Digital transformation. Consolidation. Growing concerns over manufacturers’ going direct. With all the shiny objects in front of distributors right now, it’s easy to ignore (and not plan for) the next big thing: the next recession.
Students of history recognize that there are two things we know about the economy. One is that cycles of growth and recession are inevitable. The second is that we rarely see the downturn coming, and we can’t always rely on economic indicators to warn us.
As an old guy who has lived through Nixon’s wage and price controls and Carter’s Misery Index, I have observed that economic predictions are nearly always wrong, and companies are always surprised when things go south. I will never forget the famous line from Paul Samuelson: “Economists have predicted nine of the last five recessions.”
The result is that if you are following the herd, you will miss the turn – and with it your opportunity to not only survive but thrive when the going gets tough.
No one can predict when we’ll see the next recession. But the economy cycles through recurring patterns and understanding how to anticipate these cycles and taking calculated risks can create opportunities to grow shareholder value in good times and bad.
Many companies fail to do that, and one reason is that the periods between downturns are long enough that institutional memory in executive suites is often lost when turnover occurs in senior positions. More importantly, too many hesitate to take the strategic risks that would position them to gain in a serious downturn.
Big Takeaway: There is competitive advantage to those that prepare for a recession before the market goes soft. The opportunity is lost if actions are taken when everyone else is taking theirs.
There Are Many Complicating Factors in Today’s Economic Environment
Signs point to a wild ride for many distributors in the next downturn. One reason: We have had low interest rates for many years and markets have grown used to them. As a result, many decisions and resource allocations have been made on the false assumption that these low interest rates will continue.
Other complicating factors: We essentially have full employment now. We also have signs that wages are starting to rise. At the same time, we are seeing the beginning of a trade war. The implications of the latter could be far-reaching and, for many, devastating. Recent market volatility hasn’t helped the anxiety levels.
Private equity firms, a major player in consolidation, make extensive use of debt in funding acquisitions, often with debt representing 60% or more of the purchase price. But as rates double or even triple what they are now, many deals would go south, which would create a loss of capital for investors. In the private-equity world, these become known as zombie funds. As these investors take a hit, they often pare back in other areas, and that ripples through the economy.
Roughly two-thirds of our GDP is generated by consumer spending. When loan and bank-card interest rates increase, spending declines as most are just trying to meet a mortgage payment. That adversely affects everyone in the economy as the resulting revenue declines can trigger cost reductions, layoffs and deferred capital expenditures, which accelerates the downward spiral.
I am old enough to remember what it is like to compete in a double-digit inflation environment; today’s approach to doing business will spell disaster for firms caught by surprise when the inevitable occurs. Most manufacturers spent the end of 2018 trying to decide how large a price increase to put out at the beginning of this year. The next couple of months will be interesting.
How to Prosper in Hard Times
Low interest rates have created an almost myopic focus on income statements; everyone is thinking about growing sales by any means possible while making a profit. Unfortunately, this won’t work in a double-digit inflation environment. The winners instead will be focused on balance-sheet ratios, which will become strategically important.
The big play with the largest impact is an aggressive reduction in inventory. Every distributor has dead or other non-performing inventory. This requires strong leadership when the market is still good. The reason the gain is worth the pain is that holding low inventory after the market goes soft puts the firm in a position to replace that inventory at a lower average purchase price as suppliers become desperate to move out their finished goods inventories. It may even be worth having an intense collection conversation with that slow-paying large customer who we know will pay even more slowly when the market turns.
The big payoff is that your gross margin doesn’t take a hit as average selling prices decline, because your average purchase price is better than your competitors who are still holding inventories from the peak.
It also means taking a few steps that may be outside your day-to-day, including:
- Running scenarios at various interest rates to determine what actions would be necessary to maintain profitability;
- determining how higher interest expenditures and recessionary declines in margin could affect your sustainable growth rate and using the insight to consider the relative attractiveness of new business;
- and reviewing your loan agreements before rates go up and negotiating improvements in your terms and conditions.
If any of this causes significant concern, seriously consider slowing expansion and investment to pay down debt. It is much easier to develop new loan agreements when you are in a strong position.
It won’t be easy. It’s hard for a company to scale back investment and expansion when, outwardly, it appears the economy is humming along. Competitors will try to take advantage, and even your own salespeople will think you’ve been out in the sun too long.
But you’re playing the game to win, not to lose. Yes, it’s a calculated risk, but a relatively small one. You’re slowing growth, not betting the company. And it may be the difference between just surviving and thriving.
This is a complex and nuanced executive challenge. My next blog post will examine staffing changes before the recession hits. Firms that are willing to change their thinking and take these strategic risks are those that will prosper through the inevitable downturns. There is another set of best practices to create competitive advantage when the economic recovery begins. We probably don’t need to write that one for a while.