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A Bittersweet Year For Corporate America


THE BUSINESS WEEK 1000

A BITTERSWEET YEAR FOR CORPORATE AMERICA

After years of torrid expansion, Minneapolis-based Best Buy Co. thought it was sitting pretty in 1994. Sales of the personal computers, VCRs, and refrigerators it stocks in its 204 megastores kept cash registers humming. And a booming holiday season topped off Best Buy's strongest year ever: Revenues rose 78%, to $4.3 billion, while profits jumped 64%, to $51 million.

A good year? Apparently not good enough. An unimpressed Wall Street decided Best Buy wasn't such a hot buy after all. Its market value has slid 20%, to $917 million, over the past year. Investors knocked 26% off its stock in just one day, after third-quarter profits fell 13% below expectations. Best Buy got the hint: President Brad H. Anderson has begun preparing for the economic cool-down that many investors predict. He is trimming plans for store openings and squeezing inventories. "We're seeing a subtle slowdown in consumer spending," he says. Anderson is also counting on Best Buy's new "Concept III" stores, which feature larger selling floors and interactive computers rather than salespeople, to drive down costs.

It's a story repeated across much of Corporate America. Record profits. Strong sales gains. And a crushing, anticlimactic "so what?" from investors, who are betting that three years of boom times are drawing to a close. Despite the recent rally, which pushed the Dow Jones industrial average beyond 4000, seven interest-rate hikes by the Federal Reserve have given Wall Street the jitters. The economy is strong, and years of restructuring have put many companies in their best shape ever. But investors are offering little applause. Even top performers such as DuPont Co., which boosted profits 382%, to $2.7 billion, or GTE Corp., which increased income 148%, to $2.5 billion, ended with single-digit gains in market value.

And those were the standouts. The merely good often saw their stocks tumble. Consider Wal-Mart Stores Inc., which sank 17%, to $54.2 billion. All told, Wal-Mart shed $11 billion in market value last year--the biggest dollar decline of any public company. Sure, the nation's largest retailer posted sales gains of 23%, to $82.5 billion, and profits rose 15%, to $2.7 billion. But investors have come to expect better from Wal-Mart--and they fear it's now just buying growth with continued store openings.

PUNY GAIN. Such tales illustrate what a bittersweet year it was for this year's BUSINESS WEEK 1000, the annual roster of America's most valuable companies. The BW 1000 ranks the largest public companies by their market value as of Feb. 28. Overall, profits swelled 34%--the biggest gain since BUSINESS WEEK began compiling rankings a decade ago. Sales rose 9%, the best showing since 1990. But the market value of the BW 1000 rose only 5%, to $4.3 trillion--the worst gain since 1988. Even that puny rise is due to February's rally: In calendar 1994, the BW 1000's market value fell 0.2%.

Rarely have the market and corporate results diverged so widely. To underscore how stingy investors have been, consider the average correlation between profit and market-value gains in the last decade. This year, the BW 1000 had to produce a 6.8% profit increase to win a 1% uptick in market value. In the past, it has taken only a 0.5% profit gain to fuel each 1% jump in market value.

Even companies with strong track records of sustained earnings growth faced a tough slog in the market. General Electric Co. retained its No.1 spot as America's most valuable corporation. But despite profits that rose 41%, to $5.9 billion, on sales growth of 8%, to $60.1 billion, GE's market value rose a measly 4%, due in part to price-fixing accusations at its industrial diamond unit and losses at Kidder, Peabody & Co. Those problems are behind GE now, but Sheldon Grodsky, research chief of New Jersey-based brokerage Grodsky Associates Inc. adds another: "The market has doubts about the sustainability of GE's growth."

That, writ large, is the story of this year's BW 1000. Operating results show Corporate America is in great shape after years of cost-cutting. Inflation, at 2.8%, remains low. Manufacturing productivity has soared 4.9% annually since 1993, while nonfarm productivity overall rose 2.3%. With wages in check, U.S. productivity far outstrips that of competing industrialized nations. And many in Corporate America say reports of the economy's imminent slowdown are greatly exaggerated. "There's plenty of steam left in this recovery," predicts David N. McCammon, Ford Motor Co. vice-president of finance.

Yet the near-stagnant market valuations reflect quite a different prediction. Wall Street believes the economy's much-anticipated "soft landing" is nigh. Lehman Brothers Inc. chief economist Allen L. Sinai blames the Federal Reserve: "Valuations were very poor for a simple reason: the ahistorical, unprecedented doubling of interest rates by the Fed." For that matter, he finds it remarkable that shares climbed at all in the face of the rate hikes: "It's testimony to the underlying health of the companies."

BLESSED FEW. Indeed, as the Fed tries to slow the economy from last year's 4% clip to a more sustainable 2.5%, forward-looking investors have become much pickier. Market value, after all, measures more than past performance; it's a collective assessment of how well a company is likely to do in the future. And signs of a slowdown are mounting. Car inventories have built up, prompting both Ford and Chrysler Corp. to announce the temporary idling of manufacturing plants, as well as big rebates. Growth in construction, home purchases, and retail spending have all weakened.

Investors today are clearly favoring only those companies likely to continue growing even if the overall economy slows. That's the case for a blessed handful of companies, for which 1994 wasn't a topsy-turvy year at all. Most were in the technology sector, where demand for semiconductors, computers, and related equipment shows no signs of letting up. Hewlett-Packard, Intel--and even IBM--saw big gains in sales or profits rewarded with run-ups in market value. But Microsoft Corp. was the star. The smash software hit Microsoft Office helped fuel a 26% rise in earnings, to $1.3 billion, on a 28% sales gain, to $5.3 billion. With PC sales still booming--and Microsoft providing a growing share of the software inside--the company isn't bracing for any kind of landing at all.

Indeed, with its long-awaited Windows 95 operating system due out in August, Microsoft should see similar sales growth in fiscal 1996, which starts in July--and it plans to boost R&D and marketing even faster than revenues. "We're big spenders," says Michael W. Brown, vice-president for finance. "Even if there's a slowdown, those investments will continue." Wall Street clearly approves: Microsoft's market value soared 56%, to $36.6 billion.

Elsewhere, Wall Street keeps raising the bar of what marks a good year, and the best managers--many of whom are now partially compensated according to stock performance--are looking for ways to cope. Many have begun to batten down the hatches, whether it's for a soft landing of moderate growth, or the hard landing of recession.

How are the best-managed companies preparing for a slowdown? For starters, they're refusing to get complacent. Many continue to invest in technology that keeps productivity improving. A flush Merck & Co. saw its market value soar 30%, largely thanks to better distribution of its drugs via its new Medco subsidiary, and subsiding fears of health-care reform. But the drugmaker knows that market pressures will continue to squeeze prices. "The pricing environment is quite intense," says chief financial officer Judy C. Lewent. So it is investing in technology to lower costs. Merck is adopting "flexible manufacturing" which will allow it to make more than one product per line. Along with other productivity measures--such as improving supply-chain management and the transfer of technology between research and manufacturing--Merck expects to save $250 million by 1997.

For many cyclical industries, though, getting shipshape means tightening the lid on spending. At Clark Equipment Co., a South Bend (Ind.) heavy-equipment maker that's spent years streamlining, senior vice-president Frank Sims says it's being cautious about adding employees or capacity despite explosive 1994 results: Earnings grew 114%, to $62.8 million, on sales of $947 million, up 37%. Instead, it is outsourcing production now that can be brought back in-house when the boom passes. "We have probably been willing to lose some sales at the peak in order to reduce the amplitude of the cycle," he says. "What things will look like in the downturn is much more a part of our thought process."

HOARDING CASH. Weyerhaeuser Co. is also loath to add capacity, though the paper industry is in the midst of its biggest boom since 1988. A surge in demand and limited capacity has led to steep increases in prices. A metric ton of pulp that cost $400 in January 1994 fetches about $825 today. But the company announced only one new paper-plant expansion in 1994--even though CEO John W. Creighton Jr. expects the up cycle to last until 1997. Instead, he's improving the yield his plants get from each log, and streamlining production to squeeze more out of current plants. Creighton's goal is to improve operating income, which was $1.2 billion in 1994, by more than a third to provide more cushion for the next downturn.

Many are hoarding cash so they won't have to slash R&D or capital spending when times get tough. Chrysler has a $7.6 billion cash pile, while Ford's kitty of cash and marketable securities hit a stunning $12.1 billion at the end of 1994. Cash can evaporate in a slump, though, so Ford CEO Alexander J. Trotman wants more. "Excess cash is an oxymoron," he says.

Still, not all of that cash will be saved for a rainy day. Although the double-digit spending boom of the last two years is over, capital investment, led by the auto makers and the computer industry, is still expected to grow 7% this year. Ford, for example, is moving full-steam in its push to overtake General Motors Co. as the biggest auto maker. Ford will spend upwards of $20 billion on increased capacity and new models by the decade's end. "This cycle will last through 1998," predicts finance chief McCammon. It's a risky move, especially considering the Big Three's poor track record foreseeing economic downturn. "They are clearly placing one hell of a bet," says management consultant Michael Treacy, author of The Discipline of Market Leaders. That's one reason why Wall Street put the brakes on Ford's market value, which fell 14% last year even as profits more than doubled to $5.3 billion.

Many companies are also expanding aggressively abroad, well aware that foreign sales can mean the difference between salvation and slump if U.S. markets slow. And for companies with big overseas operations already, the plummeting dollar is good news: Their goods will be comparatively cheaper, and repatriated profits will be higher.

International muscle is the key reason the fortunes of Coca-Cola Co. now appear so much better than those of rival PepsiCo Inc. With 68% of its sales already garnered abroad, Coke is intensifying its international push. It has strengthened marketing in much of Western Europe and is spending heavily to build bottling capacity in once-closed markets in Eastern Europe, China, India, and Russia. In Eastern Europe alone, Coke has spent $1.5 billion since 1991. It's gone from having virtually no presence in Eastern Europe to being market leader, decimating rival Pepsi-Cola along the way. Meanwhile, PepsiCo's stock has been depressed by troubles in its U.S. restaurant business. Such distractions allow Coke to pull farther ahead. "There's no way they can catch us" overseas, crows Coke CEO Roberto C. Goizueta. "A hundred billion dollars will not build [Pepsi] the infrastructure the Coca-Cola Co. has today."

Goizueta's bluster reflects a very good year. Coke's international sales shot up 18% in 1994, while U.S. sales increased 15%. That fueled a 17% rise in profits, to $2.6 billion, on revenues up 16%, to $16.2 billion. With Coke's strength abroad likely to buffer any U.S. slowdown, its market value soared 27%, to $70.2 billion. Overall, Coke's market value grew $14.9 billion--the biggest gain of the BW 1000.

Still, not everyone is looking so far afield for new markets; many companies are fighting for position in promising new sectors being created by technology at home. Nowhere is that more true than in telecommunications, where everyone from traditional phone companies to cable-TV providers to Hollywood moguls are scrambling for position. Uncertainty over the eventual winners, not to mention the huge risks of entering new markets, has kept stock prices for the entire sector under pressure. After Bell Atlantic Corp.'s proposed merger with cable giant Tele-Communications Inc. was scuttled, for example, much of the hype over its stock fizzled, sending market value down 2%, to $23.4 billion.

But Bell Atlantic is hardly licking its wounds. It's put its core local-telephone business on a diet of cost-cutting: 9% of its 60,000 employees will be laid off by 1997. And it's also pushing hard to build new businesses, such as its booming $1 billion cellular services unit. Bell Atlantic plans to invest huge sums--some $2.2 billion annually through 1999--on upgrading its telephone network with new digital switches and adding facilities for interactive video and wireless communications services. "We're still seeing [cellular] growth rates on the far north side of 50%," says CFO William O. Albertini. As a new generation of personal-communications service evolves in the coming years, "You'll see the same [growth] occur."

For now, however, such new sectors offer far larger potential than profits. Most of Corporate America will have to settle for about 10% profit growth in 1995, predicts economist Sinai. While slightly above average by historic standards, that's far from the 26% companies have averaged since 1992--and whether it will be enough to satisfy investors remains to be seen.

Yet even as corporate titans complain that strong operating results warrant better treatment by the market, Sinai says few are sharing the wealth with shareholders by raising dividends. Average dividend yields for the BW 1000 remain low, and the average return--the stock price plus the dividend, divided by the previous year's price--was just 8% last year. The average return for the BW 1000 for the prior eight years has been 22%. Having cut dividends during the recession, many are reluctant to raise them. Instead, they favor stock repurchases to boost share prices. "If CEOs are concerned about the dichotomy between profits and valuation," says Sinai, "one way [to close the gap] is a dividend increase in cash-rich Corporate America."

If that's not an option, more might consider borrowing a page from Hollywood, where companies looking to pump their shares have raised the traditional courting of institutional investors and equities analysts to a high art. Viacom Inc. is being particularly aggressive. It needs to get its stock price up to 48--and keep it there--under the conditions of its complicated acquisition of Paramount Communications and Blockbuster Entertainment. But despite strong cash flow and a huge windfall from the success of the movie Forrest Gump, Viacom's difficulties in selling its cable business knocked the stock to around 45. So in late February, the company invited key institutional shareholders and analysts to a three-day, all-expenses-paid meeting at the tony Four Seasons Santa Barbara Biltmore Hotel in Southern California.

The gambit apparently paid off. The stock soon climbed to near the crucial 48. If Viacom can keep it there--and boost it to 52 by summer as promised--the company is in the clear. But if it falls short, Viacom will have to issue new shares worth hundreds of millions. "We don't anticipate issuing any shares," says CFO George S. Smith Jr.

Maybe not. But wringing four more points out of investors could be tough. As even companies turning in stellar performances are discovering, the market is a lot like Forrest Gump's box of chocolates these days: You never know just what you're going to get.

COMING IN FOR A LANDING

How the best-managed companies are preparing for an economic slowdown:

KEEP SPENDING ON MACHINERY AND NEW TECHNOLOGY In the long run, smart buys of new technology lead to big cost-savings, and more efficient manufacturing leads to lower costs and fatter margins.

DON'T ADD TOO MUCH CAPACITY Some companies particularly bruised in the last downturn figure it's better to lose some sales now rather than add capacity that won't be needed in a year or so.

DON'T FATTEN PAYROLLS Despite record profits, most companies resist adding staff. Instead, many outsource.

LOOK OVERSEAS Expanding overseas markets means that U.S.-based multinationals are not entirely at the mercy of the domestic economy.

AMASS PLENTY OF CASH Many companies are hoarding piles of cash. When the downturn comes, those with the strongest balance sheets will feel less pain.By Elizabeth Lesly in New York, with Joseph Weber in Philadelphia, James B. Treece in Detroit, and bureau reports


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