Serious Money: The first-quarter reporting season is under way in the United States and, following five consecutive years of double-digit earnings growth, it appears the boom in corporate profits is set to come to a screeching halt.
Consensus estimates for growth in the first quarter have been slashed by five percentage points since the beginning of the year to below 4 per cent, the slowest rate of growth since the first quarter of 2002.
Expectations for 2007 as a whole have dropped to below 7 per cent but the reacceleration to double-digit growth anticipated during the year's final quarter is unlikely to happen. A more realistic assessment suggests earnings will advance by no more than 3 per cent this year at best. The boom in corporate profits is at an end.
Corporate profitability has soared to record levels in recent years. Return on equity, at more than 16 per cent, is well above its historical average, as too are net margins which, at 9 per cent, are three percentage points above their long-term mean.
The primary factors contributing to the corporate sector's fortunes can be traced to the cautious attitude adopted by management throughout the current economic cycle and the subsequent rise in operating leverage. The current profit upturn began with a business sector beset by over-investment and too much debt, not to mention the fraudulent activities that came to light at companies such as Enron and WorldCom and the onerous regulation that followed.
Balance sheet repair and capital discipline became paramount in corporate boardrooms. The inevitable caution contributed to an unprecedented drop in interest expenses and depreciation charges, which between them declined by more than four percentage points as a share of GDP.
Meanwhile, the hiring of labour at the lowest annual rate following the nine recessions since 1950 saw wages fall to a record low relative to GDP.
Continued capital discipline afforded big business greater pricing power in several sectors.
Not surprisingly, pre-tax profits as a percentage of GDP soared by roughly 5½ percentage points to record levels.
Unfortunately, the factors that drove profitability ever higher have reversed direction.
The sluggish economy has caused unit growth to slow and pricing power to wane. Revenue growth is slowing just as cost increases are placing downward pressure on margins. Wage increases have moved above 4 per cent and, including benefits, the year-on-year advance is closer to 6 per cent.
Simultaneously, labour productivity growth has turned south, which means that labour costs will command a greater share of profits. Increased shareholder pressure is forcing firms to utilise excess cash and interest costs are set to rise.
Furthermore, rising raw material prices typically affect cost structures with as much as a 12-month lag, which suggests that the full impact of increasing input costs in recent years has still to be felt. Consequently, margins are only beginning the long march downward that could see a full-blown earnings downturn begin towards the end of the year.
The cautious attitude adopted by corporate America throughout the current upturn has caused many to believe that an earnings downturn will be mild. The optimism is misplaced given that there are few opportunities to trim costs.
The miserly investment of recent years could have long- lasting consequences and is already appearing in US labour productivity numbers, which are at the lowest levels in more than a decade and below those of both Germany and Japan.
Is it really that bad? The answer is yes. Under pressure to create value, the actions of corporate management are instructive. Liquidity balances have been increasingly directed to share buyback programmes, a cyclical phenomenon and a reflection of temporary earnings increases. Dividends, which typically reflect a company's long-term earnings power, have dropped to a record low as a percentage of earnings.
Meanwhile, total cash distributions to shareholders exceeded capital expenditures for the first time ever in 2005, an outcome that was repeated last year and, consequently, investment spending as a share of profits has dropped to a four-decade low.
Corporate America's trust in the sustainability in current levels of profitability is hardly awe-inspiring. The implications for productivity and sustainable growth should not be under- estimated.
The blue-sky optimists on Wall Street believe that low valuations, easier monetary policy later in the year and a re-acceleration of economic growth means that the coming slowdown in profits is already reflected in stock prices.
They are wrong. Valuations are not cheap, with prices trading on more than 20 times trend earnings, while economic growth in nominal terms is at levels that have spelled danger for the corporate sector in the past.
