| BUSINESSWEEK ONLINE : DECEMBER 13, 1999 ISSUE | ||||||||
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| BUSINESS OUTLOOK
U.S.: A Vise Is Tightening around Profits Higher costs and interest rates will crimp the bottom line next year Powerful demand is generating an abundance of profits for Corporate America. That's the story you could read from the Commerce Dept.'s top-line data on third-quarter economic growth and corporate profits. But if you're one of those investors expecting continued double-digit earnings growth through next year, you might want to give those numbers a closer look. The economy grew at a blistering 5.5% annual rate last quarter. Measured from the year before, growth was 4.2%, and pretax book profits soared 10%. But two factors accounted for nearly all of that earnings gain: a huge rebound in foreign-based profits after a disastrous third quarter in 1998 and a jump in inventory values, especially at oil companies, reflecting a surge in oil prices. Of the $78 billion increase in profits over the past year, higher inventory values accounted for $46 billion, and the bounceback in earnings from overseas operations added $27 billion. Exclude those two, and corporate earnings barely rose from a year ago, even after accounting for the destructive effects of Hurricane Floyd. Domestic profits, adjusted for inventory values, some 84% of total corporate earnings, increased only 0.7% from last year, while earnings at domestic nonfinancial businesses fell 1.1%. So what's going on here? In a nutshell, higher costs for labor and materials, as well as higher interest rates, are squeezing the bottom lines of many U.S. businesses, especially small companies and those lacking pricing power. The bad news: That vise is more likely to get tighter than looser in 2000. Foreign earnings count, of course, but the rebound so obvious in last quarter's data will not be repeated in 2000, and neither will the jump in inventory values. Earnings from overseas operations surged 30.6% from a year ago, after plummeting 21.1% in 1998's third quarter (chart). It was the largest such increase in 12 years, just after the mid-1980s plunge in the dollar. The trade-weighted dollar's 6% drop in the year ended in August helped to boost earnings after they were converted into dollars, but the post-Asia-crisis rebound in foreign economies was the key factor last quarter. Clearly, the global rebound will continue to lift overseas earnings next year, but compared to the huge gains in 1999, growth will be much less. Besides, foreign earnings are only 12% of overall profits. That's why further earnings expansion in 2000 will have to be homegrown. But despite rock-'em-sock-'em demand in the U.S., especially by consumers, domestic profits were lackluster, based on the Commerce Dept.'s tally. It's important to note some key differences in Commerce's earnings data and those followed by investors, such as the earnings per share of the Standard & Poor's 500-stock index. First, Commerce surveys some 20,000 companies of all sizes and stripes, not just 500. Commerce also provides adjustments for changing inventory values and uses a consistent measure of depreciation. As a result, S&P 500 earnings reflect very large companies that are most likely to have sizable overseas operations. Within this group, the impact of big oil and energy companies also can be large. Not surprisingly, S&P 500 earnings soared more than 20% last quarter. The more comprehensive Commerce data strongly suggest that U.S. businesses face increasing difficulty making a buck. That is especially true among smaller businesses, which don't have the flexibility of big corporations to cope with sharply higher raw materials prices and skilled-worker shortages amid extremely tight labor markets. Also, smaller companies are typically price takers who have little pricing power. According to Commerce figures, profit margins, while still high, have been under pressure--and declining--for two years (chart). Nonfinancial businesses, on average, earned 11.6 cents on each dollar of real output in the third quarter, down from 12.1 cents the year before, and from an expansion peak of 12.8 cents two years ago. To be sure, strong productivity growth has boosted profits, but note that even with productivity improving at a stellar 2.7% annual clip during the past two years, this measure of profit margins is still falling. That's because, despite the restraining influence of productivity, unit labor costs are nevertheless outpacing prices, a trend that began two years ago. Don't expect any relief in 2000. Amid few signs that labor-market pressures are abating, wages and benefits seem destined to accelerate in coming months, while a further speedup in productivity growth is highly unlikely. At the same time, consider that producer prices for raw materials--even excluding energy and food--have risen at a 25% annual rate over the past six months, the fastest in 4 1/2 years. Companies will also be shelling out more in interest expenses. The impact of the Federal Reserve's three interest-rate hikes since June are already working their way into corporate borrowing costs, and further Fed rate increases in 2000 cannot be ruled out. Businesses have been piling on debt in recent years, and interest costs last quarter posted the largest quarterly jump in two years. One plus for profits: Top-line revenue growth will continue to be robust well into next year, given the turnaround in export demand and the unrelenting vigor in consumer spending. The nation's purchasing managers reported continued brisk business activity in November, although the pace slowed a bit from October. The National Association of Purchasing Management's composite index slipped to 56.2% from 56.6% the month before, but those levels are higher than the third-quarter average, and they are consistent with economic growth of greater than 4%. Moreover, households headed into the crucial holiday shopping season with high confidence and plenty of income. Personal income surged 1.3% in October, the largest monthly rise in nearly six years. The increase was helped by some special factors, but even accounting for those, the gain was very good. Also, given plentiful jobs and the rebound in stock prices in recent weeks, consumers are feeling especially optimistic. The Conference Board's index of consumer confidence rose more than five points in November, to 135.8, not far from the three-decade high of 139 hit in June (chart). Households report upbeat assessments on both present conditions and on expectations for the next six months. Holiday shopping, already off to a generous start by most surveys, seems destined to be exceptionally strong. But amid rising costs, businesses will find it increasingly difficult to take advantage of such buoyant demand. The coming cost squeeze will be resolved in two ways: Companies that can raise prices will do so, and those that cannot will take a hit on the bottom line. As the Commerce Dept. data show, some businesses are already feeling the pinch. By JAMES C. COOPER & KATHLEEN MADIGAN _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP |
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RELATED ITEMS U.S.: A Vise Is Tightening around Profits CHART: Overseas Earnings Boost the Bottom Line CHART: A Growing Squeeze on Margins CHART: High Spirits among Holiday Shoppers INTERACT E-Mail to Business Week Online | |||
