“Economists have correctly predicted nine of the last five recessions,” is a famous quirk illustrating the foolishness of relying on the past to predict the future. No one can predict the timing or depth of the next economic downturn. But, when it arrives, flexibility will make a big difference.

According to a 2007 McKinsey report, companies with greater financial, operating and product flexibility stand a far better chance of survival and are better positioned to make the most of new opportunities.

In comparing the financial performance of 1 300 mostly industrial companies before, during, and after the 2000-01 recession (1995 – 2005), McKinsey identified how companies made the most of a recessionary environment and emerged as industry leaders.

Many organisations weren’t prepared for the 2000–01 recession. McKinsey estimates that almost 40% of the US’ leading industrial companies and banks toppled from the first quartile in their respective sectors.  Simultaneously, 15% of the pre-recession challenger brands vaulted to the top.

Although recessions strike different sectors in different ways and at different times, McKinsey discovered that the post-recession leaders in most sectors shared certain characteristics.

“Entering the downturn, they typically maintained lower leverage on their balance sheets, controlled operating costs well, and diversified their product offerings and business geographies,” says McKinsey.

These fundamentals gave them a greater degree of strategic flexibility, which became even more valuable during the recession.

McKinsey says the leading US industrial and banks that emerged from the 2000-01 recession, increased pre-recession business flexibility by focusing on the following strategic levers:

Interestingly, another McKinsey study, which looked at the performance of 1 000 mainly industrial US companies between 1982 and 1999, found that the companies that retained or gained market leadership during the 1990–91 recession, were not afraid to spend their cash reserves on strategic acquisitions. In addition, these companies aligned their spending with competitive opportunities, instead of tightening their belts on operating expenses.

Balance sheet flexibility

McKinsey says many companies emerged as leaders through two types of capital expansion during the recession:

• Organic growth  - internal investment 
• Inorganic growth, like mergers and acquisitions (M&A), alliances and joint ventures (JVs)

Of those that increased their asset bases through capital expenditure and acquisitions, the more successful companies spent less on M&A and focused more on organic growth.

For example, in 1999 (before the recession) average capital expenditure at leading companies was 8% higher and M&A growth 13% lower than their less successful peers’.

But, by investing in and inorganically growing their businesses during the recession, some companies overtook their competitors. Companies that emerged in the top quartile in 2000, spent 15% more on capital expansion and concluded 7% more M&A deals — possibly buying cheaper assets from distressed sellers.

Moreover, they were able to pay suppliers faster, enabling them to negotiate good contract terms, lower prices and better service deals.

The winners leveraged the benefits of balance sheet flexibility achieved before the recession.

For example, the post-recession industrial leaders’ average net debt-to-equity (D/E) ratio before the recession was roughly half that of their less successful competitors. In addition, they held more cash.

McKinsey says executives can build flexibility into a company’s balance sheet by: reducing the capital intensity of the business model resisting the urge to use additional debt to finance dividend growth or share buybacks

Companies that improved profitability through growth, but didn’t increase dividends payouts, also emerged as winners.

These companies gradually decreased the dividend payout ratio from a peak of 40% in 1995, to 32% in 1999. At the first signs of the recession, they cut dividend payouts aggressively, reducing the payout ratio to 28% in 2000.

In contrast, less successful companies kept dividend payouts before the recession stable at 35% in 1995 and 33% in 1999. At the start of the recession in 2000, average dividend payouts increased to 38%.
 

Operating flexibility

McKinsey says many of the industry leaders that emerged during the 2000-01 recession, focused on reducing costs without damaging the long-term health of their businesses.

By adopting a more flexible approach to overhead and operational costs before the recession, the winners successfully cut selling, general, and administrative (SG&A) costs, which is difficult to achieve in the short-term.

As conditions changed, the winners were able to redeploy their funds, assets and employees, which allowed them to cut SG&A costs by a further 3%.

McKinsey says the following measures helped US retailer Talbots, which entered the recession as a challenger, emerge as an industry leader:

• Increasing workforce flexibility during the growth period of the 1990s, by adding part-time workers at almost double the rate of salaried workers
• Increasing the number of hourly and part-time employees by a respective 14% and 16% a year between 1998 and 2000. The number of salaried employees increased by only 9%
• As the recession took hold in 2000 and 2001, Talbots radically moved its advertising mix away from TV and catalogue operations toward focused activities targeting customer groups with the highest sales potential. Although this reduced the company’s ratio of advertising expenses to revenues (from 5.5% of revenues in 2000 to 4.3% in 2001), Talbots maintained advertising levels far above the sector average
• Its ratio of advertising expenses to revenues was 120% higher than the sector average in 2000 and 80% higher in 2001
• In comparison, the less successful companies drastically cut R&D and advertising spending, which also cut off the stream of potential opportunities these expenditures may have created

Flexible product offerings
McKinsey says the post 2000-01 recession leaders’ offered more diverse products and had a bigger geographical footprint than their less successful peers, before, during and after the recession.

Successful companies also managed their customer and product portfolios proactively, before the recession.

For example, US telecommunications company Verizon coupled its expanding customer-base with increasing average revenues per user to offset falling call prices.

Average revenues per user fell across the industry as per-minute revenues dropped by nearly 20% a year between 2000 and 2003.

“By adapting its service mix toward broadband and value-added services, Verizon maintained its winning status throughout the recession,” says McKinsey research report, which may help managers and boards may prepare for an imminent recession.

Useful links:

• Richard F. Dobbs, Tomas Karakolev, and Francis Malige, “Learning to love recessions,” The McKinsey Quarterly, 2002 special edition: Risk and resilience, pp. 6–9.