Experts Say Tricks, Low Rates

 Lead to Extra Earnings Growth

 

 By FRED R. BLEAKLEY

 Staff Reporter of THE WALL STREET JOURNAL

 

 In the lengthy, puzzling economic expansion of the

 1990s, one of the biggest mysteries is how

 companies have managed to increase profits at more

 than twice the rate of the economy.

 

 Nominal gross domestic product, the government's

 broadest economic measure, has been rising at an

 average of about 5.75% a year since 1991. That

 pales in comparison with the average annual growth

 rate of 17% for corporate profits. During many

 previous business cycles, the difference between

 corporate profits and the economy has been much

 smaller, often just one or two percentage points,

 except during the high-inflation years.

 

 Corporate chieftains boast that profits are doing

 better than the overall economy because companies

 have fewer workers, new technology and more

 production. Politicians cite America's growing

 ascendancy in world business. On Wall Street, many

 stock analysts and economists say such trends

 herald the dawning of a new era in which higher

 productivity can lead to higher profit margins,

 which in turn can drive profits at a higher growth

 rate than the overall economy.

 

 Accounting Magic

 

 As exciting as these theories may sound, not

 everyone is convinced they are true. Indeed, some

 economists point to a more mundane, perhaps more

 sobering, explanation for growing profits. A big

 chunk of the extra earnings growth, they say, is

 due simply to lower interest costs and some

 accounting magic.

 

 "It's easy to be sucked into the 'new-era thinking'

 of something special going on with corporate

 profitability," says Martin Barnes, an economist

 who follows the U.S. market for Bank Credit Analyst

 Research Group in Montreal. But, he adds, "while

 there has been some improvement in productivity,

 what has really supercharged earnings" has been a

 drop in interest costs, fewer write-offs for

 depreciation expenses and some artful tax dodging.

 

 Economists, of course, have long been aware that

 corporate balance sheets have benefited in the '90s

 from declining interest rates and lighter debt

 loads. But some believe the kick from such trends

 has been much stronger than generally recognized.

 

 Adjusted for changes in interest costs and

 depreciation expenses, corporate profits would have

 risen on average about 10% a year in the period

 beginning April 1991 and ending June 1997,

 estimates Mr. Barnes. If adjustments for lower

 taxes are also deducted from the 17%, profit growth

 would have been about 7%, close to nominal GDP

 growth, he says.

 

 Case Studies

 

 To see how lower interest and depreciation costs

 can boost earnings, consider the case of

 International Business Machines Corp. and United

 Technologies Inc., two of the many corporations to

 restructure in recent years.

 

 By writing off old plants and equipment in the year

 they are closed, a company no longer takes a

 depreciation charge against the assets in later

 years. In the case of IBM, which has shuttered

 numerous plants in recent years, depreciation

 expenses dropped to 5% of revenue in 1996 from an

 average of 7% in 1990-94. The difference, in 1996

 revenue, is $1.64 billion, or 18% of the company's

 $9.02 billion in pretax profit last year.

 

 At United Technologies, which has been aggressively

 paying down debt, interest costs fell from $362

 million in 1990 to only $221 million last year --

 as interest as a percentage of sales declined from

 1.7% to 0.9%. The savings accounted for about 15%

 of the gain in earnings over the period, says Bear,

 Stearns & Co. analyst Steve Binder. United

 Technologies says the total contribution from lower

 interest and taxes was more like 20% of earnings,

 with most of it from lower taxes.

 

 Indeed, many global companies have benefited from

 tax holidays and other tax incentives as more of

 their profits come from overseas sales. Which

 countries offer the best tax rates gets factored

 into the decision of where to locate a plant. The

 U.S. also encourages more export sales by charging

 a lower corporate tax rate (29%) on earnings from

 export sales than the typical 35% it charges on

 domestic pretax earnings.

 

 Just the Opposite

 

 It isn't that often that lower interest charges

 play hero to corporate earnings, says Moody's

 Investors Service Inc. chief economist John Lonski.

 "It didn't happen in either the 1970's or 1980's

 economic recoveries, when rising debt costs were a

 drag on profits," he says. This time around, they

 are just the opposite.

 

 One reason: Shortand long-term rates have been

 lower throughout the 1990s, some 20% to 30% lower

 now than in 1989, for instance. Another: By paying

 down debt and using cash for more new purchases of

 capital equipment, companies have relatively less

 debt on which to pay interest. Mr. Lonski estimates

 the debt portion of book-value capital for

 nonfinancial corporations has declined from 48.6%

 in 1990 to 45.7% at the end of 1996.

 

 Adding it up, the total savings in interest

 expenses came to about $70 billion last year over

 what was paid in 1989, says Kenneth Safian of

 Safian Investment Research in White Plains, N.Y. He

 estimates interest costs for nonfinancial

 corporations have fallen from $150 billion a year

 in 1989 to just over $80 billion last year. "Most

 people have overlooked how important interest

 savings have become to profitability," Mr. Safian

 says.

 

 Clouds on the Horizon?

 

 If the economists crunching the numbers are right,

 however, the favorable interest and depreciation

 trends may not be as favorable in the near future.

 Charles Clough, chief investment strategist of

 Merrill Lynch & Co., believes "the big write-offs

 have been taken," so depreciation expenses will be

 rising. When a company writes off plants or

 equipment, it takes a big one-time charge against

 reported earnings and then takes no depreciation on

 the assets in later years. But Wall Street tends to

 ignore the one-time charges in computing operating

 earnings. Then in later years, with less

 depreciation, investors think earnings are

 improving. But actually, says Mr. Clough, the gain

 is for a nonoperating reason.

 

 Asks Robert Barbera, chief economist of Hoenig &

 Co., "Is the last five years a good sketch of the

 next five?" His answer: "Unequivocally no." He sees

 interest rates as well as worker-compensation costs

 rising over the next year as the economy keeps

 growing at a healthy pace. "That suggests to me

 that the top line [sales] becomes the bottom line

 and corporate profits grow closer to the overall

 growth rate of the economy."

 

 That isn't so bad, of course. And many companies

 will clearly beat the averages, thanks to extra

 efficiencies kicking in from new technology and

 other capital spending. But Mr. Barbera doubts

 there will be double-digit growth for the vast

 majority of companies, even if "they contend they

 can continue the magic."

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