JOEY
The Wall Street Journal -- November 3, 1997
Doubts on Asia Cut Confidence in Profits
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By Greg Ip
Staff Reporter of The Wall Street Journal
Will the debacle in Southeast Asia undercut the remarkable growth in U.S. corporate profits? Maybe, maybe not. But it's that very uncertainty that appears to have played a big role in the stock market's tumble.
The third quarter was another strong one for corporate America, and so far the implosion of Hong Kong's stock market and Asian economic turmoil have produced no surge in estimate-cutting.
But Asia has created enormous uncertainty about which companies will be hurt, which will benefit, and by how much, and that, analysts say, is undermining the confidence in profit growth that explained the high, and rising, price-to-earnings multiples investors were willing to assign to stocks.
Investors have beaten down valuations in the past two weeks because of "uncertainty about the earnings estimates they are using, rather than as a result of lower estimates themselves," strategists at Smith Barney Inc. said in a Friday report. "The markets' violent reaction to problems in a region which represents just 3% of overall U.S. gross domestic product reflects equities' vulnerability to any question about the sources of future earnings growth."
Says Smith Barney strategist John MacNeil, "More of what's happening is psychological: We don't know what will happen, so we'll discount the worst case."
Certainly, the current profit situation still looks great. In the third quarter, 690 companies on the Dow Jones U.S. Stock Index saw their profits rise a healthy 12.7% from a year ago, well ahead of the second quarter's 10.6% pace, according to data compiled by First Call Corp. They beat analysts' estimates by 1.8 percentage points, a spread that is down from 2.3 percentage points in the second quarter. But Chuck Hill, director of research at First Call, says that's because many sectors such as semiconductors and commodities had a profit slump in 1996, and analysts' estimates were too low when those sectors bounced back in the first half of the year.
More to the point, Mr. Hill said he has seen no downward revisions as a result of the recent debacle in Asia.
That may be about to change. On Friday, Smith Barney semiconductor analyst James Barlage cited Asia for lowering his 1998 earnings estimate for Intel Corp. to $4.25 a share from $4.70, although he maintained his "buy" rating on the stock.
The prospect of slower growth in Southeast Asia, he says, probably will reduce the growth in world-wide personal-computer sales to 15% from 17% next year, hitting Intel's microprocessor sales.
But there's a silver lining that illustrates why the impact of the turmoil is so unclear. Mr. Barlage says Intel's gross margins might actually benefit because it does so much assembly and testing in the region, and the fall in local currencies will reduce its costs.
So future profits could be under pressure. There's just no evidence of it, yet. Indeed, Peter Canelo, strategist at Morgan Stanley, Dean Witter, Discover & Co., examined a list of 18 technology companies with above-average exposure to Asia and found that although they did miss analysts' estimates more than most companies in the third quarter, they didn't any more than technology companies with minimal Asian exposure -- suggesting the problem lay elsewhere. (Technology companies are considered among the most vulnerable to Asian problems due to a large presence in that region.)
"You can't see Southeast Asia in these numbers," he said. "We had some negative price trends in memory chips and some of the semiconductors before. It's just a little early to take a look at these numbers and come to any strong conclusions."
Still, you might want to get ready. "For some reason, stocks always seem to go down before estimates do," cracked Tom McManus, U.S. investment strategist for NatWest Securities Corp.
The companies considered most vulnerable to earnings hits are those involved in construction and engineering in Asia, such as United Technologies Corp. (which makes elevators, among other things), and Ingersoll-Rand Co.; those with big exports to the region, like Boeing Co.; and some financial companies, like Citicorp. Most beat estimates in the third quarter, and those that missed did so for reasons that appear unrelated to Asia, Mr. Hill says.
Mr. Canelo suspects there are revisions to come, but at present analysts are holding off. "I don't know how much company guidance the analysts are getting. Judging from our shop, it's like they're listening to anything the company will say, and the companies aren't saying much," he said.
But despite that expectation, neither Mr. McManus nor Mr. Canelo is prepared to take down his overall earnings estimates for next year. Mr. McManus noted that major multinationals like Coca-Cola Co. don't just sell in Asia; they also produce in Asia, so lower currencies there imply both lower costs and prices. Furthermore, unlike jumbo jets and elevators, their products are low-priced, and thus less subject to economic vagaries. "I think people have it completely wrong when they say you have to watch out for the big consumer multinationals. These companies are the safe havens," he said. Indeed, Coke was up last week, closing at $56.625 from $55.50 a week earlier.
Analysts at Prudential Securities have similar mixed outlooks. Arguing there will be no backlash from weakened demand, given Asia's small share of most PC manufacturers' sales, they argue that most computer makers will enjoy lower component costs from Asia, which will lower PC costs and stimulate demand. (The one loser they cite is Apple Computer Inc., with 24% of its sales in this region.) United Technologies and Boeing, with meaningful Asian exposure, are at risk but Sunbeam, Corp., owing to lower sourcing costs, could benefit.
One reason there has been no rash of profit estimate cuts so far is that Asia's problems still seem relatively inconsequential for the U.S. economy, at least relative to those of Latin America in late 1994 and early 1995, at the time of Mexico's peso devaluation and the ensuing steep recession in some Latin American economies. "Even the most pessimistic forecasts do not call for a repeat of the 1995 Mexican meltdown," noted Edward Kerschner and Michael Geraghty, strategists at PaineWebber Group. "Remember that in 1995, despite the upheaval in Latin America and sluggishness in Europe, S&P 500 operating earnings per share rose 18% and stock prices surged 34%."
But for the time being, such forecasts remain shrouded in uncertainty.
David Shulman, chief equity strategist at Salomon Brothers Inc., said last week that the Asian turmoil has severely shaken the belief that global growth, most prominently in Asia, created an almost unlimited horizon for robust, noninflationary growth, justifying sky-high valuations for U.S. stocks. Hong Kong's troubles "knocked the prop out from under that part of the bull market thesis," he said.
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