Profit Growth Hits the Brakes

Remember single-digit earnings gains? They're back after a long absence.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

April 2, 2007

The coming earnings season will be a subdued one as companies in the S&P 500 post average profit gains of about 4% for the first quarter. The result will mark the first time in about five years that quarterly profits haven't risen in double digits. Investors won't be surprised, though. They saw the earnings slowdown coming, which largely explains why they have been shying away from stocks so far this year -- the S&P 500 index is just barely positive after climbing nearly 14% in 2006.

Blame the profits pause on broadly weaker domestic demand, reflected in the modest sub-3% pace of economic growth since the second quarter of last year. Companies also have seen their key costs go up, particularly those for labor as gains from productivity diminish. Combined, these factors are squeezing the profit margins of many firms.

Expect an average 7% earnings gain for the full year, less than half the increase companies chalked up in 2006. Profits growth is likely to accelerate a bit in the second half as the economy improves, while lower energy prices compared with last year will also give businesses some breathing space. But there's little chance that the rise in labor costs -- roughly two-thirds of total expenses for the average firm -- is going to ease much for the remainder of 2007.

Milton Ezrati, senior economic and market strategist with Lord Abbett, says this year's profits will "still be healthy enough to support continued corporate expansion and equity prices. But it'll be a big change nonetheless from the remarkable earnings surprises of the past few years."

At the sectoral level, energy and materials producers will come in at the bottom of the heap. Energy firms' profits will decline about 5% on average this year following an increase of about 25% in 2006. Materials firms -- those making items such as chemicals, paper, construction materials and metals -- also produced average earnings gains of 25% last year, but this year, they will be in flat territory. For both sectors, the paucity of profits will be a direct result of lower average materials prices compared with last year.

On the flip side will be companies in health care and technology, both of which will tally average profit increases of about 15%. Strong demand for medical equipment, diagnostic technology and health services will buoy the bottom lines of health care companies, while technology firms will benefit from strong export demand and IT upgrades by domestic businesses.

In consumer products, it pays to differentiate between staple and discretionary vendors. With economic growth on course to slow by nearly a percentage point to 2.5% from last year's pace, consumers will cut back on nonessential purchases of items such as new autos, media products and restaurant meals. Overall, this consumer discretionary sector stands to post a meager 2% average profit advance. But makers of consumer staples -- food, beverages and household products -- will probably see profits increase a respectable 10% on average.

High short-term interest rates and mortgage default problems will hurt banks, limiting profit gains in the industry to about 5% on average following a 23% jump last year. But there will be a wide range of outcomes for banks, since not all will be touched by subprime mortgage woes.

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