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Like It or Not, You're in the Euro Zone

CFOs have to prepare for almost anything in Europe. The good news: it's not all bad news.
Randy Myers, CFO Magazine
April 15, 2012

Sure, you've got worries: the fragility of an economic recovery still straining to create jobs, the impossible-to-predict outcome of the Federal Reserve's expansive monetary policy, and forecasts of trillion-dollar-plus federal deficits stretching out for years, to name just three.

Yet, as serious as each of those may be (not to mention all of them in the aggregate), for many CFOs the European debt crisis, headlined by beggar-thy-neighbor Greece, now tops the list. Even with the bleeding stanched (at press time, anyway) the underlying problems have the potential to trigger a new global recession and throw trade and currency relationships into disarray.

Recession in Europe would weigh on multinationals that do business there, on U.S. companies that export to the Continent, and ultimately on supply-chain partners of all sizes. U.S. banks with exposure to European debt could see their balance sheets and income statements weakened if those debts slip into default. And smaller companies that thought Europe was a comfortable place to begin a global expansion strategy may find their first forays overseas to be disappointing or even disastrous. Even U.S. companies with no direct business connection to Europe could feel the effects of further trouble there in the form of another blow to already shaky consumer confidence.

At $4.6 billion Meritor, a manufacturer of axles, brakes, and wheel assemblies for the heavy-truck market, CFO Jay Craig and his C-suite colleagues are not panicking. In fact, they still expect their company to enjoy increased revenues and profits from continuing operations this year, despite an expected slowdown in their European business. But neither are they waiting passively to see how the latest Greek drama plays out. After all, their 102-year-old company now operates 36 manufacturing plants around the world, sells in more than 70 countries, and counts Swedish truck and heavy-equipment manufacturer AB Volvo as its largest customer. For months, Meritor's treasury team and other key executives have been working with the company's investment banks to assess how Meritor could be impacted by the euro-zone crisis, and how they might minimize any potential fallout.

More concretely, the company has cut costs in its European operations, selling one of three axle plants there this year and reducing its hourly workforce. The company also has looked into whether it should change its foreign-currency hedging practices, and is assessing whether it should continue to transact business in euros with suppliers outside the euro zone.

The company is also having plenty of conversations with almost every entity it does business with. It is stepping up communications with customers, for example, in order to get a better handle on demand. It's talking more often with suppliers, to make sure they retain sufficient liquidity as bank credit tightens across Europe. And it is staying in closer contact with the banks in its revolving credit facility, to make sure they understand the company's financial condition and business prospects.

While the company's response is thorough, Craig readily admits that some aspects of the debt crisis remain outside its control. "I don't think we're too concerned about the technical banking implications of the crisis," he says. "We're more concerned about when Europe's consumers and businesses will be allowed to have confidence in their path going forward, so that underlying demand can be restored. That's the most difficult issue for us to forecast."

David Rhodes and Daniel Stelter, senior partners at The Boston Consulting Group (BCG), have taken a stab at it, but even they identify at least four potential outcomes. The best would be a "successful muddling through," in which European governments restructure debt where necessary, stabilizing the euro and avoiding a recession but subjecting Europe to a long period of low growth and deleveraging. Alternatively, Europe could enter into a recession characterized by deflationary pressures, akin to what Japan has been experiencing for the past two decades, which would increase pressure on debtors and lead to lower demand and more austerity measures.

Scenario Planning, or Not
At the opposite end of the spectrum, the Continent could succumb to significant inflation, triggered either by an economic recovery attributable to aggressive monetary policy or a public loss of trust in money. The fourth and worst outcome would be a breakup of the euro zone, potentially triggering a traumatic global recession. Consulting firm McKinsey has estimated that a breakup would trigger a 9% decline in the gross domestic product of the euro zone and wreak havoc on cross-border trading.

Given these dramatic scenarios, it's not surprising that many companies, like Meritor, are laying plans for how they might cope. Others, surprisingly, are not. "Some companies are very pessimistic and paranoid, while others are quite fatalistic and not that worried about it," observes Gerry Hansell, a senior partner with BCG. Adds BCG senior partner Danny Friedman, "We've been saying that companies should have a planning team looking at the extreme scenarios. I have clients that would view that as a pretty strange idea, and other clients that have already done it."

Those who are drafting contingency plans are focusing their attention on three key areas: the threat the debt crisis poses to Europe's economy and its impact on their businesses; cash and liquidity, including currency risk; and supply chain sustainability.


Living in a 1-2-6 World
With the threat of a European recession on the horizon — many economists now expect one — U.S. companies must decide where to focus their resources. Management consultant Ken Favaro, senior partner with consultancy Booz & Co., suggests planning for what he calls a "1-2-6" world, in which Europe grows around 0% to 1% annually "if it's lucky," the U.S. at around 2% a year, and the rest of the world at about a 6% rate.

Kathleen Wolf, CFO of privately held Atari International Contracting, a global real estate developer with offices in Tampa, Florida, and Doha, Qatar, says her company has already made a number of strategic adjustments. It is pursuing more work in the Middle East, for example, and has altered its strategy in Europe to reflect the weak real estate market there. Now, it is more likely to renovate an existing hotel than tear it down and build a new one, or to create multifamily rental units at one of its residential projects rather than condos.

The company is also seeking to keep its liquidity levels high. "We see a lot of banks in Europe trying to dump properties," Wolf says. "We're using [our higher] liquidity to be opportunistic and grab some of those properties at prices that allow us to be more flexible in what we do with them."

Jamie Pierson, CFO of YRC Worldwide, which provides trucking services in the U.S. and transportation logistics around the globe, says his company has downsized its business over the past 24 months as it anticipates slower economic growth around the world. "We are as lean as we have [ever] been on any number of fronts," he says. "We have not only cut head count to the bone, to the point that we are as productive as we have been at any time in our recent history, but we have also made our balance sheet much leaner." YRC has, he says, looked into every corner of its balance sheet, extracted all the liquidity it can, and stockpiled it in the form of cash and credit facilities. "We did this knowing that if there is a marked slowdown in the economy at large, we'll be prepared," Pierson says.

Pierson is particularly concerned about how a European recession might affect U.S. exports, and what that would do to his customers' shipping volumes. He's also wary of the headline risk associated with the euro zone's debt crisis, particularly as it pertains to Greece, and what that might mean for consumer confidence in the States. "Greece as a percentage of global GDP may be no more than a rounding error, but it gets a disproportionate amount of press," he says. "If you don't know that, you might think the world was coming to an end. It's not, but you have to allow for that kind of thinking."

Favaro of Booz & Co. agrees with Pierson's strategy. "The best insurance against calamity," he says, "is a strong competitive position and an efficient balance sheet."

Cash and Liquidity
Both of those objectives demand an intense focus on cash. Sandy Cockrell III, national managing partner in charge of Deloitte LLP's U.S. CFO Program, says U.S. companies should know exactly where their cash is and, to the extent it is tied up in potentially risky European locales, either in the form of bank deposits or receivables, get as much of it as possible into safer havens.

Andrew Witty, chief executive at UK-based GlaxoSmithKline (GSK), recently disclosed that since the beginning of last year, his company has been sweeping cash it raises in other European countries out of banks there on a daily basis and sending it to GSK's home country, where it considers the cash more secure. Meritor's Craig says his company has long had an active cash-pooling arrangement in Europe that provides an efficient cash mobilization structure for the company.

Cockrell also urges companies to turn European receivables into cash faster, giving sales personnel incentives to get it done if necessary. SeraCare Life Sciences hasn't gone that route yet, but CFO and interim CEO Gregory Gould says his company has tightened credit terms for some customers in southern Europe, where the region's sovereign debt problems are greatest. "If we used to give a customer a $50,000 line of credit, now it's probably down to $30,000 — just so we have less exposure," Gould says.

Consultants also are encouraging U.S. firms to reassess their banking relationships, solidifying ties with sound banks, limiting the amount of assets allocated to any one bank, and perhaps severing relationships with any whose exposure to troubled European debt they deem too high. Banks' downstream relationships are important, too. "You might say you don't want certain banks providing your loan program," says BCG's Hansell, "but you have to know whether the banks you are depending on are dependent on those other banks."

U.S. companies also need to assess how their balance sheets would be affected if Greece or another of the weaker European countries exited the euro zone and devalued their new currencies, or if all the upheavals in the euro zone dramatically recasts the dollar-euro relationship.

Atari International Contracting's Wolf notes that this is a big issue for real estate developers, who must figure out what will happen to their cash flows from rental income if the euro collapses. Such concerns reportedly scotched a recent deal for private-equity firms in the United States and the UK to purchase 27 office buildings in Barcelona. "We're looking at all of our existing contracts," Wolf says. "I think we've come to the conclusion that we need to find out what the worst-case scenario would be and implement a clause that addresses it, because right now most contracts don't. We also have to look at the legalities — what can you do if a country changes its currency? It's not something that was thought of when the euro was created."


Atari hasn't canceled any deals over this issue to date, but it did drop out of a potential joint-venture agreement when its prospective partner balked at sharing risks overseas. "The instability in Europe brought up a lot of the questions that were at issue," Wolf says.

The European debt crisis could play out over a period of many years, but it also could end cataclysmically — with a Greek default on its sovereign debt triggering a domino effect among other systemically weak countries, for example, or a split between the relatively healthier northern European euro-zone countries and their weaker counterparts in the south. A complete dissolution of the euro still remains possible, and a Greek exit is certainly not off the table.

Because the resolution could be fast-moving, Favaro urges CFOs to develop contingency plans now — and then be ready to change those plans as events unfold in unpredictable ways. "Crises tend to lower the water level for everybody, but not always in a uniform way," he says. "CFOs need to figure out which of their businesses would be most exposed, and come up with preemptive moves that address various contingencies."

Easier said then done, of course. But from the time of its creation, the European Union has often been referred to as America's "51st state," and while many people on both sides of the Atlantic chafe at the cultural implications of that label, CFOs can't afford to ignore its very real economic ramifications.

Randy Myers is a contributing editor of CFO.


What, More Worries?
Three tactical areas euro-minded CFOs can address today

"We definitely have the euro on our mind," says Jeff Taylor, CFO of Rahr Malting, of Shakopee, Wisconsin. "Unfortunately, I don't have any good answers as to how this crisis is going to play out."

He does, however, have a new appreciation for the ways in which currency-hedging strategies may need to be rethought. In addition to producing its own malt domestically, Rahr imports malt from European suppliers via short- and long-term purchase agreements. Historically, the company has hedged its euro exposure using swaps and options. But over the past year, says Taylor, some of the company's European board members have been receiving "dire warnings of the fragility of the euro from their own European executives," unsettling Rahr's management team.

Recently, Rahr suspended its hedging activity for a month when the euro looked particularly fragile. One concern was that if the euro collapsed, competitors that buy on the spot market would have been able to snap up product at steep discounts and dramatically undercut Rahr's prices. Another was that if prices fell dramatically in Europe, customers that normally purchase Rahr malt as well as European malt might switch to European product exclusively, saddling Rahr with excess inventory.

Taylor says Rahr may have to modify its currency-hedging strategy, though he is not yet committed to any one course of action. Options include changing the time frame in which it hedges, or changing the percentages of its purchases that are hedged, most likely by buying more product on a spot basis and less on a hedged basis.

Supply Chains, and Cash
Other companies may be more focused on the potential for the European debt crisis to disrupt global supply chains. In any but the most benign of outcomes, some European suppliers will likely find it difficult to access the bank credit they need to meet commitments to customers. U.S. companies should work closely with critical suppliers to assess their financial strength and, where possible, plan for how to help them through any liquidity crisis, perhaps by adjusting payment terms or localizing supply chains.

Jonathan Cunningham, principal with capital-markets consulting firm Aequitas Advisors, says U.S. companies may want to consider raising cash while interest rates remain extraordinarily low. If the debt crisis worsens, companies will have ample reserves, and if conditions improve, they will be able to fund expansion. In between those extremes, cash-rich companies will be better positioned to make opportunistic acquisitions.

"There are people waiting for this crisis to trigger a wave of liquidity-oriented business auctions," says Gerry Hansell, a senior partner with The Boston Consulting Group. "In fact, we have one client already working hard on deals in Europe. The CFO said he doesn't control what happens in Europe, but he wants to be ready to move fast. He's viewing this as much as an opportunity as a threat." — R.M.




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