Corporate America Braces for the Shakeout
Whatever happened to "get big fast"? During the 1990s, U.S. companies were responsible for one of the biggest capital-spending booms in history. Executives raced each other for what they bravely called "first-mover advantage," expanding far beyond what their current demand would justify. It amounted to a huge leap of faith: If you build it, customers will come.
As we now know, that was misjudgment on a massive scale. The expansion was premised on the expectation of economic growth of 4% or more as far as the eye could see. When growth slowed in 2000 and the first half of 2001, it started becoming clear that vast overcapacity existed in everything from airlines and retailing to technology and telecom. U.S. factory capacity utilization stood at just 76% in August--the lowest level since July, 1983, when the U.S. was recovering from the devastating recession of 1981-82. Although companies began to cut back this year, many avoided drastic retrenchment, hoping the economy would soon recover.
Now companies are throwing in the towel. In the aftermath of September 11, consolidation is accelerating from a trot to a gallop. Companies are abruptly withdrawing from unprofitable lines of business, cutting workers, selling out to rivals, and in the last resort, going out of business. Says Robert J. Barbera, chief economist at Hoenig & Co.: "There was an enormous desire to hold their breath...and then feel very clever for not having fired or cut into capacity." Now, says Barbera, "we are going to get a lot of capitulation from companies."
Top on the list are troubled airlines and the rest of the travel industry. But they've got plenty of company. The tech and telecom sectors, which led the investment boom, are also due for massive consolidation. So is the fragmented health-care industry and the overbuilt retail sector. And while other countries have been slower to restructure, consolidation will be a worldwide phenomenon. On Oct. 2, for instance, Swissair, once a great blue-chip airline, grounded its fleet and filed for protection from creditors. The Swiss government pledged loans to keep it aloft until Oct. 28.
Few will escape because the September 11 attacks gave a fresh blow to an already weakened economy. At the same time, they have provided cover for cutbacks that would have seemed too harsh before, even if they made economic sense. Moreover, the much tougher times may persuade regulators to approve mergers they might previously have questioned, provided they can be convinced that acquisition targets were on the verge of closing anyway. Says Federal Trade Commission Chairman Timothy J. Muris: "It's possible...a merger can help efficiency and in that sense help consumers."
"MORE EFFICIENT." For people thrown out of work at a time when jobs are scarce, consolidation is nothing but bad news. Many economists expect the unemployment rate to surpass 6% within a few months, up from 4.9% in August and 3.9% last fall. Typical is battered telecom gearmaker Nortel Networks Corp. (NT ), which said on Oct. 2 that it would slash 20,000 jobs on top of the 30,000 cuts already announced this year.
But for the economy as a whole, the elimination of excess capacity is a necessary prelude to economic recovery. The people and money that are tied up in overbuilt businesses--Web hosting, for example--can be redeployed in new companies and markets that need financing and skilled workers. "We're making companies more efficient," says Martin D. Sass, CEO of Resurgence Asset Management, a New York-based "vulture" firm that gets control of failing companies by buying their distressed debt and restructuring them.
For suddenly weaker companies, more mergers are likely. That's especially so in the airline industry, though some critics of the $15 billion U.S. airline bailout say it could prop up weak carriers. As if to confirm their fears, Midway Airlines Corp. (MDWYQ ), which is in bankruptcy and stopped flying on Sept. 12, is now trying to get its planes back in the air with its share of bailout money. Long-struggling US Airways Group Inc. is another candidate for liquidation or sale, though UAL Corp. (UAL )--rejected once on antitrust grounds--is unlikely to bid for it again.
Across the country, companies are halting projects and dropping product lines. Mandalay Resort Group (MBG ) has stopped work on a $280 million convention facility in Las Vegas. Condé Nast Publications Inc. said on Oct. 1 that it's saying au revoir to 66-year-old Mademoiselle magazine. A week earlier, General Motors Corp. (GM ) said it won't make two old muscle cars, the Camaro and the Firebird.
Where cutbacks aren't enough, there's bankruptcy court. Already this year, bankruptcies ran at a record pace, according to BankruptcyData.Com, a unit of New Generation Research Inc. Some 173 publicly traded U.S. companies had filed for protection from creditors through the end of August, nearly equal to the full-year record set in 2000. Most of the bankruptcies stemmed from excess debt and other problems exacerbated by the slowdown. Federal-Mogul Corp. (FMO ), for instance, the Southfield (Mich.) auto parts maker that filed for Chapter 11 on Oct. 1, was burdened by asbestos lawsuits. Renaissance Cruises in Fort Lauderdale, Fla., announced Sept. 25 that it was filing for Chapter 11. One of the weakest players in the industry, it cut short cruises in the Mediterranean and South Pacific and flew home 2,400 passengers.
As in any slowdown, it helps to have cash. Industry leaders will buy weaker rivals, or invest to keep the heat on struggling rivals through the downturn. On Oct. 2, Wal-Mart Stores Inc. (WMT ) announced its biggest expansion, saying it will open as many as 325 stores next year and move or enlarge 115. General Electric Co. (GE ) and Tyco International Ltd. (TYC ) are on the acquisition trail. These are good times for contract manufacturers, too. San Jose (Calif.)-based Flextronics Inc. (FLEX ) is getting work from companies like Xerox Corp. (XRX ) and Hewlett-Packard Co. (HWP ) that are closing factories.
DEALS ON HOLD. So far, considation through mergers has yet to kick in. The market turmoil since September 11 has put new deals on hold and upset pending ones. An 18% fall in the stock of the General Motors Corp. unit that operates the DirecTV satellite service has jeopardized an acquisition bid by Rupert Murdoch. The News Corp. (NWS ) CEO now wants to reduce the $6 billion cash payment GM had demanded. "We need to go through a sorting-out period," says Howard B. Schiller, co-head of Goldman, Sachs & Co.'s M&A practice in the Americas.
Still, some companies are so weakened that their deals can't wait. After four years of trying to rebuild AT&T (T ), CEO C. Michael Armstrong is trying to negotiate a "merger of equals" with BellSouth Corp. (BLS ), the Atlanta-based Baby Bell, even as he faces a liquidity problem. WorldCom Inc. (WCOM ) is another weakened long-distance player in need of a strong partner.
The hard-hit tech industry will see downsizing of its own. In 1999, there were about 300 public software companies, vs. about 130 today. And only half that many will be around in two years, predicts Goldman Sachs analyst Thomas P. Berquist. Most midsize, public companies will die, not be bought, software executives say. Oracle CEO Lawrence J. Ellison says "it's not worth it" to take on the rivals' unhappy customers.
The personal computer industry is also ripe for paring down. But as in software, PC companies are reluctant to buy weaker competitors for fear of inheriting problems. That's one reason that Gateway Inc. (GTW ) and Apple Computer Inc. (AAPL ) aren't considered immediate takeover targets. The reluctance to do deals was strengthened when executives saw the market's disdain for Hewlett-Packard's agreement to buy Compaq Computer Corp. (CPQ ) Although the pact looks likely to go through--in part because Compaq has few other choices--the drop in HP's stock price has reduced the value of its bid to about $17 billion from $25 billion when it was announced on Labor Day.
TOO MANY HMOS. Well before September 11, retailers had begun to dial back on their massive overexpansion of the 1990s. Everyone from the newly formed AOL Time Warner Inc. (AOL )--which announced plans to close all 130 Warner Bros. stores back in January--to trendy clothier The Limited Inc. (LTD ) had begun to trim stores. But those moves are paltry compared with what could now hit retailers. The next several quarters "could be the cleansing of the retail landscape," says analyst Richard Church of Salomon Smith Barney. A weak Christmas season will lead to even more substantial scaling back of retail space. Saks Inc. (SKS ), for one, could be forced to sell its regional units or put itself on the block, analysts say. The company says it has no such plans. And even Kmart Corp.'s (KM ) turnaround effort could be in jeopardy.
A wave of capacity-reducing mergers in industries with scads of small players will also hit. One such industry is health care, which accounts for more than 10% of GDP. Daryl Veach, a partner at Ernst & Young, estimates there are 500 to 700 health-maintenance organizations with less than 100,000 members each that are too small to survive on their own. "These companies need to achieve economies of scale," says Leonard D. Schaeffer, CEO of WellPoint Health Networks Inc. (WLP ), the nation's fourth-biggest health plan.
Ultimately this purging and merging will set the stage for a healthier economy. But first, companies, communities, and workers must brace for pain and uncertainty.
By William C. Symonds in Boston and Peter Coy in New York, with Jim Kerstetter in San Mateo, Ronald Grover in Los Angeles, Robert Berner in Chicago, and bureau reports