A Head Of Steam On The Factory Floor

Profits are up, capacity's tight, and companies are building new plants

Only a couple of months ago, it looked like the manufacturing sector was losing steam. Profit growth had slowed from 2004's scorching pace. Worries about the exodus of production to China and the loss of jobs had resurfaced as payroll figures sank lower and inventories began piling up. Add in rising interest rates and high energy prices, and it's easy to see why investors were cashing out.

Turns out U.S. manufacturing still has plenty of spunk. A gust of investment spending, led by the transportation and energy sectors, has boosted demand for industrial gear. Orders for nondefense capital goods excluding aircraft -- a good proxy for business investment -- jumped 3.8% in June, vs. a 0.6% decline in May. The big winners: communications gear, computers, and machinery. "Some of these guys who were basically going out of business are getting a shot in the arm," says James V. Gelly, chief financial officer of Rockwell Automation Corp.

It's a virtuous cycle that pushed the group to the top of the earnings heap in the second quarter, and one that will power growth throughout 2005. According to analysts' consensus estimates, earnings at the 54 industrial companies in the Standard & Poor's 500-stock index should climb 19% this quarter and 22% in the next, excluding one-time items. That comes after a projected 19% increase in the second quarter, a growth rate twice that of the index. Only energy and materials did better. Just as impressive, the surge came despite the weakness in domestic autos.

Among manufacturers, makers of industrial equipment and transportation gear are the stars. Thanks to strong demand in the U.S. and overseas, Caterpillar Inc. (CAT ) reported a 34% jump in second-quarter profits, to $760 million, on a 23% rise in sales, to $9.4 billion. Both are records -- and Cat execs promise more, boosting its 2005 earnings forecast to $2.85 billion. Boeing Co. (BA ) also hiked its outlook, while other industrial-equipment makers such as Ingersoll-Rand Co. (IR ) and Eaton Corp. (ETN ) surprised Wall Street and upped their full-year numbers, too.

The roots of these returns go back to the industrial recession that stretched into 2003. To survive, most manufacturers cut costs to the bone by eliminating inefficient equipment and slashing headcounts. Today, with limited production capacity and strong worldwide demand, companies have been able to raise prices. At Cat, for example, price hikes of around 5% added $470 million to revenues this quarter. In the second quarter, 3M Co. (MMM ) jacked up prices by 2% in the U.S.

Companies are using the money from price hikes to pay for new equipment and plants and to hire employees. Manufacturing investment in the second quarter grew to an annualized rate of $15.1 billion, up 26% in a year, according to Economy.com. Indeed, tightness on the factory floor is forcing Eaton to spend around $400 million on capital expenditures this year. Eaton is hiring too, with 400 jobs posted on its Web site. At Cat, U.S. payrolls are up by 10,000 over the past year, to 82,250.

Despite those gains, however, the strong profits are not generating overall job growth. Offshoring continues, and new domestic factories often require a fraction of the headcount. Manufacturing jobs in the U.S. fell by 60,000, to 14.3 million in the year through June. More will be lost. In recent months Eastman Kodak Co. (KMP ) plans to let go of 6,000.

Still, even as the industrial recovery enters its third year, manufacturers remain upbeat. Though analysts expect profit growth will slow to 13% in the first quarter of 2006, China's July revaluation of the yuan by 2.1% has increased hopes that exports will grow anew and the sector will surprise again. For a long-suffering group, good news of any size is welcome.

By Adam Aston in New York and Michael Arndt in Chicago

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