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Many firms urgently need more cash to boost their liquidity and to help ward off the economic ills.
Economist Staff, The Economist
November 24, 2008
At first glance Citigroup, a giant of American banking, and Wolseley, a British firm that makes building products, have little in common. The former is part of the plumbing of the global financial system; the latter is the world’s biggest distributor of pipes, bathroom fittings and other plumbing paraphernalia. Yet both have found themselves on the rapidly growing list of victims of the global economic turmoil. Citigroup has been hammered by the fallout from the subprime-mortgage debacle and its repercussions in financial markets. But as the chaos spills into the real economy, firms in many different industries are being infected by it. Hence Wolseley has seen demand for its products dry up as the number of new homes being built has plummeted.
Now they have something else in common: this week both announced a further round of mass lay-offs. On November 17th Vikram Pandit, Citi's boss, said his bank would shed a whopping 52,000 jobs in the next few months, bringing the total number of planned job cuts to 75,000, or 20 percent of the bank's workforce (see article). On November 18th Chip Hornsby, Wolseley's boss, announced another 2,300 job cuts at his firm. Once these employees have departed, his company will have cut 14,500 jobs, or roughly 18 percent of its total.
With Messrs. Pandit and Hornsby, bosses at many other firms have been cutting hundreds of thousands of jobs. Apart from carmakers and other manufacturers, the list of those laying people off now includes Pepsi bottlers, law firms, retailers, media companies, chemicals producers and even technology firms. All are desperately seeking a cure. And the most attractive medicine on offer looks like cash.
Hoarding for Hard Times
Preserving cash in such formidable times will present managers with an unprecedented test of their skills. "We've come through a half-century of history where recessions have been sort of mild," notes Richard Sylla, a professor at New York University's Stern School of Business. "But never have problems in the financial sector been as great as they are now."
Faced with huge difficulties of their own, banks have tightened their purse strings, lending less and driving up the cost of credit to consumers and corporations. That is compounding an already grim prognosis for the world economy. This week Japan said its economy had shrunk for the second quarter running. Much of Europe is in a similar state. And a new survey by the Federal Reserve Bank of Philadelphia has shown that many economists believe the United States went into recession in April and will not emerge from it until the middle of 2009.
Opinions differ as to how long and deep the global slowdown might be. But the combination of a battered banking system and shell-shocked consumers mired in debt suggests it could be particularly hard for many businesses, whatever the duration. So bosses are rushing to secure as much cash as they can now to see their companies through the downturn.
How times change. Not long ago companies with cash piles were assailed by corporate activists to return money to shareholders. Nowadays it is only a slight exaggeration to say that the more cash that investors see in a firm's coffers, the happier they are. A recent report from Citigroup's investment bank shows that since the credit crisis began the returns of firms with ample liquidity have outperformed those of their cash-strapped industry peers by almost 7 percent. Before the crunch, cash-rich firms were generally underperforming.
There is a big risk that some behemoths will run out of money. Moody's, a credit-rating agency, says its liquidity-stress index, which tracks the cash position of heavily indebted American firms, shows they are feeling as pinched as at any time since late 2002. Among those most at risk are some casinos and carmakers. Harrah's Entertainment, a Las Vegas-based casino, is trying to persuade creditors to renegotiate its payment terms to avoid a default. General Motors (GM), along with Ford and Chrysler, is lobbying Congress for a bail-out after burning through billions of dollars in the third quarter of the year.
Few companies are in as bad shape as the three American carmakers. Yet that is no excuse for complacency. Faced with such difficult markets, firms in many industries are likely to see sales fall, bad debts soar and cash flows deteriorate sharply — if they have not done so already. Although every company's situation is unique, there are some common themes that managers would do well to bear in mind when tackling the current crisis.
Don't Bet on the Bank
One thing not to take for granted, even for firms with strong balance-sheets, is that they will get access to external capital. For the foreseeable future, bank credit is likely to be harder to come by and will certainly be more expensive than when the financial crisis began. Strong companies may be able to issue corporate debt at a more reasonable price, but that market remains fragile. Although government action has unblocked the commercial-paper market, an important source of short-term funding, the cost of tapping it remains very high for all but the healthiest of issuers.
Faced with all this, some companies such as Marriott International, an American hotel group, have drawn down bank credit lines, even though they did not need the money urgently. Many of these so-called "revolving credit facilities" were set up during the boom, when credit was cheap. A recent paper by two Harvard Business School economists, David Scharfstein and Victoria Ivashina, shows that between April 2006 and April 2008, such credit lines grew by 36 percent, to $3.5 trillion.
However, some analysts argue that tapping relatively cheap bank credit is not wise unless firms really need the money. They argue that rating agencies and investors are likely to see this as a black mark against managers who have increased leverage for no good reason. But in such uncertain times, that may be a small price to pay for securing a cushion of cash.
A few companies have tapped new pools of capital, like sovereign-wealth funds, to bolster their finances. In July GE, an American conglomerate, set up an $8 billion, 50-50 joint venture with Mubadala, an investment arm of Abu Dhabi, to invest in areas such as clean energy and aviation. Mubadala is expected to become one of GE’s ten largest shareholders.
A third way to raise cash is to sell businesses no longer central to a firm’s strategy. Although prices for corporate assets have been depressed by the downturn, this has not deterred some companies from putting them up for auction. This week, for instance, GM and Ford sold shares in Suzuki and Mazda respectively. By selling their stakes back to the Japanese firms, the American carmakers raised a total of $770m of badly needed liquidity.
Managers can also boost liquidity by letting less cash go out of the door. Several big companies including Alcoa, an American aluminium giant, Target, an American discount retailer, and AkzoNobel, a Dutch firm that makes paint and specialty chemicals, have recently cancelled plans to buy back shares using what was previously viewed as excess cash. Companies are starting to trim dividends too, though this will be unpopular with investors expecting a regular stream of income.
Stretching out the payments on bank debt can also preserve cash. And firms should look out for opportunities to refinance existing loans early to give themselves greater financial flexibility. Sprint Nextel, a troubled American telecoms company, recently replaced a $6 billion revolving credit facility with a $4.5 billion loan agreement due in 2010. The terms allow Sprint to have a higher ratio of debt relative to its profits, making it less likely that it will breach covenants associated with its debt. That gives Sprint, which has been losing subscribers, a slightly better chance of surviving the downturn.
A particularly tough challenge is to generate even more cash from existing operations. The Hackett Group, a consulting firm that specialises in this area, reckons that a typical multinational with revenues of about $23 billion can save up to $400m a year by taking a hard look at how it runs areas such as finance, human resources and technology. For example, in a recent study the consultants point out that many first-generation outsourcing efforts have shifted only parts of a process offshore. Firms should review these to see if they can "lift and shift" the whole to cheaper places.
The Daily Grind
Another area that needs to be put under the microscope is working capital, or the cash that gets tied up in day-to-day operations. "The first place to look for this money is in a firm's inventory," says Wayne Mincey, Hackett’s chief operating officer. All too often, poor sales forecasting and production planning mean that a lot of cash ends up trapped in a company's warehouses in the form of unwanted products. Hackett reckons that the same $23 billion company could save as much as $1 billion a year by improving the lines of communication between executives responsible for sales, procurement and production.
At the same time, managers need to avoid swinging to the opposite extreme. Faced with a more difficult economic environment, retailers in particular have been thinning out inventories to free up cash. But if their sales forecasting is not on the button, companies risk annoying consumers who cannot get hold of their products because they are out of stock.
In a downturn, some firms might be tempted to squeeze suppliers. But they should think twice. Many sophisticated supply chains now stretch across continents and rely on just-in-time delivery. The slightest glitch can cause chaos. To make matters worse, many suppliers have also been hit by the credit crunch and are in need of more cash themselves. According to a recent report in the Financial Times, some companies such as Daimler, a big German carmaker, are so concerned about the financial health of vital suppliers that they are bending over backwards to help.
The problem with working-capital initiatives is they can take a long time to pay off. Yet many managers are under pressure to turn their firms' fortunes round fast. Hence the predilection for swift and sizeable lay-offs. Announcing earlier this month that Sun Microsystems would cut 5,000-6,000 jobs, Jonathan Schwarz, its chief executive, said he was taking "decisive actions" to align the company's business with new economic realities.
As well as pruning workforces, many manufacturing, metals and mining companies are idling some factories and mothballing others. Capital expenditure is also being axed. After its third-quarter profit fell by more than half, Alcoa cancelled all its "non-essential" capital projects. Severstal, Russia's biggest steelmaker, has canned most of an $8 billion investment plan.
Large companies are not the only ones with a laser-like focus on cash. Small start-ups are also watching every penny more closely than ever. Many of their fresh-faced founders can barely remember the downturn triggered by the dotcom bust in the early part of the decade. Yet at the urging of venture capitalists with somewhat longer memories and plenty of cash at risk, firms across California’s Silicon Valley and beyond have been making big cuts in their relatively small budgets. The goal is to reduce their "burn rates," or the speed at which they are getting through their backers’ money.
So is all this hyperactivity encouraging? The answer is a qualified yes. Firms that remain standing through a brutal recession will be those that have taken the phrase "cash is king" to heart. Yet there is a risk that in a rush to build up their cash mountains, cuts could be made too fast and too deep when a more targeted approach to surgery is needed. For instance, a recent article in the McKinsey Quarterly points out that technology budgets are a favourite place to make cuts, but indiscriminate chopping will be more damaging than ever before because IT systems are now so tightly interwoven with everything from supply chain management to the determination of pricing strategies.
Another reason for caution is that firms on a cash crusade can all too easily choke off investment in promising new products. That would be a huge mistake because, paradoxically, a recession can be a fantastic time to launch innovations. For one thing, tougher times can make consumers reconsider many of their purchasing decisions, leaving them open to trying something new. For another, a less crowded marketplace makes it easier — and cheaper — to create awareness of a new offering.
Scott Anthony of Innosight, a consulting firm, points out that during the dotcom bust Apple launched its first version of the iPod music player and that in America alone more than ten other "disruptive" innovations started during the same period. Experienced senior executives are convinced that this downturn will produce a new crop of world-beating businesses. In a recent speech to the Council on Foreign Relations, a think-tank, Sam Palmisano, the boss of IBM, said he was certain that he would see new leaders emerging who would "win not by surviving the storm, but by changing the game."
Firms who want to be winners coming out of the downturn will also need the financial resources to seize any opportunities that arise during it. Interviewed in the Harvard Business Review, John Chambers, the boss of Cisco Systems, a network equipment-maker, said the firm tended to make more aggressive investments during bad times than good ones. When its rivals pulled back from Asia during the region's financial crisis in 1997, Cisco deliberately increased its presence there, gaining a leading position it has never relinquished. Cisco's experience is a timely reminder that while having plenty of cash is a powerful remedy in surviving a recession, if it is also deployed wisely it can produce a champion when the downturn ends.