outlook for us corporate profits which are the leading sectors?

Copyright ©2003 Global Insight, Inc.

Outlook for US Corporate ProfitsOutlook for US Corporate ProfitsWhich are the Leading Sectors?Which are the Leading Sectors?

Mark Killion, CFAManaging Director

April 29, 2003

Copyright ©2003 Global Insight, Inc. 2

Outlook for US Corporate ProfitsOutlook for US Corporate Profits

Corporate Profits are key to: understanding asset valuation, credit quality anticipating the CapEx cycle and employment growth

Corporate GAAP Profits (SEC) are more volatile than NIPA Operating Profits (IRS via BEA)

What have been the recent trends in each?

ROE Framework to analyze the prospects for corporate profits

Impact of operating leverage and financial efficiency

Which sectors are winners and losers?

Agenda:Agenda:


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Profits as S&P 500 GAAP from SEC (EPS, LHS)

Profits as NIPA from IRS via BEA (Bill.$, RHS)

Profits as S&P 500 GAAP (EPS, LHS)

Profits as NIPA (Bill.$, RHS)

S&P 500 US$ Earnings Per Share US Domestic Corporate Profits US$ Billion

Corporate GAAP Profits (filed with SEC) are more volatile than NIPA Operating Profits (filed with IRS and used by BEA) due largely to Balance Sheet impacts

Recent examples:

2000 -- Goodwill Write-Offs, Decline in Credit Quality

2001 -- Corporate Fraud, Asset Impairment, Bankruptcy & Bad Loans

2002 -- Expensing Stock Options, CEO Certification, E&O Insurance

2003 – Year of Pension Expense Adjustment, Change in Executive Compensation Structure

Two Measures of US Corporate ProfitsTwo Measures of US Corporate Profits


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Current NIPA Corp. Profits Growth (LHS)

Profits Share of Corporate GDP (RHS)

Corporate Profits Share of Nat'l Income (RHS)

How Does the Current Profit Recession Compare to the Previous Profits Recession of 1988-1992?

U .S. Corporate Profits in Quarters After Cycle Peaks (88-92 Vs. 97-02)(Index = 100 at Cycle Peak of Corporate Profits: 1988 Q4 and 1997 Q4)

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140

-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20Number of Quarters Following Peaks of 88Q4 & 97Q4

Index

100 =

Cycle

Peak

Index for 1988 Q4 to 1992 Q1 Index for 1997 Q4 to 2002 Q4 1997 Q4 to 2002 Q4--No CCA Adjustment

97Q4 - 02Q4 -- No CCA Adj.

97Q4 - 02Q4 -- With CCA Adj.

88Q4- 92Q1 -- With CCA Adj.

How are Profits Faring in the Business Cycle?How are Profits Faring in the Business Cycle?

National Profits Growth Rate (LHS), and Profits as Shares of Income (RHS)

(Percent)


The Adjustment for Capital ConsumptionThe Adjustment for Capital Consumption (to fit “bottom up” (to fit “bottom up” Profits with “top down” GDP) Has Become UnreliableProfits with “top down” GDP) Has Become Unreliable

Capital Consumption Adjustment to U.S. Corporate ProfitsAdjustment from Tax-Based to Economic Depreciation Rates. A Postive Number Indicates a Boost to

NIA Corporate Profits by Taking Back Some Depreciation Claimed aginst Profits

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1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

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CCA Adjustment in US$ (LHS) CCA Adjustment as % of Base (RHS)

(Corporations Report Tax-Based Depreciation Lower Taxable Profits)

CCA Adjustment in US$ (LHS)

CCA Adjustment as % of Base


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2001-II

2001-III

2001-IV

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2002-IV

Wholesale Trade

Receipts from Rest of World

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1995 1996 1997 1998 1999 2000 2001-I

2001-II

2001-III

2001-IV

2002-I

2002-II

2002-III

2002-IV

Food & Related ProductsFinancial NonBankingElectricity & Utilities

Sectors with Positive and Improving ProfitsSectors with Positive and Improving Profits(Billions of US$)(Billions of US$)

Sectors with Positive and Steady ProfitsSectors with Positive and Steady Profits(Billions of US$)(Billions of US$)

Which US Sectors are Generating Profits?Which US Sectors are Generating Profits?


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1995 1996 1997 1998 1999 2000 2001-I

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2002-III

2002-IV

Banking (In Federal Reserve System)

Retail Trade

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1995 1996 1997 1998 1999 2000 2001-I

2001-II

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Electronic & Electrical

Steel & MetalsTransportation Services

Sectors with Steady Profits Now Under Sectors with Steady Profits Now Under Moderate PressureModerate Pressure

(Billions of US$)(Billions of US$)

Sectors where Past Losses are Turning into Sectors where Past Losses are Turning into Profits RecoveryProfits Recovery

(Billions of US$)(Billions of US$)

Which US Sectors are Seeing Profits Weakness?Which US Sectors are Seeing Profits Weakness?


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1995 1996 1997 1998 1999 2000 2001-I

2001-II

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2001-IV

2002-I

2002-II

2002-III

2002-IV

Petroleum & Coal Products

Chemicals & Products

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1995 1996 1997 1998 1999 2000 2001-I

2001-II

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2001-IV

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2002-II

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2002-IV

Industrial Machinery & Equip.

Motor Vehicals & PartsCommunication Services

Sectors with Exposure to Oil Related FactorsSectors with Exposure to Oil Related Factors(Billions of US$)(Billions of US$)

Sectors With No Recovery Yet in ProfitsSectors With No Recovery Yet in Profits(Billions of US$)(Billions of US$)

Which US Sectors are Generating Profits?Which US Sectors are Generating Profits?


Return On Equity (ROE) as Measure of ProfitabilityReturn On Equity (ROE) as Measure of Profitability

ROE Framework IdentityROE Framework Identity::

Return on Equity (NI/Equity) =Return on Equity (NI/Equity) =

Profit Margin (NI/Sales) *Profit Margin (NI/Sales) *

Asset Turnover (Sales/Assets) *Asset Turnover (Sales/Assets) *

Financial Leverage (Asset/Equity)Financial Leverage (Asset/Equity)

Where: NI = Net Income; Equity = Book Value of Where: NI = Net Income; Equity = Book Value of Equity, Valued at the End of the Preceding Period; Equity, Valued at the End of the Preceding Period; Assets are Total Current Period; Sales are Gross;Assets are Total Current Period; Sales are Gross;

( * Denotes a multiplication sign)( * Denotes a multiplication sign)

DuPont Ratio InterpretationDuPont Ratio Interpretation::

ROE is always described by some combination of:ROE is always described by some combination of:

profit margins,profit margins, reflecting efficiency in production, the mixture reflecting efficiency in production, the mixture of fixed versus variable cost and/or the presence of pricing powerof fixed versus variable cost and/or the presence of pricing power

asset turnover,asset turnover, showing the degree to which company assets showing the degree to which company assets are generating salesare generating sales

financial leverage,financial leverage, showing the extent to which the asset showing the extent to which the asset base is financed by debtbase is financed by debt

In this framework, the component “DuPont” ratios In this framework, the component “DuPont” ratios outline the relationship that profits have with sales, outline the relationship that profits have with sales, pricing power, balance sheets and industry structure. pricing power, balance sheets and industry structure.

““DuPont System” ROE FrameworkDuPont System” ROE Framework shows the shows the rate of return that rate of return that management earns on capital provided by the shareholdersmanagement earns on capital provided by the shareholders

(Profits calculated (Profits calculated relative to the equity interest, after accounting for payments to all other capital suppliers)relative to the equity interest, after accounting for payments to all other capital suppliers)


Return On Equity Return On Equity shows shows rate of return that management rate of return that management earns on capital provided by the shareholdersearns on capital provided by the shareholders

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ROE (%) LHSMargin (%) RHS

Financial Leverage (Ratio) RHSAsset Turnover (Ratio*10) RHS

What has been the Return on Equity What has been the Return on Equity Performance?Performance?

US Posted Excellent ROE record through 1997:US Posted Excellent ROE record through 1997:

Problem of Falling Asset Efficiency, related to M&A Problem of Falling Asset Efficiency, related to M&A purchases and CapEx spendingpurchases and CapEx spendingLargely offset by Production Efficiency, Rising MarginsLargely offset by Production Efficiency, Rising MarginsIncrease in Operating LeverageIncrease in Operating Leverage

Pressures on margins built up from Mid 1990s:Pressures on margins built up from Mid 1990s:

Compression from Asian / Russian crises in 1998Compression from Asian / Russian crises in 1998Increase in Financial leverage to compensateIncrease in Financial leverage to compensate

What Happened in 2001-2002?What Happened in 2001-2002?

High operating leverage killed margins when growth slowedHigh operating leverage killed margins when growth slowedDeteriorating credit quality and corporate malfeasanceDeteriorating credit quality and corporate malfeasanceMarkets forcing a de leveraging of balance sheetsMarkets forcing a de leveraging of balance sheets

Component RatiosROE in %

US Corporate Return on EquityUS Corporate Return on Equity Total for 1500 US Corporations in the Total for 1500 US Corporations in the

GICS Sector Classification SchemeGICS Sector Classification Scheme


Sector Level Return On Equity Sector Level Return On Equity shows some saints shows some saints and sinnersand sinners

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ROE for Health CareROE for Health CareTotal for all US Corporations in the Total for all US Corporations in the

Health Care GICS SectorHealth Care GICS Sector

ROE in % Component Ratios

ROE Telecommunication ServicesROE Telecommunication ServicesTotal for all US Corporations in the Total for all US Corporations in the Telecommunications GICS SectorTelecommunications GICS Sector


Sector Level Return On Equity Sector Level Return On Equity shows a tale of two shows a tale of two different consumer sectorsdifferent consumer sectors

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ROE for ROE for Consumer StaplesConsumer StaplesTotal for all US Corporations in the Total for all US Corporations in the

Consumer Staples GICS SectorConsumer Staples GICS Sector

ROE in % Component Ratios

ROE for ROE for Consumer DiscretionaryConsumer DiscretionaryTotal for all US Corporations in the Total for all US Corporations in the

Consumer Discretionary GICS SectorConsumer Discretionary GICS Sector


How Much Financial Leverage Will Markets Allow?How Much Financial Leverage Will Markets Allow?

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Interest Expense as % of Total ExpenseFinancial Leverage Ratio (Asset/Equity)Ratio of Debt to Equity (RHS)

Measures of Financial LeverageMeasures of Financial Leverage Totals for 1500 US Corporations in the Totals for 1500 US Corporations in the

GICS Sector Classification SchemeGICS Sector Classification Scheme

Which Sectors have Restructured Which Sectors have Restructured their Balance Sheets?their Balance Sheets?

Sectors that have Sectors that have notnot materially increased materially increased their leverage, remain in good shapetheir leverage, remain in good shapeHealth CareHealth CareFinancialsFinancials (Used Leverage 1996-7 but quickly unwound it) (Used Leverage 1996-7 but quickly unwound it)Consumer StaplesConsumer Staples

Sectors that had increased leverage in late Sectors that had increased leverage in late 1990s, but have now reversed that trend:1990s, but have now reversed that trend:EnergyEnergyInformation Technology Information Technology (used equity not debt)(used equity not debt)

Sectors with significant financial leverage:Sectors with significant financial leverage:Consumer Discretionary:Consumer Discretionary:

Autos in bad shapeAutos in bad shapeMedia is reformingMedia is reforming

Sectors with Assets (A/E) Down, but Debt (D/E) Up:Sectors with Assets (A/E) Down, but Debt (D/E) Up:Capital GoodsCapital GoodsIndustrial MaterialsIndustrial MaterialsTelecommunicationsTelecommunicationsUtilitiesUtilities


Improvement in Profit Margins remains the most likely source of near term earnings growth:

This economy was built for speed – interaction among operating leverage, capacity utilization, profit margins

Significant cost reductions already achieved Many sectors will need growth in CapEx to generate profits increase

Financial Re Structuring has been in vogue, but will markets allow for additional debt?

CapEx increasingly funded with retained earnings Return on Investment receives greater scrutiny by investors Raising the profile of net income relative to current operating profits

Asset turnover is at low point, there is room to rise from here, but long term trend is down

Already quite a lot has been accomplished in asset re pricing, adjustments for credit quality, impairment write-offs

Yet any sizeable increase in M&A and CapEx will limit room for much further improvement in asset efficiency

How Will ROE Rise From Here?How Will ROE Rise From Here?


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Energy

Materials

Industrials

Consumer Staples

Cons. Discretionary

Health Care

Financial

Technology

Telecomm's

Utilities

All Commerce

1998-2000 2001-2002 2003 2004-2007

Outlook for US Sector ProfitsOutlook for US Sector Profits

Sector Profits Set for a Cyclical ReboundSector Profits Set for a Cyclical Rebound(Average Percent Growth of US Sector Operating Profits, Top 10 GICS Economic Sectors)(Average Percent Growth of US Sector Operating Profits, Top 10 GICS Economic Sectors)


Title Goes HereTitle Goes Here

Thank you!Thank you!

Mark Killion, CFAManaging Director

World Industry ServicesGlobal Insight, Inc.Global Insight, Inc.

Phone: 610 490 2547email: [email protected]

outlook for us corporate profits which are the leading sectors?

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