Thoughts on managing through Financial Crisis

SOFT LANDINGS FROM THE McKINSEY

More difficult times for Asian business may be just ahead, say many economists. In a conversation with CFO Asia, Hong Kong-based McKinsey & Co. partner Alan Lau shares his thoughts on how corporates can come through the slowdown with a soft landing.

You have argued that by the time you know there’s a slowdown, it’s too late to respond. What should CFOs be doing now?

The first is maintaining flexibility on the balance sheet, which in some ways is the most obvious one. Before you head into a recession you should try to cut down on the amount of leverage that you have so that you can keep your cash level high. And don’t be overly aggressive on your dividend policy. You could reduce the payout. But at a minimum, if you are borrowing money to increase dividends—which we do see a lot of companies do—you should stop.

Wouldn’t investors see a dividend cut as a warning sign about your company?

Cutting the dividend dollar per share is going to be a little bit of a risky move. But we have seen it done. One example is a major apparel retailer in the United States, which cut dividends [during the 2000-2001 recession]. But they had a very explicit plan to say, “We’re refocusing on opening new stores and also renovating existing ones.” To be sure, the market did not understand that and they suffered initially with their stock price. But after investors saw the results of the store openings and the renovations, they started rewarding them. For the next four to five quarters they outperformed their peers by 10 to 15 percent every quarter.

What about cutting leverage? Isn’t corporate debt in Asia less than it was during the last big slowdown?

Compared to the financial crisis in 1997, there is much lower leverage. And there’s less mismatch on the currency side, which is a good thing. But if you look at the interest rates in a lot of the Asian economies, they are still often twice as expensive as the rates in the United States. Just based on the very high costs in Asia, being cautious on leverage makes a lot of sense if you think you might be heading into a slowdown.

What should CFOs be doing about controlling overheads?

If we look back at a couple of examples of how successful companies have done it, they don’t try to do a one-off big slash and burn by cutting SG&A—instead, it really is a steady decline. We’ve done research on a set of over 1,000 U.S. companies [regarding their financial performance before, during, and after the 2000-2001 recession in the United States] and looked at what distinguishes those in the top quarter in terms of profitability and revenue growth. It’s very consistent: the winners sustain 2-to-3 percent lower SG&A going into a recession. And it’s a very sustained decrease in expenses rather than a big one-off cut. Of course, you need to structure your operation in such a way that you can do it.

What is the right structure?

It’s about making your costs variable. There’s outsourcing, of course, but at the very basic level it’s thinking about how many full-time and part-time workers you actually want on your payroll that gives you the flexibility. For companies that make TVs and handsets, for example, it’s very common to outsource manufacturing. Obviously, there are a lot of reasons why you do this; it’s not just about costs. But the fact is that they’ve set up the operation in such a way that gives them flexibility going into any slowdown to say “I want to scale back.” And of course it works both ways. When it picks up, then you can actually expand.

How should companies change project funding? It can be hard to convince people to cut expenses before a crisis is at hand.

It’s true, people just don’t scale back. One correlation we’ve run is the budget allocated for a specific project this year compared with last year: the correlation between the two was 0.85. So there’s just a tendency of rolling on even if it’s not the right thing. But there are many things that require you, if you’re a prudent manager, to review it on a more frequent basis. For example, the fact that the interest rate is going up in many of the markets, or that the equity risk premium has gone up, so your cost of capital has gone up. Some of your projects must have slipped.

But the other thing is that companies systematically underspend on low-profile projects, like maintenance. So, it is something for the CFO to review to say, “Where am I spending money this year, given that I’m heading toward a slowdown? Am I spending enough money on maintaining the network, such as renovating existing stores?” Maybe opening a new store in a great shopping mall is the high-profile project, but renovating an existing one is a better use of your capital. And it’s the latter that often gets overlooked.

What does your research say about M&A investments?

The winners and losers have a very different investment pattern. In an expansionary period, the winners focus more on organic growth and less on M&A. So, for example, in an expansionary period, winners would spend 8 percent more compared to non-winners on organic growth and 13 percent less on M&A. But when they come into the recession they spend 15 percent more on organic growth, and 7 percent more on M&A. That’s a big shift.

It’s easy to understand if you think from the angle that there are a lot of cheap assets available in a recession. And it’s really in periods like this that a lot of the competitive landscape gets redefined. One of the facts that we’ve seen in the last downturn in the United States was that a third of the leading U.S. industrial companies got toppled off their leadership position. And the attackers buy up that wreckage. How you spend on organic versus inorganic [growth] makes a huge difference.

Does the budgeting and forecasting process need to change?

Having rolling forecasts would make a huge difference to a company that has a shorter product life cycle, or that’s very much affected by the external environment. For example, if you’re a mobile handset maker, your forecasts might show you that with a recession coming you need to do a lot more of the lower-end handsets rather than the higher-end handsets. So I just need to cut down on production and stop adding capacity.

You can also use the budget as a tool to get yourself into the discussion of what is the right project to spend money on. There’s nothing that should prevent the CFO from asking, “Are we selling into the right channels?” or “Do we have the right products?” So, if it’s a TV set, are we just selling to Best Buy and Circuit City in the U.S., or are we selling to Wal-Mart as well? In a recession, if you just flip on the first selling channel and not the second one, you’re not going to capture the set of customers that you need to get you through the period.

Do you think companies in Asia are better positioned to cope with a slowdown than they were 10 years ago?

I think the answer is yes. The debt level is much lower than in the previous cycle and the domestic economies are actually supporting a huge part of the revenue and the growth of companies. Also, I think this slowdown is going to be much more gradual. In 1997 currencies devalued by 30 to 50 percent—it was a crisis. Frankly, a lot of people were caught by surprise. You have the opportunity to prepare this time.