Experts Say Tricks, Low Rates

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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