Drifting Back To Earth

Third-quarter profit growth, while respectable, slowed from its sizzling pace

The tally is complete, and it's now official: Corporate profits have returned from the stratosphere. Earnings at the 900 companies in BusinessWeek's Corporate Scoreboard rose 19% in the third quarter from the previous year -- a smart pace, but decelerating from a 41% hike in the second quarter. And if it weren't for an impressive showing by the energy patch, the slowdown would have been even more evident. Take away Exxon Mobil Corp. (XOM ) and other big energy companies, and the profit increase slowed to 16%.

Any double-digit profit rise is nothing to sneeze at, of course. But this is the first time in six quarters that earnings gains from the previous year failed to top the 20% mark. Blame the cooler economy and rising costs: the cost of money, by way of higher interest rates; the cost of labor, in slowing productivity; and the cost of basic commodities, including oil. In fact, things looked worse at the start of the third quarter, when analysts had forecast only a 13.9% earnings rise from continuing operations for the Standard & Poor's (MHP ) 500-stock index, according to Thomson First Call. Now, senior analyst Gint Rimas says growth will probably be about 17% after pockets of strength -- in energy, materials, and technology -- unexpectedly emerged during the quarter.


The difference between BusinessWeek and First Call earnings is that Scoreboard profit numbers are based on reported income from continuing operations before extraordinary items, as defined by generally accepted accounting principles. That definition includes such items as asset sales and charges for layoffs. Thus, the 19% increase for third-quarter Scoreboard profits would be 26% if you factored out $38 billion in one-time items. And the 41% rise in second-quarter profits was helped by the fact that some big companies were coming off huge 2003 losses or acquisition-based write-offs. First Call's numbers, on the other hand, are based on analysts' estimates and exclude certain unusual items.

Any way you cut it, things were bound to slacken given the deceleration in the economy. Real gross domestic product grew only 3.7% in the three-month period -- down from the 4.3% pace Wall Street expected. "Third-quarter profits are a mixed picture of an economy that's undergoing a transition," says Stuart A. Schweitzer, managing director and global investment strategist at J.P. Morgan Fleming Asset Management.

Yet even as the economy slowed, strong business spending continued to swell revenues. The machinery, Internet software and services, and computer-chip sectors all recorded sales gains of 20% or more, and electronic equipment and instruments surged 18%. Total Scoreboard revenues climbed 13% -- the fourth straight quarter of double-digit gains. Of the 60 Scoreboard industries, 57 had higher revenues, while margins rose to 6.3%, vs. 6% the previous year.

At the top of the earnings heap this quarter were the oil companies -- no surprise, given the runup to $50-a-barrel crude. Boosted by rising worldwide demand and tight supplies, ExxonMobil, the world's largest energy producer, saw a 56% profit jump, to $5.7 billion. That ensured Exxon was once again the total profits leader. ConocoPhillips' (COP ) earnings shot up 61%, to $2 billion, on a 34% revenue gain. Getting an additional boost from asset sales and its booming international gasoline refining and marketing business, ChevronTexaco Corp. (CUX ) saw a 50% profits jump, to $2.9 billion.

Similarly, pricing power and insatiable worldwide demand continued to lift results in the basic materials sector. Steel producer Nucor Corp. (NUE ), for example, was able to raise the average price per ton for its steel and steel products by 87% from the previous year, to $668 per ton. The higher selling prices, combined with the integration of two newly acquired mills, pushed Nucor's third-quarter earnings to $415.4 million, up from $16 million the year before. Sales more than doubled, to $3.2 billion. Meanwhile, the continued strength in housing helped drive larger volumes and higher prices for wood products. At timber giant Weyerhaeuser Co. (WY ), one-time gains of $208 million -- which included the sale of timberland -- pushed profits up 624%, to $594 million. "Prices had the biggest positive effect on our third-quarter earnings," CEO Steven R. Rogel told analysts.

Profit gains in the technology sector were respectable but not spectacular. Microsoft Corp. (MSFT ) raked in the most profit for the group, making $2.9 billion, up 11% from the year before. IBM (IBM ), however, saw a meager 1% increase, to $1.8 billion. The new breed of dot.commers turned in stronger performances. Yahoo! Inc. (YHOO ), for example, saw profits nearly quadruple, to $253.3 million, benefiting from more ads on its non-search-area sites. And fresh off its initial public offering in August, search kingpin Google Inc. (GOOG ) raked in $52 million, up 154% from its previous-year quarter, thanks in part to strong international sales.

Even with some high-profile product disasters, the drug industry still managed to crank out a 36% profit gain. Merck & Co. (MRK ) took a major hit with the withdrawal of its painkiller Vioxx. Product returns, the write-off of Vioxx inventory, and the cost of the withdrawal itself all helped push Merck's income down 29%, to $1.3 billion. But big rebounds at other pharma houses more than made up the difference: Without the drag of costs associated with its Pharmacia acquisition, Pfizer Inc. (PFE ), boosted earnings by nearly 50%, to $3.3 billion. And Wyeth (WYE ) swung to a $1.4 billion profit -- up from a $426 million loss the previous year, when it took a charge related to litigation surrounding two of its diet drugs, Redux and Pondimin.


Meanwhile, the major investment banks, which appeared to be invincible in recent years, turned in results that were decent but hardly stellar. Mergers and stock offerings remain in the dumps and rising interest rates are making it more difficult for banks to generate big trading profits. Goldman, Sachs & Co. (GS ), for example, saw a 30% jump in profits from the year before, to $879 million. But that was 41% less than second-quarter earnings. At Morgan Stanley (MWD ), income fell by 17%, to $862 million, in large part because its trading operation bet wrong on rates.

The biggest loser this quarter was AT&T (T ), which suffered a staggering $7.1 billion net loss. The culprit: a $12.5 billion charge to write down the book value of its land-line network and pay severance for 7,500 workers as it retreated from the consumer long-distance businesses. Sprint Corp. (FON ) and MCI Inc. (MCIP ) also wrote down long-distance assets, resulting in losses of $1.9 billion and $3.4 billion, respectively. But telecom equipment makers are emerging from the funk that began with the stock market slump in 2000. Lucent Technologies Inc.'s (LU ) profits more than tripled, to $348 million, on the strength of its mobile and high-speed networking businesses. Strong cellular-phone sales helped push up Motorola Inc.'s (MOT ) net by 313%, to $479 million.

It's not news that airlines are struggling. After months of chopping costs to close the gap with nimble discounters, big carriers got walloped by soaring fuel prices. As a group, airlines posted a loss of $1.2 billion. Half of that was generated by near-bankrupt Delta Air Lines Inc. (DAL ), which spilled $646 million worth of red ink. Once again, one of the few bright spots was low-cost Southwest Airlines (LUV ), where profits jumped 12%, to $119 million. Southwest kept costs in check by lowering the ratio of employees to aircraft and by prepurchasing fuel at lower prices.

Don't expect much improvement in coming months. The economy is expected to keep cooling, while high energy and commodity prices will eat into the bottom line. Interest costs are likely to become more of an issue, too. The Fed Reserve was expected to hike its key interest rate by one-quarter of a percentage point, to 2%, on Nov. 10. So analysts are looking for profit growth of 15.3% in the fourth quarter and only 8.9% in first quarter of 2005, according to a First Call survey. Sung Won Sohn, chief economist at Wells Fargo & Co. (WFC ), compares the slowdown to speeders who suddenly see a cop at the side of the road: "We had been traveling at 70 miles an hour. Now we're slowing down to 55. [Profit growth] is back to a more normal pace." Executives and investors will just have to get used to fewer thrills.

By Stephanie Anderson Forest in Dallas, with bureau reports

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