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.
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
"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.
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
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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