RESTORING AMERICA’S COMPETITIVE EDGE : Inflation-Fattened Firms Forced on a Crash Diet : Business Wakes Up to New Environment

“For the first time in decades,” boasted a recent report by Merrill Lynch & Co.,

“U.S. industry is taking stock” of its once tried-and-true business strategies--and scrapping those that no longer work.

The brokerage firm, ever bullish on America, sang the praises of dozens of companies that are restructuring to devote all their efforts “toward improving efficiency, bolstering profitability and enhancing competitive positions.”

But if many U.S. corporations are now striving to become lean and mean, the transformation has been painfully slow in coming. And the key question remains: Why weren’t American managers making those tough decisions all along?

The answer lies buried deep in the inflationary psychology that dominated American life in the late 1970s and early 1980s.

Most American business executives, lulled by the ease of generating steadily higher profits and overconfident about the threat posed by foreign competition, were as much as a decade late in beginning to streamline their operations for the inflation-free world that they must now live in.

Steven McLin, chief of strategic planning at BankAmerica Corp., described the complacency prevailing not only at his troubled San Francisco-based financial institution but also among American business in general:

“In the 1960s and 1970s, we were all making a lot of money. We thought it was because we were smart. But because we were making so much money, it masked a lot of problems we were creating.”

Top executives received ever-mounting salaries and perquisites even as their tardy recognition of the new business environment exacted punishing costs--slower economic growth, lost markets for U.S. companies and less attractive jobs for American workers--on almost everyone else.

Even before the first oil shock in 1973, American business leaders began blaming outside forces--stagnant productivity, rising foreign competition, inflated wages, unruly consumers and adverse government policies--for interfering with their ability to generate profits.

But few corporate executives dared question how their own business practices contributed to deteriorating industries and an increasingly uncertain economic outlook.

“For years, American managers had blinders on about themselves,” said James O’Toole, author of “Vanguard Management” and a leading management scholar at the University of Southern California’s business school.

As prices escalated, thousands of the nation’s most sophisticated investors and executives, like millions of smug homeowners gloating over the rising value of their property, became convinced that high inflation would allow them to continue generating healthy profits indefinitely.

Most executives of established corporations quickly discovered that they could stay one step ahead of the game simply by raising prices and expanding output of existing products rather than by making the far more difficult choices on how to cut costs, modernize operations and bring innovative technologies to market ahead of their domestic and foreign competitors.

Borrowed to the Hilt

The prospect of never-ending inflation made borrowing irresistible because loans could be repaid with deflated dollars. Many firms hit upon a veritable cornucopia of riches by borrowing to the hilt to finance corporate takeovers and speculate in apparently risk-free assets such as oil, land and other natural resources.

But when inflation rates collapsed, so too did thousands of corporate structures built on the shaky foundation of ever-rising prices.

“The flip side of inflation is not as pretty as some people think,” said Irwin Kellner, chief economist for Manufacturers Hanover Trust in New York. “You had several generations of managers running corporations who didn’t think twice about raising prices in response to stronger demand or higher costs. But today, to paraphrase the ad, these companies are having to make money the old-fashioned way--they have to earn it. Many are not accustomed to doing that, and they’re crying the blues.”

The fall from corporate grace has come with startling suddenness for many companies.

Fluor Corp., for example, skyrocketed during the worldwide construction and energy boom of the 1970s, growing fat and happy on billion-dollar engineering projects required to fuel the grandiose plans of oil-rich OPEC countries, starry-eyed Latin American government planners and megawatt-hungry utility executives.

Times were so good at the Irvine-based firm, Chief Executive David S. Tappan Jr. confessed earlier this year, that Fluor ended up owning “a lot more (real estate) around the world than we remember acquiring. We went into it when we had more money than we knew what to do with.”

Ill-Timed Splurge

Looking for diversification opportunities and convinced that the prices of raw materials would continue to escalate, Fluor plunged deeply into debt in 1981 by spending $2.2 billion to acquire St. Joe Minerals Corp.--just as the price spiral was unraveling, oil prices were leveling off and the value of basic commodities was plunging.

Ever since, it has been struggling to pick up the pieces from the ill-timed splurge and to cope with weak demand for its megaprojects by drastically cutting back its operations and laying off thousands of highly skilled employees.

Burdened by a long-term debt that soared 14-fold in 1981 to $1.1 billion and locked into interest rates as high as 15%, the company was forced to slash its capital spending and sell off most of the assets that it acquired in the deal in an effort to reduce its debt burden to tolerable levels.

Recently, Fluor announced further write-offs of $410 million that are expected to leave the firm with losses of more than $600 million for the year. It hopes such drastic pruning will finally clear the underbrush for improved growth over the next few years.

“If our markets remain depressed, Fluor should still deliver gradual improvement,” Tappan said. “When our markets improve, we are ready to respond and would expect dramatic gains.”

While inflation temporarily propelled dozens of solid business stars such as Fluor into all too short-lived corporate supernovas, the sparkle of inflationary profits during the 1970s also bedazzled many of the nation’s traditional business giants into the illusory belief that they were continuing to outshine their rivals.

Radical Transformation

Eastman Kodak, for instance, had long been one of the bluest of the blue chips, relying on its century-old dominance of the photography business to become a glittering jewel in the American corporate crown.

But in the 1970s, even as it continued to rack up record sales and profits, Kodak was faltering in its efforts to develop new markets and fend off challenges from Japanese competitors.

Only this year, after a prolonged period of eroding profitability, did Kodak begin a radical transformation.

Kodak’s difficult scramble to regroup is mirrored at scores and scores of other major U.S. corporations.

“Cutting costs is the whole name of the game in U.S. business today,” said A. Gary Shilling, an economist who heads his own consulting firm in New York. “The idea of protecting domestic labor and people who’ve been with the company forever has disappeared. The United States has been clearly revealed as the world’s high-cost producer. That’s why things have happened so quickly.”

To Shilling and other analysts, it was clear that the problems were simmering just under the surface even before inflation began its unexpectedly rapid retreat about four years ago.

From 1978 to 1982--a period that covers both the most virulent price spiral and the start of disinflation--after-tax profits averaged 6% a year at more than 500 of the nation’s largest corporations surveyed by Business Week.

But using inflation-adjusted accounting--a practice first required by the Securities and Exchange Commission in 1976 over the objections of business leaders--profits actually fell over that same period by 2% annually.

Sales Went Flat

Similarly, the strong sales gains reported by major corporations, averaging 10% a year over that five-year period, look much weaker when the beguiling charms of inflationary growth are dropped. Adjusted for inflation, those corporate sales were actually flat from 1978 through 1982.

Not only did inflation mask many of the weaknesses of U.S. industries, but the sagging dollar that accompanied it also contributed to the cosmetic glow of prosperity in the late 1970s by falsely convincing most companies that they were cost-competitive with their foreign rivals.

“Inflation and the weak dollar covered up a lot of sins,” admitted Edward Smith, chairman of Omark Industries, the Portland, Ore.-based company that is the world’s leading maker of cutting chain for chain saws.

With the dollar strong and inflation under control, Omark--recently acquired by Blount Inc. of Montgomery, Ala., for $280 million--has been forced to eliminate inefficiencies that it didn’t even recognize only a few years ago.

“We were riding high in 1980 and 1981,” Smith said, “but after the dollar rose, we realized that we might even have to cut prices if we wanted to retain our market share. We had to get all the fat out, and even some of the lean.”

That meant, among other things, shutting two relatively new plants and laying off 350 workers in Puerto Rico this year to consolidate manufacturing operations elsewhere.

Some Acted Quickly

But while many executives were ignoring the warning signals--or deciding that they were only temporary--a few corporate pioneers were prompted to launch their own radical restructurings years before their industry brethren.

Sometimes more farsighted than others but often just in more desperate straits, they are now in many cases reaping the benefits of the wrenching changes in business strategy and corporate culture that began for some of them more than a decade ago.

“I saw the handwriting on the wall in 1972 when I went to Japan and looked at Sony’s first three-quarter-inch videotape player,” said Donald N. Frey, chairman and chief executive of Bell & Howell, once a leader in the home movie camera business, which has been rendered nearly extinct by video recorders.

Frey, looking back at more than a decade of restructuring and “asset redeployment” at the Chicago firm, says his strategy over that period boiled down to: “If you can’t beat them, join them.”

So rather than hanging on to its film-based business until the bitter end, Bell & Howell pioneered the videotape duplicating industry and today is the largest tape duplicator in the world.

And, expanding from its traditional audio-visual programs for schools, the company became a leader in career education, textbook publishing and computer-based microfilm systems for information retrieval.

Board Backed Management

Bell & Howell’s directors stuck with Frey’s top management team through a “lot of tense meetings,” he admits. “We were fortunate to have continuity of management--that’s rare. We were left here long enough to figure out from our mistakes how to get out of the valley of the shadow of death.”

He had enough to turn Bell & Howell around, Frey points out, because its executives were not under constant pressure from notoriously short-term-oriented institutional investors to produce instant results.

“Wall Street gave us up for dead when our stock hit bottom in 1974,” Frey said. “That may have been the best thing that ever happened to us.”

The results suggest that Bell & Howell has achieved much of what it hoped to accomplish through the decade-long restructuring.

Earnings, after slumping for several years and then hitting bottom in 1979 with a loss of $24.9 million, gained ground steadily, with the company reporting a profit of $33 million last year.

Return on shareholders’ equity more than doubled to 13.7% (Frey’s goal is 17%) from a bleak 6% in 1978, the year before Bell & Howell shut down its consumer photo division.

Other firms, sometimes prodded by outsiders, foresaw the drastic upheavals coming in their industry and developed new approaches to meet the impending challenges.

For instance, Southern California Edison, motivated largely by inflation-induced high interest rates and anticipated weakness in the demand for energy, shifted in 1980 from building nothing but huge coal and nuclear power plants to pursuing a diversified strategy based on energy efficiency and smaller co-generation facilities in which industrial users convert their wasted heat into electricity that they feed into the electric company’s grid.

Difficult Readjustment

This radical approach in an industry that is one of the most hidebound in the country required a difficult readjustment in the face of private attacks and public doubts from dozens of utility executives around the country.

“We had to overcome a conditioned reflex to simply defend the traditional practices of our industry,” said Howard Allen, chairman of the giant utility. Allen says the genesis of the shift grew from a trip he made to West Germany with utility regulators and industry outsiders to observe co-generation facilities.

The new approach helped the Rosemead-based utility avoid the nuclear debacles currently wracking much of the power industry. It also smoothed the way with state regulators and tough critics such as the Environmental Defense Fund--and enabled SoCal Edison to produce some of the strongest financial results in the industry.

“Southern California Edison is on the leading edge of the industry,” said Irvin (Chip) Bupp, a business professor at Massachusetts Institute of Technology and a leading utility consultant. “They have led the change from a cadre of management that grew up in the ‘50s and only knew how to build and build--to a new era where utilities are forced to keep a much closer eye on the financial side of the business to avoid disaster.”

For most executives, however, even the onset of low inflation, the strong dollar and lofty real interest rates in 1982 failed to shake their confidence in the old ways.

With most economists predicting a renewed burst of inflation just around the corner, many executives found it safest to avoid the difficult decisions that would be required to restructure their companies to make money in a sustained environment of low inflation.

Urged to Wait

John Rutledge, president of the Claremont Economics Institute, said sarcastically: “In board room after board room across the country, chief executives sit with glum faces and listen as experts explain how rising deficits, a crushing debt burden and an impending crash of the dollar are going to send the U.S. inflation rate soaring again--soaring all the way back to levels that will validate the inflationary strategies that those same chief executives adopted for their companies in the late 1970s.

“Paying someone to tell you that the biggest mistake of your life was actually a shrewd piece of strategic planning is big business today.”

But now, in the fourth year of low inflation, more and more top executives are belatedly acknowledging the need to adapt to the new environment by rushing to restructure their firms. They candidly admit that their prime motivation is the fear of failure if they don’t.

“The sense of invincibility of American business is gone,” said USC’s O’Toole. “Their self-confidence has been shaken to the core. That’s what makes them willing to try some new things that would have been rejected out of hand five or 10 years ago.”

Times staff writer John M. Broder contributed to this story.