Factories: The Gears Are Turning

After three years of recession, demand is surging. The comeback looks real

A year ago, Navistar International Corp. (NAV ) was almost out of gas. With sales of its heavy-duty trucks down almost 40% from 1999's peak, the company was toting up losses for the third year in a row. And with no sign of an imminent turnaround, management was putting the screws on labor, threatening to shut down Navistar's big-rig factory in Ontario unless unionized workers went along with deep cuts in pay, benefits, and jobs.

Today, Navistar is barreling along. The Warrenville (Ill.) company in late February boosted its 2004 sales forecast to 25% above last year's levels. Navistar has just recalled 110 laid-off workers in Ontario as it prepares to ramp up production for the spring to twice the level of a year earlier. And down at its truck-assembly plant in Springfield, Ohio, output is up 36% from last year's levels. The way things are going, Chairman and Chief Executive Daniel C. Ustian says he just might bump up the numbers after another quarter. "I don't think we've seen yet how good it can get," he says.

After three long, extremely painful years, American manufacturers are finally coming back. Over the past several months, factory output has rebounded sharply, growing at its fastest pace in two decades. Enriched by rising profits, businesses are replacing equipment that is now worn out or outdated. With the sharply higher demand leading inventories to be drawn down to their lowest levels ever relative to sales, many plants have little choice but to crank up production to restock the warehouse. And the slumping dollar has also fueled demand by making U.S.-made goods much cheaper than products from Europe and Japan. The combination has many executives, who only a year ago watched a similar surge of orders fade away, cautiously optimistic that this time around the recovery has legs. "We feel real good about it," says Nickolas W. Vande Steeg, chief operating officer at factory-equipment maker Parker Hannifin Corp. (PH ), which has seen its orders surge 20% so far this year.

Certainly, there's plenty in the recent economic data to bolster confidence. In its latest monthly survey of factory-sector purchasing managers, the Institute for Supply Management said its February index of manufacturing activity, while down slightly from January, remained robust. The index has now turned in its strongest four-month streak in 20 years. Moreover, the recovery appears to be broadening. According to the Federal Reserve's latest Beige Book, released on Mar. 3, manufacturing activity rose during January and February in 11 of the 12 Federal Reserve districts. Add it up, and it looks like this recovery has lots of oomph. Indeed, the National Association of Manufacturers is predicting that factory-sector output will climb 6% in 2004, two full percentage points more than the overall economy. And if those expectations come to pass, factory hiring should finally begin to grow in the months ahead.

NO CUSHIONS. Sharp turns of this sort often lead to short-term headaches, of course. With demand for many goods surging far more than expected, the factory sector also shows some signs of struggling to keep up for the first time since the glory days of the 1990s. The ISM report also reported that backlogs are growing and delivery times are lengthening amid the fastest rise in raw-material and component prices since 1995. Many steel products were in such tight supply that factory owners and economists are starting to warn of spot shortages and production bottlenecks. "Nobody's got an inventory cushion," says Diane Swonk, chief economist at Bank One Corp. (ONE ).

The sheer strength of the manufacturing revival has taken executives and economists by surprise. Although the surge in orders began last fall, it has picked up speed and broadened out this year. A combination of factors explains the shift. For starters, many companies held off big purchases as they struggled to cut costs. Instead, they ran their truck fleet or computer network an extra year or two. But after three years of underinvestment, it's starting to cost more to maintain old equipment than to buy new stuff. Just as important, many now have the money to up capital spending or order replacement goods. Thanks to last year's 76% surge in corporate profits, the biggest in over 30 years, companies have begun to turn the spigots on capital spending. Richard J. DeKaser, chief economist at Cleveland's National City Corp. (NCC ), expects cap-ex to climb 13.6% in 2004, vs. 5.2% last year. "It's pedal to the metal," he says.

In addition, companies have kept inventories low coming out of the downturn, leaving them with little stock to draw from as sales turned up. Their reluctance to fill the supply chain made sense even as the economy gained steam last year. Over the past few years, many manufacturers had boosted output before when orders ticked up, only to see the goods get stacked up when sales quickly tapered off again. But now, after months of stronger demand, many companies have drawn inventories down so low they can't fill orders anymore unless they hike production. As manufacturers gain faith that growth will remain strong, output should move into higher gear as warehouses are restocked, economists say.

The dollar's decline also could help sustain the nascent turnaround. Exports haven't helped much yet, but a third of respondents to the NAM's annual membership survey, released on Feb. 23, believe they'll see greater foreign sales this year; just 4% believe exports will fall. Also, imports are becoming pricier, which should shift more orders to domestic producers.

The surprisingly strong upturn is lifting everyone from old-line manufacturers like Navistar to high-tech outfits such as Qualcomm Inc. (QCOM ). The San Diego microchip maker has been blindsided by demand from mobile-phone producers. Sales of phones using Qualcomm's CDMA technology totaled 37 million in the yearend quarter, up from a forecast of 32 million, as wireless outfits signed up new customers in droves. And with sales for the current quarter also running ahead of predictions, inventories have been drained. Says Chairman and CEO Irwin M. Jacobs: "We had to scramble to provide sufficient supply to meet the demand."

SMALL HIRING STEPS. Some are scrambling more than others to fill orders. Virtually every company that uses steel or other commodity metals is getting walloped with higher prices; many are also facing longer lead times for deliveries. Bottlenecks like that are retarding the factory-sector rebound, claims Bank One's Swonk. But she and other economists believe such curtailments are likely to be fleeting. As prices rise, output of goods such as steel will rise, too. Plus, sharp price runups and spot shortages typically are a sign of strength, occurring when demand outstrips supply.

Still, for all the factory sector's renewed vigor, the $64 million question remains: When will the strengthening order books translate into a rise in manufacturing payrolls? Since the factory sector tumbled into recession in mid-2000, manufacturing has lost more than 2.8 million jobs, or one in every seven, as employers moved work to low-wage sites outside the U.S. or simply folded. Now, though there are few signs of robust hiring, the slide in jobs appears to be bottoming out.

While most big manufacturers remain reluctant to staff up, many of their smaller brethren are starting to add to the headcount. That's fairly typical at this point in the cycle, since smaller firms often carry little inventory and maintain leaner payrolls. Take Manitowoc Co. (MTW ). The $1.6 billion industrial company is adding 600 employees at its shipyards in home-state Wisconsin and Ohio, to handle new orders for oil tankers and Navy combat ships. After three years of almost unrelenting recession, manufacturing is 2004's comeback kid.

By Michael Arndt in Chicago, with Faith Arner in Boston, Arlene Weintraub in Los Angeles, and Rich Miller in Washington

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