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Pinching the Pennies in Europe


Anticipating a jump in economic growth, Spanish electricity giants Endesa and Uni?n El?ctrica Fenosa had been planning since 2001 to spend hundreds of millions of dollars building new gas-fired power stations during the next three years. But under shareholder pressure to cut debt, management at the two utilities abruptly changed course earlier this year and quietly decided to cut spending, not boost it. Like other highly leveraged euro-zone power providers, they recently put some major investment projects on hold rather than raise already high debt-to-equity ratios. As a result, just 1,200 megawatts of new capacity will come on line in Spain next year -- a fraction of the 6,400 Mw expected.

With the war in Iraq out of the way, business executives, bankers, and politicians had hoped that an upsurge in capital spending would help kick-start Continental growth. After all, interest rates are at their lowest levels in more than 50 years, meaning that investment projects are relatively cheap to finance. Besides, economists normally expect a sharp rebound in capital outlays at this stage of the economic cycle, as industry prepares for the next upswing.

But what's happening in utilities is being repeated across large swathes of the economy. Companies as diverse as German airline Lufthansa and Belgian financial-services giant Fortis are trimming their budgets for new plant, equipment, and acquisitions in the face of historically high -- and rising -- levels of debt. Just look at France T?l?com. In the first quarter of this year, the company saved $385 million by slashing capital spending. CEO Thierry Breton wants to cut $30 billion from the telecom giant's $76 billion debt over the next three years. "We're going to see significant reductions in capital expenditure," he says.

At the beginning of the year, it looked as if an investment upswing was on the way. The PricewaterhouseCoopers Management Barometer, which surveys the business plans of executives in multinational corporations, found that 44% of European business leaders who were interviewed in the final quarter of 2002 planned to make major new capital investments this year. "We were certain our customers would increase their investment spending in 2003," says the chief economist of a large German capital-goods manufacturer. "But that turned out to be wishful thinking."

That's mainly because the record levels of debt that burden many euro-zone companies make it almost impossible for management to justify any increases in capital spending. It isn't as if there were a huge overhang in total factory capacity. Capacity utilization rates are well above levels in the 1993 recession and just 0.3% below the average of the past ten years, according to Datastream. Yet Richard Reid, chief equity economist at Citigroup in London, predicts overall euro-zone capital spending, which slumped some 4% last year, will decline a further 1% in 2003. "That could be another drag on the already sickly economy," he says. "It is all very disappointing."

Many European companies increased their debt dramatically in the late 1990s as they rushed to finance acquisitions, build new plants, and, in the case of telecom companies, buy intangible assets, namely third-generation (3G) mobile licenses. Overall, euro-zone corporate-sector debt -- which economists define as bank loans, bonds, and pension liabilities -- rose from 60% of gross domestic product in 1997 to almost 80% last year. In the U.S., by contrast, corporate indebtedness grew far more slowly during the same period -- from 57% of GDP to around 69%.

And that's only part of the story. Continental companies' so-called gearing ratios -- debt as a percentage of their market capitalization -- show that their balance sheets are far weaker than those of their American counterparts. According to the European Central Bank, the average euro-zone corporate gearing ratio had reached 110% by the beginning of this year. That's almost twice as high as the U.S. level. As a result, more companies are going belly-up. Creditreform, a research outfit that tracks bankruptcies, says a record number of German corporations will go bust this year -- most smothered by a rising tide of debt. "The outlook is bleak," says Creditreform chief Helmut Rodl.

Telephone companies such as the Netherlands' KPN and Deutsche Telekom, which shelled out billions on mobile licenses at the end of the 1990s, have some of the highest ratios. But many smaller manufacturing companies, such as German automotive and power distributor Moeller and Dutch medical technology supplier Jomed, aren't in much better shape. Many euro-zone companies are now so heavily in debt that their shareholders and bankers are demanding urgent action to hold down leverage in order to strengthen balance sheets and boost stock prices.

One of the easiest ways of doing that is to cut back on investment. That's one reason KPN Mobile says it will slash this year's spending on 3G equipment from the more than $6 billion it planned to less than $2 billion. Decreased spending by traditional engines of economic growth such as energy utilities is bad news for major suppliers such as Germany's Siemens, construction companies like France's Bouygues, and gas suppliers, including Spain's Enagas. Antonio Gonz?lez, Enagas chairman, says orders for natural gas this year are far lower than anticipated, which could eat into revenues and profits next year. "We have received guarantees of just $330 million from electricity companies who want us to provide them with gas," he laments. "That's much less than expected."

Some executives are already sounding the alarm. Siemens CEO Heinrich von Pierer says: "Weakness in capital spending across our major regions and markets is a concern." His power-generation group has seen orders fall 35% in the first quarter. Michael Hartnett, director of European equity strategy at Merrill Lynch & Co., says that sagging investment is one more drag on depressed stock prices. Some companies, including France T?l?com and conglomerate Vivendi Universal, are reducing debt by raising fresh equity and selling off noncore subsidiaries. But with the capital markets in a weakened state, only a few corporations are in a position to do so profitably. Others have little choice but to cut back spending. No pain, no gain. But for Europe, the gain is long in coming. By David Fairlamb in Frankfurt with Carol Matlack in Paris


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