorated information technology sector; and among basic materials producers, which benefited from strong international demand. In fact, the materials sector was one of the standout performers in the quarter, with profits up 86% on sales growth of 17%.

The ability to raise prices was a crucial factor in the unexpectedly strong quarter, especially for oil, chemical, and metal companies. "A lot of companies are gaining pricing power, so margins are going up very nicely," says Sung Won Sohn, chief economist at Wells Fargo & Co. (WFC ) Quarterly profit margins rose to 7.6%, from 6.1% the previous year.

Yet profit growth will probably slow considerably in the second half. On July 30, the Commerce Dept. revealed that the economy grew at a slower-than-expected annual rate of 3% in the second quarter, down from a 4.5% clip in the first. Consumer spending, which accounts for two-thirds of the economy, rose an anemic 1%, the weakest showing in three years.

Bad news out of Iraq, rising interest rates, and surging oil prices -- reflected in $2-per-gallon gas in many regions -- took a toll on consumers. Add in subsequent disappointing numbers on job growth, durable goods orders, housing starts, and retail sales, and it looks as if the economy will almost certainly lose steam. "Any cooling down of economic growth necessarily means a cooling down of profits," says Stuart A. Schweitzer, managing director and global investment strategist at JPMorgan Fleming Asset Management (JPM ) and JPMorgan Private Bank (JPM ).


Moreover, one of of the biggest drivers of higher profits, productivity gains, is also likely to slow. That's because as companies hire more workers, output per worker will inch downward. Mark M. Zandi, chief economist at Inc., predicts that after expanding more than 4% in both 2002 and '03, productivity growth will downshift to less than 2% this year and next. "This is the end of the profits party," predicts Zandi.

Try telling that to Big Oil, though. Booming worldwide demand for its products is expected to keep oil prices close to the $40-a-barrel mark. Thanks to those high prices, quarterly earnings for the sector rose 77%, year to year, to $16 billion. Getting an additional boost from improved margins at its U.S. refineries, ConocoPhillips (COP ) saw an 84% leap in profits, to $2 billion. Refining and marketing profit alone at the nation's largest refiner shot up 155%, to $818 million for the quarter. At ChevronTexaco Corp. (CVX ), profits more than doubled from the year-ago quarter, to $4.1 billion. That placed ChevronTexaco second among profit leaders this quarter. In first position was Exxon Mobil Corp. (XOM ), where profits picked up 39%, to $5.8 billion.

But the industry with the biggest impact on overall earnings growth was pharmaceuticals, driven by a big swing at Pfizer Inc. (PFE ) The drugmaker posted a $3.7 billion loss in the second quarter of 2003 after charges of $5.1 billion, mainly related to the acquisition of Pharmacia Corp. (PFE ) In the latest quarter, Pfizer posted profits of $2.8 billion. Meanwhile, quarterly earnings at Johnson & Johnson (JNJ ) doubled, to $2.5 billion. Like Pfizer, J&J had a big charge a year ago -- about $900 million -- related to acquisitions. And despite tough competition in the market for cardiac stents from Boston Scientific Corp. (BSX ), J&J benefited from strong performance across its diverse portfolio, including healthy gains for its rheumatoid arthritis drug Remicade. At Merck & Co. (MRK ), though, profits fell 1%, to $1.8 billion, partly because of higher costs from licensing deals as Merck tries to bolster its pipeline.

This was also a quarter when some big smokestack companies posted strong numbers. Alcoa Inc. (AA ), the world's largest aluminum maker, saw a hefty 86% jump in earnings, to $404 million. Sales rose 11%, the biggest quarterly gain since 2000, driven by demand from auto makers, the aerospace industry, and the construction business. CEO Alain J. Belda expects pricing power will continue "as demand continues to grow at a robust rate" through 2007 on top of a shortage of alumina, the raw material from which aluminum is made. On July 9, Alcoa hiked prices another 5% to 10% on some aluminum alloys. All told, aluminum prices have risen about 30% in the past year. For the future, Alcoa sees much of its demand coming from China. Steel, meanwhile, has done even better, with prices nearly doubling in the past 12 months. No wonder then that U.S. Steel Corp. (X ) earned $211 million, compared with a paltry $3 million in last year's second quarter, while Nucor Corp. (NUE ) profits surged to $251.4 million from $8.4 million.

Tech continued to do well, as business spending on equipment and software rose at a 10% clip in the quarter. (In the previous year such spending grew by 11%.) Profits surged 15% at bellwether IBM (IBM ), to $2 billion, thanks in part to strong growth in Asia and other overseas markets. At Intel Corp. (INTC ), the world's largest chipmaker, second-quarter earnings increased 96%, to $1.8 billion, on an 18% gain in sales to computer and gadget makers. Boosted by strong sales of high-end Macs and its hot iPod portable music player, Apple Computer Inc. (AAPL )'s profits soared 221%, to $61 million.

Yet while the software business as a whole saw earnings climb 60% in the second quarter, the industry also saw the worst spate of disappointments since it tanked in early 2001. Why? Too many software makers vying for the same tech budgets. Analysts say spending appears to be consolidating around a handful of big software makers such as Microsoft Corp. (MSFT ), whose earnings rose 81%, to $2.7 billion, and security specialist Symantec Corp. (SYMC ), which blew through Wall Street's expectations. Earnings jumped 123%, to $131.2 million, on a 48% sales gain. At the other end of the spectrum, PeopleSoft Inc. (PSFT ), locked in a yearlong fight to avoid a hostile takeover by Oracle Corp. (ORCL ), saw earnings tumble 70%, to $11 million. The battle scared off prospective customers.


Other laggards included diversified financial services, media, and utilities. The biggest loser was the airline sector, which is being squeezed by fierce competition and high fuel costs. Airlines racked up a $1.9 billion loss during the second quarter vs. a $941.2 million profit the previous year. A big contributor to that showing was Delta Air Lines Inc. (DAL ), which reported a $1.96 billion loss -- the largest single loss in our survey.

As the domestic economy cools, analysts expect profit growth of only 15% in the third quarter and 15.7% in the fourth, according to a First Call survey. "The fact is, earnings growth will decelerate. That's not a prediction. That's a given," says veteran earnings forecaster Charles L. Hill, CEO of Boston's Veritas et Lux. The good news is that as long as the recovery does not fall totally off track, earnings growth will continue. It just won't provide the dazzle of the past few months.

By Stephanie Anderson Forest in Dallas, with Amy Barrett in Philadelphia and Jim Kerstetter in San Mateo, Calif.

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