Pamela Huggins, vice president and treasurer at $7 billion diversified manufacturer Parker Hannifin Corp., recalls how it wasn't until early last year that the company was convinced the recession of 2001 was really over. New orders for the Cleveland-based producer of everything from aerospace equipment to refrigeration devices were mostly flat until early 2004, some 18 months after the official end of the recession. Then, business took off like a rocket. "We really had a tremendous ramp-up," says Huggins, with year-over-year order spikes between 20% and 30% across many divisions, and similar growth into this year. At the same time, an earlier overhaul of Parker's procurement and manufacturing methods toward leaner, lower inventory approaches chopped operational costs, pushing profit margins to near record levels. The newfound efficiency also allowed Parker Hannifin to cut its capital spending as a percent of sales dramatically, from 5.1% in 1998 to about 1.9% this year. The result: record cash flow.
It's been a long time coming, but from earnings to margins to investment spending, the U.S. business sector is having its best run since the stock market meltdown that began in 2000. The performance has exceeded all but the most optimistic forecasts. A July survey by Standard & Poor's Corp. found a record $634 billion of cash and equivalents on hand at the 376 industrial companies in the S&P 500. Even more significant, the ratio of cash to market capitalization for the group stands at 7.7%, the highest since 1988. Profit margins are back near their recent historical peaks of the late 1990s and the surge in earnings has brought with it a sharp rebound in business investment spending, which climbed 10.6% in 2004, its best rise since 1998. But as with every great party, things eventually have to wind down, and that is where the outlook is heading. Steady rises in labor and energy costs are already causing economists to ratchet down their earnings expectations for the remainder of this year and into 2006. Even at bullish Parker Hannifin, there has been a noticeable cooling off from the heady pace of orders over the last twelve months. "We're continuing to see an increase in orders … but we're seeing a moderation in the growth, toward more normalized growth going forward," says Huggins.
Not everyone agrees on the timing, but all agree that the recent fall in productivity numbers from 4%-plus toward more historical norms at or below 2% means the current pace of profit growth must eventually slow. Although economists generally expect corporate profits to remain robust into 2006, some slowing of the growth rate is widely expected. Howard Silverblatt, equity market analyst at Standard & Poor's, expects the string of 12 consecutive quarters of double-digit operating earnings rises for the S&P 500 to come to an end during the currently reported (second) quarter, but still rise at a healthy 8% pace. "If you've got labor costs going from zero to 4%, then profits have to fall," says Ian Shepherdson, chief U.S. economist at High Frequency Economics. "The double-digit trend in earnings and capital spending will be coming to an end."
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LABOR AND OIL? SOUNDS FAMILIAR
Which costs most undermine continued growth? Following a long period of declines, unit labor costs started heading higher late last year. Although many agree that one-time events, including a surge in option expensing and yearend bonuses, influenced the trend to some extent, it also looks like more permanent factors, including slower productivity gains, are at work. Unit labor costs per hour inched 1.47% higher in the third quarter last year, then rose another 3% in the fourth quarter and 4.3% in the first quarter of 2005, on a year-over-year basis. "The labor market is tightening," says Peter Hooper, chief U.S. economist at Deutsche Bank Global Markets. "Workers are going to catch up with the huge productivity gains we've had." He expects profit growth will slow considerably from the 17% range of 2004 to 11% this year and 5% in 2006. The sharp run-up in energy costs has been another surprise this year, but an even bigger surprise may be the fact that companies and consumers have so far absorbed it better than many expected they could. Companies are far more efficient at using oil than they were in the 1970s and 1980s, when in real terms prices were higher than today. But should oil remain at the $60 level into next year, or even rise further, it will have its own impact on earnings. In a recent letter to Congress, Federal Reserve Chairman Alan Greenspan said the economy "seems to be coping pretty well" with recent rises in oil prices. He added that analysts at the Fed had also estimated that higher energy prices will cut growth by about 3/4 of a percentage point in 2005. The bigger fear, of course, is the impact of a supply shock triggered by political instability in Iran, Saudi Arabia or Iraq, which would likely push prices even higher. Whatever the cause, the concern among the business community is real, as seen by the results of Treasury & Risk Management's biannual economic confidence survey of CFOs, treasurers and controllers. When asked to name the single biggest threat to the U.S. economy over the next 12 months, 44% of the 346 respondents cited the price of oil, well ahead of terrorism (14%), the value of the dollar (10%) or sharply higher interest rates (19%).
Where will companies go from here, given that margins and profits may have peaked? Admittedly, most have cash sloshing around in corporate coffers and faced with a slowdown in productivity rates, some may be forced to ramp up capital spending to avoid getting squeezed by lower cost competitors. "This is an aspect of the economy still growing at a lively pace. I think capital spending into 2006 will slow, but continue to outpace the U.S. economy," says John Lonski, chief economist at Moody's Investors Service. He expects business investment, or as the government calls it, non-residential fixed investment, to rise 8.8% this year and 6.7% in 2006.
SPENDING OPTIONS
But particularly in the face of declining equity prices, there will be competing uses for cash, including share buybacks, dividend increases, mergers and acquisitions and overseas investments. When asked about capital spending plans, the responses to the T&RM survey were slightly more bearish than in the past. Where 43% said this time they expected their companies to increase spending in the next six months, 46% answered affirmatively in December and 49.3% a year ago. While companies have the luxury of weighing options today, the numbers suggest there may be a limited window of opportunity.
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