Good-Bye to Pumped-Up Profits?
Companies will be hard-pressed to match even their third-quarter earnings performance

Is Corporate America's turbocharged profit machine running out of gas? Judging by the third-quarter performance of most companies, the question almost seems farcical: Thanks to strong showings by energy, semiconductor, and pharmaceutical companies, among others, the 900 on BUSINESS WEEK's Corporate Scoreboard were able to post a collective 18% rise in third-quarter profits from the same period the year before. Sales for the period rose 17%.

But lurking behind those pumped-up profit reports are ominous warnings from giants such as IBM ( IBM) and WorldCom Inc. ( WCOM) about their continuing ability to sustain the double-digit gains to which investors have become accustomed. Already, the spike in energy costs, combined with higher borrowing costs, a slowing domestic economy, and a plunging euro, are creating new headwinds that are likely to buffet Corporate America's sales and earnings performance for quarters to come.

These new threats haven't been lost on Wall Street, where analysts have been feverishly marking down fourth-quarter estimates for the bellwether companies in the Standard & Poor's 500-stock index. The confident 15.6% growth projected for fourth-quarter earnings as of early October has given way today to a far more cautious 11.7%. That pales next to the 21% growth in the same period last year. Some of the biggest reassessments have come in the technology sector, which led to October's Nasdaq stock swoon. ''There's a decompression going on in earnings expectations,'' notes Edward E. Yardeni, chief investment strategist for Deutsche Bank Securities.

The outlook for next year is even more sobering. Analysts expect that the S&P group's profit growth for all of 2001 will slow to 12.9%--and that could be revised later into the low single digits, predicts Charles L. Hill, director of research at First Call/Thomson Financial. That compares with full-year growth of 18% last year, and a projected 19% this year. ''The risk we could have a hard landing has come up significantly in the last month or so,'' Hill says.

DOUBLE TEAM. Blame it on a double team of higher energy costs and the earlier rate hikes by the Federal Reserve that are only now working their way through the economy. That combination is likely to slow U.S. growth from this year's 5%-plus rate to 3% in 2001, says Joshua Shapiro, chief U.S. economist at Schroder Investment Management. The deceleration will have an outsized effect on corporate profits--slashing the increase for all public and private companies to as little as 2.5% next year, by Shapiro's estimates. ''It won't take much in the way of an economic slowdown to trigger a problem with profits,'' he says.

To be sure, Corporate America has proven the naysayers wrong before. It was only two years ago that the 900 scoreboard corporations, whacked by the Asian economic collapse, turned in a mere 2% profit increase, and some experts were predicting sustained sluggishness. Thanks to strong investments in computers and other productivity enhancers, restrained wage growth, and a booming U.S. economy, corporations sprang right back. Now, though, economists believe that a similar performance will be tougher to pull off. Labor costs are climbing sharply as companies remain unable to raise prices yet continue to bid for workers in a tight labor market. ''We're seeing a very dramatic acceleration in wage costs,'' says Kenneth J. Matheny, senior economist at St. Louis-based Macroeconomic Advisers LLC (chart, page 93).

To their credit, many sectors booked solid third-quarter performances in the face of these growing obstacles. Energy companies rode the OPEC-orchestrated hike in global oil prices to nearly double their profits. Exxon Mobil Corp. ( XOM) recorded the biggest overall profit figure of our 900 scoreboard companies and the biggest quarterly profit in U.S. history, $4.5 billion, for a gain of 105%.

General Electric Co. ( GE) produced the second-largest profit total of the group, $3.2 billion, marking a steady 20% gain from the year-earlier period. That was off impressive double-digit profit growth in six of the company's seven industrial businesses, including its power-turbine and medical-equipment units. GE also bucked a weak market in plastics and reaped a bounty of Olympic and election-year advertising at NBC.

Shortages of key electronic components pushed up profits at semiconductor makers by 119%, as customers scrambled for chips used in everything from cell phones to the new Sony PlayStation 2 videogame machine. The industry's turnaround was illustrated by Micron Technology Inc. ( MU), which reversed last year's $17 million third-quarter loss with a $727 million gain. Drugmakers' 137% earnings gain for the period was helped greatly by comparisons with the previous year, when American Home Products Corp. ( AHP) reported a huge $2.6 billion loss because of a charge to settle lawsuits over the diet drug fenfluramine. Still, some of the biggest pharmaceutical houses racked up impressive gains off the strength of their blockbuster drugs: Merck & Co. ( MRK) reported income of $1.8 billion, up 19%, partly on an 18% jump in sales of Zocor, its cholesterol-lowering drug. And Pfizer Inc. ( PFE) said profits jumped 23%, to $1.4 billion, as sales of its own cholesterol product, Lipitor, rose 22% in the quarter.

Even some companies buffeted by the collapsing euro were able to wring out higher profits. IBM, for instance, managed to hold down overall expenses, which fell to 18% of revenues during the first nine months of 2000, from 19.5% the year before, for a savings of $1 billion, according to Toni Sacconaghi, a Sanford C. Bernstein analyst. As a result, Big Blue was able to boost its profits by 11%, to $2 billion in the third quarter, despite heavy exposure to the declining European currency that helped slow revenue growth nearly by half, from 5% to 3%. But for all the company's success at what Chief Financial Officer John Joyce calls ''basic blocking and tackling,'' he is concerned that the euro's continued swoon could further erode IBM's bottom line: ''The impact in the fourth may be larger due to the euro and the difficulty of hedging.''

Whether the profits machine keeps humming along or screeches to a halt depends largely on the tech sector, which has generated as much as one-third of economic growth over the past several years. Despite an impressive surge in profits for the tech-sector companies in the S&P 500 during the July-to-September stretch, analysts are frantically lowering their outlooks for the traditionally strong fourth quarter: According to Hill, the consensus forecast for the group has dropped from the 29% increase expected in early October to 17%. And that's way off the 40% year-over-year profit growth that tech companies showed in the third quarter. Looking forward, profit gains at tech companies are now expected to slow to 19% in 2001, vs. the 32% increase forecast for this year.

What's darkening the profit outlook for tech? For PC makers, it's a fear that they've saturated the U.S. market, coupled with the dollar's rise against the euro, which is crimping demand in key areas overseas. And as the froth evaporates from the Internet sector, and many struggling Web startups run out of cash, several analysts see a slowdown in demand for networking equipment, software, and other services.

FIERCE COMPETITION. Signs of a PC slowdown grow bigger by the day. On Nov. 2, analyst Eric Ross of brokerage Thomas Weisel Partners LLC issued a report projecting sales of 130 million units for this year, up 16%. That compares with his earlier estimate of 20% unit growth. Still, many analysts and tech executives remain optimistic about their prospects. Dell Computer Corp. ( DELL), after increasing its profits an average 68% in each of the past five years, still is expected to boost its bottom line 36% in the fiscal year ending this January, and another 27% the year after that. Over at Gateway Inc. ( GTW), one of Dell's leading PC rivals, Chief Executive Jeffrey Weitzen, believes that the computer market will still grow in the mid-teens and that Gateway will expand even faster by generating new business from warranties and Internet services. ''I don't believe this is a doom-and-gloom, going-nowhere market at all,'' says Weitzen, whose company reported a 35% surge in third-quarter earnings.

In telecom, it's harder to deny that hard times are at hand. Established players are wrestling with fierce competition from a bevy of new, unregulated entrants. The outlook for construction of networks and other equipment is mixed, but Merrill Lynch & Co. this month projected a 5% decline in 2001 capital expenditures. While the industry as a whole suffered a big drop in third-quarter profits, First Call is now predicting a 19% profit plunge in the fourth quarter. Among those warning of trouble ahead is WorldCom. The telecom giant reported a 12% drop in third-quarter profits, and it is increasingly challenged by consumers shifting to wireless technologies, a free fall in long-distance rates to as little as 5 cents a minute, and unfavorable exchange rates. ''We're facing our share of industry challenges, including pricing pressures,'' sighs WorldCom CEO Bernard J. Ebbers. Goldman, Sachs & Co. analyst Frank Governali expects WorldCom's fourth-quarter profits to drop 43%. He predicts a further 9.5% drop in 2001.

Any turmoil in the telecom industry is certain to ripple through other sectors. Already, analysts at Morgan Stanley Dean Witter are predicting a slowdown in the red-hot optical communications market, given that AT&T ( T), WorldCom, and the other telecom behemoths are expected to trim their capital spending. Networking companies remain at least outwardly optimistic that any cutbacks by the major players will be more than offset by new orders from myriad new entrants. ''We cannot see and do not find meaningful evidence of an industry slowdown,'' says JDS Uniphase Corp. ( JDSU) President Jay Abbe. His company chalked up the biggest single loss of the third quarter--$1 billion, compared with a $114 million loss the previous year. But after excluding merger-related charges, payroll taxes on stock-option exercises, and some investment income, JDS said it would have reported net income of $177 million--or nearly triple its year-earlier figure on the same basis. And it booked third-quarter revenues of $786 million, compared with $230 million in the same period last year.

Telecom's woes also have implications for Wall Street. With its booming capital programs, the industry accounts for nearly one-third of all securities in the issuing pipeline. Goldman, Sachs analyst Richard K. Strauss recently cut his fourth-quarter earnings estimates for several bellwether brokers--including Lehman Brothers ( LEH), by 12%, to $1.20 a share, Morgan Stanley Dean Witter ( MWD), by 8%, to $1.20 a share, and Merrill Lynch ( MER), by 7%, to 80 cents a share--after citing declines in investment banking and trading revenues that could lead to lower earnings. Stock and bond deals in the five weeks through Nov. 7, for instance, dropped about 14% in dollar terms, to $142.7 billion, according to Thomson Financial Securities Data. ''It's clear there's not enough time to save the fourth quarter,'' says Strauss. ''In the current environment, deals just aren't getting done.'' For 2001, Strauss maintains that the major brokerages and asset-management firms will record an 8% hike in earnings.

After a couple of years of heady profit growth, it's inevitable that the laws of gravity would take over eventually. Corporate America is almost certain to find the climb more difficult next year. Semiconductor companies, for instance, have responded to their prosperity by spending heavily on new factories, which has raised fears that a glut of new capacity will force companies to cut prices and lower their profits. And drugmakers face a number of key patent expirations in 2001. That doesn't mean the earnings party is over. But it may be time to check the medicine cabinet to make sure it's stocked with plenty of aspirin.

By Dean Foust in Atlanta, with David Rocks in New York, Andy Reinhardt in San Mateo, and bureau reports

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Good-Bye to Pumped-Up Profits?

TABLE: Winners and Losers in Quarterly Profits

CHART: Hitting the Brakes on Corporate Earnings

CHART: Aftertax Profits Quarter By Quarter

CHART: Industries with the Biggest Dollar Change in the Quarter

Bigger Payroll Bill: Not as Scary as It Seems

CHART: Labor Costs Are Heading Ever Higher

TABLE: Third Quarter 2000 Corporate Scoreboard (.pdf)

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