Profits Keep Flowing--but Real Story Is Below Surface

Alchemy supposedly went out of style with the Dark Ages, but a cursory look at U.S. corporate earnings reports this year hints at a revival.

How else can it be that so many companies continue to turn mediocre sales increases into spectacular earnings gains?

Consider the third-quarter report from Avery Dennison, a Pasadena-based company that makes adhesive labels, various office products and specialty chemicals.

Avery’s sales rose just 5% in the quarter ended Sept. 30, to $819.3 million. Yet the company’s bottom line showed a 30% surge, to $46.6 million in the quarter from $35.8 million a year earlier.

And the number most investors focus on--earnings per share--rose even more sharply at Avery, to 89 cents in the latest quarter from 67 cents a year earlier, for a 33% gain.

Little wonder that Avery’s stock price hit record highs last week, ending Friday at $64.875 on the New York Stock Exchange, up from $60.125 the week before.

Earnings growth has been the primary fuel of Wall Street’s bull market for the last four years. The more a company earns, the higher the stock price goes, generally speaking.

But for most companies, earnings don’t grow consistently forever. There are ebbs and flows. And it’s the ebb that the stock market’s bears have been predicting for more than a year now.

The bearish bet has been that corporate earnings growth would decelerate markedly as companies finally run out of restructuring moves, as competition increases and as long-suppressed costs begin to rise--especially wages, with the U.S. labor market so tight.

In fact, earnings growth has slowed this year for many companies, compared with 1995 growth. But as third-quarter reports have demonstrated in recent weeks, profits aren’t falling off a cliff, even though business activity supposedly geared down a bit in the quarter.

How are companies managing to keep earnings aloft? There could be a mass cooking of the books going on, but if that’s the case, it must be the greatest conspiracy in the history of the world.

A random look at a few big firms’ third-quarter reports turns up clues about what’s really going on: There’s a still-strong emphasis on controlling costs, continued global sales expansion, use of free cash to buy back stock and a focus on business lines that yield higher profit margins.

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Take Avery, for example. Chairman Charles D. Miller told shareholders that the quarter’s results “reflect our commitment to focus on and invest in our high-economic-value and profitable businesses, while expanding into new geographic markets.”

Avery continues to develop new product extensions for its self-adhesive (i.e., you don’t have to lick ‘em) label technology, for instance. The company is now making self-adhesive postage stamps for the U.S. Postal Service and battery labels for Duracell’s PowerCheck batteries.

Avery won’t say how high its profit margins are on those specific products, but investor relations manager Wayne H. Smith says, “We wouldn’t be in those businesses unless they met our return-on-capital requirements.”

Meanwhile, Avery says it added significantly during the quarter to its presence in the Latin American market for pressure-sensitive labels by acquiring a majority interest in the leading Argentina-based producer of such labels.

The company also has been expanding aggressively in Asia, Smith says. As more companies worldwide use inkjet printers to churn out mailing or product labels, Avery’s self-adhesive labels are riding that trend, he says.

On the expense side, Avery managed to hold the “cost of goods sold” entry on its income statement to $559 million in the quarter, up just 1.9% from a year earlier.

Smith says the company has benefited from stable raw material prices and from increased productivity at its new and upgraded plants worldwide: “We’ve spent a lot of energy making sure we’re very efficient in production.”

That cost control meant that the firm’s gross profit--sales minus cost of goods sold--rose nearly 11% in the third quarter from a year earlier, to $260.5 million.

And that was enough of an increase for the company to bear an 8.4% rise in marketing, general and administrative expenses in the quarter, along with higher taxes, and still report the aforementioned net income of $46.6 million.

Finally, Avery reduced its number of shares outstanding to 52.2 million at Sept. 30 from 53.1 million a year earlier. That allowed the profit earned in the quarter to be spread over fewer shares--hence the 33% rise in per-share earnings.

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The story was somewhat different during the quarter at conglomerate AlliedSignal, one of the 30 companies in the blue-chip Dow Jones industrial average. But the outcome--double-digit earnings growth--was the same.

AlliedSignal’s sales actually fell 4.2% in the quarter, to $3.35 billion from $3.50 billion a year earlier, reflecting the company’s divestiture of its automotive brake business in April.

But AlliedSignal’s cost of goods sold fell even more sharply than sales, dropping 7.2% from a year earlier. And the company allowed selling, general and administrative expenses to rise only modestly, up 2.7% from a year earlier.

The result: a 12.4% increase in earnings before taxes and interest, producing a record “operating profit” margin for AlliedSignal.

That’s the ongoing plan, Chairman Lawrence A. Bossidy told shareholders: Get out of low-margin businesses (like brakes) and shift to “differentiated, high-growth or high-margin products,” such as auto air bags and turbochargers for diesel-powered vehicles.

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What’s more, Mark Greenberg, AlliedSignal’s investor relations manager at its Morristown, N.J., headquarters, says the company’s cost-control emphasis doesn’t focus solely on head count issues, which was Bossidy’s initial focus when he took over in 1991.

“If you’re increasing your margins by simply cutting heads, there’s a limit to how long you can do that,” Greenberg notes. “But if you figure out, through technology, how to better your manufacturing process, how to get tighter tolerances on your machines, for example [to reduce product waste] . . . then you can do that forever.

“Bossidy’s mantra is ‘6% productivity [annual gains] forever.’ ”

For professional money managers whose livelihoods depend on picking the right stocks--and that generally means the stocks with the best long-term earnings prospects--there is plenty of skepticism that mantras like Bossidy’s can be obeyed ad infinitum.

For one thing, there is an economic recession out there somewhere, and when it hits, and consumer and business demand falls for all sorts of products and services, productivity gains aren’t going to help many businesses overcome the simple fact that they’ll be selling less stuff.

“When things are good, profit margins can be great, but when things go bad [in the economy], a company’s margins can get worse than you ever thought they could,” says Ralph Wanger, a veteran investor who manages the Acorn stock mutual fund in Chicago.

To put it another way, Wanger said, 20% earnings gains can be honestly achieved with 5% sales growth, because “it sure works the other way: You can get a 20% earnings drop on just a 5% sales decline” if a company is suddenly caught by a fall-off in sales and costs don’t decline fast enough.

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It’s tough to protect against a sudden economy-wide recession, but in the meantime some pros at least want to be sure that the earnings their companies are generating now--when times are relatively good--are genuine.

Reading a company’s quarterly “10-Q” financial statement (the document filed with the Securities and Exchange Commission) is no easy task for average investors. But Robert Olstein, manager of the Olstein Financial Alert stock fund in White Plains, N.Y., and a specialist in judging the “quality” of earnings, suggests that investors who own individual stocks pay attention to a few key items.

For one, he says, “If you see inventories [on the balance sheet] building up at a much faster pace than sales, it’s a red flag.” That could portend deep price cuts to move product in coming quarters.

Also, Olstein checks earnings as reported to shareholders versus earnings as reported to Uncle Sam in the annual 10-K statement. A big difference in the two numbers could indicate that a company is playing accounting games that may bite shareholders later. Finally, Olstein studies a company’s cash-flow statement, which tells you how much free cash the business is generating.

Earnings can look good for a time even if underlying cash flow is deteriorating, Olstein points out. But eventually a firm that can’t generate rising amounts of cash can’t do the things that make shareholders happy and the stock price rise--like share buybacks, acquisitions and dividend boosts.

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Blood From Stones?

Here are a few examples of major U.S. companies that continue to wring strong profit growth from what in many cases are modest sales gains, or even sales declines.

Third-quarter increase in:

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Earnings Company Sales Earnings per share Avery Dennison +4.6% +30.2% +32.8% United Technologies +5.1% +21.0% +21.0% Philip Morris +4.3% +14.9% +17.5% AlliedSignal -4.3% +16.6% +16.9% Delta Air Lines +7.7% +18.4% +16.0% DuPont +2.8% +16.8% +15.9% Anheuser Busch +3.3% +11.0% +13.8% Bristol-Myers Squibb +9.7% +9.3% +10.3% Procter & Gamble -1.4% +9.3% +10.2%

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Results are as reported, including any extraordinary items.

Source: Companies listed