Corporate Profits Getting Squeezed on All Sides
Economists are still debating whether the United States is headed for, or indeed is already in, a recession.
But the debate on the corporate profit picture is pretty much over: Earnings continue getting mugged so badly that Wall Street analysts are nearly ready to abandon hope of any growth for many firms in 2001.
An “earnings recession”--at least two quarters of lower profits compared with a year earlier--is already a foregone conclusion for the first half of this year.
Now, even the second half of the year seems shaky. The consensus of analysts is that there will be close to zero profit growth in the third quarter for the blue-chip companies in the Standard & Poor’s 500 and about 6% growth in the fourth quarter.
Charles L. Hill, research director at earnings-tracker First Call/Thomson Financial, noted that the fourth-quarter growth estimate has been trimmed from 15% in just the last two weeks. Before long, the analysts will slash their estimates for both quarters well into negative territory, Hill predicted.
Fears over corporate America’s fading bottom line have been a driving force in the stock market plunge, now the deepest since at least 1987 for most market indexes.
Yet many experts insist the U.S. economy has merely slowed and isn’t actually contracting. Why, then, are corporate earnings faring so badly?
The most obvious answer is weaker sales. Manufacturing, business and retail sales are poised for their worst combined quarter since 1991, at the end of the last recession, said John Lonski, chief economist at Moody’s Investors Service.
More cautious consumer spending is only part of the story. Many companies, worried about the economic outlook, are opting to reduce or suspend capital-spending programs. A new machine tool, phone system or software package may promise savings down the road, but canceling the order means savings now.
Software giant Oracle last week said it would lay off 900 employees, citing customers’ abrupt postponements of planned purchases. Cisco Systems, Compaq Computer, Intel and Motorola--to cite just a few tech giants--’fessed up earlier to declining orders and have announced even deeper staff cuts.
Well beyond technology, sales overall are grinding down to the point where Lonski projects barely a 1% gain for the first quarter compared with the first quarter of 2000.
Worse, profits are tumbling even faster than sales, for a number of reasons.
One factor is increased competition from abroad. The dollar last week soared to a 22-month high against the Japanese yen and a three-month high against the euro. This is happening despite record U.S. trade deficits and the Federal Reserve’s most aggressive interest-rate-cutting campaign since the early 1990s.
“Import prices are still falling,” said Edward Yardeni, chief investment strategist at Deutsche Bank Securities in New York. The competition from Japanese exporters has been unremitting since the Asian crisis of 1998, Yardeni said, but it only intensifies as the strong dollar makes those imports cheaper for Americans.
To hang onto market share, U.S. companies are cutting prices and offering more generous financing terms, he said.
And not all the price competition is foreign: No less a free-market guru than Warren Buffett, chairman of Berkshire Hathaway, complained recently that State Farm Mutual Automobile Insurance was competing unfairly against his Geico unit by charging too little for its auto policies.
Buffett, in a letter to Berkshire shareholders, said State Farm has been selling policies at a loss to grab customers. “The willingness of the largest player in the industry to tolerate such a cost makes the economics difficult for other participants,” he griped.
The rest of the dismal profit story is on the cost side. Oil, natural gas and electricity had their biggest price surges in a decade last year, saddling firms with costs that, for the most part, they lacked the muscle to pass along to their customers.
Procter & Gamble, America’s largest household-products company, Thursday announced 9,600 new layoffs on top of more than 7,000 cuts announced earlier. The Cincinnati-based maker of Pampers diapers and Ivory soap has been hurt by rising costs and economic problems in overseas markets, such as Turkey.
Although it is the market leader in many product categories, P&G; found out last year how tough it is to be a price leader when it tried to push through some price hikes to reflect rising raw materials costs. Rivals refused to match its moves and started taking away customers, so P&G; was forced to rescind the increases.
For many companies, wage and benefit costs also continue to rise, despite soaring layoffs. Average hourly earnings for 97 million U.S. workers rose at a 4% annual rate in January and February, even as the economy slowed, government data show.
Those are increases that companies could comfortably absorb in recent years because worker productivity was rising even faster than pay. But now, with productivity growth threatened by the economy’s slowdown, higher wage costs have to come out of the bottom line.
Seattle money manager William A. Fleckenstein, long one of the most bearish voices on the stock market, puts his finger on one source of higher wage costs.
“Companies for years have been paying their employees in bloated stock options,” Fleckenstein said. Now, as stock prices keep falling, more workers will spurn options in favor of cash, leading inevitably to rising wages, he said.
An economic slowdown also exposes the risks inherent in companies’ use of leverage. Many big businesses borrowed heavily in the 1990s, often using bond debt to finance stock repurchases. Corporate bond issuance has hit record levels in recent years.
Even as sales slow, interest costs still have to be paid--though that burden will be lessened as the Federal Reserve continues to cut interest rates.
Another drag on the profits of such tech companies as Yahoo and Cisco Systems are the drooping fortunes of venture-capital investments that they made in smaller tech firms, especially ones they hoped would grow into major buyers of their products and services.
The failure of many such firms has left the investing companies with worthless stock. Worse, it also has eliminated the start-up companies as potential customers for the bigger firms and in some cases has resulted in a flood of used equipment into an already saturated market.
Arguably, some of the current wave of profit disappointment stems from companies’ efforts in recent years to keep investors happy at all costs, some experts say.
Wall Street constantly admonishes investors to be in the market for the long haul, yet it ranks companies by their quarter-to-quarter performance. Miss the earnings consensus by a penny a share and watch your stock get pummeled.
The pressure to meet Wall Street expectations pushes chief financial officers to squeeze for every last nickel of profit--and sometimes more.
“When the earnings environment gets tough, like it did last fall, they’ll try any trick in the book,” said David M. Blitzer, chief investment strategist at Standard & Poor’s. But the bag of tricks--legitimate ones, anyway--has a limit, and at this point in the downturn, many companies have used up all their lifelines, he said.
Without a cushion of further accounting creativity or inflated dot-com shares, then, some companies are feeling every bump in the economic road. That’s why each new jolt results in a new profit warning, and why layoff notices have come in a series at some firms, analysts say.
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The Fading Bottom Line
Companies across a broad swath of industries have warned that earnings this year will be down from 2000, or up only modestly. A sampling of companies, their 2000 earnings per share and analysts’ average estimate for 2001 results:
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2000 2001 Est. change, Company EPS est. EPS 2000 to 2001 McDonald’s $1.46 $1.54 +5% Bank of America 4.72 4.91 +4% Deere & Co. 2.06 1.99 --3% Charles Schwab 0.60 0.54 --10% DuPont 2.73 2.46 --10% Ford Motor 3.26 2.58 --21% Delta Air Lines 6.81 3.95 --42% Intel 1.51 0.69 --54% Motorola 0.84 0.20 --76% Georgia-Pacific 2.89 0.66 --77%
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Earnings are results from continuing operations. Sources: IBES/Thomson Financial, Bloomberg News, Times research
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Profits: The Long Boom
The surge in corporate earnings since 1991 provided the basic underpinning for the great stock bull market of the last decade. Here’s a look at earnings growth of the blue-chip Standard & Poor’s 500 companies:
Operating earnings per share for the S&P; 500 index companies
1991: $22.20
1992: $24.65
1993: $28.50
1994: $33.00
1995: $38.79
1996: $42.54
1997: $46.76
1998: $45.79
1999: $50.96
2000: $56.00
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Source: Goldman Sachs & Co.
