Outlook for US Corporate Profits Which are the Leading Sectors?

1. Outlook for US Corporate ProfitsWhich are the Leading Sectors? Mark Killion, CFA Managing Director April 29, 2003

2. Outlook for US Corporate Profits Agenda: • Corporate Profits are key to: • understanding asset valuation, credit quality • anticipating the CapEx cycle and employment growth • Corporate GAAP Profits (SEC) are more volatile than NIPA Operating Profits (IRS via BEA) • What have been the recent trends in each? • ROE Framework to analyze the prospects for corporate profits • Impact of operating leverage and financial efficiency • Which sectors are winners and losers?

3. Two Measures of US Corporate Profits Corporate GAAP Profits (filed with SEC) are more volatile than NIPA Operating Profits (filed with IRS and used by BEA) due largely to Balance Sheet impacts Recent examples: • 2000 -- Goodwill Write-Offs, Decline in Credit Quality • 2001 -- Corporate Fraud, Asset Impairment, Bankruptcy & Bad Loans • 2002 -- Expensing Stock Options, CEO Certification, E&O Insurance • 2003 – Year of Pension Expense Adjustment, Change in Executive Compensation Structure S&P 500 US$ Earnings Per Share US Domestic Corporate Profits US$ Billion Profits as S&P 500 GAAP (EPS, LHS) Profits as NIPA (Bill.$, RHS)

4. How are Profits Faring in the Business Cycle? National Profits Growth Rate (LHS), and Profits as Shares of Income (RHS) (Percent) How Does the Current Profit Recession Compare to the Previous Profits Recession of 1988-1992?

5. The Adjustment for Capital Consumption(to fit “bottom up” Profits with “top down” GDP) Has Become Unreliable

6. Which US Sectors are Generating Profits? Sectors with Positive and Steady Profits(Billions of US$) Sectors with Positive and Improving Profits(Billions of US$)

7. Which US Sectors are Seeing Profits Weakness? Sectors where Past Losses are Turning into Profits Recovery(Billions of US$) Sectors with Steady Profits Now Under Moderate Pressure(Billions of US$)

8. Which US Sectors are Generating Profits? Sectors With No Recovery Yet in Profits(Billions of US$) Sectors with Exposure to Oil Related Factors(Billions of US$)

9. Return On Equity (ROE) as Measure of Profitability “DuPont System” ROE Frameworkshows 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 all other capital suppliers) • DuPont Ratio Interpretation: ROE is always described by some combination of: Øprofit margins, reflecting efficiency in production, the mixture of fixed versus variable cost and/or the presence of pricing power • asset turnover, showing the degree to which company assets are generating sales • financial leverage, showing the extent to which the asset base is financed by debt • In this framework, the component “DuPont” ratios outline the relationship that profits have with sales, pricing power, balance sheets and industry structure. • ROE Framework Identity: • Return on Equity (NI/Equity) = • Profit Margin (NI/Sales) * • Asset Turnover (Sales/Assets) * • Financial Leverage (Asset/Equity) • Where: NI = Net Income; Equity = Book Value of Equity, Valued at the End of the Preceding Period; Assets are Total Current Period; Sales are Gross; • ( * Denotes a multiplication sign)

10. Return On Equity shows rate of return that management earns on capital provided by the shareholders • What has been the Return on Equity Performance? • US Posted Excellent ROE record through 1997: • Problem of Falling Asset Efficiency, related to M&A purchases and CapEx spending • Largely offset by Production Efficiency, Rising Margins • Increase in Operating Leverage Pressures on margins built up from Mid 1990s: • Compression from Asian / Russian crises in 1998 • Increase in Financial leverage to compensate • What Happened in 2001-2002? • High operating leverage killed margins when growth slowed • Deteriorating credit quality and corporate malfeasance • Markets forcing a de leveraging of balance sheets US Corporate Return on Equity Total for 1500 US Corporations in the GICS Sector Classification Scheme ROE in % Component Ratios

11. Sector Level Return On Equity shows some saints and sinners ROE Telecommunication Services Total for all US Corporations in the Telecommunications GICS Sector ROE for Health Care Total for all US Corporations in the Health Care GICS Sector ROE in % Component Ratios ROE in % Component Ratios

12. Sector Level Return On Equity shows a tale of two different consumer sectors ROE for Consumer Discretionary Total for all US Corporations in the Consumer Discretionary GICS Sector ROE for Consumer Staples Total for all US Corporations in the Consumer Staples GICS Sector ROE in % Component Ratios ROE in % Component Ratios

13. How Much Financial Leverage Will Markets Allow? • Which Sectors have Restructured their Balance Sheets? • Sectors that have not materially increased their leverage, remain in good shape • Health Care • Financials (Used Leverage 1996-7 but quickly unwound it) • Consumer Staples Sectors that had increased leverage in late 1990s, but have now reversed that trend: • Energy • Information Technology (used equity not debt) • Sectors with significant financial leverage: • Consumer Discretionary: • Autos in bad shape • Media is reforming • Sectors with Assets (A/E) Down, but Debt (D/E) Up: • Capital Goods • Industrial Materials • Telecommunications • Utilities Measures of Financial Leverage Totals for 1500 US Corporations in the GICS Sector Classification Scheme

14. How Will ROE Rise From Here? • Improvement in Profit Margins remains the most likely source of near term earnings growth: • This economy was built for speed – interaction among operating leverage, capacity utilization, profit margins • Significant cost reductions already achieved • Many sectors will need growth in CapEx to generate profits increase • Financial Re Structuring has been in vogue, but will markets allow for additional debt? • CapEx increasingly funded with retained earnings • Return on Investment receives greater scrutiny by investors • Raising the profile of net income relative to current operating profits • Asset turnover is at low point, there is room to rise from here, but long term trend is down • Already quite a lot has been accomplished in asset re pricing, adjustments for credit quality, impairment write-offs • Yet any sizeable increase in M&A and CapEx will limit room for much further improvement in asset efficiency

15. Outlook for US Sector Profits Sector Profits Set for a Cyclical Rebound(Average Percent Growth of US Sector Operating Profits, Top 10 GICS Economic Sectors)

16. Title Goes Here Thank you! Mark Killion, CFA Managing Director World Industry Services Global Insight, Inc. Phone: 610 490 2547 email: mark.killion@globalinsight.com