Corporate Finance

The Coast Is Clearing

As the recession eases, CFOs see new opportunities on the horizon.
Randy MyersDecember 1, 2010

Heading into 2010, executives at Taiyo Yuden Co. Ltd., a Tokyo-based producer of electronic components, were upbeat about their prospects. Demand for their products was often outstripping supply, ushering in a first half that would prove to be “very strong,” recalls Joseph Wilkinson, vice president of operations and CFO of the company’s North American division, Taiyo Yuden (U.S.A.) Inc., in Solana Beach, California.

But that, as they say, was then. These days the outlook at Taiyo Yuden is more somber. While the company still expects revenues for its current fiscal year (which ends in March) to grow to about $2.6 billion from $2.1 billion the prior year, Wilkinson says much of that growth will have come during its fiscal first half. While the company’s mobile-phone sector remains strong, its other divisions are experiencing what Wilkinson describes as “a bit of a downturn.”

The Great Recession technically ended in June 2009, according to the National Bureau of Economic Research. But given continued high unemployment and sluggish growth, it hardly feels that way. Finance leaders looking for a clear read on the overall economy and their specific markets still find their view clouded by uncertainty about everything from consumer demand, health-care costs, and the strength of the dollar to tax policy, the federal debt, and the political outlook.

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The result? Despite improving corporate profits and substantially stronger balance sheets, most U.S. companies expect modest-at-best improvement in the economy next year, and plan only tepid investment in the plant, people, and equipment that would be needed to drive a more robust recovery.

“This environment of uncertainty is driving a degree of caution that becomes a self-fulfilling prophecy,” laments Nick Tomashot, CFO, treasurer, and secretary at Groveport, Ohio-based Pinnacle Data Systems, a $30 million manufacturer and service provider in the diversified computer system industry.

Even at his own firm, which sees pent-up demand among its customers and “wants to be prepared to ride that wave as companies begin to make new investments in equipment,” Tomashot says the goal for 2011 is modest: grow share in markets where the company already competes. “We’re not at a point,” he says, “where we will do a lot of risk-based investment.”

To be sure, companies in different industries face different challenges. To go beyond broad generalizations, we interviewed finance executives at a number of companies across the country, large and small, private and public, to find out how they plan to move forward given the uncertain economic outlook that will mark the start of the new year.

Managing a Soft Landing
“Cost-cutting for us is over,” says Taiyo Yuden (U.S.A.) CFO Wilkinson. “Obviously, we’re always going to be looking for ways to be more efficient, but overall cost-cutting is essentially complete. Now, if the opportunity presents itself, we’ll go out and do some hiring and spend money on business development in certain areas. We’ve already hired a couple of engineers and other key people, but we’re being very cautious and taking our time.”

While worldwide demand continues to soar for mobile phones, the same can’t be said for laptops and PCs. And the demand for flat-screen TVs, undeniably one of the hottest products in consumer electronics over the past few years, has also fallen: manufacturers began to scale back production in late summer and early fall, when they would normally be running at peak capacity to prepare for Black Friday and the start of the holiday shopping season. “Everyone sees a slowdown,” Wilkinson says. “It’s not a drop off the cliff, but people are trying to manage their inventories to have a soft landing and then get back to steady growth.”

From that perspective, Wilkinson says, the outlook for the U.S. holiday shopping season is not particularly bright, at least as it pertains to consumer electronics. “I think there is a potential overstock situation that needs to be corrected,” he says, “and this most likely relates to the economic news we are constantly hearing, and its impact on consumer confidence.”

He does see a “glimmer of hope” in the number of corporate clients the firm has seen coming to its Silicon Valley office to discuss ideas for new technology, and he hopes that signals the start of a technology-driven recovery. “But with the consumer side so uncertain, and politicians arguing back and forth,” he says, “it’s hard to know what to think or believe.”

Demand Will Come, but When?
Although it believes it has opportunities to grow market share in the business segments where it already competes, Pinnacle Data Systems remains focused on “actions it can control,” says CFO Tomashot. Entering the recession with a workforce of just over 200, the company pared down to about 100 employees in the depths of the downturn. Since then, it has added back about 20 of those lost positions.

“We made tremendous progress over the last two years, taking our overhead down by a third,” says Tomashot. “But we still have the mind-set that every cost is an investment. We’re scrutinizing every dollar that goes out the door and questioning the value and the return on investment that it’s going to deliver.”

Over the past 18 months, Pinnacle has focused on growing its electronics-repair and logistics-services business, which provides warranty repair services for large computer-systems companies. That business was attractive during the downturn, says Tomashot, because demand in that sector is driven not by new-equipment sales but by the installed base of equipment already in the field. With customers paring inventories to reduce working capital, he says, Pinnacle was able to grab market share and post a 25% year-over-year revenue gain in this sector.

As for its other segments, “Demand will come,” says Tomashot. “But I’m not going to predict when, so over the near term we’re still focused on driving profitability.”

One consequence of sustained profitability, he adds, should be access to better financing terms. Despite posting losses in 2008 and 2009, the company was able to secure a credit revolver in April 2009. However, that facility was based largely on the quality of its working capital, specifically its accounts receivable. “We do business with world-recognized blue chip OEMs [original equipment manufacturers],” Tomashot explains. Since then, the company has returned to profitability and pared its borrowings against its credit revolver to nearly zero. “We’re focused now on sustaining profitability to get more EBITDA-based lending,” he says.

Optimistic about — Yes! — Housing
For American Woodmark, a $406 million Virginia-based maker of kitchen cabinets, the key objectives in 2011 are to maintain its balance-sheet strength by generating positive free cash flow and to invest in new products to gain market share, says CFO Jonathan Wolk.

To some degree, the company has no choice but to pursue growth. It has already reduced its break-even point by nearly half since 2006, Wolk says, largely through an aggressive cost-cutting program that culminated with the closure of 2 of the company’s 14 manufacturing facilities and the suspension of production operations at a third. The company also reduced its salaried workforce and continued to embrace lean-manufacturing initiatives. While American Woodmark expects to find additional cost-cutting opportunities in 2011, Wolk says, they are likely to be minor by comparison.

That’s where its complementary growth initiatives come in. Throughout the recession, American Woodmark continued to introduce new product lines at six-month intervals, Wolk notes, and as a self-described “value player” was able to increase its share of a shrinking market during the height of the downturn. The company is also expanding its sales reach through entrée into a new distribution channel, although Wolk was unwilling to discuss details of that move when we spoke to him in October.

Perhaps most surprising, American Woodmark is also reasonably optimistic about the economy. Wolk notes that the private sector created 863,000 jobs in the first nine months of 2010, according to government data, and says his company expects that new single-family home sales will increase by double digits in 2011. Both should help a company whose fortunes are closely tied to the health of the housing industry.

“We’ve got a couple of other things that give us wind at our back in terms of the housing market, namely population growth and household growth,” Wolk adds, noting that the nation’s population has continued to grow by 3 million people per year and that household growth, while it has lagged because of the economy and job losses, is starting to improve. Even though new-home construction is likely to remain at less than half what it would be in a normal economic environment next year — perhaps 650,000 to 700,000 units, Wolk says — American Woodmark sees the potential for double-digit growth in its own market sector.

All that optimism, however, won’t lead to many new hires, Wolk admits. “Companies like ours,” he says, “want to see the whites of the recovery’s eyes before we hire.”

Help Wanted
One company that does plan to staff up is SeraCare Life Sciences, a $44 million life-sciences company in Milford, Massachusetts. Made confident by five consecutive profitable quarters, the company plans to beef up its sales-and-marketing and research-and-development teams. While the company expects a continued slow and jobless recovery in 2011, “a lot of our customers seem to have loosened up their research budgets, and we think we have an opportunity to grow the product side of our business,” says CFO, treasurer, and secretary Gregory Gould.

SeraCare makes diagnostic controls, plasma-derived reagents, molecular biomarkers, and other products used in the discovery, development, and production of human and animal diagnostics and therapies. It also provides research services for government and corporate clients in the molecular biology, virology, immunology, and biochemistry markets.

After a 2009 so bleak that the company cut jobs, tabled some planned investments, and worried whether its lenders would even continue to fund it, SeraCare turned things around this year, Gould says. Growth was particularly striking on the services side, he notes, as clients, particularly in the government sector, loosened their grip on their research budgets. By the end of the third quarter, the company had more than $12 million in the bank, no debt on its balance sheet, and just $100,000 of capital leases.

Suddenly, banks that were once wary of lending money are now offering SeraCare lines of credit and funding for potential acquisitions. “At some point,” Gould says, “we will probably go out and pull down a credit facility, just to give us more options going forward.”

For Parsons Brinckerhoff Inc., the $2.5 billion transportation engineering firm that can trace its roots back to its 1885 design for New York City’s first subway, success in 2011 will hinge on overseas growth and, perhaps, a new embrace of mass transit on these shores.

“About 80% of our U.S. business comes from the government sector, and we see that as continuing to be extremely weak,” says chairman and former CFO Richard Schrader. “We project revenue in that sector to be flat, a reflection of the situation at the state and local level, where two-thirds of the states and many municipalities have significant budget deficits.” By contrast, he says, the firm sees continued double-digit growth in its Australian operations, which account for about 10% of its revenue, and also strong growth in southeast Asia and China, and good prospects in northern Europe.

One sector that does look promising in the United States, at least near-term, is transportation, with airports and runways in need of upgrade and politicians once again talking about high-speed rail projects. Parsons Brinckerhoff is the high-speed-rail program manager for the state of California, and that contract, along with similar initiatives elsewhere, should bolster the firm’s U.S. business in the near term. Whether politicians follow through with the long-term funding needed to see most of the current high-speed rail initiatives come to fruition, however, is an open question.

Parsons Brinckerhoff has cut general and administrative expenses by about 2% over the past couple of years, Schrader says, and foresees another 1%-to-2% reduction next year, thanks in part to synergies with its new (as of 2009) parent, UK construction giant Balfour Beatty. In the meantime, the company is selectively hiring in markets where it sees opportunities to grow, including the aviation, water, and environmental sectors. The company also has what Schrader calls a “pretty robust M&A target list,” and expects to close some acquisitions in 2011.

So Much for Statistics
Having been in business since 1847, privately held Rahr Malting Co., a $400 million producer of malt and other brewing supplies in Shakopee, Minnesota, knows something about riding out economic downturns. Assuming that it’s going to be a “modestly difficult year” for the economy in 2011, Rahr CFO Jeff Taylor says the company’s goal is to continue its balanced approach to financial performance and capital investments.

“We are not looking to grow or expand capacity in our core business,” explains Taylor. “Everyone in our industry is grabbing the same piece of the pie right now, if not a smaller piece. However, we may be looking to diversify if we find something that may have another stability factor to it.”

As part of its balanced approach, Rahr didn’t jump on the cost-cutting bandwagon during the recession. It did not lay off any of its 200-plus employees, for example, and actually undertook a two-year implementation of an enterprise-resource-planning system that should be finished by next August. Rahr decided to make that investment now, Taylor says, both to enhance its risk-management capabilities and to take advantage of favorable pricing it was able to obtain in a weak economy. But, he adds, the weak economy also convinced Rahr to forgo any substantial growth investments in its core business, at least for the time being.

“You’re always going to do a return-on-investment analysis, and right now you just can’t make the numbers work,” he says. “Whether it’s legislative or consumer uncertainty, you can’t say it’s worth putting the money in — especially when we have found, at least in our industry, that costs for building capacity have not come down a lot. We still believe a practical recession is continuing, even if GDP statistics may declare it at an end.”

Randy Myers is a contributing editor of CFO.



Will Tax Laws Change?

Companies must grapple with many forms of uncertainty these days, and whether the GOP’s retaking of the House of Representatives will help or hurt remains, well, uncertain.

Election results were still being tabulated when talk turned to a variety of potential corporate tax breaks. One interested observer is David Lewis, Eli Lilly & Co.’s vice president for global taxes and chief tax executive. While declining to forecast how the economy will perform, Lewis says uncertainty about the U.S. tax policy next year is weighing on business executives across the country. “International tax revenue raisers that fall on U.S. companies alone are not helping in terms of that uncertainty,” Lewis says. “Nor are discussions around whether or not we should repeal deferral [of taxes on U.S. corporate profits held abroad], or significantly limit deferral.”

Lewis says the government should be making “bold, courageous, and permanent” changes to tax law that reduce corporate income tax rates, encourage the repatriation of corporate profits now trapped outside the United States, and permanently extend the tax credit for research and development. He also suggests that the U.S. consider adopting some of the “new and creative” policies Europe has enacted to lower taxes on income earned on intellectual property. — R.M.



Commercial Real Estate
So Far, So Good

Economists and investors worried about the fragility of the economy heading into 2011 can point to any number of troubling signs, but one potential peril may be less threatening than it seemed just a year ago.

For some time now, there has been widespread concern that the foreclosure tsunami roiling through the residential sector of the real estate market will wash over the commercial sector, too. So far it isn’t happening, says Brian Schaefgen, CFO of Harbor Group International in Norfolk, Virginia, a private real estate investment and management firm with a $2.7 billion real estate portfolio.

“Lenders appear to have taken the approach that they’re going to get through this and are just rolling out loans two or three more years until things start to stabilize,” Schaefgen says. “Properties are definitely not being taken back by the banks and they’re not being sold at huge discounts. That has happened selectively, but there’s been no huge onslaught.”

Accordingly, Harbor Group plans to continue buying real estate in 2011, albeit strategically, in markets where it sees appealing demographic characteristics, such as large government operations that can stabilize the local economy.

Beyond more-patient banks, Schaefgen says his firm also has seen occupancy rates in its residential properties ramp up by 200 to 400 basis points over 2009 levels. The company’s properties are even raising rents in parts of Texas, Virginia, and elsewhere, he says, emboldened by an influx of renters with jobs in hand.

Finally, he says, lenders are becoming more amenable to, well, lending. “We recently acquired a million-square-foot office property in New York,” says Schaefgen. “A deal like that would have been difficult to get financed in 2009, and could not have been done in 2008.”

Schaefgen’s optimistic outlook extends to the economy as a whole. He predicts that 2011 will be a year of modest growth in terms of employment, earnings, and consumer confidence. “As pressure for earnings continues to grow, larger companies should begin to deploy built-up cash stockpiles into new ventures and R&D opportunities,” he says. “That should improve the flow of capital across industries and lead to stronger economic growth nationwide.” — R.M.