Earnings Growth Likely to Slow After Latest Gains

Big third-quarter corporate earnings gains have been a feast for investors starved for other good news recently, but analysts are warning that profit growth will provide Wall Street with lighter fare in the future.

With 84% of blue-chip firms having reported results, operating profits for the Standard & Poor’s 500 companies are on track for a 22% increase in the third quarter from a year earlier--the largest gain since the first quarter of 1995, according to earnings tracker First Call Corp. in Boston.

Results were expected to look good in part because last year’s third quarter was so bad for many companies, experts note. Financial companies in particular were slammed a year ago by the global market turmoil that followed the Russian currency devaluation.

This year, earnings at many U.S. companies have benefited not just from a strong U.S. economy but also from recovery in Asia and strength in Europe.

But analysts say the third quarter is likely to be the high-water mark for profit growth for some time to come. And that worries some Wall Street pros, given that stock prices overall remain at high valuations--suggesting that investors expect stellar profit gains as far as the eye can see.

Some experts also are more concerned about earnings “quality”--that is, the accuracy and scrupulousness of reports, and whether growth is coming from companies’ basic businesses or from one-time gains.

Shares of Tyco International Corp. and of a few other companies have been pounded recently on concerns about the companies’ accounting practices.

Charles L. Hill, First Call’s director of research, argues that companies’ interest in using accounting games to boost reported profits is as strong as it has been at any time since the 1960s.

“There is no question that analysts and companies are trying to push the envelope on what gets excluded” from costs to determine final earnings, Hill said.

He cited a number of practices criticized this year by Securities and Exchange Commission Chairman Arthur Levitt, such as the lumping of certain expenses into “restructuring charges” rather than ongoing costs, and the write-off of “in-process” research and development expenses when technology companies merge.

If they can get away with charging off normal operating costs in a one-time restructuring expense, companies can fluff up future profits, Hill noted.

It’s up to industry analysts to ferret out these abuses, Hill said. But so far, he said, most investors, as well as many analysts, aren’t focusing much on earnings-quality issues.

For now, strong reported third-quarter earnings gains have clearly helped power the stock market higher during the last two weeks, as worries about interest rates have eased and many investors have focused on the generally healthy business climate.

Besides the Asian crisis, last year’s third-quarter earnings overall were depressed by a General Motors strike and the effects of an inventory buildup among some personal computer makers.

With those factors out of the picture this year, earnings gains have been stellar for what happen to be the three biggest industry sectors in the S&P; 500: technology, financial services and consumer cyclicals (including autos, notably GM itself).

The tech, financial and cyclical sectors should post third-quarter earnings gains of 31%, 36% and 41%, respectively, when all results are in, according to First Call.

But without the benefit of weak year-ago comparisons going forward, those sectors are expected to post growth of 14%, 19% and 7% for the fourth quarter, First Call projects.

Also, warnings from IBM and some other tech giants about slower fourth-quarter growth are depressing overall expectations for the tech sector.

For the consumer cyclical companies, the fourth-quarter growth falloff will represent both a reversion to normal patterns and a tougher comparison with the fourth quarter of 1998, when GM cranked up its output to make up for sales lost during the strike, Hill said.

Meanwhile, two industry sectors that surprised some analysts in the third quarter--energy and transportation stocks--did so for the same reason: higher oil prices.

The energy sector, after posting first- and second-quarter profit declines of 45% and 20%, respectively, is bouncing back with a 50% gain projected for the third quarter and a projected 101% gain for the fourth quarter, Hill said.

But transportation stocks, which suffer when fuel costs rise, are expected to show overall earnings down 15% for the third quarter, although part of that slump is due to overcapacity in the airline industry, Hill said.

Looking ahead, big gains by energy and other basic materials companies won’t keep overall S&P; 500 earnings growth from tailing off slightly in the fourth quarter, however.

A big reason: Those sectors now lack the clout they used to have, as technology and financials have grown to dominate the economy and market.

The new reality was reflected in last week’s decision by Dow Jones & Co., publisher of the Wall Street Journal, to add tech giants Microsoft Corp. and Intel Corp. to the Dow Jones industrial average, while dropping energy stalwart Chevron Corp.

For the fourth quarter, S&P; 500 earnings growth now is projected at 19%, First Call said.

For full-year 1999, profits are expected to be up 17% for the S&P; 500.

But next year, growth is expected to fall to about 13%, Hill said. To arrive at that figure, he splits the difference between the average estimate of industry analysts--17%--and the more pessimistic 9% projection by Wall Street stock-market strategists.

Although a 13% gain may seem modest given the soaring profits of recent years, it is still nearly double the 7% average annual earnings growth of the last 20 years.

But whether it would be enough to support greater stock market gains remains to be seen.

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Earnings Growth by Industry

Paced by strong earnings in the three biggest industry sectors--technology, financial services and consumer cyclicals--companies in the Standard & Poor’s 500 index are on track to post a 22% average profit gain in the third quarter. A look at sector and S&P; 500 earnings gains each quarter, measured against the year-earlier quarter in each period.

1999 average earnings growth:

*--*

Sector QI QII QIII* QIV* Technology +42% +42% +31% +14% Financial services +14 +15 +36 +19 Consumer cyclicals +20 +31 +41 +7 Consumer staples +4 +6 +5 +19 Energy --45 --20 +50 +101 S&P; 500 +10.5 +14.7 +22.0 +19.0

*--*

* Estimated

Source: First Call Corp.