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This Recovery Is The Real Deal


Almost everything seemed to go right for profits in the third quarter. With tax cuts fueling consumer spending, the economy grew at its fastest pace since 1984: Gross domestic product surged 7.2%. Corporations continued to hold inventories in check and cut costs. The result: Earnings at the 900 companies on BusinessWeek's Corporate Scoreboard jumped 41% from a year earlier, for the third straight quarter of double-digit gains.

Can it last? The U.S. economy almost certainly won't keep up the third quarter's torrid pace. Those tax-refund checks are cashed, and U.S. companies aren't creating nearly as many new jobs as they did in past recoveries. Thus, most economists expect GDP growth will ease to a 4.5% pace in the fourth quarter. Still, there's a sense that businesses are over the hump and profits should keep rising. "We're going from a very hesitant recovery to one that's dynamic and capable of running on its own without help from fiscal policy," says Robert V. DiClemente, chief economist at Salomon Smith Barney (C).

Up to now, profits have been driven largely by the twin engines of consumer spending and productivity. The Scoreboard companies managed to keep cutting costs and boosted earnings far beyond their aggregate 9% sales gains for the quarter. Profit margins rose a full one-and-one-half percentage points from year-earlier levels, to 6.5%. But the big change is that Corporate America is beginning to open its pocketbook. In the third quarter, business investment in technology and equipment grew 11.1%, the fastest rate in three years, according to Commerce Dept. statistics released in late October. That long-awaited investment surge "is the real indicator that the recovery is here to stay," says Brian S. Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson Inc. in Chicago.

Silicon Valley is the biggest beneficiary of that investment boom. At Intel Corp. (INTC), the world's largest chipmaker, earnings jumped 142% in the third period, to $1.7 billion, on the strength of record shipments of higher-priced computer microprocessors. Healthy sales of its newest generation of desktop computers and its iPod music player helped put Apple Computer Inc. in the black with a profit of $41 million, vs. a $45 million year-ago loss.

And in a key sign of increased stability for the long-troubled telecommunications equipment sector, Lucent Technologies Inc. (LU) reported its first profitable quarter since March, 2000. Strong wireless and fixed-phone equipment sales and deep cost-cutting helped Lucent edge into the black, with earnings of $99 million, compared with a $2.8 billion loss a year ago. Chief Executive Officer Patricia R. Russo recently was moved to tell analysts: "It's time to close the chapter on what has been an extended, challenging period for both Lucent and the industry. The worst seems absolutely behind us."

ENERGIZED

Profits in the energy sector were a bright spot this quarter, thanks to oil and natural gas prices that stayed persistently high following the invasion of Iraq. In fact, one big reason oil prices haven't fallen as much as some had hoped is that production in Iraq still has not rebounded to prewar levels. Moreover, oil prices are expected to stay at current levels in the near term. OPEC unexpectedly announced at its September meeting that it would cut production by 900,000 barrels a day beginning Nov. 1. Meanwhile, domestic natural gas markets remain tight as producers continue to face difficulty keeping pace with the growing demand for clean-burning gas.

With all that, Big Oil was happily in the black this quarter. ChevronTexaco Corp. (CVX) saw profits of $1.98 billion, vs. a loss of $904 million a year ago. At Exxon Mobil Corp. (XOM), earnings shot up 39%, to $3.65 billion. And at ConocoPhillips, the combination of high energy prices and better margins in its huge refining operations helped lift income from continuing operations to $1.25 billion vs. a loss of $74 million in the year-ago quarter. The third quarter of 2002 included two months of earnings from Phillips Petroleum Co. and one month of the combined companies of Conoco Inc. and Phillips Petroleum, which completed their $15 billion merger in August of last year. That deal created the U.S.'s third-largest energy company.

The financial-services industry also turned in a better quarter. A revived stock market helped boost income from equity and bond underwriting, as investment banking activity finally began to pick up. Lower provisions for delinquent loans also helped. With many banks having written off bad debt during the bear market, the need to reserve for new losses has diminished. And three years of cost-cutting also helped boost profits. The Securities Industry Assn. expects Wall Street to post its most profitable year ever in 2003, earning $22.5 billion -- more than triple last year's profits and higher than the record of $21 billion in 2000. Citigroup (C) racked up profits of $4.7 billion, a 27% increase and the biggest quarterly total for any Scoreboard company. At J.P. Morgan Chase & Co. (JPM), earnings rose more than 40-fold from a year earlier. That was its third straight profitable quarter -- the first time that has happened since the merger that created the company three years ago.

Even the beleaguered airline industry began to show signs of life, thanks to a busy summer travel season. AMR Corp. (AMR), parent of American Airlines, eked out a $1 million profit, vs. a year-ago loss of $924 million. It was helped by a massive $4 billion cost-cutting effort, including big labor concessions. Continental Airlines Inc. (CAL) earned $33 million, before a $100 million gain from selling ExpressJet Holdings Inc. (XIT) stock. But don't expect miracles from the chronically ailing airlines, especially as they slog through the traditionally weak winter season. Says Continental CEO Gordon M. Bethune: "We think it's going to be pretty tough out there for the next six months."

MISSING THE PARTY

In fact, there are plenty of sectors that have yet to join the profits parade. The recovery has yet to trickle down to most heavy manufacturers. Earnings at bellwether General Electric Co. (GE) fell 2%, to $4 billion, as CEO Jeffrey R. Immelt warned that GE's full-year earnings would be at the lower end of analysts' estimates. The company's power systems, plastics, and aircraft engine divisions remain weak. The auto business also struggled, with Detroit benefiting more from its finance operations than its manufacturing muscle. It was largely on the strength of mortgage lending at its GMAC unit that General Motors Corp. earned $425 million, reversing an $804 million net loss in the year-ago quarter. Meanwhile, fierce competition and scant demand for local phone services continue to slam the Baby Bells: Verizon Communications Inc. (VZ), the nation's largest telephone company, saw earnings fall 59% in the third quarter, to $1.8 billion.

BACK OF THE PACK

Amgen was a rare bright spot in a dismal landscape for drugmakers. The company turned in a $612 million profit, up from a $2.6 billion loss last year when Amgen took a $3 billion special charge. But industry leaders Merck & Co. and Pfizer Inc. were still in the doldrums, with earnings up only 6% and off 1%, respectively. Merck (MRK), Pfizer (PFE), and other big drugmakers are suffering from having few new blockbusters to fuel profits. Meanwhile, litigation costs tied to diet drugs Redux and Pondimin turned Wyeth's (WYE) $1.4 billion profit a year ago into a loss of $426.4 million.

The biggest loser this quarter, however, was R.J. Reynolds Tobacco Holdings Inc. Hobbled by the onslaught of discount brands and continuing lawsuits, it racked up a third-quarter net loss of $3.45 billion. RJR is now betting that bulking up will keep future profits from going up in smoke. It has announced that it will buy the U.S. cigarette business of British American Tobacco PLC (BTI).

Look at the bright side: Lagging industrial sectors leave plenty of room for profit improvement in months ahead, provided the economy settles into steady growth. Most analysts expect just that: Those surveyed by Thomson First Call (TOC) estimate profit gains of about 22% in the fourth quarter for Standard & Poor's 500-stock index companies, and a more sustainable 12% pace in the first half of '04. Says Charles L. Hill, director of research at Thomson First Call: "Things are going to slow down and revert back to a more gradual trend line."

Yes, future profits gains may be less dazzling. This quarter, after all, will be a tough act to follow. But as long as earnings keep rising, it won't be hard at all to just sit back and enjoy the show. By Stephanie Anderson Forest in Dallas, with Mara Der Hovanesian in New York, and bureau reports


Steve Ballmer, Power Forward
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