Copyright ©2003 Global Insight, Inc. Outlook for Corporate Profits Which are the Leading Sectors? Mark Killion, CFA Managing Director August 2003

Copyright ©2003 Global Insight, Inc. 2 Outlook 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:

Copyright ©2003 Global Insight, Inc. 3 Profits as S&P 500 GAAP (EPS, LHS) Profits as NIPA (Bill.$, RHS) S&P 500 US$ Earnings Per ShareU.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 Changes Recent 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 Profits Source: 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 ? How Are U.S. Profits Faring in the Business Cycle? U.S. Corporate Profits in Quarters After Cycle Peaks (88-92 vs ) (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. 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. BEA

Copyright ©2003 Global Insight, Inc. 5 Sectors with Positive and Improving Profits (Billions of US$) Sectors with Positive and Steady Profits (Billions of US$) Sectors with Positive and Steady Profits (Billions of US$) Which U.S. Sectors Are Generating Profits? Source: U.S. BEA Annual Last 8 Quarters Annual

Copyright ©2003 Global Insight, Inc. 6 Sectors With Steady Profits Now Under Moderate Pressure (Billions of US$) Sectors Where Past Losses are Turning into Profits Recovery (Billions of US$) Sectors Where Past Losses are Turning into Profits Recovery (Billions of US$) Which U.S. Sectors Are Recovering or Stalling? Source: U.S. BEA Annual Annual Last 8 Quarters

Copyright ©2003 Global Insight, Inc. 7 Sectors with Exposure to Oil Related Factors (Billions of US$) Sectors With No Recovery Yet in Profits (Billions of US$) Sectors With No Recovery Yet in Profits (Billions of US$) Which U.S. Sectors Are Generating Profits? Source: U.S. BEA Annual Annual Last 8 Quarters

Copyright ©2003 Global Insight, Inc. 8 One-year Historical $EPS Growth for U.S. Sectors Ranked by Fastest to Slowest EPS Growth (Latest 4 Quarter EPS Dollar Increase over Previous 4 Quarters: Q Q EPS as $ Increase/Decrease over Q Q EPS ) Which U.S. Sectors Are Generating Profit Growth? -$1.54 $1.35 $19.94 $11.5 $2.32 $13.54 $8.35 $1.9 $8.27 Source: Standard & Poor’s

Copyright ©2003 Global Insight, Inc. 9 Compare the Latest Profits Trends in the U.S. to the U.K. United States Corporate Profits Growth Rate (LHS) and Profits as Shares of GDP (RHS ) (Percent) United Kingdom Corporate Profits Growth Rate (LHS) and Profits as Shares of GDP (RHS ) (Percent) Source: GII World Economic Service

Copyright ©2003 Global Insight, Inc. 10 What Are the Latest Trends in European Profits? Compare Germany to France France Corporate Profits Growth Rate (LHS) and Profits as Shares of GDP (RHS ) (Percent) Germany Corporate Profits Growth Rate (LHS) and Profits as Shares of GDP (RHS ) (Percent) Source: GII World Economic Service

Copyright ©2003 Global Insight, Inc. 11 Return On Equity (ROE) as Measure of Profitability ROE 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) 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) DuPont Ratio Interpretation: ROE is always described by some combination of: ROE is always described by some combination of:  profit 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. “DuPont System” ROE framework shows 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) Source: Investment Analysis and Portfolio Management, By Frank K. Reilly & Keith C. Brown By Frank K. Reilly & Keith C. Brown South-Western, Nov South-Western, Nov

Copyright ©2003 Global Insight, Inc. 12 Return On Equity shows rate of return that management earns on capital provided by the shareholders. What Has Been the Return on Equity Performance in the United States? U.S. posted excellent ROE record through 1997:  Problem of falling asset efficiency, related to M&A purchases and CapEx spending  Largely offset by production efficiency and 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 ?  High operating leverage killed margins when growth slowed  Deteriorating credit quality and corporate malfeasance  Markets forcing a de-leveraging of balance sheets Component Ratios ROE in % U.S. Corporate Return on Equity Total for 1,500 U.S. Corporations in the GICS Sector Classification Scheme Total for 1,500 U.S. Corporations in the GICS Sector Classification Scheme Source: Worldscope Company Financial Statements

Copyright ©2003 Global Insight, Inc. 13 Return On Equity for European Listed Companies United Kingdom Corporate Return on Equity Corporate Return on Equity Total for 300 Corporations in the GICS Sector Classification Scheme Total for 300 Corporations in the GICS Sector Classification Scheme Continental Europe Corporate Return on Equity Corporate Return on Equity Total for 500 Corporations in the GICS Sector Classification Scheme Total for 500 Corporations in the GICS Sector Classification Scheme Component Ratios ROE in % Component Ratios Source: Worldscope Company Financial Statements

Copyright ©2003 Global Insight, Inc. 14 What Is the Sector ROE Performance? Five-year Historical ROE for U.S. and Continental European Sectors Ranked by European Perspective – Largest to Smallest (Average ROE for U.S. & European Sectors—excl. U.K.—Average over , Top 10 GICS Economic Sectors) Source: Worldscope Company Financial Statements & GII Calculations

Copyright ©2003 Global Insight, Inc. 15 Sector Level Return On Equity —Health Care Comparison of Europe and United States ROE in %Component Ratios European Health Care Total for all European (excl. U.K.) Corporations in the Health Care GICS Sector U.S. Health Care Total for All U.S. Corporations in the Health Care GICS Sector ROE in %Component Ratios Source: Worldscope Company Financial Statements

Copyright ©2003 Global Insight, Inc. 16 ROE in %Component Ratios ROE for U.S. Telecommunication Services Total for All U.S. Corporations in the Telecommunications GICS Sector ROE for European Telecommunication Services Total for all European (excl. U.K.) Corporations in the Telecommunications GICS Sector Sector Level Return On Equity —Telecommunications Comparison of Europe and United States Component RatiosROE in % Source: Worldscope Company Financial Statements

Copyright ©2003 Global Insight, Inc. 17 Sector Level Return On Equity shows a tale of two different U.S. consumer sectors Component RatiosROE in % ROE for U.S. Consumer Staples Total for all U.S. Corporations in the Consumer Staples GICS Sector ROE in %Component Ratios ROE for U.S. Consumer Discretionary Total for all U.S. Corporations in the Consumer Discretionary GICS Sector Source: Worldscope Company Financial Statements

Copyright ©2003 Global Insight, Inc. 18 Sector Level Return On Equity shows a tale of two different European consumer sectors ROE for European Consumer Staples Total for all European (excl. U.K.) Corporations in the Consumer Staples GICS Sector ROE for European Consumer Discretionary Total for all European (excl. U.K.) Corporations in the Consumer Discretionary GICS Sector ROE in % Component Ratios Source: 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? Source: GII World Industry Service

Copyright ©2003 Global Insight, Inc. 20 Will Profit Margins Rise in Key Growth Sectors? Technology and Financial Sectors in U.S. and Europe Operating Profit Margin for All Companies in the Financial Sector in the GICS Classification Scheme Operating Profit Margins (Excludes Depreciation and Write-offs) (Comparison between U.S., U.K., and Continental Europe) Operating Profit Margin for All Companies in the Technology Sector in the GICS Classification Scheme Source: Worldscope Company Financial Statements

Copyright ©2003 Global Insight, Inc. 21 Degree of Operating Leverage 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 Shows Higher Leverage, Below 1 Shows Lower Leverage ( ) Sector DOLs for World Total: Industrial Chemicals 0.71 Medical Technology 0.80 Communication Services 0.86 Wholesale & Retail Trade 1.07 Drugs & Medicine 1.10 Banking & Insurance 1.33 Motor Vehicles 1.71 Source: GII World Industry Service

Copyright ©2003 Global Insight, Inc. 22 How Much Financial Leverage Will Markets Allow? European Totals for All Non-financial Corporations in the GICS Sector Classification Scheme U.S. Totals for All Non-financial Corporations in the GICS Sector Classification Scheme Measures of Financial Leverage (Financial Multiplier, Gearing Ratio, and Interest Expense Ratio) Source: Worldscope Company Financial Statements

Copyright ©2003 Global Insight, Inc. 23 Sector Level Return On Equity —Industrials Sector Level Example of the Use of Financial Leverage European Industrials Sector Total for all European (excl. U.K.) Corporations in the Industrials GICS Sector Measures of Financial Leverage Return On Equity ROE in %Component Ratios Source: Worldscope Company Financial Statements & GII Calculations

Copyright ©2003 Global Insight, Inc. 24 Which U.S. Sectors Have the Highest Gearing Ratio (Debt to Equity)? Sectors with Steady/Declines in D/E Ratio Sectors with High/Buildup in D/E Ratio U.S. Sector “Saints” and “Sinners” with Financial Leverage (Gearing Ratio: Ratio of Debt to Equity) Source: Worldscope Company Financial Statements & GII Calculations

Copyright ©2003 Global Insight, Inc. 25 Which European Sectors have the Highest Gearing Ratio (Debt to Equity)? Sectors with Declines in D/E Ratio Sectors with Buildup in D/E Ratio European Sector “Saints” and “Sinners” with Financial Leverage (Gearing Ratio: Ratio of Debt to Equity) Source: Worldscope Company Financial Statements & GII Calculations

Copyright ©2003 Global Insight, Inc. 26 Rank of U.S. & European Sector Profits Growth Long-term “Normalized” Sector Profits Growth (Average Percent Growth of Operating Profits, Forecast for , Top 10 GICS Economic Sectors) Source: GII World Industry Service

Copyright ©2003 Global Insight, Inc. 27 Thank you! Mark Killion, CFA Managing Director World Industry Services Global Insight, Inc. Phone: