Withhold the Praise for Corporate Cosmetic Surgery

Job cuts and restructuring charges don't guarantee a reversal of fortune for ailing companies.
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Corporate America's steady diet of spending cuts and asset sales isshowing up in the unemployment numbers, but many companies are still waiting for their restructuring moves to lift the bottom line.

Just because a company records a big restructuring charge, experts say, the firm isn't necessarily taking charge of its business. And just as no diet is a quick fix, it'll take more than just an economic recovery for most businesses to get back in shape. Economists say the deep cuts in capital spending and payrolls generally lag behind economic recoveries.

"Downsizing certainly does not lead to an immediate turnaround incompanies, and may not work at all," said Kenneth De Meuse, a professor of management at the University of Wisconsin-Eau Claire. De Meuse tracked the financial performance of Fortune 100 companies, before andafter a restructuring, from 1987 to 1998. "Too many times, the stock market wants instant results, and that's not going to happen," he said.

Slimming for Profit

During the past year, corporations have been paying for the excesses of the late 1990s, when companies fattened up investments, workforces and inventories, in anticipation of unbridled demand. Restructurings, and particularly layoffs, have intensified since the terrorist attacks on Sept. 11, as evidenced by Friday's Labor Department report, which showed that 415,000 jobs were lost in October, bringing the unemployment rate to 5.4%.

According to data by Morgan Stanley's equity strategist team, U.S.firms in the S&P 500 will take a record $125 billion in restructuringcharges this year, with the bulk

82% of the total charges coming from the tech sector. The last time such widespread charges were seen was in 1992, when the U.S. economy was stepping out of a recession.

Strategists say the rash of restructurings will depress short-termeconomic activity, though the actions should lead to earnings growth and recovery. "There is an extremely strong case for a cyclic upturn in earnings to follow corporate action," Steve Galbraith, Morgan's equity strategist, wrote in a recent report. "It is crucial for investors to consider that the third-highest level of operating earnings growth for the S&P in the last 50 years occurred in 1993 -- the year after an all-time record for restructuring charges was announced."

Morgan's study found that companies taking charges ofmore than $1 billion end up financially stronger and exceed their previous peak levels of operating margins, return on earnings, and return on capital. Watch for tech earnings to grow something on the order of 40% to 50% in 2002, Galbraith wrote.

But Professor De Meuse said the turnaround isn't always swift. Hisstudy of Fortune 100 companies found that large companies didn't see a financial improvement until at least three years after downsizing.

No Quick Fix

Investors are skeptical of restructurings. According to Galbraith, companies over the past decade that have taken chargesunderperformed the market by almost 20 percentage points in the yearfollowing the charge. Investors often interpret downsizing as a confession of wrongdoing.

"You can be restructuring to survive and it'll simply be a sign ofweakness," agreed Larry Wachtel, equity strategist at PrudentialSecurities. "No one's very impressed with that." And sometimes the cuts are merely cosmetic. "It's easier to get in there and start slashing away at the cost part of the income statement than it is to jump in and generate revenues," said Patrick Gaughan, president of Economatrix Research Associates and a business professor at Fairleigh Dickinson University in New Jersey.

How does one differentiate between a solid restructuring plan and asuperficial one? Make sure companies are "hitting at all the issues of the business," said J. Randall Woolridge, a professor at Pennsylvania State University. "I think it's important to look out for a well laid out plan instead of

restructuring on a piecemeal basis."

Investors should also determine if cyclical factors, such as excess capacity, are affecting an entire industry. The telecom sector is a case in point, said Wachtel. Many telecom stocks have suffered as a result of cost cuts, but "I'd say

that's the key to their survival," Wachtel said. For instance, earlier this week, French telecom equipment maker



disclosed plans to slash 10,000 additional jobs, meaning the company has cut its total workforce by about one-third since the start of the year. Nevertheless, the stock surged 8.5% after the latest announcement, as investors apparently figured the cuts could lead to improved business by the second half of 2002.

"I'll look at what else the company is doing other than cutting people to control costs," said De Meuse, who criticized layoffs as a way for executives to please investors, but not much else. Stock pickers should also do some in-depth digging for things like the salary levels of top executives. Indiscriminate job cutting is also a warning sign, said De Meuse, noting that successful restructuring plans are those that employ selective, rather than across-the-board, job cuts.

With downsizing becoming the rule, Wall Street should learn how to tell a cosmetic change from a turnaround.