This week we are updating our forecast for The Value Line Industrial Composite (last published in Selection & Opinion on November 6, 2009). The Industrial Composite represents the pooled results of 886 major industrial companies and provides a yardstick for evaluating the historical performance and future prospects of the diverse industrial businesses reviewed by Value Line. All of the companies included in the Composite must possess operating histories of at least eight years. Unlike Value Line's stock market averages, the Composite is weighted by company size. Forecasts for the Industrial Composite have been published in Selection & Opinion since July 11, 1975.
The Damage Done
The final tallies for 2009 are in, and as expected, earnings among the companies comprising the Industrial Composite declined for a second consecutive year. In fact, the profit downturn accelerated last year, as share net tumbled 22%, versus a relatively mild drop of 3% in the preceding year.
Volatility in the energy sector was one of the key factors behind the deterioration in results. After many years of surging profits, the tide turned in 2009, as reduced demand and lower commodity prices caused earnings to slump to levels last seen in 2004. In fact, about two-thirds of the decline in net profits for the Industrial Composite as a whole can be attributed to energy companies of which there are but 50. Share earnings were also hindered by a paucity of stock buybacks, as companies conserved their capital while waiting to see how the financial crisis and recession played out.
Still, even after pulling energy companies out of the equation, operating profits declined 8% in 2009, indicative of a difficult operating environment for U.S. industry as a whole. Revenues were particularly weak, falling 7% (excluding energy). On the positive side, operating margins held up nicely, given the pressure on the top line. This was likely at least partly attributable to the decline in commodity prices, from the elevated levels of mid-2008, but also reflects the aggressive efforts of many companies to realign their cost structures to the realities of a challenging economic climate.
On the Mend
With the recession apparently behind us, a partial profit recovery looks to be under way. Revenues are beginning to head higher at most companies, but the rate of growth, in the aggregate, is likely to be confined to the low single digits. Consumers will likely remain reluctant to return to the freer-spending ways that characterized much of the preceding decade until there are more indications of life in the housing and labor markets. Still, the incremental revenues, layered on top of streamline cost structures, should result in wider operating margins and a respectable 6%-8% advance in operating profits in 2010.
From a balance-sheet perspective, U.S. industry has emerged from the recession in fairly strong shape. Companies have been keeping a much closer watch on their capital in recent years, as reflected in lower capital spending and reduced share repurchases. Even dividend payouts, which had roughly doubled over the previous decade, were pared back in 2009.
As suggested by last year's results, the performance of individual sectors can deviate quite substantially from that of the broader Industrial Composite. Most notably, the past decade was a rollercoaster ride for energy companies: enjoyable, but at times unnerving. By our calculations, sector profits advanced by at least 40% in four of the past 10 years, though this same period also included two years in which the bottom line fell in excess of 35%, including a decline of 56% in 2009.
By comparison, healthcare companies enjoyed relatively smooth sailing during the first decade of this century. Despite two recessions, the sector generated increased sales and earnings in each of the past 10 years. Admittedly the rate of growth slowed from the first to the second half of the decade (from the mid-teens to mid-single digits), suggesting that patent expirations and the deep recession of 2008-2009 took a toll. And, with the sector still sorting out the ramifications of recent legislation, the well-worn Wall Street maxim that past performance doesn't guarantee future results seems particularly appropriate here.