From the July-August 2008 issue of Treasury & Risk magazine

Don't Count on Profits

Profitability remains a difficult challenge even after the economy returns to health next summer, and beyond. Before the economy went south, profit growth was fairly strong. Above average productivity gains were offsetting subdued gains in labor costs. Back in the golden era (1995 to 2005), price hikes were kept to not much more than 2%. But that was enough to generate strong profit growth, which set off a long and strong bull market on Wall Street. The number of workers increased on average 1.1% annually, earnings rose about 4% a year and workers' real spending power increased by 2.2%. With a productivity gain of a little more than 2% profits (net of inflation) rose 5% a year, which rallied stocks.

Those days are gone. Productivity growth is, and will likely continue to be, somewhat slower going forward. With baby boomers retiring and fewer middle-age managers to replace them, workers will remain scarce and expensive, with the work force expected to grow by 0.7% between 2005 and 2015, pushing wages higher. What's more, the retirees aren't just workers but consumers with tighter budgets. While not an immediate concern, these factors should be considered in five- to 10-year plans.

Even without the housing bust and credit market freeze, these favorable conditions were not sustainable. Health insurance premiums were bound to start rising faster than hourly compensation, and even though the difference between the two is not nearly as wide as it was two decades ago, it has been enough to force changes, including pushing more of the cost on to the employee.

While some productivity gains have been generated from implementing information, communication, and technology, they are already showing signs of moderating. And while businesses can handle lower productivity gains in a world of scarce and expensive labor, the increased global competition and resulting inability to push through price hikes comprise the breaking point. What's more competition is likely to intensify over the next decade. One assumption then is that inflation won't grow beyond the current 2%. No acceleration in pricing, a slight deceleration in productivity and increased pressure to limit rising labor costs will combine to limit profit growth over the next 10 years to perhaps only half the growth of the past decade. It's not surprising then that so many C-suite executives are pessimistic.

True, a stronger economy will help deliver more profits on higher volumes, but unit prices could be halved. Labor cost cutting remains as difficult a goal as hiking prices in the expected business environment. And with profit growth slowing, where is the incentive for shareholders to remain as invested in stocks?

Will companies outsource more to limit profit margin erosion? Of course they will. They will also review what they produce. This has already started. One can no longer buy an Oldsmobile. They stopped making them. Fewer models, not just of cars, is another way companies will try to limit profit margin erosion. There will be other strategies as well. But the bottom line is that protecting the bottom will not end even the economy gets healthy again.


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