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October 19, 2000

Recent Financial Market Turmoil
Puts a Crimp on Capital Spending

By JACOB M. SCHLESINGER and GREGORY ZUCKERMAN

Staff Reporters of THE WALL STREET JOURNAL

In Fort Worth, Texas, the turmoil in the financial markets is having a direct impact on Burlington Northern Santa Fe Corp., where railroad executives plan to cut capital spending by 9% next year, partly because the costs of raising money are now so high.

In Atlanta, the markets are casting a shadow on an Internet consultant called iXL Enterprises Inc. The company has ratcheted down capital spending plans for 2001 by more than 40% from this year, and could go even further, "depending on what the broader market does," says Chief Financial Officer Michael J. Casey.

And in Rochester, N.Y., the markets are feeding a broader gloom at Eastman Kodak Co. The photo giant is trimming its $1.1 billion spending plan for this year by 10%, and it is hoping to pare an additional $100 million next year. "We're managing the company as if there will be the 'R' word next year," says Bob Brust, chief financial officer. "I've been around a long time and it sure smells like one."

The 'R' word is "recession," a term many people thought had been erased from the American economic lexicon. Now, if more companies believe big cutbacks are in order, the odds rise that the much-heralded soft landing -- where growth slows enough to prevent inflation but doesn't push up unemployment -- becomes something harder.

Turbulent Trading

At the heart of these cuts are the recent troubles in the financial markets. Companies issuing bonds rated below investment grade -- known as junk bonds -- now have to pay interest rates of 13% or more to get investors to buy new bonds. That's up from 11% earlier this year and 9% in early 1998. And that means companies have to spend more of their money on interest payments.

Stock prices, meanwhile, are down 16% from their peak. Wednesday, in turbulent trading, the Dow Jones Industrial Average closed below 10000 for the first time since March, finishing at 9975.02, down 114.69, or 1.1%. The Nasdaq Composite Index sank to its lowest intraday level of the year, before rebounding a bit to close down 42.40, or 1.3%, at 3171.56. The market for initial public offerings appears to be weakening. Of the 27 deals that were expected to go public last week, only 14 did. They raised about $4 billion out of a possible $6 billion, making those IPOs, collectively, one of the weakest performances in several months.

Market turmoil can be both a cause and an effect of cutbacks in capital spending, producing a downward spiral as the two reinforce each other. "If the sell-off in the stock and bond markets is not relatively quickly reversed, it will contribute to a deceleration in capital spending," says Chris Varvares of Macroeconomic Advisors, a St. Louis forecasting firm. "To the extent that you lose capital spending, you lose a lot of the good things we've seen in this economy in recent years, like faster productivity growth and higher earnings."

ISI Group economist Ed Hyman was even more dire in a recent report: "A very high correlation has developed between swings in the stock market and swings in the economy," he wrote. "We currently have odds of recession at 40%, but if the stock market continues to get hit, odds of recession will increase."

A growing concern: Corporate debt levels are already at record levels, and companies are defaulting on their interest payments at the fastest rate in almost a decade. If the economy slows, companies will have more difficulty keeping up with their debt payments, raising the odds that they'll slash all kinds of spending to save money.

There are still plenty of reasons to be optimistic. Consumer confidence remains near historical highs, unemployment is at a 30-year low, and inflation, despite Wednesday's slight rise, is still remarkably calm. The strong dollar has kept capital flowing in from abroad, and even with the recent market turmoil, American financial markets are still providing plenty of money for growth. Companies with high credit ratings can actually get a lower rate on bonds than they did earlier this year, as long as they can find investors willing to buy their bonds.

The consensus forecast of leading economists surveyed by Blue Chip Economic Indicators expects Gross Domestic Product growth of 3.5% in 2001. That's down from this year's expected 5.2%, but hardly a downturn.

In addition, the drive by companies to take advantage of new technologies remains strong. Corporate spending is "heavily driven by the technological opportunities that are out there," says Martin Baily, the chief White House economist and an expert on corporate investment and productivity.

Signs of life were evident in the tech sector Wednesday. Even amid the market downdraft, network analyzer Ixia had a successful IPO reminiscent of Nasdaq's heyday, with its stock closing 58% above the initial offering price. Two technology leaders, Microsoft Corp. and Sun Microsystems Inc., released upbeat earnings on strong demand for their products.

The tech boom continues for Medtronic Inc., the big Minneapolis based medical device maker, which is pushing ahead with an ambitious 28% boost in capital expenditures for the fiscal year ending in April. Profits remain strong enough that the company continues to be able to fund that $400 million plan from its own coffers, without turning to volatile financial markets. Plans for new factories and production space in Switzerland, Puerto Rico and Arizona remain on track, too, "to meet increased demand" for new neurology and cardiology products, says Arthur D. Collins Jr., chief operating officer.

And for some companies that are facing higher capital costs, rising productivity -- the driving force of the economic boom -- minimizes the impact. Lear Corp., a Southfield, Mich., automotive supplier, says new efficiencies have offset the higher interest rates it pays for its borrowing.

Federal Reserve officials, who helped engineer the slowdown to date with a series of interest rate increases during the past year, still see spending and other economic indicators as strong. They regard recent events as merely a deceleration from hyper-charged growth to more normal levels.

"If the economy is growing at more than a 5% annual rate and suddenly it appears over the course of several months that it is growing in the range of 3% or so, it's going to feel slow, but it is not by any historical standard," Fed Vice Chairman Roger Ferguson said in an interview last week. Fed Chairman Alan Greenspan will give a closely watched speech on the New Economy in Washington this morning, his first public comments on economic conditions in weeks.

Investment Spending

Since this economic expansion began in the spring of 1991, its special trait has been the boom in investment spending, which has kept growth strong and raised productivity. For five years running, business spending on nonresidential fixed investment has contributed a full percentage point or more to growth in the gross domestic product. From the 1960s through the 1980s, that figure was often closer to half a point, or even negative.

The surge in investment has been strongly linked to the surge in stock and bond markets. Strong demand for capital equipment -- especially for computers and the like -- has pushed up revenue, profit, and stock prices for many companies. hat, in turn, has allowed them to expand. When investors were scoring big gains in the junk bond market in recent years, upstart telecommunications companies were able to take advantage of the easy money. They sold a record $27 billion of bonds last year alone to build newfangled, high speed communications networks, key lanes in the emerging information superhighway.Now, the door to financing has abruptly shut for many of these companies, some of which have paltry earnings, or none at all. Just $15 billion of these telecom bonds have been issued this year, and the market is getting more inhospitable daily, especially to growing companies dependent on the cash. This leaves many telecom companies under pressure, with work on new networks under way.

Down Other Avenues

Williams Communications Group Inc. is building the biggest nest generation fiber-optic network in the country, but has finished only 27,000 of the network's 33,000 route miles. Although Williams says it has enough money to reach mile 33,000, analysts expected Williams to tap the stock or bond market to raise cash to extend the network and increase its capabilities. But that may not be possible if the bond and stock troubles continue for a while. Though banks are still lending, they also are pulling in the reins to lower-rated borrowers, and they don't usually provide long-term lending like the bond market "Companies like Williams that have relied on the public markets to fund their business models will have to pursue other avenues, like tapping private equity or banks, but their options are limited," says Aryeh Bourkoff, a telecom analyst at UBS Warburg LLC. While Mr. Bourkoff says Williams should make out fine, "many telecom companies that do not have strategic partners will be forced to file for bankruptcy."

"We have many funding options at our disposal and aren't forced to go back to the public markets at any time soon," says Howard Kalika, treasurer at Williams.

For other businesses in other industries, the new math of the markets -- with higher capital costs and lower returns -- does equal cutbacks. Burlington Northern Chairman Robert Krebs estimates that the company's return on invested capital is about 9.5%, while its cost of capital is now 11%-12%. Higher fuel prices and an expected slowdown in customers moving freight have injected further uncertainty into the railroad's profits. As a result, it is deferring projects, such as adding more double track to its routes connecting Chicago with the West Coast, or expanding routes to Wyoming's coal fields.

Stock Instead of Steel

The company now considers it a better investment to buy its own stock than to buy new equipment. "Right now, buying our stock appears more attractive than laying new steel," Mr. Krebs says. "One way to improve the return on capital is you spend less capital." Host Marriott Corp., which owns 130 hotels and resorts in North America, expects to cut its capital budget by 20% next year, after completing some major projects this year, like a 500 room addition to its Orlando hotel. That's because the price-to-earnings ratio of its stock is half what it was three years ago, when many of the big projects were launched, "making our cost of capital substantially higher than it used to be," says Chief Executive Christopher Nassetta.

So now the company, instead of expanding, is focusing on moves to boost the profitability of existing properties. The hotelier spent $200,000 to add plush furnishings and a business lounge stocked with drinks and treats to rooms at a Chicago hotel. The cost, says Mr. Nassetta was "minimal, ... but the payback is incredible," allowing Marriott to boost rates per night by $90 to $100.

Beyond capital spending, some analysts are expecting other corporate budget cuts as well as a slowdown in growth and profits. Merrill Lynch Co. just this week scaled back its forecast for U.S. advertising growth in 2001 -- to 5.5% from an earlier projection of 6.9%. Online advertising is now seen growing 15% to 20% next year, down from the previous Merrill forecast of >30% to 40%.

A 'Nervous Nellie' Issue

Those are still strong numbers. Time Warner Inc.'s chairman, Gerald Levin, Wednesday scoffed at worries of a broader advertising slowdown as "spurious" and a "nervous Nellie manufactured issue." Announcing strong earnings and revenue growth at a news conference, Mr. Levin declared, "we have the most resilient economy in the world."

A key sign of that resilience is that corporate profits remain strong. The stock market has been tumbling because earnings haven't been growing at the outsized pace that investors have been expecting. But companies are still expanding earnings at a good pace, which means they've got plenty of cash on hand to spend if they want to.

Prudential Securities economist Richard Rippe estimates that pretax profits this year will jump by 15.2%, nearly double the pace of 1999. For next year, he sees a 6.8% rise. As a result, he expects net cash flow this year to increase by 11.8% and a further healthy 8.8% next year.

In Mr. Rippe's view, the recent market swoon "will exert a little more restraint at the margin" in capital spending. "But the overall economy, profits and cash flow are the dominant determinants of capital spending," he adds. "It would take a much worse economic environment in order for companies to really start slashing capital spending budgets." The bottom line is that Mr. Rippe expects a slowing, but not a plunge, in capital spending next year. He sees growth of about 8.5% in 2001, down from about 15% in 2000.

General Motors Corp.'s stock is trading near its 52 week low after announcing a 5.5% drop in net income last week. But that hasn't sent budgeters back to the drawing board. The firm's spending decisions depend more on its cash on hand, says spokeswoman Toni Simonetti. And the company had $13.5 billion at the end of the third quarter, half a billion more than its goal.

Cincinnati based Fifth Third Bancorp went ahead this week with groundbreaking on a new operations center that required doubling its construction budget to $120 million over the next year. The project is funded out of internal revenue growth, not capital markets. Even many of the struggling dot-coms and Internet firms vow to keep up spending despite their market woes, sensing that demand for the end products-- if not their stock -- continues to soar.

Search engine company AltaVista Co. recently was forced to put off its initial public offering, but the company still expects to add $10 million to capital spending next year, a 25% increase over this year. The company has seen its customer base grow 68% per year, and doesn't see a letup. "Our requirement for capital equipment is a function of the number of people who use our services," says Chief Financial Officer Ken Barber.
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--Daniel Machalaba, William M. Bulkeley, Kara Scannell, Rebecca Smith, Patrick Barta and Amy Merrick contributed to this article.
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"TALKING IT OVER & THINKING IT THROUGH"

1) Give five examples of corporations that are Crimping on their Capital Spending.

2) Economist Ed Hyman is reported saying that "A very high correlation has developed between swings in the stock market and swings in the economy". How would you explain this statement to the average person on Main Street?

3) Make a list of the "determinants of capital spending" that are noted is this article.

4) Do you see text book concepts 'in action' in this article? Explain. Illustrate with graphics where applicable.
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