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Flexibility is key: McKinsey
found that there's one key common characteristic of the companies which emerged
as post-recession leaders - flexibility during the recession
According to consulting firm McKinsey, almost
40 per cent of leading US industrial companies toppled from the first quartile
of their sectors during the 2000-01 recession. A third of leading US banks met
the same fate. But at the same time, 15 per cent of companies that were not
industry leaders prior to the recession, vaulted into that position during it.
To understand how to make the most of a
recessionary environment, McKinsey analysed the performance before, during and
after the 2000-01 recession of 1,300 US companies from a broad range of sectors.
It then identified which of these companies
emerged from the recession having gained or maintained leadership status.
For these leaders, it looked at the
characteristics they exhibited before the recession that might help explain why
they outperformed their peers.
'Although recessions strike different sectors
in different ways and at different times, the post-recession leaders in most of
the sectors we explored had characteristics in common,' says McKinsey.
It found one key common characteristic among
the post-recession leaders - flexibility during the recession.
'Entering the downturn, they typically
maintained lower leverage on their balance sheets, controlled operating costs
well and diversified their product offerings and business geographies,' says
McKinsey.
'Such fundamentals gave them a greater degree
of strategic flexibility, which became even more valuable during the recession.
'And although previous recessions aren't
necessarily a guide to future ones, we believe that flexibility can make a
notable difference by allowing managers to take advantage of the opportunities
the next recession might provide.'
Expanding during recession
Whatever the position the companies had
within their sector before the downturn, many that emerged from it as leaders
expanded their businesses during the recession. The expansion included organic
activity - that is, through internal investments - and inorganic activity such
as mergers and acquisitions (M&As), alliances and joint ventures.
But McKinsey found a difference in the mode
of expansion before and during recession. Before recession, the more successful
companies, on average, spent less on M&As and focused more on organic
growth.
In 1999, for example, leading companies had,
on average, capital expenditure that was 8 per cent higher and growth through
M&As that was 13 per cent lower than their less successful counterparts.
During the recession itself, however, better
performers leapfrogged the competition by continuing to invest and growing
inorganically.
In 2000, companies that emerged in the top
quartile spent 15 per cent more on capital expenditure and conducted 7 per cent
more M&As.
The M&As most likely arose from the
opportunities to buy cheap assets from distressed sellers. In addition, the
successful companies were able to pay their suppliers faster, probably to
negotiate lower prices and better service, says McKinsey.
However, to be able to expand and invest
during difficult times requires a strong and flexible balance sheet. And this
has to be built up before a recession.
McKinsey found that for industrial companies
that ultimately emerged as sector leaders, the average net debt-to-equity (D/E)
ratio before the recession was roughly half that of their less successful
competitors.
What's more, the post-recession leaders also
held more cash on their balance sheets prior to the recession than their less
successful counterparts.
Now that we are entering a possible
recession, the good news is that a lot of Singapore corporations are in very
good financial shape.
I downloaded all the Singapore listed
companies and their debt to common equity ratio as well as their total debt to
total assets ratio. For the former, the median is 26 per cent, and the latter,
14 per cent.
The question now is whether Singapore
companies will use their balance sheet flexibility to make expansions wisely.
Starbucks was a company which had a lot of
financial flexibility during the 2000-01 recession. In 1996 it had D/E ratio of
8 per cent, compared with an average of 14 per cent for the restaurant sector.
Its managers consistently reduced the company's leverage every year until 1999.
That year, the D/E ratio was only 2 per cent, while the industry average hit a
high of 31 per cent.
Starbucks achieved the debt reduction by
expanding the proportion of licensed outlets from 7 per cent in 1998 to 13 per
cent in 1999 and 23 per cent in 2000.
So how do companies build flexibility into
their balance sheet? Though it may be too late to execute it now, this knowledge
may come in handy in a future downturn.
One way is to reduce the capital intensity of
the business model. Another is to resist the urge to use additional debt to
finance dividend growth or share buybacks.
McKinsey found that as profits grew during
expansion, companies that emerged as winners refrained from increasing their
dividends.
Their dividend payouts gradually decreased
from a peak of 40 per cent in 1995 to 32 per cent in 1999. Then they cut
dividend payouts aggressively at the first sign of recession, reducing payout
ratio to 28 per cent in 2000.
In contrast, before the recession their less
successful counterparts kept dividend payouts roughly stable - at 35 per cent in
1995 and 33 per cent in 1999 - and even increased them to an average of 38 per
cent in 2000 as the recession began.
Operating flexibility
As a matter of good management practice,
companies should - regardless of business cycles - aim to keep costs low without
damaging the long-term health of their business.
Also, it is best if companies keep their
operations flexible so funds, assets and personnel can be redeployed easily as
conditions change.
Take the example of US catalogue operator and
retailer Talbots. In the years before the recession, it increased the intake of
part-time workers at a higher rate than salaried workers.
And in the throes of the recession, it
radically shifted its advertising mix away from TV and catalogue operations
towards focused activities that targeted customer groups with the highest sales
potential.
According to McKinsey, although this strategy
somewhat reduced the company's ratio of advertising expense to revenue - from
5.5 per cent of revenue in 2000 to 4.3 per cent in 2001 - Talbots maintained
advertising levels far above the sector in general.
Its ratio of advertising expense to revenue
was 120 per cent higher than the sector average in 2000, and 80 per cent higher
than in 2001.
'Such measures helped Talbots emerge from the
recession as a leader in the sector, though it entered the recession as a
challenger,' says McKinsey.
In contrast, less successful companies cut
their research and development and advertising more deeply, putting them at a
disadvantage for tapping the opportunities such expenditure might create.
Before recession, their productivity per
employee was also lower than the leaders, and so they had to lay off more
employees during the downturn.
This could have had the effect of damaging
their ability to attract and retain talent in the future. So, companies that are
thinking of mass lay-offs, take note.
Product offerings
McKinsey also found that companies that
emerged from the recession as industry leaders generally had more diversified
product offerings and a greater geographic presence before, during and after the
recession than did their less successful counterparts.
This pattern was particularly true for
companies that led their industries before the recession and retained this
status after it. Their sales were roughly twice as diversified by segment as
those of companies that ceased to be leaders. By geography, the difference was
smaller.
But leaders that retained their status were
about 20 per cent more diverse in this respect.
Successful companies pro-actively managed
their customers and product portfolios before the recession.
McKinsey cites US telecom company Verizon,
which coupled an expanding customer base with increasing average revenue per
user to offset falling call prices.
Average revenue per user fell throughout the
industry as per-minute revenue dropped by almost 20 per cent a year from 2000 to
2003. By altering its service mix towards broadband and value-added services,
Verizon maintained its winning status through the recession.
Starbucks, meanwhile, added innovative
value-added services (including Wi-Fi Internet access in its stores), the
Starbucks Card and improved customer service during the recession.
It resisted offering massive discounts. As a
result, in 2002 the company again posted comparable store sales growth of 6 per
cent, achieved through traffic growth of over 8 per cent.
Overall, a downturn can be a great
opportunity to hire talent, to continue spending on long-term strategic
initiatives and to target acquisitions.
Companies that are enjoying strong balance
sheets, as well as operational flexibility and product diversity, are in a good
position to take advantage of the current slowdown and reap outsized value for
shareholders. - 2008 June 14 SINGAPORE
BUSINESS TIMES
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