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Layoffs: Short-Term Profits, Long-Term Problems

The millions of layoffs in the past year have been bad news for almost everyone—except, that is, for investors. Companies turned smaller payrolls and other expense cuts into better-than-expected profits, fueling a 31% advance in the Standard & Poor's 500-stock index in the past year. "It's been a cost-cutting rally," says Terry Morris, senior equity manager at National Penn Investors Trust Co. There are now more questions on Wall Street about the long-term impact of all this job-shedding. But, for a year, aggressive job cuts have improved investor perceptions of many stocks. Starbucks (SBUX) has closed 900 stores and eliminated 19.3% of its employees, which according to Bloomberg data is one of the highest reported rates of layoffs among S&P 500 companies. The company scaled back U.S. growth plans that analysts and executives agreed had become too ambitious. Such deep cuts seem to have paid off. Last quarter, Starbucks increased its earnings to 20¢ per share from 1¢ per share a year earlier. The company's shares are up 150% since the beginning of 2009. And Starbucks did so without seriously hurting its corporate image or customer service, says Morningstar (MORN) analyst R.J. Hottovy. That's a common worry after job cuts in the retail and restaurant industry. But, he says, "based on improving store traffic trends, I really don't think that's the case here." Short-Lived Boost?The S&P 500's big gains of the past year have taken place at the same time that U.S. nonfarm payrolls have tumbled by 5 million jobs, according to Labor Dept. data. In that environment, former Starbucks baristas aren't the only job-seekers now watching their former employer appear to prosper without them. So perhaps it's a comfort that the boost from job cuts may be very short-lived. Companies could make such deep cuts—and in many cases needed to do so—because of equally steep drops in revenue. At the request of Bloomberg BusinessWeek, market research firm IBISWorld compared estimated job losses in retail industries with those industries' sales losses in 2009. There was a close correlation. U.S. supermarkets and grocery stores boosted employment 0.2% in 2009, as sales rose an estimated 0.2%. Hardware stores shed 3.6% of their workforce last year, IBISWorld estimates, while sales fell 3.6%. The correlation between sales and job losses wasn't so perfect for most retail industries, of course. For example, recreational vehicle dealers saw sales drop an estimated 48.2%, but dealers could cut payrolls only 19.2%. "A lot of these companies are right-sizing their businesses for a lower level of demand," says Channing Smith, a portfolio manager at Capital Advisors. Layoffs reflect executives' belief that the sales slump could persist, an implication that should concern investors. "You worry that demand is going to be slower coming back," he says. Layoffs' "Diminishing Returns"Market participants and economists disagree on how fast the economy can recover in 2010. But most observers agree that, at least for now, the economy has stabilized. That may be good news for American workers. When it comes to layoffs, "at some point you've got diminishing returns," Morris says. In 2010, he will be looking for companies to show sales growth, not just profit growth driven by reducing expenses. By now, "most of these job cuts should be complete," says Alan Gayle, senior investment strategist at RidgeWorth Investments. Layoffs make sense when they're a proactive effort to deal with a new economic environment, he says. If a company is continuing to cut jobs in order to meet profit targets, it could be a sign of serious problems with its business model, Gayle argues. There is evidence companies are slowing their layoffs. Initial jobless claims hit a 17-month low of 433,000 during the week of Dec. 26, down from a peak of 674,000 in March. There is also evidence that some companies may even start hiring. Caterpillar (CAT) cut about 18,700 full-time jobs in the past year. But Jim Owens, the chief executive of the construction equipment maker, told Bloomberg TV in December that he expects to rehire laid-off workers in 2010. "We'll gradually begin to call people back and to rebuild our overall sales and ability to ship product," Owens said. Cautious HiringStill, many companies look likely to delay hiring as long as possible. "Companies are being cautious in their hiring," says Michael Yoshikami, president and chief investment strategist at YCMNET Advisors. "And, given [the] economic challenges ahead of us, I think that's wise." Alcoa (AA) has cut about 21,500 jobs since June 2008. Those layoffs netted Alcoa $325 million in cash savings last year, and another 3,100 job cuts are planned, Alcoa Chief Financial Officer Charles D. McLane Jr. said Jan. 11. Alcoa is less optimistic than Caterpillar about rehiring workers. "We estimate that 75% of these positions are permanent reductions and therefore sustainable," McLane told analysts. In 2009, companies slashed jobs en masse. But this year they're dealing with the consequences, as widespread unemployment takes a serious toll on the economic recovery. The massive job cuts of the past year may also have political implications. In 2010, many large U.S. companies could continue to show healthy profits, especially from overseas sales. That wouldn't look good to many Americans. You could see "these companies doing well but many Americans struggling," Smith says. "I don't think this is going to sit well with politicians." As a result, the threats of higher corporate taxes could increase. Some worry that companies cut too much during the downturn, eating into future growth prospects—such as research and development budgets—or sapping their ability to take advantage of a robust recovery. "You just have to trust that management is cutting what they should," says Morris. It could be a long time before the success or failure of the radical surgery is apparent.
Steverman is a reporter for Bloomberg News in New York.

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