Profits face headwinds

Profit growth is trending down, after years of strong returns. SMEs are the most worried.

Surprising resilience of profit growth is good news for companies big and small. It shows that a strong economy and the resultant business and consumer spending is sufficient – given sound cost controls – to power continued profit growth.

With the December interim profit reporting season entering its final phase, listed companies have surprised on the upside. Despite some notable disappointments – such as Foster’s, Insurance Australia Group and Tabcorp – about 48% of companies have managed to beat expectations, according to AMP Capital.

Investment advisory group Wren Research says a sample of 174 companies shows a median net profit jump of 21.4% in the December half, led by the resources sector, which posted median net profit growth of 27%. On a weighted average basis (adjusted for market capitalisation), average net profit rose by 42.4%, average sales revenue was up 17.9% and the average net profit margin was 17.5%.

It sounds like a recipe for the continuation of the halcyon period for company profits that has characterised much of this decade. Wren says profit growth for the S&P/ASX 300 stocks has averaged 19.1% compound over the past three financial years, compared to the average of earnings growth since 1975, at 9.3% a year.

The natural consequence of this profit bonanza has been share price rises: local shares (as measured by the benchmark S&P/ASX 200 index) have more than doubled in since 2003. If you add in the healthy flow of dividends generated by the outstanding profitability of Australian companies, the sharemarket has delivered a total return since February 2003 of 130%.

But earnings growth is trending down. Wren Research expects the market’s average profit growth figure to fall to 8.1% in 2006-07, which would represent a seven-year low. Investors who understand regression to the mean – the tendency, over the long term, of statistical series to return to normality – would not quibble with that.

Australia’s small-to-medium businesses (SMEs) are not missing out on these salad days for Australian companies.

The February 2007 National Australia Bank business survey found SME profitability improved in the December 2006 quarter, with the profitability index climbing by five points to 25 index points. The survey had 42% of SMEs reporting good/very good profit conditions and 17% reporting poor/very poor profit conditions.

But the St George-ACCI Index of Business Conditions for the December quarter found profit growth was flat despite reasonable growth in sales revenue. The bank’s small-business survey showed that small-business conditions eased over the December quarter and that profit growth was poor.

Like big listed Australia, SMEs are also tempering their profit expectations. The NAB survey shows the 12-month profit outlook of SMEs weakening, with a net 29% of SMEs anticipating an increase in profits over the next year, down from 32% previously.

The St George-ACCI index found smaller firms, although positive, were less confident than medium and larger businesses.

The profit outlook is stronger among SMEs that have lower turnover, of $2–3 million a year. The most optimistic group was smaller SMEs in health and financial services, while mid-range SMEs’ profit outlook was most favourable in financial and accommodation services.

Among the larger SMEs (those with annual sales of $5–10 million) the profit outlook is strongest in business and transport and storage sectors.

Although the outlook remains positive, National Australia Bank chief economist Alan Oster says SMEs remain concerned about the outlook for consumer demand, the availability and cost of labour and – to a lesser extent – interest rates. In short, Australian SMEs appear have the same list of potential banes as their listed counterparts.

Go to our story, 10 steps to stronger profits for how to deal with profit pressure.