Cost Cuts Lift Profits but Hinder Economy

By MARK WHITEHOUSE and TIMOTHY AEPPEL U.S. stocks notched new 52-week highs again on Monday, thanks to corporate America showing better-than-expected profits. But that optimism belies deep worries among company executives about the strength of the economic recovery. Tool maker Black & Decker Corp. said earnings this quarter will be roughly twice its earlier forecast, while Dutch consumer-goods conglomerate Royal Philips Electronics NV also reported an unexpected profit. The Dow Jones Industrial Average rose 20.86 points to 9885.80, its highest since Oct. 6, 2008. The S&P added 4.7 points to 1076.19. More Philips Posts a Profit Amid Cost Savings Ahead of the Tape: Intel's Star to Keep Twinkling WSJ.com/Earnings: News, data and more Starting with aluminum giant Alcoa Inc., which Thursday reported its first profitable quarter in a year, 78% of the 32 U.S. companies that have so far reported have beat analysts' expectations. Even so, third-quarter earnings for S&P 500 companies are predicted to fall about 25% from a year earlier, according to data provider Thomson Reuters. In an ominous sign for the economy, much of the profit is being eked out through cost cuts. Executives say they are hesitant to reinvest such profits into their businesses. With large portions of their factories, fleets and warehouses sitting idle, some say they probably won't see reason to do so for a year or more. That means job growth and any significant rise in business spending could be a long time coming. That creates a chicken-and-egg problem at a time when the unemployment rate is already nearly 10%: Without more jobs, U.S. consumers will have a hard time increasing their spending; but without that spending, businesses might see little reason to start hiring. Already, the economy is being starved of investment it needs to nurture growth. Net private investment, which includes spending on everything from machine tools to new houses, minus depreciation, fell to 0.1% of gross domestic product in the second quarter of 2009, according to the latest government data. That's the lowest level since at least 1947. "Things have stabilized, but we're trying to be extremely cautious and not anticipate the recovery before it occurs," says William Zollars, chief executive of YRC Worldwide Inc., one of the country's biggest trucking companies. "Like every other company in America, we're looking to cut back as much as possible." Freight tonnage at YRC was down 35.3% from a year earlier in the second quarter. Mr. Zollars says he hasn't seen his clients, who range from retailers to heavy industry, doing much restocking to prepare for increased business. In coming weeks, the details of earnings reports -- including items such as capital expenditures, as well as revenues for companies that sell capital goods -- will demonstrate the extent to which executives are turning their relative optimism and cash into actual investment. Bellwether companies include Intel Corp., International Business Machines Corp. and General Electric Co., scheduled to report earnings this week, followed by heavy-equipment maker Caterpillar Inc. (Oct. 20) and conglomerate Honeywell International Inc. (Oct. 23). So far, the signs aren't good. Alcoa's $77 million profit came as the company slashed its research and development spending to $39 million, down 36% from a year earlier. And while companies are finding the credit-market thaw is making it easier to borrow money they would need to expand, many are stashing these funds rather than spending them. Of the 100 largest bond issues globally this year, only seven listed expansion, investment, capital expenditures or research and development as the purpose of the money-raising, according to Dealogic. In industries ranging from apparel to heavy machinery, executives say they don't yet have enough faith in the recovery to take significant risks. Guess Inc. President and Chief Operating Officer Carlos Alberini says the fashion company plans to open 17 new stores in North America this year, compared with 60 last year. Guess intends to boost its store openings next year to develop new brands such as the G by Guess line, but the expansion plans are rare in an industry still dominated by caution, he says. "The environment is more stable," says Mr. Alberini. "But most companies will probably take more time before they start investing in growth opportunities." Even so, corporate executives on average say they are a lot more optimistic than they were a year ago, amid the financial turmoil that followed Lehman Brothers Holdings Inc.'s bankruptcy filing. In a recent survey conducted by the Conference Board, 51% of chief executives said they expect conditions in their industries to improve over the next six months, compared with 12% in the fourth quarter of 2008. Economists are also more upbeat about the broader outlook for earnings. Consulting firm Macroeconomic Advisers expects corporate profits across the economy to rise 8.3% in 2010, after rebounding 27% this year from last year's 25.1% plunge. One big obstacle: Many industries have excess capacity that, even if the economy perks up, will take many months to absorb. Mike Arnold, president of the bearings and power transmission group at Timken Co., says his company was running at only 35% of capacity as of the end of the second quarter. Last month, Timken successfully raised $250 million through a bond issue, but the funds will be used to refinance long-term debt maturing in February. The company slashed its capital expenditures by more than half in the first six months of this year compared with the same period a year ago. Mr. Arnold says it has no plans to boost spending anytime soon. "We've now spent the last 12 to 14 months just surviving," says Mr. Arnold, whose company is expected by analysts to report a loss of 25 cents a share on Oct. 29. Mr. Arnold says he isn't seeing signs of any upturn aside from the effects of government stimulus, which he views as transitory. The cautious mood is reflected in companies' new orders for nondefense capital goods such as computers, trucks and office furniture, which in August were down 0.4% from the previous month and down about 20% from the same month a year earlier. Even some companies that initially weathered the downturn are now more cautious. Cummins Inc., a Columbus, Ind.-based maker of big diesel engines, was humming through the first 10 months of last year thanks to booming foreign sales. But in October, the bottom fell out. Truck sales skidded world-wide, dropping 70% in the U.S. That ricocheted through a vast network of suppliers of metal, steel and tires. Cummins cut costs as fast as it could, shedding about 15% of its global work force of 50,000 people, or about 9,000 people, says president and chief operating officer Tom Linebarger. The company reported 81% lower earnings in the second quarter, but still beat analysts' expectations. The company reports third-quarter results on Oct. 30, and Mr. Linebarger says, "Generally, revenues have stabilized -- we're beginning to see forecasts that stay the same week to week." Still, Cummins has no plans to start spending on new capacity. It is investing about $350 million in 2009, about 50% less than it would have if markets hadn't slid, Mr. Linebarger says. The company recently brought back about 900 U.S. workers to handle what is expected to be a temporary uptick in demand. Mr. Linebarger says Cummins will probably have to let them go again. "The politicians want people to think things are getting better, because a better mood feeds a turnaround," Mr. Linebarger says. "Things are getting better, but compared to what." Write to Mark Whitehouse at mark.whitehouse@wsj.com and Timothy Aeppel at timothy.aeppel@wsj.com