WINNING IN A RECESSION - EIU Canback · outperformers stick to the discipline of repaying debt in...

WINNING IN A RECESSION

Canback Consulting

Canback Consulting

Canback Consulting, a member of The Economist Group, is a global management consulting firm anchored in science, predictive analytics and consumer market knowledge. It serves some of the world’s largest companies through five practices – Strategy, M&A Due Diligence, Sources of Growth, Corporate Finance, and Organizational Performance

WINNING IN A RECESSIONCanback Consulting

It is becoming increasingly likely that the current economic expansion is approaching an end. The inverted treasury yield curve,1 trade wars, and mixed global events are putting pressure on the business cycle. Canback’s recession predictor, which is based on a Federal Reserve model and has correctly predicted every recession since 1985, is above its 2007 levels. It indicates a 46% probability of a U.S. recession in March 2020 (Exhibit 1).

For companies, the gut reaction when facing a recession is often to focus on controlling costs – slim down operations, squeeze suppliers, reengineer the core business. While this is certainly important to survive a recession, it may not be enough, or may even be an obstacle to thriving during and after one. Instead, our analysis of the performance of companies before, during, and after the last recession shows that:

• Companies that work towards building financial flexibility and economic resiliency before recessions enter them strategically prepared to take advantage of soft labor and asset markets

• Those companies that use this flexibility to invest in growth-oriented strategies and to introduce product innovations preempt their competition and position themselves to increase market penetration when the economy recovers.

1985-2020

For companies, the gut reaction when facing a recession is often

to focus on controlling costs ... this is certainly important to survive a recession but may not be enough thrive in and

after one

Canback’s recession predictor indicates a 46% probability of a

U.S. recession in March 2020

EXHIBIT 1: PROBABILITY OF A U.S. RECESSION

Indicates recession

Prob

abilit

y of

a re

cess

ion

100%

80%

60%

40%

20%

0%1985 1990 1995 2000 2005 2010 2015 2020

1

Today


Recessions always act with remarkable predictability. A detailed analysis by economists at the National Bureau of Economic Research (NBER) shows that recessions occur consistently about once every 10 years. Once recessions hit, economic output recovers in 2 years but the collapse of asset market generally lasts about 5 years.2

However, all recessions are not created equal. Recessions sparked by financial crises rather than by other economic or geopolitical factors are generally much longer and more severe. These recessions also hit advanced economies harder than emerging ones, partially due to lower downward wage flexibility in advanced markets.

Though recessions are different in scale and longevity, their drivers remain both similar and consistently reliable in their predictive power. Thus, understanding what outperformers did right during recent recessions could help companies prepare for the next one.

Recessions sparked by financial or banking crises rather than by

other economic or geopolitical factors are

much more severe

WHAT RECESSIONS MEAN

2

HOW COMPANIES SHOULD PREPARE

When preparing for recessionary phases, companies must think of their decisions under 2 broad themes (Exhibit 2). While each listed consideration is typically important, this paper will focus on the most significant issues companies face during such times: leverage and cost. We will discuss the interconnectedness of these issues with many of the other topics when exploring paths to company success.

EXHIBIT 2: RECESSION CHECKLIST

FINANCIALCONSIDERATIONS*

STRATEGICINITIATIVES

Hard metrics: leverageHard metrics: operating costsSoft metrics: relationship ecosystemSoft metrics: knowledge

Market share growthNew segment developmentInnovationLife cycle extensionProcess and sourcing optimization

Pre-recession During recession Post-recession

How to prepare How to adjust practices How to lead the future

Across business cycle recession

impacts

* Description in the references

Primary focus of this paper


We begin by developing an understanding of who the outperformers were in the last recession and why they were able to succeed where others struggled. Our analysis yields some interesting results:

• Outperformers do not cut costs more than other companies during recessions. Therefore, when cost optimization is used as a tool for short term survival, it must be paired with other strategies to ensure long-term success

• Companies that lower debt before, rather than during a recession can use the consequent financial flexibility to take advantage of a weak asset market and perform the best during an economic downturn3

• Outperforming companies use their higher financial flexibility to innovate and expand during recessions, when these strategies can truly set them apart and on a path to post-recession success

WHAT CAN WE LEARN FROM THE PAST

WHO ARE THE OUTPERFORMERS?

We analyze the performance of 1,165 of the largest public companies in markets impacted by the Great Recession. We focus on each company’s internal success (profitability, represented through EBIT margin) and the external perception of that success (market value/book value of equity). Using these two key indicators, we define two distinct groups of companies:

• Outperformers: those companies that, when viewed using our two key indicators and normalized by industry, were either not affected by the recession or were among the fastest to recover to or exceed pre-recession levels

• Others: companies that were affected by the recession and were not able to bounce back quickly

We identify 223 companies that are market outperformers across and within industries by assessing time needed to recover from the crisis as well as relative stock price and profitability changes. Our set of outperformers do no better on revenue growth relative to other companies. Despite this, we find that outperformers grow their EBIT margin and keep their MV/BV stable during the 2008-2009 recession, therefore emerging from it unfazed. Other companies, however, suffer significantly on both metrics, and take between 4 and 6 years to recover to 2006 levels. Exhibit 3 illustrates these differences in outcomes.

3

Cost optimization, while necessary to ensure

short term survival, does not hold the key to long

term success


EXHIBIT 4: SUCCESS INDICATORS BEFORE AND AFTER RECESSION

Interestingly, outperformers are not simply those firms that were successful before the recession. Exhibit 4 shows that outperformers after the recession are firms that were distinctly average relative to their industry before it. This finding indicates that all firms, irrespective of their position before a recession, can succeed during and after one by taking the right steps to utilize a recession’s opportunities.

Company position relative to industry average, 2006 vs. 2009

Company EBIT margin relative to industry average

Com

pany

MV/

BV re

lativ

e to

indu

stry

ava

rage

Outperformers Others

4

4X

3X

2X

1X

0-2X -1X 0 1X 2X 3X 4X

4X

3X

2X

1X

0-2X -1X 0 1X 2X 3X 4X

2006 2009

25% 26%

10%39%

13% 39%

20%28%

% outperformers by quadrant shown

Industry average

EXHIBIT 3: KPI EVOLUTION2006-2009


Key performance indicator

Revenue MV/BV EBIT margin

Change(as % of total)

Time(years)

23% 28%

-1%-26%

34%

-12%

3 31

6

14

Industry average


Key finding 1: They did not focus more on cost optimization during the recession

To evaluate the efficiency of outperformers’ core operations we analyze their operating expenses relative to their sales. Operating expenses are our area of focus because other key costs are generally more tied to product decisions and financing.

We find that, when controlling for industry, outperformers have lower operating costs relative to their sales than do other firms (Exhibit 5). Though this is clearly an important distinction, what is interesting is that there is virtually no difference in the expense trends of outperformers either before, during, or after a recession.

WHAT DID OUTPERFORMING COMPANIES DO DIFFERENTLY?

EXHIBIT 5: OPERATING EXPENSES/SALES

Greatrecession


Ope

ratin

g ex

pens

es/s

ales

30%

25%

20%

15%

0%2006 2008 2010 2012 2014 2016 2018

5

We can see that the outperformers were not necessarily unique before the recession. Instead, they took several notable steps that allowed them to stand out during and after the recession. Three key findings explain outperformer success:

Controlling for inter-industry differences, 2006-2018


EXHIBIT 6: NET DEBT/EBITDA2006-2018

Greatrecession

Net

deb

t/EBI

TDA

3.2

2.4

1.6

0.82006 2008 2010 2012 2014 2016 2018

6

Cost structure optimization is a key aspect of operational success. However, it only works when it is not constrained by organizational silos and short-term cost reduction thinking. Reactionary cost cutting yields limited benefits while doing long term harm. Only when viewed through a holistic lens that balances a company’s short and long term needs can cost-optimization produce lasting results.

Key finding 2: Outperformers were disciplined in their financial management before the recession

Starting from the same point as other companies in 2006, outperformers stick to the discipline of repaying debt in 2007-2008, when cash flows exist (Exhibit 6), while underperformers divert funds to share buybacks and other expenses until the crash.

Underperformers are forced to repay debt during the credit crunch of 2009, but they must often do so on a reduced cash flow base and therefore with only limited success.

By paying back their creditors with discipline, outperformers leave themselves the room to borrow when credit becomes available again as it did in 2010.



Therefore, outperformers can make the best of the openings that the downturn creates, thereby recovering from any profit or revenue compression.

Key finding 3: They focused on innovation and growth during the recession

During recessions there is a marked difference in the areas outperformers, helped by their lower debt levels, focus on. An analysis of the restaurant and foodservice industry – an industry hit hard by the recession – shows that outperformers treated the 2008 recession as an opportunity to innovate and grow. While other companies largely focused on costs and process efficiency, outperformers focused on bringing product innovations to market, acquiring competitor assets at a discount, and growth in core and new markets (Exhibit 7).

Operational excellence and efficiency are key drivers of company success. However, placing a focus on cost drivers during economic downturns actually stops companies from discovering and nurturing the innovation and growth opportunities these cycles provide.

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EXHIBIT 7: AREAS OF FOCUS IN THE RESTAURANT AND FOODSERVICE INDUSTRYIndustry outperformers vs. the rest, 2008-2009

Geographicexpansion

Market share

Innovation

Processefficiencies

Costs

OthersOutperformers

100%13%

67%13%

100%36%

75%67%

75%33%


Companies can prepare themselves for the end of the current economic expansion by:

While this paper does not go into detail on other key metrics companies should consider within the recession checklist framework, they remain nonetheless critical to success. Canback has broad experience both in partnering with companies to help determine priorities for debt management, product innovation, and growth strategy as well as in other areas for companies to consider when gearing up for a recession:

• Our sophisticated market opportunity evaluation frameworks, rooted in our analytical rigor and proprietary income database, help companies take the long view on growth and prioritize areas of focus

• With a deep product and pricing knowledge, we understand and quantify the market for innovative product ideas, ensuring investment in R&D is used optimally

• Our high-resolution analysis of long-term financial data, along with our senior leadership’s decades of corporate finance management experience allows us to create strategies that balance the urge for growth with the need for deft financial management

Companies must go beyond the standard cost efficiency frameworks to a broader, financial flexibility based thinking during recessions. With rigorous analytical ability to help uncover recession-led opportunities and a deep understanding of consumers behaviors and product markets, Canback can help firms gear up to win in any economic climate.

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HOW COMPANIES CAN PREPARE

By going beyond the standard cost efficiency

frameworks to a broader, financial flexibility-based thinking, Canback can

help firms gear up to win in any economic climate

Winning approach

VS

Typical approach

Financial and cost decisions based on normal planning during recessions

Disciplined, forward looking financial management to retain flexibility, maintain credit access

Focus on short-term cost reduc-tion during recessions

Maintenance of cost structures based on short and long term plans

Avoiding bold actions and inno-vations during recessions

Applying financial flexibility to take advantage of opportunities for innovation during recessions

ABOUT THE AUTHORS

REFERENCES

Philip Burgin-Young is a senior manager and leads the marketing committee at Canback Consulting, based in Boston.

Parth Jhaveri is a consultant at Canback Consulting, based in Boston.

Dr. Staffan Canback is founder and managing director at Canback consulting, based in Boston.

Our dataset was comprised of all public companies globally with revenues larger than USD 2 billion for the three consecutive years ending in 2018. We focused on companies based in regions that were affected by the recession and which had reliable data available. We controlled for industry differences when analyzing company profitability and market value and selected only those companies that beat both the market and their respective industries on both metrics as outperformers.5

1. “U.S. Department of the Treasury.” Daily Treasury Yield Curve Rates, 14 August 2019, www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield.

2. Rogoff, Kenneth, and Carmen Reinhart. “American Economic Association Meetings.” International Aspects of Financial Market Imperfections, 2008.

3. Williams, Terri. “Can You Recession Proof Your Organization?” The Economist Corporate Network, 2019.

4. Moody’s Investor Service, BVDINFO. “Company Data and Information.” Osiris, 2018.5. Biggiero, Lucio, et al. “Financial Performance Measurement: a Multicriteria Methodology.” Journal of

Financial Decision Making, vol. 1, no. 2, Dec. 2005, pp. 37–55.

*We split terms by hard (financial figures) and soft (other shorter-term financial levers). Leverage refers to debt relative to profit, operating costs are the costs of business excluding the cost of production of goods or services (COGS), “relationship ecosystem” refers to level of company interactions with customers and suppliers, and “knowledge” refers to expertise and experience in industry.

Canback Consulting

For more information, visit www.canback.comor email us at [email protected]

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WINNING IN A RECESSION - EIU Canback · outperformers stick to the discipline of repaying debt in...

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