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A Crisis in Capital Spending?

It was the economic rocket fuel of the late 1990s. As the explosive surge in business investment propelled the economy, companies boosted capital spending on everything from high-tech computers to low-tech trucks. Productivity and profits took off in tandem. The economy entered a golden era of rapid growth and low inflation. It was, in the words of former Treasury Secretary Lawrence H. Summers, that rarest of events, an investment-led expansion.

Now, those days are gone. Economists and business leaders alike worry that the 1990s investment boom could turn into a new-millennium bust, dragging the economy down with it. As the risk of an inventory-driven recession fades thanks to quick action by companies to bring down bulging stocks, economists have shifted their focus to capital spending as the next tripwire that could upset the economy.

At the moment, they don't much like what they see. Profit-pinched companies have begun to hack away at their capital budgets. In the fourth quarter, capital spending fell at an annualized 1.5% after growing by more than 20% in the first quarter of 2000. What's most worrisome is the possibility of companies radically cutting spending to make up for the buying binge of the past few years. "The worst is still to come," says Richard B. Berner, chief U.S. economist for Morgan Stanley Dean Witter. "We're just beginning to see the weakness in capital spending."

Until now, companies have largely managed to protect their budgets for such crucial things as technology spending; instead, low-tech capital spending has taken much of the hit. Outlays on such things as trucks, industrial machinery, and other low-tech gear has been in a slump since the middle of last year. In the fourth quarter, it dropped 5%, and further weakness looks to be in store. In a typical lament, Tim Solso, CEO of Cummins Inc., the Columbus (Ind.) maker of truck engines, says: "We are in a severe downturn." Cummins is cutting 2,000 jobs and closing nine plants in a response to a 52% drop in big-truck engine sales in the fourth quarter.

Now, the pain is spreading to the stalwarts of the New Economy as cash-strapped corporations have decided they must take the knife to their once-sacrosanct high-tech capital budgets as well. In a string of announcements that has jolted the markets over the past several weeks, Cisco Systems, Nortel Networks, Dell Computer, Hewlett-Packard, and a host of others have warned that revenues will fall short of expectations because of cutbacks in capital outlays by their customers. As a result, they warn, profits will suffer.

Indeed, fears that an extended slump in capital spending could cause the the tech sector to tank--and with it the economy--have sent stock prices skidding lower. On Feb. 21, even once-unstoppable Sun Microsystems Inc. added to the pessimism. Its shares dropped by over 10% after Merrill, Lynch & Co. warned that profits will fall short of expectations. Overall, the technology-laden Nasdaq Composite Index fell 49.42 points, or 2.1%, on Feb. 21, to 2269, its lowest level in almost two years.

Until a few months ago, execs at such companies as Sun viewed outlays for computers and other efficiency-enhancing gear as virtually impervious to the economic downdraft. Sure, growth in such spending would slow a bit. But few thought these outlays might actually decline.

It's clearly time to re-think that assumption. In the fourth quarter, spending on information-processing equipment grew just 2.3% after adjusting for inflation. And economist Ben Broadbent of Goldman, Sachs & Co. says incoming orders suggest that tech spending could fall a nominal 4% in the first quarter. That would be the first decline in 10 years. "It's a nerve-wracking time," says Broadbent.

Worse yet, the spate of recent warnings from purveyors of virtually every type of tech equipment makes clear that there's little sign of a recovery on the horizon. High-tech executives who were pinning their hopes on a bounce-back after June are now talking gloomily of business staying weak until the end of the year. "We see [the weakness] continuing into the fourth quarter," says Nortel Chief Operating Officer Clarence J. Chandran. The Canadian telecom-gear maker shocked Wall Street with the announcement that it would lose money in the first quarter because debt-strapped telecom companies have slashed capital outlays. Other tech companies had similar grim tidings. "We are not counting on a return to double-digit revenue growth this year," said Hewlett-Packard Co. CEO Carleton S. Fiorina. And Agilent Technologies Inc., the HP spin-off that sells a variety of computer chips, testing equipment, and components to other tech companies, is hurting, too, as its customers trim capital budgets. On Feb. 20, CEO Edward W. Barnholt cut Agilent's 2001 sales-growth forecast to a range of 10%-15%, down from 19%.

As a result, high-tech companies are responding just like their old-line manufacturing counterparts: They're hunkering down--slashing costs and payrolls in moves that will send ripples throughout the economy. The same day Agilent lowered its growth target, VA Linux Systems Inc., the Fremont (Calif.) software and computer company, said it would lay off about 139 of its 556 employees and take a restructuring charge because of a slowdown in tech spending. And Intel Corp. CEO Craig R. Barrett sent an e-mail to all employees detailing Intel's plans to cut discretionary expenses by 30% this year. While Intel says it still plans to spend $7.5 billion on capital expenditures and $4.3 billion on research and development, some analysts think it's only a matter of time before they get cut as well.

What's behind the rapid crunch in capital spending? Business investment has been hit by a triple whammy of pinched profits, tougher financing terms, and slow growth. Corporate profits fell 11% in the fourth quarter of last year--the worst performance since the recession year of 1991. And further weakness looks likely. According to First Call/Thomson Financial strategist Joseph S. Kalinowski, the consensus on Wall Street is that corporate earnings of the Standard & Poor's 500-stock index will fall 2.8% in the first quarter and 1.3% in the second quarter before recovering in the second half. Lower earnings mean companies will be even more inclined to squeeze capital spending.

Even before the swoon in profits, corporations had been relying more and more on external financing to fund their capital budgets. Last year, companies used internally generated cash from profits and depreciation to cover just three-quarters of their capital budgets. That's close to the lowest level in the past two decades. The remaining money was raised from the financial markets and banks--easy enough to do in recent years, when stock and bond markets were booming and banks were free with their cash. But now, investors and bankers are getting stingier. Without the outside financing, current levels of capital spending could prove unsustainable.

That is already proving to be the case in the debt-ridden telecom industry. Susan Kalla, an equities analyst at BlueStone Capital Securities, expects telecom service providers to cut capital spending by 9% this year after a 17% increase in 2000. One big reason: Burned equity and capital markets will no longer fund a big runup in infrastructure spending.

There's more to telecom and other high-tech companies' problems, however, than a tougher financing environment. The bigger issue is a glut of capacity. As the dot-com bubble ballooned, high-tech companies began to believe their own hype about the limitless boundaries to their business and acted accordingly. They lent money to customers and sharply boosted capacity by an astounding 50% last year, according to Federal Reserve figures. Now that the dot-com bubble has burst and the economy has slowed, high-tech companies are suffering. That's one big factor, for instance, behind the pressure on Sun Microsystems.

Still, the bottom hasn't fallen completely out of high tech. Companies are trimming tech outlays, not slashing them. "People are very, very judicious in adding capacity," Nortel Networks Inc. CEO John Roth told analysts on Feb. 15. "This is a discipline that we really didn't see last year." Adds Dell Senior Vice-President Joseph A. Marengi: "They're being more surgical in what they spend. There's uncertainty--a softness in spots--but it isn't a major pullback in IT spending."

Federal Reserve Chairman Alan Greenspan is hoping that it won't turn into one. He's betting that, like so many other aspects of the New Economy, the investment boom of the 1990s is a departure from the past. True, companies probably went overboard and spent too much on computer gear and a post-Y2K buying binge. But there's no need for that boom to result in an extended bust, Fed logic goes. After all, computers and software are productivity-boosting assets that depreciate rapidly and get replaced quickly.

Could this time be different? Despite two half-point cuts in interest rates and the prospect of a big tax cut on the horizon, CEOs show little sign that they're done taking the knife to investment budgets. "We plan on being very conservative in 2001," says Scott C. Arves, COO at Schneider National Inc. in Green Bay, Wis., the country's largest truckload freight carrier. If that sort of cautiousness continues, the same forces that ignited the boom could wind up badly burning the New Economy. And recovery may take far longer than New Economy fans would have ever guessed. By Rich Miller in Washington, with Robert D. Hof and John Shinal, in San Mateo, Roger O. Crocket, Michael Arndt, and Ann Therese Palmer in Chicago, David Rocks in New York, and bureau reports

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