The stock market is up. Corporate profits are beating Wall Street's expectations. And for the first time in more than two years, more analysts raised than lowered their forecasts for Standard & Poor's (MHP) 500-stock index companies. With all the good news in the air, one might assume the fog over the economy is finally lifting and managers are positioning their companies for renewed growth.
But executives remain skittish about predicting their fortunes. In a typical downturn, this would be the time when they start to think about rebuilding—after months of cost-cutting and depleted inventories. Instead, many are bracing themselves for new rounds of painful cuts. The problem: Cost-cutting boosted earnings in the second quarter but few can predict when sales will bounce back. If companies become too spooked to respond to sparks in the economy, the result may be moves that extend the length and depth of the downturn.
Right now, many feel trapped in a waiting game. Honeywell International (HON) CEO David M. Cote says he wants to avoid layoffs and is asking many of his 120,000 staffers to prepare for weeklong unpaid furloughs in the coming months. Atlanta-based Home Depot, which began to feel the impact of softer home prices in 2006, has done everything from exit businesses to revamp its procurement process to manage costs. "We will have a harder time planning for the up than we did for the down," says Chief Financial Officer Carol B. Tomé. With sales expected to drop 9% this year and signals mixed in the housing market, she's not sure when demand will come back. Tomé admits that it will take courage to "step out and say, 'O.K., I think sales are going to increase.'"
THE CONSUMER MYSTERYWhile it may be hard to manage through the current state of uncertainty, economists predict most companies will see improvement in the second half. Over the past 18 months, U.S. businesses have radically slashed inventory, payroll, and capital spending. That was both a response to the cratering economy and a major factor in the speed of its decline. The first step in every recovery is to reestablish profits without a rebound in sales, notes James W. Paulsen, chief investment strategist of Wells Capital Management. About 77% of the companies reporting so far have beaten analysts' earnings estimates, according to Thomson Reuters. As profitability returns, investors feel more confident about getting back into the stock market. "And there's nothing better to get a CEO to hire somebody or make a capital investment than their stock price going up," argues Paulsen. The problem now, he explains, is that on Main Street and in the C-suite, panic has merely given way to purgatory.
The biggest unknown is what to expect from consumers. With credit in short supply and unemployment on the rise, they remain reluctant to spend. Supermarket giant Safeway (SWY) witnessed that phenomenon in the second quarter. It posted a worse-than-expected sales drop of 6.5% as customers traded down to lower-priced generic products. And Americans are unlikely to open their wallets until they feel certain about their own job security. Says Ed Yardeni of Yardeni Research: "The important thing is for businesses to stop firing."
As long as the external environment remains in doubt, companies will continue to focus on what they can do internally. Ari Bousbib, president of commercial companies at United Technologies (UTX), says he is starting to see signs of life in areas like China and the refrigerated trucking business in the U.S. But overall constraints on credit have curbed major construction projects and orders. "We can only control our costs [and] cannot really control the top line," says Bousbib.
Even within the same industry, some companies are taking dramatically divergent paths. Toy giant Hasbro (HAS) has pushed ahead with big investments to spur growth. It helped produce two major movies this summer—Transformers: Revenge of the Fallen and G.I. Joe: The Rise of Cobra— in an effort to boost related toy sales. The company is also spending $300 million to launch a new cable television network with Discovery Communications (DISCA). "We're reinventing, reigniting our brands," says CEO Brian Goldner, who reported a 5% jump in earnings, to $39 million, in the second quarter. "We're very careful about how we do it." Rival Mattel (MAT), meanwhile, is on track to cut $200 million in costs by 2010, an effort that boosted profits 90% in the second quarter even as sales fell 19%. "We went into this year with the expectation that revenues would be challenged," says CEO Robert A. Eckert. "We realigned infrastructure so when sales come back we can leverage that."
Many leaders are trying to both contain costs and place bets for future growth. Packaging giant Ball Corp. (BLL) has launched several new products in the past year, including new caps that allow consumers to reseal aluminum beverage cans. But CEO R. David Hoover says the company has also focused on cutting costs, which allowed it to post a 33% jump in earnings in the last quarter, even as sales slid. "We feel positive about the second half of the year," says Hoover. "We also know that in this economy we cannot become overconfident."
Managers are right to be cautious. "We probably face more real uncertainty now than we've had in 25 years," says a McKinsey & Co. director, Lowell Bryan. He describes several scenarios for how the recession could play out: a nascent recovery that produces reasonable growth by the middle of next year; extended pain as damaged banks curb lending and consumer defaults rise; weak growth spurred by government money; or a further dip as companies resist hiring and investors lose faith in the U.S. economy. Leaders aren't sure "whether they should be building bunkers or laying out growth strategies," Bryan argues. "As Churchill would have said, we're at the end of the beginning."
Business Exchange: Read, save, and add content on BW's new Web 2.0 topic networkTaking the Long ViewNow that managers have made the obvious cuts, what's next? Companies need to retool to accommodate a new reality of lower revenues and profits, says a recent paper from the Boston Consulting Group. Shareholders may be prepared to give companies a break while they implement fundamental changes, too. A BCG survey of 135 institutional investors found that 72% would rather see companies bolster their competitive position than chase short-term profits.To view the paper, go to http://bx.businessweek.com/business-strategy/reference/