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Outlook for Corporate Profits

Which are the Leading Sectors?

Mark Killion, CFA


Managing Director

October 2003

Copyright ©2003 Global Insight, Inc.


Outlook for Corporate Profits – Agenda:

® Corporate Profits are key to:


w understanding asset valuation, credit quality
w anticipating the CapEx cycle and employment growth

® NIPA Corporate Profits to illustrate recent trends


w The “cleanest” measure of current operating earnings
w Sector level profits are more reliable than the “Top down” headline
total profits number
® ROE Framework to analyze future prospects for profits
w Impact of operating leverage and financial leverage
w Market discipline forces a more efficient use of CapEx & Debt
® “Normalized” Earnings Growth for Sectors
w Which sectors enjoy the fastest growth?
w Which sectors have stock prices that are relatively rich or cheap?

Copyright ©2003 Global Insight, Inc. 2


Two Measures of US Corporate Profits

S&P 500 US$ Earnings Per Share US Domestic Corporate Profits US$ Billion
55 1100
Corporate GAAP Profits (filed
50 1000 with SEC) are more volatile
Profits as S&P 500 GAAP (EPS, LHS) than NIPA Operating Profits
45 900
(filed with IRS and used by
40 800 BEA), largely due to:
35 700 --Balance Sheet Impacts
--Regulatory Changes
30 600
Recent examples:
25 500 ® 2000 -- Goodwill Write-Offs,
20 400 Decline in Credit Quality
® 2001 -- Corporate Fraud,
15 300 Asset Impairment,
Bankruptcy & Bad Loans
10 200
Profits as NIPA (Bill.$, RHS) ® 2002 -- Expensing Stock
5 100 Options, CEO Certification,
E&O Insurance
0 0
2003 E ® 2003 – Year of Pension
2004 E
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002

Expense Adjustment,
Change in Executive
Profits as S&P 500 GAAP from SEC (EPS, LHS) Compensation Structure,
Profits as NIPA from IRS via BEA (Bill.$, RHS) Dividend Taxation

Copyright ©2003 Global Insight, Inc.


Source: Standard & Poor’s, US BEA, GII Forecasts 3
How are US Profits Faring in the Business Cycle?

How Does the Current Profit Recession Compare The “Top – Down” Adjustment for Capital
to the Previous Profits Recession of 1988-1992? Consumption Has Become Unreliable!
(CCA Adjustment from Tax-Based to Economic Depreciation Rates Where A
U.S. Corporate Profits in Quarters After Cycle Peaks (88-92 Vs. 97-03) Positive Number indicates a Boost to NIA Corporate Profits -- by Taking Back
(Index = 100 at Cycles Peak of Corporate Profits: 1988 Q4 and 1997 Q4) Some Tax Based Depreciation Claimed against Profits)

140 200 25

Adjustment as % of Profits
88Q4-94Q1 with CCA Adj. 180

Adjustment in Bill. US$


130
160 20
Index 100 = Cycle Peak

120 140
110 120 15
97Q4-03Q2
CCA Adj. 100
100
80 10
90 60
80 40 5
97Q4-03Q2 -- No CCA Adj. 20
70
Bottom Scale Shows the Number of Months Prior and After the Previous Peak.
0 0

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003-II
2003-I
60 -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 20 21 22

Index for 1988 Q4 to 1994 Q1--With CCA Adjustment CCA Adjustment in US$ (LHS)
Index for 1997 Q4 to 2003 Q2--With CCA Adjustment
CCA Adjustment as % of Base (RHS)
Index for 1997 Q4 to 2003 Q2--No CCA Adjustment

Copyright ©2003 Global Insight, Inc.


Source: US BEA 4
Which are the Largest Sectors?

Sector Shares of S&P 500 Total ® Banking and Finance is the largest
Market Capitalization, in Percent S&P 500 sector in terms of sales,
profits and market capitalization
Energy
Utilities
Telecomm 3%
6% ® Financial’s share of Market Cap.
Services Materials
3% 3% would roughly double if leasing &
Industrials other finance is taken from Autos,
11%
Industrial, Retail, etc.
Inform'n
Technology Consumer
18% Discretionary ® In Europe the Financial Sectors’
11%
share of Total Market Capitalization is
Financials Consumer even higher (29%)
21% Staples
11%
Health Care
13% ® The US Financial sector accounts for
33% of Total US NIPA profits

Source: Standard and Poors


Poors,, GII Calculations
Copyright ©2003 Global Insight, Inc. 5
How Concentrated are Sectors?

Global Sales Concentration Ratios for GICS 10 Economic Sectors


(Percent of Total Worldwide Sales Accounted for by the Sales of the 10 largest Companies Within Each Sector)

Energy

Telecomm Svs.

Utilities

Technology

Financials

Consumer Discr.

Health Care

Consumer Staples

Basic Materials

Industrials

0 10 20 30 40 50
Sales of Top 10 Companies as % of Total World Sector Sales
(Source: Top Ten Company Sales from WorldScope; Total Global Sales
Sales from GII’s WIS)

Source: Worldscope Company Financial Statements &


Copyright ©2003 Global Insight, Inc. GII Calculations 6
How Have Key Sectors Fared Recently?

--Sectors that have done well: --Sectors Hard Hit with No


® Financial sub sectors such as Recovery Yet:
Mortgages, Securities, Leasing ® Industrial Machinery and
® Retail, Wholesale trade Equipment
® Consumer Non Durables ® Steel & Primary Metals
® Motor Vehicles and Parts
--Sectors that were hit hard ® Telecommunication Services
but are now recovering:
® Electronics, Hardware IT
® Fabricated Metals --Oil and Energy have Surged
® Airlines and Transportation --Chemicals and products are
Services
stable but remain well
below the 1990s peaks

Copyright ©2003 Global Insight, Inc.


Source: GII World Industry Service 7
Which US Sectors are Generating Profits?

Leading Sectors with Improving Profits Sectors with Steady Profits – Future Pressure?
(Billions of US$) (Billions of US$)

250
100

90
200
80

70
150
60 Retail Trade
50 Banking (In Federal Reserve System)
100 40
Financial--NonBanking
Receipts from Rest of World 30
50 20
10
0 0
1996 1997 1998 1999 2000 2001 2001- 2001- 2002- 2002- 2002- 2002- 2003- 2003- 1996 1997 1998 1999 2000 2001 2001- 2001- 2002- 2002- 2002- 2002- 2003- 2003-
III IV I II III IV I II III IV I II III IV I II
Annual Last 8 Quarters
Annual Last 8 Quarters

Copyright ©2003 Global Insight, Inc.


Source: US BEA 8
Which US Sectors are Recovering or Stalling?

Sectors with Steady or Improving Profits Sectors with Past Losses Turning into Recovery
(Billions of US$) (Billions of US$)

100 25
Food & Related Products Electronic & Electrical
90 Wholesale Trade Fabricated & Welded Metal Products
20
80 Electricity & Utilities Transportation Services
70
15
60

50 10
40

30 5

20
0
10
1996 1997 1998 1999 2000 2001 2001- 2001- 2002- 2002- 2002- 2002- 2003- 2003-
0 III IV I II III IV I II
-5
1996 1997 1998 1999 2000 2001 2001- 2001- 2002- 2002- 2002- 2002- 2003- 2003-
III IV I II III IV I II
Annual Last 8 Quarters Annual Last 8 Quarters
-10

Copyright ©2003 Global Insight, Inc.


Source: US BEA 9
Which US Sectors are Recovering or Stalling?

Sectors With No Recovery Yet in Profits Sectors with Exposure to Oil Related Factors
(Billions of US$) (Billions of US$)

40 40 Petroleum & Coal Products


Industrial Machinery & Equipment
Motor Vehicals & Parts 35 Chemicals & Products
30
Steel & Primary Metals 30

20 Communication Services 25

20
10
15

0 10
1996 1997 1998 1999 2000 2001 2001- 2001- 2002- 2002- 2002- 2002- 2003- 2003-
III IV I II III IV I II 5
-10
0
1996 1997 1998 1999 2000 2001 2001- 2001- 2002- 2002- 2002- 2002- 2003- 2003-
Annual Last 8 Quarters III IV I II III IV I II
-20
Annual Last 8 Quarters

Copyright ©2003 Global Insight, Inc.


Source: US BEA 10
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
to all other capital suppliers)

ROE Framework Identity:


Identity: DuPont Ratio Interpretation:
Interpretation:
ROE is always described by some combination of:
Return on Equity (NI/Equity) =
Ø profit margins, reflecting efficiency in production, the mixture
of fixed versus variable cost and/or the presence of pricing power
power
Profit Margin (NI/Sales) *
Øasset turnover, showing the degree to which company assets
Asset Turnover (Sales/Assets) * are generating sales

Øfinancial leverage, showing the extent to which the asset base


Financial Leverage (Asset/Equity) is financed by debt

Where: NI = Net Income; Equity = Book Value of


In this framework, the component “DuPont”
DuPont” ratios
Equity, Valued at the End of the Preceding Period;
outline the relationship that profits have with sales,
Assets are Total Current Period; Sales are Gross;
( * Denotes a multiplication sign)
pricing power, balance sheets and industry structure.

Source: Investment Analysis and Portfolio Management,


Management,
By Frank K. Reilly & Keith C . Brown
Copyright ©2003 Global Insight, Inc. South--Western, Nov, 2002.
South 11
Return On Equity shows rate of return that management
earns on capital provided by the shareholders

US Corporate Return on Equity What has been the Return on Equity


Total for 1500 US Corporations in the
GICS Sector Classification Scheme
Performance in the US?
ROE in %
Component Ratios
20 8 US Posted Excellent ROE record through 1997:
18
16
7 ØProblem of Falling Asset Efficiency, related to M&A
purchases and CapEx spending
14
6 ØLargely offset by Production Efficiency, Rising Margins
12 ØIncrease in Operating Leverage
10 5
8 Pressures on margins built up from Mid 1990s:
4
6
ØCompression from Asian / Russian crises in 1998
4 ØIncrease in Financial leverage to compensate
3
2
0 2 What Happened in 2001-
2001-2002?
1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

ØHigh operating leverage killed margins when growth slowed


ROE (%) LHS ØDeteriorating credit quality and corporate malfeasance
Margin (%) RHS
Financial Leverage (Ratio) RHS ØMarkets forcing a de leveraging of balance sheets
Asset Turnover (Ratio*10) RHS

Source: Worldscope Company Financial Statements &


Copyright ©2003 Global Insight, Inc. GII Calculations 12
What is the Sector ROE Performance?

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 1998-
1998-2002, Top 10 GICS Economic Sectors)

Consumer Staples
Energy
Health Care
Financials
Utilities
Materials
Industrials
Total
Information Technology
Consumer Discretionary
Telecommunication Svs.

0 5 10 15 20
United States Europe

Source: Worldscope Company Financial Statements &


Copyright ©2003 Global Insight, Inc. GII Calculations 13
How Will Corporate ROE Rise From Here?

® Improvement in Profit Margins remains the most likely source


of near term earnings growth:
w Interaction among operating leverage, capacity utilization, profit margins
w Some operating cost reductions already achieved
w 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?
w CapEx increasingly funded with retained earnings
w Return on Investment receives greater scrutiny by investors
w 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
w Already quite a lot has been accomplished in asset re pricing, adjustments
for credit quality, impairment write-offs
w Some sectors showing recent pickup in asset turnover
w Yet any sizeable increase in M&A and CapEx will limit room for
improvement in asset efficiency

Copyright ©2003 Global Insight, Inc.


Source: GII World Industry Service 14
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
20 20

15 15

10 10

5 5

0 0
'91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02

-5 -5
United States United States
United Kingdom United Kingdom
Europe (X UK) Europe (X UK)

Source: Worldscope Company Financial Statements &


Copyright ©2003 Global Insight, Inc. GII Calculations 15
How Do Sector Profits Change with Sales Growth?

Degree of Operating Leverage


Sector Beta Relating Operating Profits to Sector Sales Growth, Where
Where a Number
Above 1 Shows Higher Leverage, Below 1 Shows Lower Leverage
(World, 1990-
1990-2002)
® Degree of Operational Leverage (DOL) 1.6
summarizes how changes in sales growth 1.4 US World Exc. US
affect profits growth
® DOL reflects mix of fixed costs Vs. 1.2
variable costs in business operations 1
® Sectors with high fixed costs and/or big
CapEx Requirements have higher DOL 0.8

Sector DOLs for World Total: 0.6

0.4
Industrial Chemicals 0.71
Medical Technology 0.80 0.2
Communication Services 0.86
Wholesale & Retail Trade 1.07 0

All Services
All Goods

Comm Svs.
Medicines
Chemicals

Publishing

Wholesale &

Banking &
Insurance
Industrial

Printing &
Drugs &
Drugs & Medicine 1.10

Retail
Printing & Publishing 1.22

Copyright ©2003 Global Insight, Inc.


Source: GII World Industry Service 16
How Much Financial Leverage Will Markets Allow?

Measures of Financial Leverage


(Financial Multiplier, Gearing Ratio and Interest Expense Ratio)

US Totals for All Non Financial European Totals for All Non Financial
Corporations in the GICS Sector Corporations in the GICS Sector
Classification Scheme Classification Scheme
5 1.5 5 1.5

4.5 4.5

4 4

3.5 1 3.5 1

3 3

2.5 2.5

2 0.5 2 0.5
'91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02

Interest Expense as % of Total Expense Interest Expense as % of Total Expense


Financial Leverage Ratio (Asset/Equity) Financial Leverage Ratio (Asset/Equity)
Ratio of Debt to Equity (RHS) Ratio of Debt to Equity (RHS)

Source: Worldscope Company Financial Statements &


Copyright ©2003 Global Insight, Inc. GII Calculations 17
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)

Sectors with High/Buildup in D/E Ratio Sectors with Steady/Declines in D/E Ratio
2.5 2

2
1.5

1.5
1
1

0.5
0.5

0 0
'91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02

Industrials Consumer Staples


Telecomm--Wireless Energy
Utilities
Auto Parts Health Care

Source: Worldscope Company Financial Statements &


Copyright ©2003 Global Insight, Inc. GII Calculations 18
Rank of US GICS Sector Profits Growth

Long Term “Normalized” Sector Profits Growth


(Average Percent Growth of Operating Profits in the US, Forecast for 2004-
2004-2008, Top 10 GICS Economic Sectors)

Health Care

Financial

Technology

Industrials

Total

Telecomm's

Energy

Cons. Discretionary

Materials

Utilities

Consumer Staples

0 1 2 3 4 5 6 7 8 9
Percent Growth of US$ Sector Profits

Copyright ©2003 Global Insight, Inc.


Source: GII World Industry Service 19
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, 1990-2002)
16 Average Growth Rate
14 Standard Deviation of Growth

12 Coefficient of Variation (COV)

10
8
6
4
2
0

Machinary
Comm.
Agricultural

Equipment
Computers

Banking &

Technology
Insurance
Medicines

Transport. &
Autos

Industrial
Services
Chemicals

Drugs &

Comm.

Medical
Storage
Copyright ©2003 Global Insight, Inc.
Source: GII World Industry Service 20
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
Forecast Normalized Earnings Growth to Historical
Volatility of Growth)
40
35
30
25
20
15
10
5
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P/E Ratio PEG - P/E Adjusted by COV


C

Copyright ©2003 Global Insight, Inc.


Source: S&P, GII World Industry Service 21
Thank you!

Mark Killion, CFA


Managing Director
World Industry Services
Global Insight, Inc.

Phone: 610 490 2547


email: mark.killion@globalinsight.com

Copyright ©2003 Global Insight, Inc. 22