Corporate Profits Increasingly to Disappoint!

OVER THE LAST few weeks I have noticed an increasing number of disappointing sales and earnings announcements. Not just in the housing sector and for retailers, but among numerous companies such as United Parcel Services (UPS), Dell (DELL), Intel (INTC), Applied Materials (AMAT), Yahoo (YHOO), Amazon.com (AMZN), eBay (EBAY), Broadcom (BRCM), Legg Mason (LM), Peabody Energy (BTU), Citigroup (C), WW Grainger (GWW), Johnson Control (JCI), Disney (DIS), Times Warner (TMX), Alcoa (AA), Lucent (LU), SAP (SAP), Aetna (AET), Dow Chemical (DOW), and Cree (CREE), just to name a few.

According to the excellent Morgan Stanley economist Gerard Minack, who follows the world from Sydney, “there is a bubble in equities, but unlike in the late 1990s, which was a rating (PE) bubble, this one is an earnings (E) bubble. Higher interest rates are deadly to a PE bubble (just as higher rates tend to be punishing, in a relative sense, for high PE stocks).

But what will pop the E bubble are signs of growth and earning downgrades. Those downgrades seem to be looming. For the first time in five years there’s a picture of uniform deceleration in the most-watched US leading indicators. Not all are below their boom/bust thresholds, but most are now declining. Housing-related indicators are falling the fastest.” David Rosenberg of Merrill Lynch sounds a similar alarm bell.

Based on an inverted yield curve, “the longest and most tenacious tightening cycle on record”, a housing market peak in January, peak corporate profit margins, rising energy prices, a decline in stock prices which has a negative impact on household net worth and increases the cost of capital, and higher consumer debt service costs, David Rosenberg sees at present an almost 40% probability of a recession.

Consequently, Rosenberg thinks that, based on GDP growth that “is almost 100% sure to slow down” in the next 12 months, and profit margins that are at “peak levels”, the consensus now expecting 11% operating EPS growth for 2007 to US$96 for the S&P 500 is “highly optimistic if not downright unrealistic”. In his view, an “outright decline in corporate earnings cannot be ruled out”. I might add that Gary Shilling sees GDP starting to decline in the fourth quarter of this year and to continue declining in the first half of 2007, with corporate profits falling at an annual rate of 10% in the fourth quarter of this year and 20% in the first half of 2007!

I have great sympathy for the economists’ camp, which forecasts that a significant slowdown or a recession will get under way in the next 12 months, with disappointing corporate profits to follow. In this respect, it is important to recognize that the share of national real income growth in this recovery has been most uncommon. According to the Center on Budget and Policy Priorities (www.cbpp.org ), “the share of the increase in overall national income, after adjusting for inflation, that has come in the form of wages and salaries has been smaller than in any other recovery since the end of World War II.

Over this recovery, only 15% of real income growth has been in the form of increases in wages and salary income. During the first 10 quarters of other recovery periods, an average of 49% of gains in national income went to wages and salaries…. The share of national income gains going to corporate profits has been significantly larger during this recovery than in any other post-World War II recovery.

Some 47% of the real increases in national income over the past two and one half years has been in the form of corporate profits. This is more than double the average of 21% during the first two and one-half years of other post-World War II recoveries” (see Tables 1 and 2).

In other words, in the current economic expansion, which began in November 2001, after-tax profit margins from current production, which includes inventory valuation adjustment and capital consumption adjustment, have risen more than in any other post-World War II recovery. The profit margin expansion – which came predominantly from declining interest rates, tax cuts, financial gains, increased leverage, cost cutting, and earnings from foreign subsidiaries – led after-tax corporate profits to expand since 2001 at a much higher rate than nominal GDP. But how realistic is it to expect corporate profits to continue to grow at a rate higher than nominal GDP?

I am aware that some economists will make the case that “the rich nations get the profits” and “the poor nations get the jobs” because of the entire outsourcing process. And therefore, according to Gavekal, one should not be surprised that “over time, profits in the US appear to rise structurally”. For now, I shall not dispute that corporate profits remain at an elevated level as a percentage of nominal GDP, but it should be obvious even to the incorrigible optimist that, in the long run, corporate profits cannot grow at a faster rate than US or global nominal GDP.

It can be seen that profit margins never stayed at a very high level for long and that, following periods during which corporate profit growth exceeded nominal GDP growth, there was always a reversal to the mean. In fact, on most occasions when profit margins began to contract, S&P 500 earnings also declined. Nevertheless, I can see one environment in which corporate profits could expand somewhat further as a percentage of nominal GDP. If commodity prices, especially oil prices, were to treble from the present level, the energy and mining companies’ profits could soar. But, at what cost?! Surely, inflation would accelerate and depress other economic sectors’ earnings, while interest rates would increase and compress equity valuations (P/Es) even further.

A thoughtful reader recently sent me an enlightening study by the Boston Consulting Group entitled “The New Global Challengers — How 100 Top Companies from Rapidly Developing Economies Are Changing the World”. This study challenges the notion that the rapidly developing economies (RDEs) get the jobs and the rich countries of the West get the “profits”.

According to the Boston Consulting Group, “many companies based in RDEs are going global fast. As this report highlights, a sample of 100 leading RDE-based companies already have combined annual revenues of $715 billion — and are growing at an annual average rate of 24% per year. Companies in this sample are gaining global market share, making major acquisitions, and emerging as important customers, business partners, and competitors for the world’s largest companies” (emphasis added – ed. note).

Of the sample of 100 leading RDE-based companies, a large majority (70) are located in Asia, followed by Latin America with 18. China is by far the dominant homebase country, with 44 of the RDE 100 companies, followed by India with 21 and Brazil with 12.

According to the report, “the RDE 100 grew at a rate of 24 percent per year from 2000 through 2004, ten times as fast as the GDP of the United States, 24 times that of Japan, and 34 times that of Germany. They earned $145 billion in operating profits, equivalent to a margin of 20% over sales, compared with 16% for the United States’ S&P 500 companies, 10 percent for Japan’s Nikkei companies, and 9% for Germany’s DAX companies.”

Moreover, 60 of the 100 RDE companies are public companies whose market capitalisation at the end of March 2006 reached US$680 billion. These companies’ total shareholder return (TSR) increased between January 2000 and March 2006 by more than 150%, while the TSR of companies listed in the Morgan Stanley Emerging Market Index rose by 100% and that of S&P 500 companies declined modestly. Now, compare that with the performance of Dell, a typical “platform” company whose book value declined by 35% and whose receivables soared by 30% year-over-year in the first quarter, according to Fred Hickey.

According to the study, the RDE 100 companies can be divided, in terms of their maturity, into three groups: the early movers, the fast followers, and the up-and comers. The early movers include companies such as Mexico’s Cemex, which “has consistently generated superior returns compared with its competitors”; Hong Kong’s Johnson Electric, the world leader in small electric motors; and Brazil’s Embraco, the world leader in compressors.

The fast followers category, which includes companies that are making rapid progress in their globalisation, consist of companies such as China’s Haier, Pearl River Piano, Hisense, and CNOOC; India’s Infosys and Bharat Forge; Russia’s Lukoil; and Turkey’s Koc Holdings.

The group of up-and-comers includes just 14 companies that are at an early stage of  globalisation or whose ambitions have, until recently, been more regional than global. Companies in this category include India’s Tata Motors, Egypt’s Orascom Telecom, and Turkey’s Sisecam.

The Boston Consulting Group is well aware that not all these companies will eventually emerge on the world stage and that many won’t survive. However, “survival for today’s incumbent companies is not guaranteed either. Clearly the success factor will be the ability to identify the new wave of RDE-based challengers and understand the rich array of threats and opportunities they present.”

My friend Richard Lawrence, who runs the value-oriented Overlook Partners Fund, recently commented favourably on Hong Kong-based manufacturer Kingboard Chemical (148 HK), a company the Fund has owned for years, and on Malaysia based Top Glove Holdings – the world’s largest manufacturer and marketer of latex gloves (TOPG MK).

In the last three years, Top Glove’s sales and profits have recorded compound growth of 52.7% and 47.8%, respectively. Moreover, in the last ten years, Richard reports that Top Glove has seen compound growth in revenues and profits of 41.0% and 40.1%, respectively.

(Kingboard has had a similar performance to Top Glove over the last few years.) So, unlike what some strategists might want you to believe, it would seem to me that the equation isn’t as simple as: profits accumulate to “rich nations”, while the “poor nations” have to contend themselves with “jobs”.

The perceptive George Karahalios, who contributed to last month’s report a timely account of the Californian real estate market, has also taken the time to examine the platform company concept in detail.

I think I have already sufficiently demonstrated that the platform company business model is actually rather vulnerable. (Look also at the performance of Wal-Mart.) I quoted the Boston Group study; thanks to Richard Lawrence, we have seen that pure manufacturing companies can be very profitable; and I have shown the poor stock market performance of Dell over the last few years.

While Dell disappointed, India’s Wipro (WIT) and Infosys (INFY – see Figure 16) have performed rather well and happen not only to create “jobs” but also “profit”. But along with a number of other important issues, George touches on one point that I hadn’t really thought through and, therefore, wish to reproduce here.

George writes: “…by implying that American companies are gaining at the expense of their Asian competitors to whom they outsource production, the Gavekal Team seems to have ignored one of the most fundamental rules of microeconomics: When a newcomer company attacks an established, dominant competitor, it usually does so by challenging it at the lowest level of technological innovation. It is much easier for a new entrant to compete for the market share of a commoditised product that is easily replicated than to develop the human capital necessary to produce more sophisticated products.

“Further, the dominant competitor is more apt to concede market share at the low end of
technological production, where profit margins are sparse, than to relinquish market share on advanced products that generate more healthy returns.

“Only if the dominant firm is a monopolist or oligopolist will it fight to preserve market share at the low end of technological production. (If there are many competitive suppliers of a commoditised product, then no one firm is financially able to defeat the others and there is no incentive to sell at a loss.) A monopolist or near-monopolist will attempt to bankrupt its competitors who challenge it at any end of the technological scale in order to protect its stronghold on more technologically advanced products that produce fat profit margins. For example, Intel (INTC) worked hard to fend off Advanced Micro Devices (AMD) by selling its lowest-end microprocessor and flash memory chips at losses whenever AMD began to grab more market share.

“Intel correctly realised that any threat to its monopoly would start at the very simplest level of technological sophistication and vigorously fought to defend its position. After years of frustration, AMD has finally produced a real challenge to Intel’s monopoly and is now on the verge of becoming the technological leader in certain segments of its business. However, for every competitor that succeeds at conquering a monopoly there are many more found in the corporate graveyard.

“Even when the Japanese companies first attacked the Big Three American automakers in the 1970s they did so by introducing very simple models – – the no-frills economy cars that were devoid of styling but served as a very cheap form of transportation. Remember the Datsun B210 or the Toyota Corolla? (Greg’s Note: I own a Toyota Corrolla.) For quite a period of time the Big Three fought to protect their market share and stave off the new-found Asian competitors.

“It wasn’t until years later that Japanese auto companies were able to introduce luxury cars (Lexus, Infiniti, and Acura) to compete with the stylish, high profit-margin brands of the Big Three (Cadillac, Lincoln, and Chrysler New Yorker Brands).

“In your writings you correctly point out that even if American platform companies are earning the majority of the profits made on selling a product, every dollar of work outsourced to China is still a dollar invested in the Chinese economy. By attacking American companies at the least sophisticated level of production, China is laying the groundwork to eventually compete with America’s most profitable, technologically advanced industries. And I suppose it’s fair to suggest that their target will not be the American financial corporations whose profits will likely disappear when global economic imbalances are righted.

“It’s a dangerous practice to extrapolate the microeconomic success of a few companies in hopes of justifying the macroeconomic imbalances of a nation. It’s even more dangerous when, in doing so, Gavekal ignores one of the most fundamental rules governing the microeconomics of dominant firms – watch out from below!

“The same rule holds true for dominant nations. It’s really not different this time.”

I must say that I like George’s concept of newcomers attacking established dominant competitors by challenging them at the lowest level of technological innovation.

Although I hadn’t really thought about it before, I have actually seen this with Japanese cars. In the early 1960s, people ridiculed them for their poor quality standards. In the 1970s, I met the owners of Samsung who were then just producing textiles, the owners of Hong Kong’s Sung Hung Kai Properties, Cheung Kong and of Henderson Land, of Taiwan’s Formosa Plastic and Far Eastern Group, and of Australia’s Westfield Group (Australia then still being an emerging economy).

I never would have dreamt that all these companies would become powerful world players, and that they would do so by initially attacking their competitors at the lowest level of technological innovation. In particular, I remember that in the early 1970s the most prestigious property group in the world and the largest by market capitalisation was Hong Kong Land; Hong Kong Chinese-owned companies focused on cheap flats only. But today, the owners of those companies are now among the world’s richest billionaires, and those people who invested in them in the 1970s made a few hundred times their initial capital!

In fact, to attack at the lowest level of technological innovation is the most natural process in history. In the precapitalistic age, barbarians would attack well-equipped and well-trained armies of empires by surprise or by luring them into unfamiliar battle grounds (such as the Teutonic Forest), by continuous hit-and-run raids, or by spreading superstition (religion) or pandemics (the siege of Kaffa).

I have also never met or heard of a mistress or a whore who recited Shakespeare’s prose in an attempt to conquer the heart (or more likely the purse) of a happily married man. Usually, she would attempt to woo him by providing him with the most basic services, such as hanging up his coat, providing him with a cold towel to refresh his face, cooking him a meal, and so on. But once she has won this battle and dominates her victim, her aspirations rise and she will attack him on a higher level that requires frequent visits to “in” restaurants and clubs, art galleries, and the opera.

As George Karahalios writes, “It’s really not different this time.”

Regards,
Marc Faber
August 30, 2006