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In challenge, there is opportunity. This truism is especially apt for companies heading into what will probably be a gloomy earnings season amid expectations of a global downturn. S&P 500 earnings forecasts for the fourth quarter of 2022 are worse than they were right after the collapse of Lehman Brothers in 2009 or during the deflation of the dotcom bubble in 2002.
Many companies will respond to this by cutting costs with an extra-large pair of corporate shears. The technology sector, for example, is in the midst of massive lay-offs. And other industries may soon follow Silicon Valley’s lead.
Plenty of corporate leaders look at a downturn as the best time to cut costs and people in order to hang on to their margins. But there is good data to show that the companies that not only survive but thrive in tough times tend to use a three-pronged approach — cuts, yes, but also a decrease in financial leverage and increasing investment in order to grab market share. Most importantly, they act proactively rather than reactively, getting their house in order before the cycle bottoms, so as to be ready to capitalise on cut-rate acquisitions or lure choice talent.
A new McKinsey study that looks at 1,200 public companies in the US and Europe between 2007 and 2011 provides a window into this wisdom. The companies that had the best shareholder return during this period (meaning those in the top 20 per cent) were the ones that did three things.
They bolstered retained earnings and working capital before the downturn. They also decreased their financial leverage. This created “reserves that they then spent on value accretion, such as acquisitions, R&D and capital investment, during the rebound phase,” says Asutosh Padhi, head of McKinsey North America.
While some cash rich industries, such as technology or energy, were and are better positioned to do these things, the strategy of pulling growth and margin levers together, rather than simply battening down the hatches and cutting, works across every sector.
If we look back at the aftermath of the 2008 financial crisis to find those companies that did well, one could point to the tech giant Qualcomm, which kept R&D high and pursued strategic acquisitions. But you could also look at a retailer like Urban Outfitters, which began 2009 with no debt and plenty of cash on hand, and was able to expand while its competitors were cutting.
None of this is rocket science. But it does require financial discipline, something that the last economic downturn in 2020 did not require of companies, since rates were still low and credit was loose. While new leveraged-loan issuance was down by nearly a third year on year to October 2022, as rates have risen, companies refinancing their existing debt this year and beyond face considerably higher expenses than they did in the past.
This includes plenty of household names across a variety of sectors. While it’s difficult to know exactly which companies are going to have major issues servicing their debt in the future, the New York-based financial analytic firm Calcbench took a stab at the question in a small study, examining 22 non-financial S&P 500 companies that filed their annual reports in the previous autumn and had a debt disclosure within that report. Of those businesses (which included companies such as Sysco, Oracle, Fox, Campbell Soup, Clorox, Seagate Technology, News Corp and Tyson), ten had annual interest expenses that were already more than 10 per cent of net income, even with average interest rates ranging from 2.38 per cent to 3.22. That’s a big debt load by percentage of net income, and one that will probably have to be rolled over at significantly higher rates.
Plenty of companies set to report over the next few weeks are in the same boat. January is the month in which investors will achieve more clarity on how much debt needs to be rolled over, and how much higher interest rates will impinge on the ability of companies to increase revenue. The overleveraged ones will find themselves boxed in and unable to do much aside from cut costs if they are to keep net income up (if indeed they can).
While cuts can keep a corporate ship afloat, they come with all sorts of downsides. Consider another transatlantic lesson from the post financial crisis period. American manufacturers slashed workforces following the crisis, but ended up losing market share in Asia to German competitors, who used a furlough system to retrain and upskill workers and repair equipment. This meant that the Germans were more quickly able to fill orders when the Chinese recovery began in 2010, because they were tooled up and ready to go, rather than struggling to rehire and retrain like US firms.
This lesson around treating labour as an asset rather than just a cost on the balance sheet has particular resonance now, when jobs markets remain tighter than usual as we go into what could be a global recession. Silicon Valley firms have room to cut their workforces given the increasing frothiness of the sector over the past few years, but many other industries are still desperate for talent. They would be wise to think about the mid to longer term before distributing too many pink slips.
While the next few months will be challenging for executives, they will be illuminating for investors. For years, easy money has disguised well-managed, proactive companies from more reactive ones. The curtain is about to be pulled back.
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