Commentary: Swing That Ax with Care

By Louis Lavelle

As the tech sector collapsed last year and rivals hunkered down for the long recessionary winter, Palm Inc. (PALM ) forged ahead. A new-product announcement whetted consumer appetites for the next big handheld, but a delayed launch slowed sales of existing Palms to a crawl. By March, demand had dried up so much that Palm had to cut 15% of its workers. Wall Street's response was vicious: Palm shares lost nearly half their value in one day and never recovered. Says Chief Financial Officer Judy Bruner: "There were a lot of questions about the viability of the business."

With the economy in the doldrums, the temptation to swing the layoff ax has never been stronger. But managers need a better plan than just reducing payroll or they risk seeing their stocks whacked. Companies with slash-and-burn approaches to cost-cutting will be punished by Wall Street because such layoffs are only stopgap measures that can't fix a fundamentally flawed business strategy.

During the 1990-91 recession, layoffs often were critical in helping U.S. business wring out inefficiency and boost productivity. Nevertheless, by undertaking deep, across-the-board payroll reductions, many companies were left temporarily ill-prepared to pull out of the slump when the downturn was over. According to recent Bain & Co. research, companies with the deepest layoffs underperformed the market by as much as 8% over the next three years. This time around, too many managers are making the same short-sighted mistake. They're opting for deep layoffs without making them part of a larger strategy to boost long-term performance.

Indeed, in an analysis of payroll reductions at companies in the Standard & Poor's 500-stock index for the 12 months through last August, Bain found that layoffs that were part of a broader business plan generally got Wall Street's blessing. When they were part of a merger, shares rose 10%. When they were part of a restructuring, the stock spiked 13%. But companies whose layoffs were mainly for cost-cutting saw price declines of an average of 2%, from 30 days before the announcement to 90 days after. Why? "Layoffs may very well be necessary, but they're never sufficient to solve long-term performance problems," says Bain director Darrell Rigby. Investors want some evidence that management is addressing those underlying problems.

It's a lesson Providian Financial Corp. (PVN ) learned the hard way. Providian, the nation's fifth-largest credit-card company, grew fat appealing to high-risk borrowers--until the economy soured and bad loans surged, knocking its share price down more than 90%. Layoffs in November did nothing to lift the stock.

Contrast that with Sears, Roebuck & Co. (S ), where CEO Alan J. Lacy announced a restructuring in January, 2001, that cut 2,400 jobs, closed 89 stores, and backed away from several smaller businesses. Wall Street bid shares up 30% over the next six months, even as earnings plunged. Says Kurt Barnard of Barnard's Retail Trend Report: "There was an inference at least that major changes would be taking place at Sears of which layoffs were only a small part." Praxair Inc. (PX ), a $5 billion supplier of specialty gases and coatings, cut 900 jobs on Sept. 28, citing a slowdown in its key aviation market. But it also announced initiatives to pull it out of the slump, including two new plants for products where demand was on the rise. The result: The value of its shares increased more than 30% in three months.

Managers should take note. Investors are quicker than ever to reward "good" layoffs and punish "bad" ones. If the business is struggling, Wall Street wants to see a coherent strategy for fixing the problem--not just a wad of pink slips.

Lavelle covers management from New York.

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