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By Shawn Tully, senior editor at large
Last Updated: April 21, 2009: 1:02 PM ET

A scary kind of leverage

The boom, however, was built on sand. America's consumers were borrowing against their homes to take vacations, go out for meals, and remodel their houses. "Families were using debt to increase their spending far faster than their incomes were growing," says economist Doug Cliggott of Dover Management, a mutual fund firm. The crunch hit hard when banks started taking big losses and radically reined in credit in the second half of last year. In the fourth quarter of 2008, consumer spending took the biggest three-month drop since the 1982 recession. That wasn't the only problem. The dollar's rising value vs. the euro and other currencies, coupled with the global recession, pounded America's exports. They dropped with the same ferocity as consumer spending.

In the fourth quarter, GDP sank a blistering 6.3%, as a pall fell over sales for the 500's vast panoply of products. It gets worse. At the same time volumes tumbled, so did prices. From September to December the consumer price index dropped 8.3% on an annualized basis as restaurants, clothing outlets, casinos, and hardware stores offered deep discounts to attract cash-strapped consumers.

Here's where the jolting reversal in operating leverage crippled profits. Not only did the Fortune 500 suffer from a sharp decline in units being sold because consumers switched from spending to saving, but profits were also hit by a disastrous shrinkage in margins. That shrinkage came in two parts. The first was the fall in prices for each shirt or lawn mower. The second proved a painful surprise: Unit labor costs actually rose in the heart of the downturn.

How did that happen at the same time unemployment rose painfully fast? The simple answer is that the deterioration in business was so sudden and stunning that companies couldn't cut their workforces nearly as quickly as their output dropped. As plants slowed down, workers had less to do. "So the hours spent on each unit rose," says Zandi. That translated into a decline in productivity. General Motors eliminated shifts at its plants, and AK Steel idled factories. In January auto systems manufacturer Visteon put workers on a four-day week for the month. But wages paid per hour actually rose because of bonuses and raises promised earlier in the year, when the labor markets were still fairly tight. All told, unit labor costs jumped 5.7% in the fourth quarter, at the same time prices for those shirts and lawn mowers crumbled. Hence, the margins for those products either became whisker-thin or turned into a loss for every unit sold. That shrinkage in margins is what constitutes the negative operating leverage plaguing the Fortune 500.

Let's examine what the collapse in operating margins did to the profits of two healthy consumer cyclicals, toolmaker Black & Decker and retailer Home Depot. In both cases the recession pounded revenues while costs fell far less, so margins and profits dropped sharply. At Black & Decker sales fell from $6.45 billion in 2006 to $6.1 billion in 2008, or $350 million. But costs fell by only half that amount. B&D's labor costs, as for most manufacturers, remained sticky, and it battled the rising price of materials such as steel. B&D's interest expense also rose by around $26 million because of the steep increase in rates on corporate debt. As a result, B&D's profits fell from $486 million to $294 million. At Home Depot sales dropped 21%, to $71.3 billion, from 2006 to 2008 as the home-remodeling boom deflated. (Home Depot also sold its wholesale distribution business.) But costs - chiefly personnel - fell 18%, or $3.5 billion less, so margins on lumber and light bulbs tightened. The decline in operating leverage helped shave profits by 61%, to $2.26 billion.

It's a force as powerful as the tide, but we know how that works. This year's profit implosion isn't any more durable than the profit bubble of two years ago. Earnings move in big cycles, and they're destined to recover as labor costs fall, the demise of weak players improves pricing, and the consumer is coaxed back to anything like normal spending, even if families remain conservative. Profits have a way of roaring out of steep slumps. And this one is about as steep as they get. To top of page

Company Price Change % Change
General Electric Co 8.79 -0.17 -1.90%
Bank of America Corp... 31.02 0.67 2.21%
Advanced Micro Devic... 32.03 1.06 3.42%
Ford Motor Co 9.03 -0.26 -2.80%
Halliburton Co 19.61 1.18 6.40%
Data as of Oct 21
Index Last Change % Change
Dow 26,827.64 57.44 0.21%
Nasdaq 8,162.99 73.44 0.91%
S&P 500 3,006.72 20.52 0.69%
Treasuries 1.79 0.05 2.58%
Data as of 2:08am ET
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