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Big Profits, Even Bigger Margins


The cash keeps rolling into Corporate America's coffers. Against the headwinds of slower economic growth, stubbornly high oil prices, and inflation jitters, first-quarter profits among the 900 companies on BusinessWeek's Corporate Scoreboard still charged forward 16% from a year ago, on a 13% increase in revenues, well ahead of Wall Street's initial expectations.

Resilient consumer spending and little letup in business investment helped fuel strong sales growth in the first quarter. When tallied, profits during the quarter reached $170.6 billion, a $23.6 billion increase from a year ago. Exxon Mobil Corp. (XOM) pumped its earnings up to $7.9 billion on higher oil prices and General Electric Co. (GM) profits soared to $4 billion on broad-based improvement. Both set first-period records. And speaking of uncharted territory, General Motors Co. (GM) drove itself to a record loss of $1.1 billion with a seemingly endless road of trouble still ahead for the world's largest auto maker.

Once you peel back the headline numbers, an even more encouraging sign emerges: Companies were able to squeeze even more earnings from each dollar of sales they made. Net profit margins -- the ratio of aftertax profits before extraordinary items to sales -- reached 7.4% in the first quarter, up from 7.2% in 2004. Margins have been north of 7% since the start of 2004 in all but one quarter. Such a run is unprecedented in the 30-year history of the BusinessWeek Corporate Scoreboard.

That streak illuminates a hidden wellspring of health in Corporate America. Sustained profit-margin growth helps explain the momentum behind surprisingly upbeat recent economic data, such as the robust April jobs report. And the stout margin levels also indicate that there's some running room left for the economy, foretelling increased pricing power, capital investment, and expansion -- even amid fears of another soft patch.

The biggest profit-margin gains came in two comparatively low-margin sectors: energy and materials, which continue to benefit from supersized jumps in oil and commodity prices. Oil prices hanging above $50 per barrel and the world's insatiable appetite for energy pushed the profit margin for that industry up to 9.1%, from 7.5% for the first quarter of 2004. Total earnings surged 50% over the period. Materials companies did energy one better: Higher metal and timber prices led margins to widen by 2.6 percentage points, to 6.3%, as profits jumped 103%.

How long can the record profit-margin run last? Already, "there are [fewer] places where margin expansion is occurring," says Robert T. McGee, chief economist at U.S. Trust Corp. Partly, that's simple cause and effect: Having reached and sustained those giddy levels, businesses naturally are enabled to increase capital spending and hiring, tightening the labor market. To be sure, if commodity prices keep spiking, and consumers get spooked, or if labor costs were to grow faster than expected, the margin momentum could slow. But the more likely outcome is good news for the U.S. economy in the long term -- more jobs and greater expansion.

So how are companies managing to get more bang from each buck of sales? Pricing power is emerging, productivity is moving in the right direction, and wages are holding in check. That has helped margins improve even beyond commodity industries, from software to banking. In fact, Google Inc. (GOOG), bolstered by online advertising growth, led all companies with a 19.6-point margin gain over the prior first quarter, to 29.4%.

By far the most common ingredient in Corporate America's formula to raise profit margins has been containing employee wages, salaries, and benefits. Companies have leverage over employees because there are plenty of Americans still looking for a job. Consider the diversified financials sector, where close to half of all revenues traditionally fund salaries and bonuses. In the aftermath of the NASDAQ bubble, Wall Street has become more prudent about employee pay. And even though banks are hiring again and bonuses are improving, they show no signs of letting compensation outpace revenues, says Robert Hansen, an equity analyst at Standard & Poor's (MHP). For proof, look at Goldman, Sachs & Co. (GS). The investment bank saw earnings grow 17% from the first quarter in 2004 but held compensation and benefit growth to just 7%.

PRODUCTIVITY GAINS

In old-line industries, squeezing labor costs is harder. But Peoria-based heavy-machinery producer Caterpillar Inc. (CAT) has instituted a two-tier wage system that pays entry-level workers substantially less than in the past. Caterpillar can hire "supplemental" workers for as little as $10 an hour. If those part-timers become full-time employees, they earn $17 an hour, vs. $22 for previous hires. The company also did away with pensions for new employees, instead offering defined-contribution 401(k) plans.

Increasing productivity is another surefire way to fatten margins. After all, if output can be boosted with the same number of workers or more advanced equipment, then a larger chunk of revenues falls to the bottom line. With raw material prices so high, becoming more efficient has never been more important. For example, productivity gains played a big role in Corning Inc.'s (GLW) scorching 353% jump in profits on a 24% rise in sales. Prices for the ultra-thin glass Corning makes for flat-panel LCD TVs and computer monitors actually fell 4% in the first quarter, as the LCD industry tries to bring their TV sets within the reach of more consumers. But because Corning was able to boost yields, while trimming labor costs, margins in its red-hot LCD business actually rose to a stunning 60%, from 58% last quarter.

With less slack in the economy, a growing number of industries are even finding some ability to raise prices -- food and chemical companies among them. What's more, having a reason for raising prices that is viewed as legitimate by customers, such as sky-high energy prices, makes it an easier proposition. And once early price increases are accepted, additional increases can be easier to implement.

PRICING POWER

The global upswing in capital investment especially helps heavy industry, such as machinery makers, as spending flows to upgrade infrastructure. Cummins Inc. (CMI), a producer of heavy truck engines and power generators, saw its first-quarter profit margins more than double, to 4.4%, from 1.9% a year ago. Price increases, which accounted for $35 million of the $97 million in profits for the quarter, were a big reason. "We were very aggressive, and I think we've made some real progress with pricing," says Chairman and CEO Theodore M. Solso. The Columbus (Ind.) company expects to raise prices even more this year.

That strong pricing environment for materials and commodities, however, means higher costs for companies down the chain. For instance, at some appliance makers, higher costs are whittling away at profits. Whirlpool Corp. (WHR) saw its profit margin drop to 2.7% from 3.4%. Even though the Benton Harbor (Mich.) company raised prices, the increases were not able to cover the additional $190 million in metal and energy costs it incurred over the quarter.

Among the worst performers in our Scoreboard, to no one's surprise, were airlines and autos, which are getting hammered by discounting, overcapacity, and high oil prices. Collectively, U.S. airlines spilled $2 billion in red ink in the first quarter, with half that belonging to Delta Air Lines Inc. (DAL). Among the major carriers, only Southwest Airlines Co. (LUV) made money. Meanwhile, led downward by GM, the entire auto group is hurting, with profits tanking 91%, to a mere $322 million.

The overall high profit margins are likely to come down, at least a bit. Further growth is likely to tighten up the labor market even beyond April's report. Some executives are already feeling the pinch. Trucking outfits such as Swift Transportation Co. (SWFT) and Werner Enterprises Inc. (WERN) are hiking wages up to 10% for a second consecutive year to entice recruits, according to James J. Valentine, an equity analyst at Morgan Stanley (MWD). Caterpillar is looking into adjusting its current two-tier wage setup because the company is having trouble attracting good employees as it ramps up production. "We have to look harder and harder to find skilled workers," says CEO James W. Owens.

Increased capital investment is following, as well. Corning expects to spend about $1 billion this year building more advanced facilities that can produce larger sheets of its LCD glass to help meet an increase in expected demand of more than 50% this year as LCD TV sales take off. And Alcoa Inc. (AA) is jacking up its cap-ex budget 80%, to $2.5 billion this year, to build new smelters to meet booming global demand for aluminum.

INFLATIONARY PRESSURES

More jobs and productivity-enhancing investment will allow the U.S. economy to get through any soft patch and keep chugging along. That scenario isn't a fait accompli -- an unwelcome side effect of higher prices are inflationary pressures that could cause the Fed to ratchet up interest rates and put a brake on growth. But right now, as companies hike prices judiciously, most economists are confident that inflation is still under control. And as the economy grows, higher revenues will translate into larger profits even if margins stall. "In an economy that is expanding, that still means substantive profit growth," says Mark Killion, managing director of world industry services at Global Insight Inc. Sounds like Corporate America may need bigger coffers.

By James Mehring in New York, with Michael Arndt in Chicago and William C. Symonds in Boston


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