Facing lean times As larger US companies file for bankruptcy, the economy is preparing for a harder landing than expected, writes Andrew Hill Published: December 11 2000 20:07GMT | Last Updated: December 12 2000 10:51GMT

American companies may still be travelling at what appears to be a healthy jog compared with the breathless sprint of earlier this year but already the vultures are circling, waiting for the weakest to drop out.

Private hedge funds and investment banks are setting up funds to buy distressed debt, law firms specialising in bankruptcy and creditors' rights are staffing up. For companies that only a year ago were running production lines at full capacity, boasting about internet-enabled inventory management and struggling to meet demand, the challenges of overcapacity, overgearing and overstocking have arrived with frightening suddenness.

The shock of decelerating growth seems greater because of the record length of this economic expansion in the US. Viewed from the boardroom, the events of the last year have narrowed the financing and expansion options for many executives who until recently appeared spoilt for choice.

Lenders began to pull in their horns two years ago but the extraordinary, technology-led surge in US equity indices tended to cover up the increasingly delicate credit situation. As Alan Greenspan, chairman of the Federal Reserve, pointed out last week, the markets grew more cautious towards the end of 1998, after the global financial crisis dried up liquidity in several markets at the same time.

The sharp decline in the Nasdaq Composite index since March, the failure of a number of over-ambitious technology companies and recent profit warnings and revisions have added to an air of corporate malaise.

Analysts from Mr Greenspan downwards are still reluctant to read too much into this. The Fed chairman pointed out last week that the telecommunications and technology shake-up "seems to reflect an inevitable winnowing process as the market begins to draw firmer conclusions about which firms will be able to establish a long-lived market niche and which will not".

But that does not make the process any more palatable for the companies being winnowed. The number of business bankruptcy filings has hovered between 9,000 and 10,000 a quarter since the beginning of 1999. But bankruptcy and creditors' rights lawyers point out that some recent filings have been large - ICG Communications, the once high-flying telecoms group - and that their own internal evidence suggests a wave of business failures to come.

Moody's, the credit rating agency, is forecasting that worldwide defaults on speculative-grade, or junk, bonds will rise from 6 per cent to 9 per cent 12 months from now, with the majority concentrated in North America. The last time there was such an increase in defaults, in the late 1980s, the result was recession, says David Hamilton, an analyst in Moody's risk management department. "When you have a boom that has been going on for as long as it has in the US, the longer the boom continues, the weaker the credit quality for the marginal borrower becomes. When you get into the late phase, you get a lot of what turns out to be questionable lending."

Not all companies face a credit squeeze. Moody's estimates the probability of default among 9,000 US and Canadian public companies at just over 4 per cent. But even sectors whose credit is good are feeling the pinch. Decelerating sales of personal computers, a surfeit of microchips and sluggish demand for mobile handsets have cut into the revenues of technology companies that investors had believed would easily weather an economic downturn. Intel, Motorola, National Semiconductor, Apple Computer and Gateway have all raised red flags over their growth forecasts in the last two weeks.

Slowing growth is also putting to the test the theory that improved technology would allow companies to manage their inventory better, almost eliminating the build-up of stocks when demand levels off. "That's turning out not to be the case: inventories are turning up in a number of industries," says Jeanne Ter rile, director of strategic research at Merrill Lynch, citing the semiconductor, electrical component and steel sectors as areas facing inventory corrections. "[Inventory] is still behaving in a sort of old-fashioned way," she says.

Companies seeking to raise money or restructure in this less propitious financial climate are under even greater pressure. The decline in the Nasdaq chilled the market for initial public offerings, cutting off equity funding to many companies, particularly in high-technology. Bill O'Connor, who specialises in creditors' rights at Buchanan Ingersoll, the New York-based law firm, says there is a "ripple or domino effect" affecting companies that depended on business from high-tech companies.

Outside the technology sector, where share prices have been stagnant for longer, the increasingly risk-averse investment climate has further constrained companies' options. David Cote, chief operating officer of TRW, the automotive and aerospace components group, says the paths open to his company are limited by its steep debt ratio, and the fact that the automotive sector, which accounts for two- thirds of sales, is already entering a downturn. That has hit the share price and makes some alternatives - such as a spin-off of specific operations - impossible. "We have taken a look at that, but the problem is that we have so much debt that even if you try to do that, you end up with two over-leveraged smaller companies," he says.

The dwindling appetite for high-yield bonds has also nearly closed the road to a leveraged buy-out for public companies seeking to increase shareholder value. On Friday, Johns Manville, the US manufacturer of construction materials, called off what would have been the biggest LBO of the year after failing to agree revised terms with Bear Stearns, the US investment bank, and Hicks Muse Tate & Furst, the private equity firm. The inability of the buyers to finance the deal in the junk bond market was one reason for its abandonment.

The boards of some LBO candidates are baffled by the disproportionate fall in their share prices, because operating conditions have only deteriorated slightly. "A lot of these companies aren't just looking at what they are currently trading at, they are looking at the 52-week high," says Charles Pieper of Clayton Dubilier & Rice, a private equity firm. For directors to consider buy-outs at lower prices, "the market for these companies is going to have to be down for long enough that these boards feel bloody uncomfortable".

So far, few US companies admit to being in difficulty, and none forecasts an old-style recession, but most are bracing themselves for a harder landing than they were expecting three months ago. "[The economy] is softening," says the chief executive of one large industrial company. "How fast? I think fast . . . How deep? I don't know, but I'm going to prepare for it to be deeper than most people think it is."

Mike Pessina, senior vice-president at Lutron, a privately owned manufacturer of lighting systems, says his company has acquired the tools to withstand a downturn. "We've built a closer relationship with our suppliers and involved them more in the overall business strategies of the company - they understand us better than they did eight or nine years ago," he says.

What most companies and investors are trying to reconcile is the gulf between the inflated expectations of a year ago and today's more moderate projections. Abby Cohen, Goldman Sachs' bullish equity strategist, pointed out last week that more than half the companies in the S&P 500 index beat analysts' forecasts for third-quarter earnings. It was "not a bad quarter - but it felt kind of crummy".

Slower earnings growth may feel odd to those used to recent rapid acceleration, but for many US companies it may turn out to be a more sustainable basis for long-term growth.

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-- Carl Jenkins (somewherepress@aol.com), December 12, 2000