By JON E. HILSENRATH and STEVE LIESMAN Staff Reporters of THE WALL STREET JOURNAL

April 17, 2001 -- Page One Feature

Brace yourself.

Over the next several weeks, hundreds of U.S. companies will report profit-and-loss statements that are going to look ugly.

According to analysts’ estimates gathered by Thomson Financial/First Call, operating profits for the companies in the Standard & Poor’s 500 declined 9% in the quarter ended March 31 from the year-earlier period. If the estimates hold up, it will be the sharpest drop since the 1990-91 recession. Second-quarter earnings are also expected to tumble 7% and the third-quarter outlook, while still barely positive, is rapidly deteriorating.

That’s a big departure from 1999 and 2000, when year-over-year quarterly operating profits frequently grew more than 20%. But some economists say the current decline doesn’t begin to tell the full story of what’s in store in the coming years.

They say that even once the economy rebounds and earnings start growing again, the outsized profit gains of 1999 and 2000 are a thing of the past. Profits in the 1990s, they say, grew out of sync with the rest of the economy, lifted temporarily by tame debt and labor costs, accounting quirks and technology investments that might never yield significant returns. They say a reversion to the mean is in the works that will translate into a period of profit gains that, at best, are in the single digits. And if consumers cut back on spending in response to their stock market losses, it will only add to the profit pain.

An Era of Write-Offs?

After an era of outsized profit growth, this might instead be an era of write-off growth, as aggressive investments spawned by the earnings gains lead to write-downs of unprofitable ventures. Just Monday, technology giant Cisco Systems Inc., warning Wall Street that its fiscal third-quarter sales and profits will be sharply lower, announced it was writing off $2.5 billion in inventory.

“I think we are in a major long-term adjustment,” says Ray Dalio, a money manager with Bridgewater Associates, in Westport, Conn.

Of course, to some the notion of a longer-term profit squeeze is an exaggeration of Monday’s negative news. Many company executives argue the earnings decline is a temporary setback -- prompted by a weak economy -- and that profits will return to double-digit growth once again. “This pause will be ... relatively short,” says Per-Olof Loof, chief executive of Sensormatic Electronics Corp., a surveillance-equipment manufacturer which said last week it would miss Wall Street’s profit expectations for the fiscal third quarter ended March 31. Sensormatic doubled profits in 2000, but when it reports on April 26, its numbers will come in at just a third of what Wall Street expected, and half of what it reported for the same quarter a year ago. Mr. Loof sees a longer-term growth rate of 25%.

While profit growth is down, companies remain highly profitable. Even a 10% decline in S&P 500 company earnings this year -- presently seen as the worst-case scenario -- would leave them near the then-record level of 1999, when per-share profits reached $52.19. And some companies, like General Electric Co., so far have charged through the economic head winds with impressive profit gains.

“I don’t think it’s over,” says Barry W. Perry, chairman of Engelhard Corp., which, among other things, produces catalysts for high-tech catalytic converters that help auto makers meet tough environmental standards. He still sees higher profits from his investments, so Englehard will boost capital spending this year despite the slowdown. “I think productivity improvements are limited only by the ingenuity of the people involved in the enterprise.”

Mr. Perry has good company. When Federal Reserve Chairman Alan Greenspan went before Congress in February to reassure anxious lawmakers about the economy, he noted that analysts and executives still expected robust long-term profit growth, at well over 15% by some estimates. “Most corporate managers appear not to have altered to any appreciable extent their long-standing optimism about the future returns from using new technology,” Mr. Greenspan said. That, he said, is likely to underpin continued investment-led growth in the years to come.

It’s possible that the overall U.S. economy can return to the strong growth track Mr. Greenspan foresees, spurred on by productivity improvements and globalization, but still be entering a period of diminished profit growth. In that case, it might well be consumers and workers, not shareholders, who would reap a bigger share of the benefits of productivity gains, in the form of lower prices and faster-rising wages.

Since 1992, S&P 500 operating profits, which exclude taxes and one-time gains and charges, have grown 11.5% on average annually. From 1951 to 1991, the growth rate was just 7.1%. No less surprising was the consistency of the earnings bounty. In the 36 quarters from 1992 to 2000, S&P earnings declined on a year-to-year basis during just one quarter, a result of the Asian financial crisis.

Fueling the profits growth was a historic period of surging operating-profit margins, which are the ratio of profits before tax and interest to revenues. With only a few exceptions, profit margins for the S&P 500 companies marched steadily upward, with companies extracting nearly 90% more profit per dollar of sales in 2000 compared with the last quarter of 1991, after falling through much of the 1970s and 1980s, according to Lehman Brothers. No period in the postwar era comes close in terms of either the amount or the duration of the increase in profit margins.

For the profit skeptics, however, corporate earnings over the long term can only grow as fast as the economy feeding them, unless companies find ways to pay their workers less, charge their customers more, or increase profits abroad. Indeed, between 1951 and 2000, pretax corporate profits and gross national product -- the value of the nation’s total output -- both increased about 7% annually on average before adjusting for inflation. But while profits grew near double-digit rates during the past eight years, the economy posted 6% annual average growth before adjusting for inflation.

Mr. Dalio of Bridgewater Associates says much of the profit gains came from workers’ pockets, and that can’t last. From 1992 to 2000, wages dropped from 66% of corporate revenues to 62%, near a historic low, as companies moved manufacturing jobs to developing countries like China and Mexico. But Mr. Dalio says companies have stretched their labor gains about as far as they can go. Indeed, wage pressures started showing signs of creeping up last year. The government’s employment cost index rose by more than 4% in 2000, the first such increase since 1991 and a possible sign of workers staking a greater claim on corporate profits.

The Stock-Market Effect

Another mystery hanging over the labor-cost question will be how white-collar workers react to the stock market plunge. Legions of New Economy workers were willing to take less in wages in recent years in return for stock options. That “understated the costs to the company [of labor] and overstated their current profitability,” says Adrian Slywotsky, a profits expert with Mercer Management Consulting. Now that the stock market has tumbled, the appetite for this form of compensation has diminished.

The immediate trouble for companies is that wage growth doesn’t slow quickly during downturns. Goldman Sachs expects average hourly earnings to continue to accelerate this year by as much as 4%, before declining to 3.5% by the end of 2002.

And there may be little additional improvement for bottom lines from debt costs. Maureen Allyn, an economist with Zurich Scudder Investments, notes that after the debt binge of the 1980s, corporate interest costs stood at about 5% of total sales. By 1999, however, after a period of falling interest rates and rising equity sales, companies had pared back their debt burden to just 2.8% of sales, giving a big boost to profit margins. While short-term interest rates are falling now, she says, “there’s no way you’re going to get that kind of benefit for another 10 years.”

Borrowing costs would have to fall to almost nothing for such a margin improvement to repeat itself, she notes. In fact, she said, the trend has started to reverse itself, in part because many companies borrowed heavily to finance the investment boom of 1999 and 2000. By the end of last year, she says, borrowing costs had crept back up to 3.1% of revenue.

When Motorola Inc. reported last week that it recorded its first quarterly loss in 16 years, tucked away in its announcement was a doubling of interest costs, to $86 million from $47 million a year ago. During 2000, as it built out its semiconductor and telecommunications operations, Motorola’s long-term debt rose by 39%, to $4.3 billion, and short-term debt rose by nearly $4 billion on top of that.

Sometimes, debt is creeping onto balance sheets where companies don’t even expect it. Dupont Photomasks Inc., which makes the blueprints from which semiconductor-makers produce microchips, last year issued $100 million in bonds that it expected to be converted into stock by 2004. But the share price has fallen by nearly 40% since then, increasing the likelihood that it will eventually have to pay off these convertible bonds instead. In March, the company also announced that it would miss its earnings target for the quarter.

Murky Accounting

While wages and debt are tangible problems investors can understand, more murky are the accounting issues that may have boosted profits during the 1990s and can detract from them in the coming years. In the annual report of Berkshire Hathaway Inc., billionaire investor Warren Buffett warns that financial “shenanigans” played a role in the profit gains of the 1990s. He says he has “observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced.”

Consider Lucent Technologies Inc., which is the subject of an investigation by the Securities and Exchange Commission into accounting irregularities. The company has acknowledged it used a host of customer incentives, one-time credits and practices like channel-stuffing, or shipping more product to its dealers than demand warranted, in order to reach sales targets. “It began with setting growth objectives that could not be sustained,” a contrite Henry Schacht, Lucent’s CEO, told analysts in December. The company has denied wrongdoing, and says it is cooperating with the SEC probe.

Some economists say that the capital-spending boom of the late 1990s also had the effect of front-loading profits for many companies, most markedly in the fast-growing technology sector. As companies across the economy scrambled to invest in new technology, the sellers of equipment -- from routers to computers to fiber-optic cable -- recorded immediate revenue. But the costs to the buyers are spread out over time in the form of depreciation. The result was an immediate gain to overall profits from the sales.

Now that output and investment have slowed, that cycle of investment-led profit gains is reversing itself. Sales by the equipment makers are slowing, while the equipment buyers are saddled with higher fixed costs, but a weaker-than-expected economy in which to reap the benefits of those investments.

Between 1986 and 2000, about 20% of earnings in any one year vanished five years later in the form of write-offs, according to Peter Bernstein, who publishes a monthly investment newsletter, Economics and Portfolio Strategy. Executives, he said, tend to take their write-offs disproportionately during times of lower profits and weak stock prices, but hold back when profits and stock prices are rising high. “Making lousy earnings look even worse is likely to do less damage to a stock whose price is probably already depressed,” he said.

ADC Telecommunications Inc., a Minnesota-based telecommunications equipment supplier, seems to be caught in an investment crunch. Net income at ADC soared 95% in 2000 as start-up telecom carriers and regional bells rushed to build out new communications lines that could carry high-speed Internet traffic. To position itself for such robust growth, ADC invested heavily. Capital spending of $375 million in 2000 was greater than the figure for the three prior years combined.

Then the telecom sector hit a wall and orders began drying up late last year. Now, ADC’s profits for the fiscal year ending in October are expected to tumble to 3 cents a share, from 47 cents in fiscal 2000. The company is paring back investment and workers and expects to take as yet unspecified charges in its second quarter ending in April as a result of layoffs, elimination of product lines and consolidation of facilities.

While he expects eventually to get back to double-digit profit growth, ADC’s newly appointed chief executive, Richard Roscitt says, “I don’t know that it ever gets back to the heady growth rates that we saw in 2000.”

Write to Jon E. Hilsenrath at jon.hilsenrath@wsj.com and Steve Liesman at steve.liesman@wsj.com

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