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Copyright ©2003 Global Insight, Inc.
Outlook for Corporate ProfitsOutlook for Corporate ProfitsWhich are the Leading Sectors?Which are the Leading Sectors?
Mark Killion, CFAManaging Director
August 2003
Copyright ©2003 Global Insight, Inc. 2
Outlook for U.S. & European Corporate ProfitsOutlook for U.S. & European Corporate Profits
Corporate profits are key to: Understanding asset valuation, credit quality Anticipating the CapEx cycle and employment growth
Corporate GAAP net income is more volatile than NIA operating profits
What have been the recent trends in each?
ROE framework to analyze future prospects for profits
Impact of operating leverage and financial efficiency
Which sectors are winners and losers?
Agenda:Agenda:
Copyright ©2003 Global Insight, Inc. 3
0
5
10
15
20
25
30
35
40
45
50
55
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
E
20
04
E 0
100
200
300
400
500
600
700
800
900
1000
1100
Profits as S&P 500 GAAP from SEC (EPS, LHS)
Profits as NIPA from IRS via BEA (Bill.$, RHS)
Profits as S&P 500 GAAP (EPS, LHS)
Profits as NIPA (Bill.$, RHS)
S&P 500 US$ Earnings Per Share U.S. Domestic Corporate Profits, US$ Billions
Corporate GAAP profits (filed with SEC) are more volatile than NIPA operating profits (filed with IRS and used by BEA), largely due to:
--Balance Sheet Impacts --Regulatory ChangesRecent examples:
2000—Goodwill write-offs and decline in credit quality
2001—Corporate fraud, asset impairment, bankruptcy, and bad loans
2002—Expensing stock options, CEO certification, and E&O insurance
2003—Year of pension expense adjustment, change in executive compensation structure, and dividend taxation
Two Measures of U.S. Corporate ProfitsTwo Measures of U.S. Corporate Profits
Source: Standard & Poor’s, U.S. BEA, GII ForecastsSource: Standard & Poor’s, U.S. BEA, GII Forecasts
Copyright ©2003 Global Insight, Inc. 4
How Does the Current Profit Recession Compare to the Previous Profits Recession of 1988-92?
How Are U.S. Profits Faring in the Business Cycle?How Are U.S. Profits Faring in the Business Cycle?
60
70
80
90
100
110
120
130
140
-7 -5 -3 -1 1 3 5 7 9 11 13 15 17 19 21
Ind
ex
10
0 =
Cy
cle
Pe
ak
Index for 1988 Q4 to 1994 Q1
Index for 1997 Q4 to 2003 Q1
1997 Q4 to 2003 Q1--No CCA Adjustment
U.S. Corporate Profits in Quarters After Cycle Peaks (88-92 vs. 97-03) (Index = 100 at Cycles Peak of Corporate Profits: 1988 Q4 and 1997 Q4)
88Q4-94Q1 with CCA Adj.
97Q4-03Q1 with CCA Adj.
97Q4-03Q1 -- No CCA Adj.
0
20
40
60
80
100
120
140
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Ad
jus
tme
nt
in B
ill.
US
$
0
5
10
15
20
25
30
35
Ad
jus
tme
nt
as
% o
f P
rofi
ts
CCA Adjustment in US$ (LHS)
CCA Adjustment as % of Base (RHS)
The Adjustment for Capital Consumption Has Become Unreliable
(CCA Adjustment from Tax-based to Economic Depreciation Rates Where a Positive Number indicates a Boost to NIA Corporate Profits, by Taking Back Some
Tax-based Depreciation Claimed Against Profits)
Source: U.S. BEASource: U.S. BEA
Copyright ©2003 Global Insight, Inc. 5
0
50
100
150
200
250
1995 1996 1997 1998 1999 2000 2001-II
2001-III
2001-IV
2002-I
2002-II
2002-III
2002-IV
2003-I
Wholesale Trade
Receipts from Rest of World
0
50
100
150
200
250
1995 1996 1997 1998 1999 2000 2001-II
2001-III
2001-IV
2002-I
2002-II
2002-III
2002-IV
2003-I
Food & Related ProductsFinancial NonBankingElectricity & Utilities
Sectors with Positive and Improving ProfitsSectors with Positive and Improving Profits(Billions of US$)(Billions of US$)
Sectors with Positive and Steady ProfitsSectors with Positive and Steady Profits(Billions of US$)(Billions of US$)
Which U.S. Sectors Are Generating Profits?Which U.S. Sectors Are Generating Profits?
Source: U.S. BEA Source: U.S. BEA
AnnualAnnual Last 8 QuartersLast 8 Quarters AnnualAnnual Last 8 QuartersLast 8 Quarters
Copyright ©2003 Global Insight, Inc. 6
0
10
20
30
40
50
60
70
80
90
100
1995 1996 1997 1998 1999 2000 2001-II
2001-III
2001-IV
2002-I
2002-II
2002-III
2002-IV
2003-I
Banking (In Federal Reserve System)
Retail Trade
-10
-5
0
5
10
15
20
25
1995 1996 1997 1998 1999 2000 2001-II
2001-III
2001-IV
2002-I
2002-II
2002-III
2002-IV
2003-I
Electronic & Electrical
Steel & MetalsTransportation Services
Sectors With Steady Profits Now Under Sectors With Steady Profits Now Under Moderate PressureModerate Pressure
(Billions of US$)(Billions of US$)
Sectors Where Past Losses are Turning into Sectors Where Past Losses are Turning into Profits RecoveryProfits Recovery
(Billions of US$)(Billions of US$)
Which U.S. Sectors Are Recovering or Stalling?Which U.S. Sectors Are Recovering or Stalling?
Source: U.S. BEASource: U.S. BEA
AnnualAnnual AnnualAnnualLast 8 QuartersLast 8 Quarters Last 8 QuartersLast 8 Quarters
Copyright ©2003 Global Insight, Inc. 7
0
5
10
15
20
25
30
35
40
1995 1996 1997 1998 1999 2000 2001-II
2001-III
2001-IV
2002-I
2002-II
2002-III
2002-IV
2003-I
Petroleum & Coal Products
Chemicals & Products
-20
-10
0
10
20
30
40
1995 1996 1997 1998 1999 2000 2001-II
2001-III
2001-IV
2002-I
2002-II
2002-III
2002-IV
2003-I
Industrial Machinery & Equip.
Motor Vehicals & PartsCommunication Services
Sectors with Exposure to Oil Related FactorsSectors with Exposure to Oil Related Factors(Billions of US$)(Billions of US$)
Sectors With No Recovery Yet in ProfitsSectors With No Recovery Yet in Profits(Billions of US$)(Billions of US$)
Which U.S. Sectors Are Generating Profits?Which U.S. Sectors Are Generating Profits?
Source: U.S. BEASource: U.S. BEA
AnnualAnnualAnnualAnnual
Last 8 QuartersLast 8 QuartersLast 8 QuartersLast 8 Quarters
Copyright ©2003 Global Insight, Inc. 8
-10 -8 -6 -4 -2 0 2 4 6 8 10
Utilites
Energy
Materials
Industrials
Health Care
Consumers Staples
Financials
Telecommunication Services
Information Technology
Dollar Change in EPS in S&P 500 -- Most Recent 4 Quarters Sum (Ending in 2003Q1) OverPrevious 4 Quarters -- Numbers Shown on LHS are Total $EPS of 2002Q2 -- 2003Q1
One-year Historical $EPS Growth for U.S. SectorsOne-year Historical $EPS Growth for U.S. SectorsRanked by Fastest to Slowest EPS GrowthRanked by Fastest to Slowest EPS Growth
(Latest 4 Quarter EPS Dollar Increase over Previous 4 Quarters: Q2 2002 -- Q1 2003 EPS as $ Increase/Decrease over Q2 2001 -- Q1 2002 EPS )(Latest 4 Quarter EPS Dollar Increase over Previous 4 Quarters: Q2 2002 -- Q1 2003 EPS as $ Increase/Decrease over Q2 2001 -- Q1 2002 EPS )
Which U.S. Sectors Are Generating Profit Which U.S. Sectors Are Generating Profit Growth?Growth?
-$1.54-$1.54
$1.35$1.35
$19.94$19.94
$11.5$11.5
$2.32$2.32
$13.54$13.54
$8.35$8.35
$1.9$1.9
$8.27$8.27
Source: Standard & Poor’sSource: Standard & Poor’s
Copyright ©2003 Global Insight, Inc. 9
Compare the Latest Profits Trends in the U.S. to the U.K.Compare the Latest Profits Trends in the U.S. to the U.K.
-4
-1
2
5
8
11
14
17
20
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
E
2004
E
18
19
20
21
22
23
24
25
26
UK NIA Corporate Profits Growth (LHS)
UK Corporate Profits Share of GDP (RHS)
United StatesCorporate Profits Growth Rate (LHS) and
Profits as Shares of GDP (RHS)(Percent)
-8
-4
0
4
8
12
16
20
24
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003 E
2004 E
2
4
6
8
10
12
14
US NIA Corporate Profits Growth (LHS)
US Corporate Profits Share of GDP (RHS)
United KingdomCorporate Profits Growth Rate (LHS) and
Profits as Shares of GDP (RHS)(Percent)
Source: GII World Economic ServiceSource: GII World Economic Service
Copyright ©2003 Global Insight, Inc. 10
-4
-1
2
5
8
11
14
17
20
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003 E
2004 E
14
15
16
17
18
19
20
21
22
France NIA Corporate Profits Growth (LHS)
France Corporate Profits Share of GDP (RHS)
What Are the Latest Trends in European Profits?What Are the Latest Trends in European Profits?Compare Germany to FranceCompare Germany to France
FranceCorporate Profits Growth Rate (LHS) and
Profits as Shares of GDP (RHS)(Percent)
-4
-1
2
5
8
11
14
17
20
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003 E
2004 E
14
15
16
17
18
19
20
21
22
Germany NIA Corporate Profits Growth (LHS)
Germany Corporate Profits Share of GDP (RHS)
GermanyCorporate Profits Growth Rate (LHS) and
Profits as Shares of GDP (RHS)(Percent)
Source: GII World Economic ServiceSource: GII World Economic Service
Copyright ©2003 Global Insight, Inc. 11
Return On Equity (ROE) as Measure of ProfitabilityReturn On Equity (ROE) as Measure of Profitability
ROE Framework IdentityROE Framework Identity::
Return on Equity (NI/Equity) =Return on Equity (NI/Equity) =
Profit Margin (NI/Sales) *Profit Margin (NI/Sales) *
Asset Turnover (Sales/Assets) *Asset Turnover (Sales/Assets) *
Financial Leverage (Asset/Equity)Financial Leverage (Asset/Equity)
Where: NI = Net Income; Equity = Book Value of Where: NI = Net Income; Equity = Book Value of Equity, Valued at the End of the Preceding Period; Equity, Valued at the End of the Preceding Period; Assets Are Total Current Period; Sales Are Gross;Assets Are Total Current Period; Sales Are Gross;
( * Denotes a multiplication sign)( * Denotes a multiplication sign)
DuPont Ratio InterpretationDuPont Ratio Interpretation::
ROE is always described by some combination of:ROE is always described by some combination of:
profit margins,profit margins, reflecting efficiency in production, the mixture reflecting efficiency in production, the mixture of fixed versus variable cost, and/or the presence of pricing powerof fixed versus variable cost, and/or the presence of pricing power
asset turnover,asset turnover, showing the degree to which company assets showing the degree to which company assets are generating salesare generating sales
financial leverage,financial leverage, showing the extent to which the asset showing the extent to which the asset base is financed by debtbase is financed by debt
In this framework, the component “DuPont” ratios In this framework, the component “DuPont” ratios outline the relationship that profits have with sales, outline the relationship that profits have with sales, pricing power, balance sheets, and industry structure. pricing power, balance sheets, and industry structure.
““DuPont System” ROE frameworkDuPont System” ROE framework shows the shows the rate of return that rate of return that management earns on capital provided by the shareholdersmanagement earns on capital provided by the shareholders
(Profits calculated (Profits calculated relative to the equity interest, after accounting for payments to all other capital suppliers)relative to the equity interest, after accounting for payments to all other capital suppliers)
Source: Source: Investment Analysis and Portfolio ManagementInvestment Analysis and Portfolio Management, , ByBy Frank K. ReillyFrank K. Reilly & & Keith C . BrownKeith C . Brown South-Western, Nov. 2002.South-Western, Nov. 2002.
Copyright ©2003 Global Insight, Inc. 12
Return On Equity Return On Equity shows shows rate of return that management rate of return that management earns on capital provided by the shareholders.earns on capital provided by the shareholders.
0
2
4
6
8
10
12
14
16
18
20
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
0
2
4
6
8
10
12
ROE (%) LHSMargin (%) RHSFinancial Leverage (Ratio) RHSAsset Turnover (Ratio*10) RHS
What Has Been the Return on Equity What Has Been the Return on Equity Performance in the United States?Performance in the United States?
U.S. posted excellent ROE record through 1997:U.S. posted excellent ROE record through 1997:
Problem of falling asset efficiency, related to M&A purchases Problem of falling asset efficiency, related to M&A purchases and CapEx spendingand CapEx spendingLargely offset by production efficiency and rising marginsLargely offset by production efficiency and rising marginsIncrease in operating leverageIncrease in operating leverage
Pressures on margins built up from mid-1990s:Pressures on margins built up from mid-1990s:
Compression from Asian / Russian crises in 1998Compression from Asian / Russian crises in 1998Increase in financial leverage to compensateIncrease in financial leverage to compensate
What happened in 2001-02?What happened in 2001-02?
High operating leverage killed margins when growth slowedHigh operating leverage killed margins when growth slowedDeteriorating credit quality and corporate malfeasanceDeteriorating credit quality and corporate malfeasanceMarkets forcing a de-leveraging of balance sheetsMarkets forcing a de-leveraging of balance sheets
Component RatiosROE in %
U.S. Corporate Return on EquityU.S. Corporate Return on Equity Total for 1,500 U.S. Corporations in the Total for 1,500 U.S. Corporations in the
GICS Sector Classification SchemeGICS Sector Classification Scheme
Source: Worldscope Company Financial StatementsSource: Worldscope Company Financial Statements
Copyright ©2003 Global Insight, Inc. 13
Return On Equity Return On Equity for European Listed Companiesfor European Listed Companies
United KingdomUnited Kingdom Corporate Return on EquityCorporate Return on Equity
Total for 300 Corporations in the GICS Total for 300 Corporations in the GICS Sector Classification SchemeSector Classification Scheme
Continental EuropeContinental Europe Corporate Return on EquityCorporate Return on Equity
Total for 500 Corporations in the GICS Total for 500 Corporations in the GICS Sector Classification SchemeSector Classification Scheme
0
2
4
6
8
10
12
14
16
18
20
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
0
2
4
6
8
10
12
ROE (%) LHSMargin (%) RHSFinancial Leverage (Ratio) RHSAsset Turnover (Ratio*10) RHS
0
2
4
6
8
10
12
14
16
18
20
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
0
2
4
6
8
10
12
ROE (%) LHSMargin (%) RHSFinancial Leverage (Ratio) RHSAsset Turnover (Ratio*10) RHS
Component RatiosROE in %
ROE in % Component Ratios
Source: Worldscope Company Financial StatementsSource: Worldscope Company Financial Statements
Copyright ©2003 Global Insight, Inc. 14
0 5 10 15 20 25
Telecommunication Svs.
Consumer Discretionary
Information Technology
Total
Industrials
Materials
Utilities
Financials
Health Care
Energy
Consumer Staples
United States Europe
What Is the Sector ROE Performance?What Is the Sector ROE Performance?
Five-year Historical ROE for U.S. and Continental European SectorsFive-year Historical ROE for U.S. and Continental European SectorsRanked by European Perspective – Largest to SmallestRanked by European Perspective – Largest to Smallest
(Average ROE for U.S. & European Sectors(Average ROE for U.S. & European Sectors——excl. U.K.excl. U.K.—A—Average over 1998-2002, Top 10 GICS Economic Sectors)verage over 1998-2002, Top 10 GICS Economic Sectors)
Source: Worldscope Company Financial Statements & Source: Worldscope Company Financial Statements & GII CalculationsGII Calculations
Copyright ©2003 Global Insight, Inc. 15
Sector Level Return On EquitySector Level Return On Equity——Health CareHealth CareComparison of Europe and United StatesComparison of Europe and United States
ROE in % Component Ratios
European Health CareEuropean Health CareTotal for all European (excl. U.K.) Total for all European (excl. U.K.)
Corporations in the Health Care GICS Corporations in the Health Care GICS SectorSector
U.S. Health CareU.S. Health CareTotal for All U.S. Corporations in the Total for All U.S. Corporations in the
Health Care GICS SectorHealth Care GICS Sector
0
5
10
15
20
25
30
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
0
3
6
9
12
15
ROE (%) LHSMargin (%) RHSFinancial Leverage (Ratio) RHSAsset Turnover (Ratio*10) RHS
0
5
10
15
20
25
30
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
0
3
6
9
12
15
ROE (%) LHSMargin (%) RHSFinancial Leverage (Ratio) RHSAsset Turnover (Ratio*10) RHS
ROE in % Component Ratios
Source: Worldscope Company Financial StatementsSource: Worldscope Company Financial Statements
Copyright ©2003 Global Insight, Inc. 16
0
5
10
15
20
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
-10
-5
0
5
10
15
ROE (%) LHSMargin (%) RHSFinancial Leverage (Ratio) RHSAsset Turnover (Ratio*10) RHS
ROE in % Component Ratios
ROE for U.S. Telecommunication ServicesROE for U.S. Telecommunication ServicesTotal for All U.S. Corporations in the Total for All U.S. Corporations in the
Telecommunications GICS SectorTelecommunications GICS Sector
ROE for European Telecommunication ServicesROE for European Telecommunication ServicesTotal for all European (excl. U.K.) Corporations in the Total for all European (excl. U.K.) Corporations in the
Telecommunications GICS SectorTelecommunications GICS Sector
Sector Level Return On EquitySector Level Return On Equity——TelecommunicationsTelecommunicationsComparison of Europe and United StatesComparison of Europe and United States
-15
-10
-5
0
5
10
15
20
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
-25
-20
-15
-10
-5
0
5
10
15
ROE (%) LHSMargin (%) RHSFinancial Leverage (Ratio) RHSAsset Turnover (Ratio*10) RHS
Component RatiosROE in %
Source: Worldscope Company Financial StatementsSource: Worldscope Company Financial Statements
Copyright ©2003 Global Insight, Inc. 17
Sector Level Return On Equity Sector Level Return On Equity shows a tale of two shows a tale of two
different different U.S.U.S. consumer sectors consumer sectors
0
5
10
15
20
25
30
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
0
3
6
9
12
15
ROE (%) LHS
Margin (%) RHS
Financial Leverage (Ratio) RHS
Asset Turnover (Ratio*10) RHS
Component RatiosROE in %
0
5
10
15
20
25
30
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
0
3
6
9
12
15
ROE (%) LHSMargin (%) RHS
Financial Leverage (Ratio) RHSAsset Turnover (Ratio*10) RHS
ROE for U.S. ROE for U.S. Consumer StaplesConsumer StaplesTotal for all U.S. Corporations in the Total for all U.S. Corporations in the
Consumer Staples GICS SectorConsumer Staples GICS Sector
ROE in % Component Ratios
ROE for U.S. ROE for U.S. Consumer DiscretionaryConsumer DiscretionaryTotal for all U.S. Corporations in the Consumer Total for all U.S. Corporations in the Consumer
Discretionary GICS SectorDiscretionary GICS Sector
Source: Worldscope Company Financial StatementsSource: Worldscope Company Financial Statements
Copyright ©2003 Global Insight, Inc. 18
Sector Level Return On Equity Sector Level Return On Equity shows a tale of two shows a tale of two
different different EuropeanEuropean consumer sectors consumer sectors
ROE for European ROE for European Consumer StaplesConsumer StaplesTotal for all European (excl. U.K.) Total for all European (excl. U.K.)
Corporations in the Consumer Staples GICS Corporations in the Consumer Staples GICS SectorSector
ROE for European ROE for European Consumer DiscretionaryConsumer DiscretionaryTotal for all European (excl. U.K.) Corporations in the Total for all European (excl. U.K.) Corporations in the
Consumer Discretionary GICS SectorConsumer Discretionary GICS Sector
-5
0
5
10
15
20
25
30
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
-5
0
5
10
15
ROE (%) LHSMargin (%) RHSFinancial Leverage (Ratio) RHSAsset Turnover (Ratio*10) RHS
0
5
10
15
20
25
30
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
0
5
10
15
ROE (%) LHSMargin (%) RHSFinancial Leverage (Ratio) RHSAsset Turnover (Ratio*10) RHS
ROE in % ROE in % Component Ratios Component Ratios
Source: Worldscope Company Financial StatementsSource: Worldscope Company Financial Statements
Copyright ©2003 Global Insight, Inc. 19
Improvement in profit margins remains the most likely source of near-term earnings growth:
Interaction among operating leverage, capacity utilization, and profit margins Some operating cost reductions already achieved Many sectors will need growth in CapEx to generate high margins
Financial restructuring 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, but long-term trend is down
Already quite a lot has been accomplished in asset repricing, adjustments for credit quality, and impairment write-offs
Some sectors showing recent pickup in asset turnover Any sizeable increase in M&A and CapEx will limit room for improvement in
asset efficiency
How Will Corporate ROE Rise from Here?How Will Corporate ROE Rise from Here?
Source: GII World Industry ServiceSource: GII World Industry Service
Copyright ©2003 Global Insight, Inc. 20
Will Profit Margins Rise in Key Growth Sectors?Will Profit Margins Rise in Key Growth Sectors?Technology and Financial Sectors in U.S. and EuropeTechnology and Financial Sectors in U.S. and Europe
-5
0
5
10
15
20
'91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02
United StatesUnited KingdomEurope (X UK)
Operating Profit Margin for All Operating Profit Margin for All Companies in the Companies in the FinancialFinancial Sector Sector in in
the GICS Classification Schemethe GICS Classification Scheme
Operating Profit Margins Operating Profit Margins (Excludes Depreciation and Write-offs) (Excludes Depreciation and Write-offs) (Comparison between U.S., U.K., and Continental Europe)(Comparison between U.S., U.K., and Continental Europe)
-5
0
5
10
15
20
'91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02
United StatesUnited KingdomEurope (X UK)
Operating Profit Margin for All Operating Profit Margin for All Companies in the Companies in the TechnologyTechnology Sector Sector
in the GICS Classification Schemein the GICS Classification Scheme
Source: Worldscope Company Financial StatementsSource: Worldscope Company Financial Statements
Copyright ©2003 Global Insight, Inc. 21
Degree of Operating LeverageDegree of Operating Leverage
How Do Sector Profits Change with Sales Growth?How Do Sector Profits Change with Sales Growth?
Degree of Operational Leverage (DOL) summarizes how changes in sales growth affect profits growth
DOL reflects mix of fixed costs versus variable costs in business operations
Sectors with high fixed costs and/or big CapEx needs often have higher DOL
Sector Beta Relating Operating Profits to Sector Sales Growth, Where a Number Above 1 Sector Beta Relating Operating Profits to Sector Sales Growth, Where a Number Above 1 Shows Higher Leverage, Below 1 Shows Lower Leverage (Shows Higher Leverage, Below 1 Shows Lower Leverage (1990-2002)1990-2002)
Sector DOLs for World Total:
Industrial Chemicals 0.71Medical Technology 0.80Communication Services 0.86Wholesale & Retail Trade 1.07Drugs & Medicine 1.10Banking & Insurance 1.33 Motor Vehicles 1.71
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
All
Go
od
s
Ind
ust
rial
Ch
em
ical
s
Dru
gs
&M
edic
ine
s
Mo
tor
Ve
hic
les
All
Se
rvic
es
Co
mm
Sv
s.
Wh
ole
sal
e &
Re
tail
Ba
nk
ing
&In
sura
nce
US World Exc. US
Source: GII World Industry ServiceSource: GII World Industry Service
Copyright ©2003 Global Insight, Inc. 22
How Much Financial Leverage Will Markets Allow?How Much Financial Leverage Will Markets Allow?
2
2.5
3
3.5
4
4.5
5
'91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '020.5
1
1.5
Interest Expense as % of Total ExpenseFinancial Leverage Ratio (Asset/Equity)Ratio of Debt to Equity (RHS)
2
2.5
3
3.5
4
4.5
5
'91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '020.5
1
1.5
Interest Expense as % of Total ExpenseFinancial Leverage Ratio (Asset/Equity)Ratio of Debt to Equity (RHS)
EuropeanEuropean Totals for All Non-financial Totals for All Non-financial Corporations in the GICS Sector Corporations in the GICS Sector
Classification SchemeClassification Scheme
U.S. U.S. Totals for All Non-financial Totals for All Non-financial Corporations in the GICS Sector Corporations in the GICS Sector
Classification SchemeClassification Scheme
Measures of Financial LeverageMeasures of Financial Leverage(Financial Multiplier, Gearing Ratio, and Interest Expense Ratio)(Financial Multiplier, Gearing Ratio, and Interest Expense Ratio)
Source: Worldscope Company Financial StatementsSource: Worldscope Company Financial Statements
Copyright ©2003 Global Insight, Inc. 23
Sector Level Return On EquitySector Level Return On Equity——IndustrialsIndustrialsSector Level Example of the Use of Financial LeverageSector Level Example of the Use of Financial Leverage
European Industrials SectorEuropean Industrials SectorTotal for all European (excl. U.K.) Corporations in the Industrials GICS SectorTotal for all European (excl. U.K.) Corporations in the Industrials GICS Sector
0
1
2
3
4
5
6
'91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '020.5
1
1.5
Interest Expense as % of Total ExpenseFinancial Leverage Ratio (Asset/Equity)Ratio of Debt to Equity (RHS)
Measures of Financial LeverageMeasures of Financial LeverageReturn On EquityReturn On Equity
0
2
4
6
8
10
12
14
16
18
20
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
0
1
2
3
4
5
6
7
8
9
10
ROE (%) LHSMargin (%) RHSFinancial Leverage (Ratio) RHSAsset Turnover (Ratio*10) RHS
ROE in % Component Ratios
Source: Worldscope Company Financial Statements & Source: Worldscope Company Financial Statements & GII CalculationsGII Calculations
Copyright ©2003 Global Insight, Inc. 24
Which U.S. Sectors Have the Highest Gearing Ratio Which U.S. Sectors Have the Highest Gearing Ratio (Debt to Equity)?(Debt to Equity)?
0
0.5
1
1.5
2
'91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02
Consumer StaplesEnergyHealth Care
Sectors with Steady/Declines in D/E RatioSectors with Steady/Declines in D/E RatioSectors with High/Buildup in D/E RatioSectors with High/Buildup in D/E Ratio
U.S. Sector “Saints” and “Sinners” with Financial LeverageU.S. Sector “Saints” and “Sinners” with Financial Leverage(Gearing Ratio: Ratio of Debt to Equity)(Gearing Ratio: Ratio of Debt to Equity)
0
0.5
1
1.5
2
'91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02
IndustrialsTelecomm--WirelessUtilities
Source: Worldscope Company Financial Statements & Source: Worldscope Company Financial Statements & GII CalculationsGII Calculations
Copyright ©2003 Global Insight, Inc. 25
Which European Sectors have the Highest Gearing Which European Sectors have the Highest Gearing Ratio (Debt to Equity)?Ratio (Debt to Equity)?
0
0.5
1
1.5
2
'91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02
TelecommunicationsEnergyMaterials
Sectors with Declines in D/E RatioSectors with Declines in D/E RatioSectors with Buildup in D/E RatioSectors with Buildup in D/E Ratio
European Sector “Saints” and “Sinners” with Financial LeverageEuropean Sector “Saints” and “Sinners” with Financial Leverage(Gearing Ratio: Ratio of Debt to Equity)(Gearing Ratio: Ratio of Debt to Equity)
0
0.5
1
1.5
2
'91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02
IndustrialsConsumer DiscretionaryUtilities
Source: Worldscope Company Financial Statements & Source: Worldscope Company Financial Statements & GII CalculationsGII Calculations
Copyright ©2003 Global Insight, Inc. 26
0 1 2 3 4 5 6 7
Energy
Materials
Consumer Staples
Utilities
Cons. Discretionary
Total
Industrials
Telecomm's
Financial
Health Care
Technology
United States in US$ Europe in Euros
Rank of U.S. & European Sector Profits GrowthRank of U.S. & European Sector Profits Growth
Long-term “Normalized” Sector Profits GrowthLong-term “Normalized” Sector Profits Growth(Average Percent Growth of Operating Profits, Forecast for 2004-08, Top 10 GICS Economic Sectors)(Average Percent Growth of Operating Profits, Forecast for 2004-08, Top 10 GICS Economic Sectors)
Source: GII World Industry ServiceSource: GII World Industry Service
Copyright ©2003 Global Insight, Inc. 27
Thank you!Thank you!
Mark Killion, CFAManaging Director
World Industry ServicesGlobal Insight, Inc.Global Insight, Inc.
Phone: 610-490-2547email: [email protected]