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Sticking To The Sweet Spot


The irrepressible, indefatigable corporate profit machine continues to mint money. Thanks to a robust economy and continued tight cost controls, profits for the 900 companies on BusinessWeek's Corporate Scoreboard rose by a better-than-expected 20% in the second quarter. While BusinessWeek's calculations include one-time gains and losses, excluding those special items still left profits up 15% -- also exceeding analysts' initial expectations.

It was a broad-based advance, with the American consumer still acquisitive in the face of rising energy costs and businesses spending even as interest rates creep higher. Add it all up, and profits during the quarter topped $185.4 billion, a hefty $30.3 billion improvement from the 2004 second quarter. The collective 7.9% profit margin recorded by these 900 companies was the highest on record since BusinessWeek began publishing the quarterly scoreboards back in 1973. The profit champ for the quarter -- not surprisingly, with oil above $60 per barrel -- was, once again, Exxon Mobil Corp. (XOM). The energy titan saw profits soar 32%, to $7.6 billion, a staggering sum that was 61% more than what the next closest company, Citigroup Inc. (C), earned in the second quarter. For the record, the biggest loser during the second quarter was an airline, UAL Corp. (UALAQ), which lost $1.4 billion.

The sales and profits run has been remarkably persistent. The second quarter marks the 10th consecutive one in which Big Business has recorded double-digit earnings gains. And it's the seventh straight quarter in which revenues have done the same. To find similarly robust sales growth you would have to go back to the dot-com boom, and before that, to the late 1980s. That momentum will be put to the test by a handful of looming challenges to the sales and profits outlook in the second half. Among them: the strengthening of the dollar, increasing labor expenses, and further interest rate hikes.

To date, what has underpinned the heady top-line run? A surprising number of companies from across the retail spectrum -- including Amazon.com (AMZN), Costco Wholesale (COST), Foot Locker (FL), Lowe's (LOW), and Wal-Mart Stores (WMT) -- have clearly benefited from strong consumer spending. All of those outfits have piled up at least four consecutive quarters of double-digit sales growth. They have company in energy-related outfits such as Valero Energy Corp. (VLO) and Amerada Hess Corp. (AHC), which have prospered from soaring oil prices. And companies that had long bemoaned a lack of pricing power have recently shown success in boosting prices: Deere & Co. and Dow Chemical Co. each used aggressive price hikes in some products to generate double-digit increases in both sales and profits.

The dollar's weakness over the past three years has also buoyed top-line growth for multinationals selling abroad -- and contributed to a windfall of profits. Johnson & Johnson (JNJ), for instance, derived two percentage points of its 11% top-line growth from favorable currency impact in the second quarter, to $12.8 billion. That, in turn, helped fuel a 14% rise in net income, to $2.8 billion, excluding onetime items. Caterpillar Inc. (CAT) also credited its record sales and earnings -- profits were up 34% -- to the lower dollar, which is stoking global demand for its heavy machinery. "People don't realize how much of a contributor the sharp drop in the dollar was to profits between 2002 and 2004," says Richard Bernstein, chief U.S. strategist for Merrill Lynch & Co. (MER).

Indeed, the dollar's new direction is just one reason many economists are questioning whether we've seen the last of the double-digit sales and profit growth for the time being. The dollar has already risen 10% against the euro and some other key currencies this year -- creating resistance that could slow both exports and foreign-earned profits in coming quarters. The dollar "is not going to be a tailwind but a head wind," says Richard Berner, chief U.S. economist for Morgan Stanley (MWD).

In recent quarters, companies have offset the rising dollar with aggressive cost-cutting and by trimming capital spending. Now, some economists believe that, flush with cash and with their factories running close to full tilt, companies will have to reinvest in new plants and equipment in the second half just to continue meeting demand. If so, that anticipated burst of new business spending could be the best chance companies have at sustaining their streak of double-digit gains in sales. Further top-line growth would also figure to help extend the healthy run for corporate profits.

But there will be plenty of pressures, as well. For example, even as the labor market tightens, many companies will need to deal with looming obligations to their former workers in coming quarters. Delta Air Lines Inc. (DAL), for one, which posted a $382 million loss in the second quarter, under current pension laws must spend $3 billion by 2008 to replenish its underfunded retirement plans. At some companies, it's already crimping profits: Unisys Corp. (UIS), the Blue Bell (Pa.)-based information technology services firm, reported a second-quarter loss of $27.1 million, thanks to its need to contribute $45.8 million to its pension plan.

FEAR THE FED

And there's the Federal Reserve. Economists now expect as much as another point in further interest rate increases between now and early 2006. The Fed's aggressive rate hikes are already pinching rate-sensitive sectors such as financial services, which saw profit growth slow from 12% to 2% year-over-year in the second quarter, according to Thomson Financial. In recent years, banks and the Wall Street houses have earned record profits by exploiting the gaping spread between short- and long-term rates.

But with the Fed's aggressive effort to raise short-term rates failing to nudge up long rates, the result has been a flattening of the yield curve. This has squeezed out the easy profit that financial service firms can earn on the carry trade. Tanya Azarch, banking analyst for Standard & Poor's (MHP), predicts revenue growth could tumble from around 5% to as little as 3% growth in the second half, as the net interest margin -- which has already fallen by nearly two-tenths of a point in the past year, to 3.43% in the second quarter -- is squeezed further in coming quarters. In other words, the easy money may already have been made. It'll be harder to register another terrific quarter next time.

By Dean Foust in Atlanta, with Amy Barrett in Philadelphia and Michael Arndt in Chicago


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