The Wall Street Journal Interactive Edition --

September 23, 1997

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."