Outlook for Corporate Profits Which are the Leading Sectors?

Transcription

1 Outlook for Corporate Profits Which are the Leading Sectors? Mark Killion, CFA Managing Director October 3 Copyright 3 Global Insight, Inc.

2 Outlook for Corporate Profits Agenda: Corporate Profits are key to: understanding asset valuation, credit quality anticipating the CapEx cycle and employment growth NIPA Corporate Profits to illustrate recent trends The cleanest measure of current operating earnings Sector level profits are more reliable than the Top down headline total profits number ROE Framework to analyze future prospects for profits Impact of operating leverage and financial leverage Market discipline forces a more efficient use of CapEx & Debt Normalized Earnings Growth for Sectors Which sectors enjoy the fastest growth? Which sectors have stock prices that are relatively rich or cheap? Copyright 3 Global Insight, Inc. 2

3 Two Measures of US Corporate Profits S&P 5 US$ Earnings Per Share Profits as S&P 5 GAAP (EPS, LHS) Profits as NIPA (Bill.$, RHS) US Domestic Corporate Profits US$ Billion E 4 E Profits as S&P 5 GAAP from SEC (EPS, LHS) Profits as NIPA from IRS via BEA (Bill.$, RHS) Corporate GAAP Profits (filed with SEC) are more volatile than NIPA Operating Profits (filed with IRS and used by BEA), largely due to: --Balance Sheet Impacts --Regulatory Changes Recent examples: -- Goodwill Write-Offs, Decline in Credit Quality 1 -- Corporate Fraud, Asset Impairment, Bankruptcy & Bad Loans 2 -- Expensing Stock Options, CEO Certification, E&O Insurance 3 Year of Pension Expense Adjustment, Change in Executive Compensation Structure, Dividend Taxation Copyright 3 Global Insight, Inc. 3 Source: Standard & Poor s, US BEA, GII Forecasts

4 How are US Profits Faring in the Business Cycle? How Does the Current Profit Recession Compare to the Previous Profits Recession of ? U.S. Corporate Profits in Quarters After Cycle Peaks (88-92 Vs. 97-3) (Index = at Cycles Peak of Corporate Profits: 1988 Q4 and 1997 Q4) The Top Down Adjustment for Capital Consumption Has Become Unreliable! (CCA Adjustment from Tax-Based to Economic Depreciation Rates Where A Positive Number indicates a Boost to NIA Corporate Profits -- by Taking Back Some Tax Based Depreciation Claimed against Profits) Index = Cycle Peak Q4-94Q1 with CCA Adj. 97Q4-3Q2 -- No CCA Adj. 97Q4-3Q2 CCA Adj. Bottom Scale Shows the Number of Months Prior and After the Previous Peak Adjustment in Bill. US$ I 3-II 15 5 Adjustment as % of Profits Index for 1988 Q4 to 1994 Q1--With CCA Adjustment Index for 1997 Q4 to 3 Q2--With CCA Adjustment Index for 1997 Q4 to 3 Q2--No CCA Adjustment CCA Adjustment in US$ (LHS) CCA Adjustment as % of Base (RHS) Copyright 3 Global Insight, Inc. 4 Source: US BEA

5 Which are the Largest Sectors? Sector Shares of S&P 5 Total Market Capitalization, in Percent Banking and Finance is the largest S&P 5 sector in terms of sales, profits and market capitalization Telecomm Services 3% Inform'n Technology 18% Financials 21% Utilities 3% Energy 6% Health Care 13% Materials 3% Industrials 11% Consumer Staples 11% Consumer Discretionary 11% Financial s share of Market Cap. would roughly double if leasing & other finance is taken from Autos, Industrial, Retail, etc. In Europe the Financial Sectors share of Total Market Capitalization is even higher (29%) The US Financial sector accounts for 33% of Total US NIPA profits Source: Standard and Poors, GII Calculations Copyright 3 Global Insight, Inc. 5

6 How Concentrated are Sectors? Global Sales Concentration Ratios for GICS Economic Sectors (Percent of Total Worldwide Sales Accounted for by the Sales of the largest Companies Within Each Sector) Energy Telecomm Svs. Utilities Technology Financials Consumer Discr. Health Care Consumer Staples Basic Materials Industrials Sales of Top Companies as % of Total World Sector Sales (Source: Top Ten Company Sales from WorldScope; Total Global Sales from GII s WIS) Source: Worldscope Company Financial Statements & GII Calculations Copyright 3 Global Insight, Inc. 6

7 How Have Key Sectors Fared Recently? --Sectors that have done well: Financial sub sectors such as Mortgages, Securities, Leasing Retail, Wholesale trade Consumer Non Durables --Sectors that were hit hard but are now recovering: Electronics, Hardware IT Fabricated Metals Airlines and Transportation Services --Sectors Hard Hit with No Recovery Yet: Industrial Machinery and Equipment Steel & Primary Metals Motor Vehicles and Parts Telecommunication Services --Oil and Energy have Surged --Chemicals and products are stable but remain well below the 199s peaks Copyright 3 Global Insight, Inc. 7 Source: GII World Industry Service

8 Which US Sectors are Generating Profits? Leading Sectors with Improving Profits (Billions of US$) Sectors with Steady Profits Future Pressure? (Billions of US$) Financial--NonBanking Retail Trade Banking (In Federal Reserve System) Receipts from Rest of World III Annual IV I II III IV Last 8 Quarters 3- I 3- II III IV I II III IV Annual Last 8 Quarters 3- I 3- II Copyright 3 Global Insight, Inc. 8 Source: US BEA

9 Which US Sectors are Recovering or Stalling? Sectors with Steady or Improving Profits (Billions of US$) Sectors with Past Losses Turning into Recovery (Billions of US$) 9 8 Food & Related Products Wholesale Trade Electricity & Utilities 25 Electronic & Electrical Fabricated & Welded Metal Products Transportation Services III Annual 1- IV I II III IV Last 8 Quarters 3- I 3- II III Annual 1- IV 2- I 2- II 2- III 2- IV Last 8 Quarters 3- I 3- II Copyright 3 Global Insight, Inc. 9 Source: US BEA

10 Which US Sectors are Recovering or Stalling? Sectors With No Recovery Yet in Profits (Billions of US$) Sectors with Exposure to Oil Related Factors (Billions of US$) 4 Industrial Machinery & Equipment 4 Petroleum & Coal Products 3 Motor Vehicals & Parts Steel & Primary Metals 35 3 Chemicals & Products Communication Services III Annual 1- IV 2- I 2- II 2- III 2- IV Last 8 Quarters 3- I 3- II III Annual 1- IV I II III IV I Last 8 Quarters 3- II Copyright 3 Global Insight, Inc. Source: US BEA

11 Return On Equity (ROE) as Measure of Profitability DuPont System ROE Framework shows the rate of return that management earns on capital provided by the shareholders (Profits calculated relative to the equity interest, after accounting for payments to all other capital suppliers) ROE Framework Identity: Return on Equity (NI/Equity) = Profit Margin (NI/Sales) * Asset Turnover (Sales/Assets) * Financial Leverage (Asset/Equity) Where: NI = Net Income; Equity = Book Value of Equity, Valued at the End of the Preceding Period; Assets are Total Current Period; Sales are Gross; ( * Denotes a multiplication sign) DuPont Ratio Interpretation: ROE is always described by some combination of: profit margins, reflecting efficiency in production, the mixture of fixed versus variable cost and/or the presence of pricing power asset turnover, showing the degree to which company assets are generating sales financial leverage, showing the extent to which the asset base is financed by debt In this framework, the component DuPont ratios outline the relationship that profits have with sales, pricing power, balance sheets and industry structure. Source: Investment Analysis and Portfolio Management, By Frank K. Reilly & Keith C. Brown South-Western, Nov, 2. Copyright 3 Global Insight, Inc. 11

12 Return On Equity shows shows rate of return that management earns on capital provided by the shareholders US Corporate Return on Equity Total for 15 US Corporations in the GICS Sector Classification Scheme What has been the Return on Equity Performance in the US? ROE in % Component Ratios 8 US Posted Excellent ROE record through 1997: ROE (%) LHS Margin (%) RHS Financial Leverage (Ratio) RHS Asset Turnover (Ratio*) RHS Problem of Falling Asset Efficiency, related to M&A purchases and CapEx spending Largely offset by Production Efficiency, Rising Margins Increase in Operating Leverage Pressures on margins built up from Mid 199s: Compression from Asian / Russian crises in 1998 Increase in Financial leverage to compensate What Happened in 1-2? 2? High operating leverage killed margins when growth slowed Deteriorating credit quality and corporate malfeasance Markets forcing a de leveraging of balance sheets Source: Worldscope Company Financial Statements & GII Calculations Copyright 3 Global Insight, Inc. 12

13 What is the Sector ROE Performance? Consumer Staples Energy Health Care Financials Utilities Materials Industrials Total Information Technology Consumer Discretionary Telecommunication Svs. 5 Year Historical ROE for US and European Sectors Ranked by European Perspective Largest to Smallest (Average ROE for US & European Sectors (X UK), Average over , Top GICS Economic Sectors) 5 15 United States Europe Source: Worldscope Company Financial Statements & GII Calculations Copyright 3 Global Insight, Inc. 13

14 How Will Corporate ROE Rise From Here? Improvement in Profit Margins remains the most likely source of near term earnings growth: Interaction among operating leverage, capacity utilization, profit margins Some operating cost reductions already achieved Many sectors will need growth in CapEx to generate high margins 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, but long term trend is down Already quite a lot has been accomplished in asset re pricing, adjustments for credit quality, impairment write-offs Some sectors showing recent pickup in asset turnover Yet any sizeable increase in M&A and CapEx will limit room for improvement in asset efficiency Copyright 3 Global Insight, Inc. 14 Source: GII World Industry Service

15 Will Profit Margins Rise in Key Growth Sectors? Technology and Financial Sectors in US and Europe Operating Profit Margins (Excludes Depreciation & Write Offs) (Comparison between US, UK and Continental Europe) Operating Profit Margin for All Operating Profit Margin for All Companies in the Technology Sector Companies in the Financial Sector in in the GICS Classification Scheme the GICS Classification Scheme '91 '92 '93 '94 '95 '96 '97 '98 '99 ' '1 '2 '91 '92 '93 '94 '95 '96 '97 '98 '99 ' '1 '2-5 United States United Kingdom Europe (X UK) -5 United States United Kingdom Europe (X UK) Source: Worldscope Company Financial Statements & GII Calculations Copyright 3 Global Insight, Inc. 15

16 How Do Sector Profits Change with Sales Growth? Degree of Operating Leverage Sector Beta Relating Operating Profits to Sector Sales Growth, Where W a Number Above 1 Shows Higher Leverage, Below 1 Shows Lower Leverage Degree of Operational Leverage (DOL) summarizes how changes in sales growth affect profits growth DOL reflects mix of fixed costs Vs. variable costs in business operations Sectors with high fixed costs and/or big CapEx Requirements have higher DOL Sector DOLs for World Total: Industrial Chemicals.71 Medical Technology.8 Communication Services.86 Wholesale & Retail Trade 1.7 Drugs & Medicine 1. Printing & Publishing 1.22 (World, 199-2) All Goods Industrial Chemicals Drugs & Medicines US Printing & Publishing World Exc. US All Services Comm Svs. Wholesale & Retail Banking & Insurance Copyright 3 Global Insight, Inc. 16 Source: GII World Industry Service

17 How Much Financial Leverage Will Markets Allow? Measures of Financial Leverage (Financial Multiplier, Gearing Ratio and Interest Expense Ratio) 5 US Totals for All Non Financial Corporations in the GICS Sector Classification Scheme European Totals for All Non Financial Corporations in the GICS Sector Classification Scheme '91 '92 '93 '94 '95 '96 '97 '98 '99 ' '1 '2.5 2 '91 '92 '93 '94 '95 '96 '97 '98 '99 ' '1 '2.5 Interest Expense as % of Total Expense Financial Leverage Ratio (Asset/Equity) Ratio of Debt to Equity (RHS) Interest Expense as % of Total Expense Financial Leverage Ratio (Asset/Equity) Ratio of Debt to Equity (RHS) Source: Worldscope Company Financial Statements & GII Calculations Copyright 3 Global Insight, Inc. 17

18 Which US Sectors have the Highest Gearing Ratio (Debt to Equity)? US Sector Saints and Sinners with Financial Leverage (Gearing Ratio: Ratio of Debt to Equity) 2.5 Sectors with High/Buildup in D/E Ratio 2 Sectors with Steady/Declines in D/E Ratio '91 '92 '93 '94 '95 '96 '97 '98 '99 ' '1 '2 '91 '92 '93 '94 '95 '96 '97 '98 '99 ' '1 '2 Industrials Telecomm--Wireless Utilities Auto Parts Consumer Staples Energy Health Care Source: Worldscope Company Financial Statements & GII Calculations Copyright 3 Global Insight, Inc. 18

19 Rank of US GICS Sector Profits Growth Long Term Normalized Sector Profits Growth (Average Percent Growth of Operating Profits in the US, Forecast for 4-8, 8, Top GICS Economic Sectors) Health Care Financial Technology Industrials Total Telecomm's Energy Cons. Discretionary Materials Utilities Consumer Staples Percent Growth of US$ Sector Profits Copyright 3 Global Insight, Inc. 19 Source: GII World Industry Service

20 Sector Operating Patterns: Growth and Volatility Coefficient of Variation (COV) How Volatile are US Sales and Earnings? Sector Growth, Standard Deviation of Growth, & the Ratio of Growth to Standard Deviation (COV): (Inflation Adjusted Sales, 199-2) Agricultural Chemicals Drugs & Medicines Computers Comm. Equipment Autos Comm. Services Banking & Insurance Average Growth Rate Standard Deviation of Growth Coefficient of Variation (COV) Transport. & Storage Industrial Machinary Medical Technology Copyright 3 Global Insight, Inc. Source: GII World Industry Service

21 How Much to Pay for Growth and Risk? Sector PEG Ratio: Sector Stock Price Valuation Metric (P/E) Adjusted for Sector Growth and Risk (COV) (PEG Ratio == P/E Ratio Divided by COV, where COV == Ratio of Forecast Normalized Earnings Growth to Historical Volatility of Growth) Energy Basic Materials Industrials Cons. Discretionary Cons. Staples P/E Ratio Health Care Financials Technology Telecomm. Svs. Utilities PEG - P/E Adjusted by COV S&P 5 Copyright 3 Global Insight, Inc. 21 Source: S&P, GII World Industry Service

22 Thank you! Mark Killion, CFA Managing Director World Industry Services Global Insight, Inc. Phone: mark.killion@globalinsight.com Copyright 3 Global Insight, Inc. 22