Cutting Costs to Increase Profits

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Thanks to some timely tailoring, shares of Gap (GPS) jumped 27% on Nov. 21 even as the retailer's sales fell 8%.

The reason for the favorable reaction was another round of successful cost-cutting at Gap, which boosted profits despite the reluctance of consumers to spend at Gap, Banana Republic, and Old Navy stores.

Across the economy, corporate executives are looking to follow a similar strategy. As a potentially nasty recession sets in and revenues drop, firms are forced to cut their way toward higher profits.

Some analysts predict the Gap can continue boosting profits next year even as revenues decline. But eventually, many analysts say, Gap must find a way to draw more shoppers' dollars—not just cut costs through inventory controls, shrinking real estate holdings, or other measures.

A Short-Term Strategy

"While expense management has been impressive, we continue to wonder how sustainable earnings growth is longer-term with deteriorating sales and given a bleaker economic outlook in '09," wrote Banc of America (BAC) analyst Dana Cohen. (BofA handles banking services for Gap.)

Many other firms are taking similar cost-cutting steps, which often involve large rounds of layoffs. Dell (DELL) was also able to increase profits last quarter despite falling sales. The computer maker said it has cut 11,000 jobs in the past year.

"It's a necessary strategy, but it's a short-term strategy," says Dan Genter, chief executive and chief investment officer at RNC Genter. After a certain point, you're no longer cutting fat from your budget, he says—you're cutting bone.

For some firms, cost-cutting can be a healthy process that repositions them for future growth. Greg Estes, portfolio manager at Intrepid Capital Management, cites Starbucks (SBUX), which is shutting down less profitable coffee shops after "growing too fast" for several years. "If and when a positive environment returns, they'll be in a better position [with] better margins and a better portfolio of stores," says Estes, whose funds own Starbucks stock.

However, Estes says that, with some exceptions, it's generally very difficult to cut costs significantly for more than four quarters. After a while, though you may be widening profit margins, you're shrinking the entire firm.

When Are Cuts Permanent?

The financial sector is the most glaring example of these sorts of permanent cost cuts. Faced with a financial crisis and a tough economy, financial firms are slashing costs, shrinking expenses and perks, and laying off hundreds of thousands of workers—sometime alongside mergers with weaker rivals, sometimes not.

For example, Citigroup (C), the recipient of a federal government bailout Nov. 24, "may end up being a shadow of what it was," Genter says. Citi, like other financial firms, faces the problem of leverage, he says. Because it built its business on borrowed money, its contraction is more striking and more permanent when that leverage goes away.

In corporate board rooms, there is a raging debate on how much and how quickly to cut as the economy slows down. If you believe the recession will be over by mid-2009, you may want to hold onto valuable employees and keep facilities open so you can profit from the recovery.