2004-05-13 / Business & Finance

Group Say Corporate Profits, Cash Flow Will Drive U.S. Economy

Group Say Corporate Profits, Cash Flow Will Drive U.S. Economy

Group Say Corporate Profits, Cash Flow Will Drive U.S. Economy

Healthy corporate profits and cash flow, along with strong economic indicators, will provide a sturdy foundation to the ongoing U.S. economic recovery, according to an analysis re-leased by The Conference Board.

Corporate profits are rising at a 30 percent annual rate, both because of huge gains in domestic corporate profitability and because strong economic growth and a low dollar are boosting business receipts from the rest of the world.

"Corporate profits have strengthened not just because of productivity and cost cutting but because corporate revenue is now growing almost 7 percent annually, which is faster than GDP," says Gall D. Fosler, Executive Vice President and Chief Economist of The Conference Board. "It is projected to grow at this rate or faster over the next 18 months."

A shift in profits from the financial sector to nonfinancial corporate business is underway. Activity in financial services has risen very gradually over the past decade, but profitability surged at the end of the 1990s as interest rates declined. Now with the economy ex-panding, the nonfinancial business sec-tor is driving profitability. Financial services profits have dropped as a share of total profits in 2002-2003, because margins are squeezed by very low in-terest rates, weak loan demand, and a declining demand for many higher-margin investment banking and risk management products.

Profitability And Growth - Linked At The Company Level

Growth and profitability are generally, but not always, aligned. The Con-ference Board analysis points out that most companies in the Standard and Poor’s 500 Index are now translating top-line growth to profits at the gross margin line. Even with all of the pricing and cost pressures in recent years, firms are managing their gross margins very effectively.

Financial services were able to grow profits faster than revenues because of declining interest rates, favorable mar-ket conditions that fostered an appetite for risk, and technological innovations that enabled them to shift the mix of activity to highly profitable off-balance- sheet transactions. But other sectors, like construction and leisure and hospitality, have been able to grow gross margins very rapidly.

Too Many Manufacturers?

Manufacturing sales grew more than 12 percent on average during the 1990s, but operating profits (i.e., earnings be-fore interest and taxes and after depreciation) grew by only 9.3 percent. Man-ufacturing firms appear to be more af-fected by administrative expenses and R&D costs than do other firms. In some sectors, like information technology, R&D costs can be very large. Even outside the technology sector, companies may spend considerable sums on R&D aimed at innovation.

But these data for manufacturing suggest that, on average, companies are not being compensated for these investments in terms of top-line revenues.

"Whatever the cause, it appears that it is not so much the direct pricing and cost pressures of the product portfolio that suppress profitability but the ope-rating and strategic decisions of the firm," says Fosler.

These decisions may be indirectly reflected in the pace of revenue growth and registered by lower-than-expected returns on investment in plant and R&D investment than was assumed in the original business plans.

"Manufacturing profitability may benefit from substantial further consolidation," concludes Fosler. "This may reverse the deterioration in the relative return on manufacturing assets."

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