The Bottom Line Is This: Watch the Top Line Too

A company’s earnings growth will drive its stock price in the long run. That’s a basic rule of investing that most stock owners grasp fairly quickly, and hold on to forever.

And for good reason. Consider Wal-Mart Stores, for example. It earned 37 cents a share in 1988. This year it’s expected to earn $1.90 a share. That works out to a 414% gain in 10 years.

Quite happy with numbers like those, Wall Street has bid Wal-Mart shares up tenfold since 1988.

Now consider Phelps Dodge Corp., the Phoenix-based copper-mining giant. It earned $6.58 a share in 1988. This year, beset by a glut of copper worldwide, Phelps Dodge might earn about $2.42 a share--or about 63% less than the 1988 total.

You surely wouldn’t call that a growth company. And the stock price reflects as much: It has barely doubled in 10 years, from a peak of $27 in 1988 to $55.56 now.

Why even that much of a gain, if earnings have declined? Because investors believe Phelps Dodge could make a lot more money, if the copper market were to improve. But ultimately, it’s still a cyclical business: You can’t count on consistent earnings growth.

The focus on corporate bottom lines becomes particularly sharp four times a year, of course, because U.S. companies report earnings quarterly. We’re now more than halfway through the third-quarter reporting season, and despite the usual teeth-gnashing leading into the season, many companies are reporting healthy year-over-year earnings growth.

Gains of 20% or more, for example, have been reported by companies as diverse as Quaker Oats, Maytag, Lucent Technologies and Southwest Airlines.

Overall, however, this still looks to be the weakest profit-growth quarter since 1991, according to earnings tracker First Call Corp. in Boston. In fact, it projects a 1% decline in third-quarter operating earnings for the blue-chip Standard & Poor’s 500 companies, in aggregate.

The stock market has certainly been dealing with that problem, along with a host of others, since midsummer. Even counting the rally of recent weeks--and the Federal Reserve Board’s two interest rate cuts since Sept. 29--the S&P; 500 index still is off 9.8% from its record high set July 17.

The major concern now isn’t with third-quarter numbers (that’s ancient history, from Wall Street’s point of view) but rather what will happen with earnings in 1999.

Even assuming the U.S. economy won’t fall into actual recession next year--an assumption many investors have made, thanks to the Fed’s new stance on rates--there are plenty of reasons why corporate earnings will be under pressure.

Those reasons include still-weak demand for U.S. exports in Asia, the probability of an economic slowdown in Latin America (another big market for U.S. exports), and the strong possibility that U.S. consumer and business spending will be weaker than this year as both groups stay wary in the wake of the global market turmoil of recent months.

John Lonski, economist at Moody’s Investors Service in New York, says that as a group, key U.S. economists now believe that nominal U.S. gross domestic product growth next year will be 3.9%. That would be the lowest figure since the 3% growth of 1991.

Nominal GDP is growth unadjusted for inflation. The usual reported figures for GDP are inflation-adjusted, to show the economy’s “real” growth in demand.

Growth in nominal GDP thus is equivalent to a retailer’s report of sales growth. And it’s a benchmark for sales growth of all U.S. companies: Ideally, you’d like demand for your companies’ products or services to exceed the growth rate of the economy overall.

But by definition, everyone can’t beat the average. If the economy itself grows at a 3.9% nominal pace, and some companies grow faster, many others will have to grow more slowly.

These are sales--the “top line”--we’re talking about. Earnings--the bottom line--can grow faster than sales, for any number of reasons.

And since 1994, that has been one of the driving forces behind the stock market’s stunning gains: Many companies have managed to wring spectacular earnings growth from fairly unexciting sales growth.

How do you produce, say, 15% annual earnings growth when your sales are growing at a much slower pace--say, 5%?

In recent years, that seeming alchemy has occurred thanks to a confluence of favorable factors:

* The corporate restructuring wave, by which many major companies have peeled away their least profitable businesses to focus on their most profitable ones, or have taken over competitors in the name of cost efficiencies.

* Productivity gains, as cost-cutting and new technology have allowed companies to make more of something at lower cost--thus increasing profit margins on the next marginal dollar of sales.

* Falling interest rates, which have reduced corporate borrowing costs--with the benefit flowing directly to the bottom line.

* A surge in stock buybacks, which have cut many firms’ shares outstanding, boosting the profit left, per-share, for remaining shareholders.

The problem now is that the benefits of those factors either have run out or at least plateaued for many companies. What many face now is a harsh reality: Without more such alchemy, earnings gains may fall closer to actual sales growth--which, for the economy as a whole, isn’t looking very promising.

The pressure on earnings didn’t just develop last quarter. For the average blue-chip company, “profit margins peaked in the third quarter of 1997 and have been coming down ever since,” says Marshall Acuff, investment strategist at Salomon Smith Barney in New York.

Hence, the U.S. stock market’s weakness in recent months might have occurred even without the economic meltdown in Russia and other global shocks.

The upshot for investors, then, is that it’s becoming more important to look not just at the historic bottom-line gains a company has achieved, but at the potential sales growth going forward.

Those companies that can’t boost sales at a decent pace may have much more trouble boosting earnings. And if stock prices still follow earnings--well, think about Wal-Mart versus Phelps Dodge.

Who boasts good sales growth these days? Wall Street still feels that it can count on such global consumer-products giants as Microsoft (sales up 26% in the third quarter) and drug titan Merck (15%). And their stocks reflect as much.

But investors are more concerned about a company like AMR, the parent of American Airlines, which posted 34% third-quarter earnings growth, but on a sales gain of just 7%.

Parker Hall, a veteran money manager at Lincoln Capital Management in Chicago, notes that for most companies, sales growth depends on three factors: unit growth (the number of products sold to consumers); pricing (i.e., whether a company holds product prices level, raises them or is forced to reduce them); and foreign-currency fluctuations (strength in the dollar versus other currencies means foreign-denominated sales are translated into fewer dollars).

“There’s no doubt that unit sales at many companies are growing more slowly” because of global economic weakness, Hall says. Likewise, he says, “pricing power is harder to come by,” thanks to cutthroat competition worldwide.

Those challenges have forced him to “moderate” his earnings growth expectations for many stocks he owns, Hall says.

Still, he believes it would be a mistake to be overly bearish about 1999 earnings growth potential for many U.S. companies. The recent weakness in the dollar could help, he notes. So might lower interest rates.

More important, he advises against underestimating companies’ ability to step up the productivity drive in the face of new adversity.

At the very least, the latter point suggests a lot more headlines in 1999 that include one of two keywords: “layoffs” or “merger.”

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Tom Petruno can be reached by e-mail at tom.petruno@latimes.com.