Asian Flu, European Sniffles

Sagging profits at blue chips signal that its economies aren't immune

The people assembled at Paris' Inter-Continental Hotel on Sept. 17 to hear a presentation by Alcatel Chief Executive Serge Tchuruk thought they knew what to expect. Naturally, Asia was a disaster area, but its problems were already reflected in the company's stock price. Then Tchuruk dropped his bombshell: Alcatel's major European customers, including Deutsche Telekom, France Telecom, and Spain's Telefonica, were slashing orders by up to 37% as their business plans changed.

Investors didn't take kindly to the surprise. Alcatel had been one of their darlings, but now they couldn't unload the stock fast enough. Its price fell 38% that day and has kept on falling despite Tchuruk's promise of a share buyback.

The reversal was a stark reflection of how dramatically Europe's business climate has changed in just a matter of weeks. As recently as mid-July, investors thought Europe was on the verge of a long-awaited boom. Like their U.S. counterparts, European companies seemed to shrug off Asia's economic meltdown for nearly a year. But ever since Russia's debt default on Aug. 17, the rot that began in the emerging markets has begun seeping across Europe's borders and into the results of its top corporations.

Withering demand from Asia, Latin America, and Russia is cutting into growth forecasts. The chances of a serious slowdown in the U.S., another key export market, have also risen. And ripple effects from the troubled global economy are likely to pressure Europe's corporate chieftains, perhaps forcing cutbacks in spending and hiring plans.

The past few days have brought a series of nasty surprises from several blue-chip companies (table). First came Alcatel's warning. Then Dutch conglomerate Philips Electronics, British entertainment giant EMI Group, and Royal Dutch/Shell Group, the world's largest oil company, all said their upcoming results are likely to be worse than expected. "The outlook is getting bleaker," says James E. Cornish, an equity strategist at BT Alex. Brown in London.

Each burst of bad news sends another shudder through investors. "People are losing confidence," says Gary Dugan, European equity strategist at J.P. Morgan Securities Ltd. in London. "They are looking for the next downgrade, not knowing where it is going to come from." Dugan is among many analysts who are rejiggering their formerly rosy forecasts. He now expects corporate earnings across Europe to rise by just 5% next year--a big drop from the 18% Morgan was forecasting in July.

ZERO GROWTH? While some companies, such as French carmaker Renault, are seeing improving results, Europe seems full of risks. Currencies of the 11 countries expected to enter the European Monetary Union are rising against the dollar and sterling, making the euro zone's goods less competitive. Britain, which takes roughly 16% of the EMU countries' exports, may have almost zero growth next year, jeopardizing sales of cars and other goods.

In this atmosphere, investors are wary of just about any company outside the usually steady pharmaceutical and utility sectors. Manufacturers' stock prices have been particularly hard hit. Fiat, for instance, was full of fire a few months ago after pouring $2.2 billion into auto plants in Brazil and Argentina. But with Brazil teetering on the brink of financial catastrophe, those investments no longer look so brilliant. Weakness in Latin America contributed to an 11.2% drop in operating earnings, to $1.2 billion, in the first half. Fiat's stock has fallen almost 40% since early September.

Analysts worry that lost sales from emerging markets will lead to a turndown at home. "The big story is how much this feeds into business confidence," says Bruce Kasman, J.P. Morgan's chief European economist. He expects European companies to trim next year's planned capital-spending increases to about 5% from roughly 10%. That could affect hiring and, therefore, consumer spending. Morgan has cut its average 1999 growth forecast for the 11 countries planning to adopt the single currency to 2.5% from 3%. BT Alex. Brown expects less than 2% growth in the core nations, Germany and France, next year.

Royal Dutch/Shell provided a recent look at what might be in store for European companies. On Sept. 18, Chairman Mark Moody-Stuart warned that the global business climate in the second half of the year will be "significantly worse" than in the first half. In the same speech, Moody-Stuart said Shell will speed up its disappointingly slow restructuring program. Redundant local headquarters in Britain, France, Germany, and the Netherlands are to be closed, with some associated job losses. Assets may be written off.

Alcatel may also have to step up its restructuring. The company still relies too heavily on its fixed-line telephone technology, a slow-growth business. Instead of spending money on switches and other traditional equipment, Europe's phone players are expanding into cellular networks and exploring the new Internet technologies. Trouble is, big European telecom players such as Alcatel and Ericsson are not well positioned for this new business.

OPPORTUNITY. Despite the pessimism, Europe could actually outperform the rest of the world. Merrill Lynch & Co., whose experts believe the biggest global growth contraction since the oil crisis of 1973-74 is in the works, remains relatively bullish on Europe, largely because of the coming single currency. "We think Europe will soften but that it will be the strongest market environment in the world," says Jerome T. Kenney, Merrill's executive vice-president for corporate strategy.

For investors, the dips in European markets could present an opportunity. Some European blue chips may have taken a more severe beating than they deserve. "There is genuine panic--which usually means a good time to buy," says Robert Friedman, a senior vice-president at U.S.-based Franklin Mutual Advisers, which has about $7.5 billion invested in Europe. But the robust recovery that Europe was hoping for after years of stagnation could turn out to be a grand illusion.

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