A global downturn might appear to give companies with sufficient resources an unprecedented opportunity to buy assets or acquire market share on attractive terms. Indeed, many nonfinancial companies seem well positioned to do so, having entered the present crisis with stronger balance sheets than they had in past recessions,1 when businesses that followed countercyclical patterns of cash utilization and spending fared much better than those with purely defensive strategies.2
Yet this crisis shows signs of being the most dire and unpredictable one since the Great Depression. At the end of 2008, most national economies were experiencing the sharpest fall in consumer and business confidence in 20 years. After an unprecedented five- to ten-year boom, commodities have experienced their steepest decline since 1945. Experts expect several quarters of negative growth and substantially higher unemployment rates. Indeed, for many companies, survival is not a certainty. What’s more, the broader forces at work in the global economy mean that the underlying economics of strategies could continue to shift with unprecedented speed and scale. Such extreme uncertainty demands constant attention, frequent changes in priorities, and strategies that anticipate and respond to a changing landscape.
Against this backdrop, the role of the chief financial officer takes on critical importance. CFOs must use their deep understanding of financials and liquidity to understand how volatile prices and demand will affect the performance of their companies, both to manage potentially lethal threats and to ensure the availability of the financial resources required for countercyclical investments. Most CFOs will need to replace traditional approaches to budgeting and planning with a more aggressive one underpinned by a reexamination of earlier assumptions about earnings and growth and about how deep the downturn will be.
A surprisingly high proportion of companies are still implicitly building their budgets and investment plans on the assumption that they will return rapidly to top-of-the-cycle performance. Many CFOs will need to challenge such optimistic assumptions by asking a few uncomfortable questions.
What’s “normal” performance?
Many executives still have unrealistic expectations about future growth and margins. In general, nonfinancial corporations performed very strongly heading into 2008, having enjoyed much higher profits and return on capital in 2006 and 2007 than at any time in the past 40 years.3 Return on equity, for example, reached 18 percent in 2007, compared with its 40-year average of 13 percent. US earnings reached 6 percent of GDP in 2007, compared with a 40-year average of 3 percent. While some reversion to the mean is underway, in 2008 performance is still likely to beat the 40-year trend.
Projecting what will be normal performance after the end of the present downturn requires careful consideration of an industry’s cyclicality and microeconomics. CFOs will need to supplement recent averages with an analysis of the structural changes likely to persist beyond the recession. Growth in demand for many natural resources, for instance, could well be structural, and supply capacity is short in the medium term. All this implies that investments in natural resources might be sound. Other industries, such as finance, may be undergoing long-run structural shifts, possibly returning to the levels of profitability and industry scale that prevailed 10 years ago.
How bad could things get?
Although most companies are already acting on the cost and investment side or have contingency plans to do so, few of them deal adequately with the type of sharp, long downturn that is now possible. Recent months have underscored the impact of changes in confidence and the role of government intervention not only in banking but, increasingly, in other industries as well. The confidence of consumers, corporations, and providers of capital, as well as the actions of governments, will of course be pivotal in determining how quickly the economy recovers. Since all these variables are difficult to forecast, companies must prepare for the worst by considering what might happen in an extreme downturn.
Where is the real opportunity?
Previous recessions have shown that downturns create organic and inorganic growth opportunities that are different from those arising in boom times.4 In the US mortgage industry, one of the earliest victims of the crisis, for example, small lenders are thriving and have increased their market share massively as large banks attend to restoring their balance sheets. The valuations of banks, car manufacturers, and natural-resource companies are down more than 50 percent, so they could represent real and unique opportunities for well-positioned companies to consolidate sectors or venture into adjacent markets. As in other recessions, some companies are already successfully buying on the cheap. But CFOs need to assess the reality of the opportunity by understanding the long-run industry economics, for a number of companies have already bloodied their hands trying to “catch a falling knife” in this downturn.
Extreme crisis planning
The new assumptions should underpin a new approach to the annual budgeting and planning process. Most companies ought to throw out the traditional one and adopt a crisis-planning mode focused strictly on cash flows, not accounting profits. For this reason, CFOs must emphasize financing decisions, capital expenditures, and working-capital changes and adopt a scenario approach that is more common in longer-term strategic planning. Ideally, the CFO should prepare two or three scenarios built upon different macroeconomic assumptions—base case to worst case. These scenarios should also reflect company-specific risks, such as the sudden unavailability of short-term funding, bankruptcies of major customers or suppliers, or a loss of access to working capital in the local currency. And the CFO must develop contingency plans in the event that these scenarios should actually come to pass.
In the best-run crisis-planning efforts we’ve seen, the CFO manages the work in a centralized “war room,” assembling a cross-functional task force that includes team members from the finance function, as well as representatives from the sales, supply chain, production, and business-management functions. The task force examines cash flow–related mechanisms, such as how many days it takes to convert raw-material expenses into customer payments for finished goods—often half a year—the extent of the sales force’s accountability for credit losses, and whether operating units have incentives to maximize cash at the expense of earnings. The task force then moves on to a more operational phase of its work, using the war room to monitor and manage payment flows, operating profitability, investments, and funding activities.
In building these plans, CFOs will need to evaluate and quantify all cash-generating measures in each scenario. Most of them will be familiar, reflecting what we know from experience are the priorities of many companies. Even so, our experience also shows that there’s value in maintaining a checklist to avoid overlooking things in the heat of battle.
Many corporations still keep their cash in several legal entities and plan their liquidity on a monthly basis, with a generous cushion. In a crisis, they should adopt more aggressive practices. Leading banks, for example, have daily liquidity updates, sophisticated estimates of cash needs up to 360 days in advance, and structural analyses of the current and projected balance sheet. As bank analysts develop their forecasts, they take into account external risks, such as currency shifts or a failure of counterparties to pay. Some banks also pool cash on a daily, even real-time, basis.
Secure short-term funding
In normal times, best practice may be for companies to engage with a number of banks that compete to provide them with credit and short-term funding. Under extreme circumstances, however, stronger partnerships with fewer, stronger banks could make more sense. Companies will find that such banks understand their needs and risks in greater detail and are willing to commit more credit, orchestrate financing, and propose innovative solutions to finance receivables. In some cases, companies are better off drawing down credit lines even if they are not yet needed.
CFOs looking to generate cash over the next 12 months often find that the single biggest opportunity is to reduce working capital by tightening up management. A global chemical company, for example, has implemented a plan to shave 25 percent off its net working capital by billing earlier, enforcing payment terms, reducing safety stocks, and improving production planning. These moves will generate additional one-off cash flows higher than the current annual operational cash flows. CFOs should also consider steps (including changing credit terms for riskier customers) to deal with a potentially dramatic increase in nonpayment. Some companies are even considering the creation of special collection units—similar to the credit workout groups banks use—to recover receivables from clients.
Streamline capital expenditures
The need for additional output drives most capital expenditures, either directly, through higher capacity, or indirectly, though higher productivity. In a recession, many companies need to reduce output, so optimizing capital expenditures may not suffice. CFOs must be prepared to cut them almost completely should the need arise, except if exiting would destroy value—particularly strategic, long-term investments that must be preserved at all costs—and maintenance investments. Companies that do need more capacity, such as a pharmaceutical business with a pipeline of new drugs, should evaluate whether to cancel projects for new factories and rely on contract manufacturing instead or to buy a distressed competitor with idle capacity.
Cost reduction contingency plans
CFOs often find that cost-cutting measures do not have the expected cash impact or take additional time to generate net savings. Headcount reductions, for example, are often cash negative in the first year because of severance payments and notice periods. Plant closures generate shutdown and opportunity costs.
Typically, the most flexible costs are procurement, compensation (such as bonus pools), and overhead (management and staff functions with flexible contracts). One global trading company, for instance, suspended activities in certain Asian countries where business in a downturn was negligible. The company relocated all its personnel but kept an address in these countries and had senior managers who could travel to them and maintain a minimal presence—and it quickly expanded its position once the market recovered. A European bank is considering a new stock option plan and postponing variable compensation until better times.
Protect funding and capital base
The current financial crisis, it is widely accepted, means that companies will need to operate with less debt. Because short-term funding is uncertain, CFOs tend to prefer longer-term capital. Together, these trends have significant consequences for balance sheet planning: CFOs, for example, will have to evaluate the trade-offs between issuing or suspending dividends. The latter course would give companies access to long-term funding now but frustrate equity holders. The former would satisfy equity holders but require the company to wait until conditions improved before accessing longer-term funding.
Planning to seize the opportunity
If funding and continuity are secure, a company can try to overtake its peers even at the bottom of a cycle. Such moves require a recession-specific planning approach to assess a range of strategic possibilities.
In the coming months, companies with the necessary resources will have a chance to pick and choose from a range of attractive small to midsize companies that are fundamentally strong but face difficulty gaining access to capital markets. Non-core divisions of larger troubled groups might also provide opportunities. Particularly at risk are companies with weak cash flows, high funding needs, poor ratings, high cyclical risks, or unstable investor bases. In mining, for example, smaller players and aggressively funded new entrants now trade for a fraction of their invested capital. So do biotech companies and specialized-equipment manufacturers whose orders have vanished. The planning process should identify and evaluate such acquisition targets so that a company is ready to pounce—if necessary lining up a financial partner such as a sovereign-wealth fund or a private-equity firm.
Reevaluate the portfolio
In downturns, companies generally desire greater focus yet hesitate to divest at depressed prices, even as lagging businesses fall further and further behind. At a European chemical company, for instance, managers resisted selling a unit in decline, arguing that only a year previously it would have fetched double the current market value. Two years later, the business had actually lost more money than the price it would have fetched earlier. Eventually, it was given away.
It bears remembering that the recession price for a sale isn’t comparable to the positive-cycle economics of keeping the business. CFOs must insist on a suitably realistic business plan or help to develop alternative exit ideas. The options include a sale to peers, payment in stock instead of cash, or a spinoff in which shareholders receive split shares as compensation. Empirical evidence suggests that such transactions do create value for the seller.5
Capital expenditures, R&D, recruiting, and advertising
In previous downturns, winners took a countercyclical approach to capital expenditures, R&D, and advertising: just when all these were least expensive, companies that had enough money outspent the competition, building strong positions for the day when the economy recovered. Recessions are also a good to time acquire talent, if new employees remain loyal after the downturn ends.
Extract value from suppliers
Companies often have a strong sense of their suppliers’ credit risk because they understand the products being offered. Some suppliers may be fundamentally healthy but still face a cash squeeze, so customers that have sufficient funding can extract better price terms from them by paying more quickly.6 Recessions are also an opportune moment to push for a restructuring of the supply chain and perhaps to acquire suppliers.
The unusual breadth and depth of the present crisis may force companies to adapt more radically than many now expect, by breaking with established rules for planning, budgeting, and investing. Cash once again is king, and all systems and decisions must be geared to preserve it while companies make conscious trade-offs to achieve their longer-term strategic objectives.