News Column

US Earnings Under Pressure

Sept. 28, 2012

Nelson D. Schwartz

Burning money

The causes of the expected decline are many. In addition to the anemic economy in the United States, much of Europe has fallen into recession while the Chinese economy, once white-hot, has slowed.

The boom in American corporate profits, which has far outpaced the gains in the broader economy since the end of the past recession, is faltering.

Giants like FedEx and Intel, two bellwethers of the global economy, are warning of lower quarterly profits because of weakness in worldwide demand. Companies outside the United States are feeling the pinch, too. Burberry, the British luxury retailer that had seemed immune to a slowdown, is offering a similar warning.

Even smaller, family-owned companies like Eastman Machine in Buffalo, New York, which makes cutting equipment for the textile industry, are wary. "We feel like we are walking on a tightrope," said Robert L. Stevenson, Eastman Machine's chief executive.

Over all, Wall Street expects quarterly profits at the typical large U.S. company to decline for the first time since 2009.

The causes of the expected decline are many. In addition to the anemic economy in the United States, much of Europe has fallen into recession while the Chinese economy, once white hot, has slowed. There is also the looming prospect of automatic tax increases and spending cuts in Washington, which has caused companies to sit on the sidelines.

After reducing spending and eliminating jobs during the recession, American companies reaped huge gains by keeping expenses down and putting off aggressively hiring new workers as economic growth slowly returned. Strong profits have also propelled the stock market higher, reassuring investors whose other assets, like real estate, have declined in value over the same period.

But while the Standard & Poor's 500-stock index reached its highest close Friday since 2007 -- after the Federal Reserve's announcement of its latest stimulus effort -- the cycle of steady earnings increases appears to have run its course.

"A lot of the profit gain you had in the last few years was a bounce from the recession and a result of very aggressive cost- cutting," said Ethan Harris, chief U.S. economist at Bank of America Merrill Lynch. "Those factors are going to be very hard to replicate."

The expected decline in profits has yet to set off big layoffs. But it is another factor that is inhibiting hiring and keeping unemployment above the politically important level of 8 percent, executives and economists say.

Last week, the Federal Reserve announced its boldest effort yet to stimulate the U.S. economy and confront persistently high unemployment. The next day, the government reported that industrial production had fallen 1.2 percent in August, the biggest monthly contraction since March 2009.

While executives welcomed the Fed's announcement, many express concern over just how much effect it will have.

More than half of managers at North American companies now expect production levels to increase in the next 12 months, down from 64 percent in the second quarter, according to a survey by CEB, a member-based advisory firm. In the same survey, the percentage of executives who expect to hire more workers fell to 34 percent from 41 percent last quarter.

"We're sort of like in this limbo environment," said Gregory T. Swienton, chief executive of Ryder System, the truck rental and transportation company. "I'd love to be able to say we're hiring, but there is no natural big growth that would require hiring."

The slowdown globally is beginning to cut into profits at large and small American companies, many of which benefited in the past few years from heightened demand abroad, even as economic growth in the United States slowed.

At Eastman Machine, orders from China and Europe are below the levels of last year, said Mr. Stevenson, the chief executive. Business has held up better domestically and, he said, he is optimistic about the long-term future of his family-owned company.

Wall Street analysts expect earnings for the typical company in the S.&P. 500 to decline 2.2 percent in the third quarter from a year earlier, according to Thomson Reuters, the first such drop since the third quarter of 2009. Earnings are expected to slide 3 percent from the second quarter of 2012.

What is more, 88 companies have already said that results will come in below expectations; 21 that have signaled a positive outlook, said Greg Harrison, a corporate earnings research analyst at Thomson Reuters.

"That's much more pessimistic than normal," Mr. Harrison said.

To be sure, pockets of optimism remain. In addition to the stock market rally this month, corporate earnings are still expected to finish 2012 up 6.1 percent from 2011, largely because gains in the first half of the year will offset any decline in the third quarter. And earnings results in the fourth quarter could benefit from a slowdown late last year, making year-over-year comparisons look better.

Looking ahead, if corporate profits enter a sustained decline, big companies are likely to face increased pressure to cut jobs, since there is much less room left to cut costs elsewhere.

After rising steadily after the recession, profit margins for S.&P. 500 companies peaked at 8.9 percent in late 2011, said David J. Kostin, chief U.S. equity strategist at Goldman Sachs. Margins are expected to fall to 8.7 percent in 2012.

Indeed, margins are eroding at some companies as revenue declines. Intel said this month that it estimated revenue for the third quarter would total $13.2 billion, plus or minus $300 million. That is off from an earlier forecast of $13.8 billion to $14.8 billion, and 7 percent below revenue a year ago. Profit margins are estimated at 62 percent, down from 63.4 percent a year ago.

Wall Street estimates that Intel will earn about $2.58 billion in the third quarter, a 26 percent drop from a year earlier. The company, which makes semiconductors, has been hurt as computer makers cut chip inventories in Asia, while demand for personal computers has been soft worldwide.

At FedEx, which warned Sept. 4 of lower-than-expected results, profits in the current quarter are projected to decline 2 percent to 6 percent. When the company reports its earnings Tuesday, analysts will watch closely for weakness in shipments in China and the United States, two major markets that have been softer than originally forecast.

While profit margins have reached a plateau in corporate America, productivity gains in the overall economy have ebbed as well. After rising at an annual rate of 2.9 percent in 2009, and at a 3.1 percent pace in 2010, productivity inched up 0.7 percent in 2011, according to the U.S. Bureau of Labor Statistics.

"There's only so much you can cut," said Chad Moutray, chief economist at the National Association of Manufacturers.



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