Is There a Silver Lining? Capitalizing on the Next Economic Downturn
Joel CohenManaging Director
Co-Head, Baird Global Industrial Investment Banking
Joe PackeeManaging Director
Co-Head, Baird Global Industrial Investment Banking
With careful planning, industrial companies can emerge from the next downturn stronger and positioned for success.
While softening demand in certain industrial end markets can be challenging, it is also an opportunity to make strategic moves that may be difficult to pursue during periods of rapid economic growth. We believe companies can optimize this opportunity and not let the next recession go to waste.
PREPARING FOR THE NEXT RECESSION
Companies need financial strength and flexibility to capitalize on opportunities that emerge in a soft economic environment. Best-in-class companies are pursuing initiatives to bolster their economic fortitude ahead of the next downturn.
Capital Structure – Ample liquidity and a strong balance sheet are critical to capitalizing on the next downturn. Sophisticated companies are developing recessionary scenarios to quantify the likely fall in EBITDA based on how they performed in the last recession, end market exposure and cost structure. Companies that feel exposed should endeavor to deleverage by staying disciplined on capital expenditures, selling non-core assets and preserving cash. Many companies are also re-examining their debt securities to ensure they have the most flexible terms possible, and some are considering raising equity to shore up balance sheets.
Variable Cost Structure – Since the Great Recession, many companies have have migrated more costs from fixed to variable to mitigate the bottom-line impact from a drop in revenue. They have done this by automating manufacturing, outsourcing non-core functions like certain design, maintenance, IT, HR, legal and finance operations, and reducing large fixed costs like excess manufacturing footprints.
Portfolio Realignment – Many businesses have diversified their end markets and entered new, less cyclical markets. They have achieved this by divesting or spinning-off highly cyclical business and acquiring assets serving noncyclical end markets such as food & beverage and medical & pharmaceutical. Several companies are exploiting secular trends within their markets, in areas like electrification, automation and IIoT (industrial internet of things), which may mitigate recessionary headwinds.
Business Model Innovation – While many companies are innovative in new product development, it is less common to see aggressive, strategic business model innovation. Companies at the forefront of model innovation know improving quality of revenue can enhance their resilience to market weakness. For example, they are investing in recurring revenue streams like aftermarket service and spare parts, subscription software and equipment leasing. They are also working to increase differentiation and customer loyalty to preserve pricing in a failing-volume environment.
Recession Plan – It is imperative that every management team has a recession plan that identifies and prioritizes actions to mitigate economic weakness. This enables them to react quickly and realign their businesses to preserve capital and shift resources to key strategic functions. In the last recession, companies that took immediate actions like reducing 401(k) contributions, giving workers unpaid time off and making headcount reductions shored up their profitability and were better able to navigate the environment than ill-prepared businesses.
PRIORITIZING STRATEGIC INVESTMENTS
Companies that prepare for a recession will be flexible enough to direct resources to initiatives that will generate strong ROIs when the economy strengthens. They may achieve even greater long-term market share expansion if their competitors are not as diligent.
Double Down on Research and Development – Many companies have made the mistake of slowing R&D investment during recessions. During the Great Recession, businesses that could afford and had the strategic vision to continue new product development programs captured significant market share from competitors when demand re-emerged.
Implement Operational Initiatives – It can be challenging to divert time and resources to operational initiatives in a strong environment where customer requirements are high. A downturn provides an opportunity to tackle initiatives such as enterprise resource planning (ERP) or customer relationship management (CRM) implementations, workforce training, lean manufacturing programs, supply chain rationalization or facility consolidations.
Pursue Strategic Acquisitions – Recessions are a unique opportunity for companies with strong balance sheets to capitalize on weaker competitors and drive industry consolidation. The psychology of entrepreneurs often evolves during a recession as they are faced with circumstances like layoffs, reducing incomes and dealing with unhappy constituents. Continued independence is often less appealing than teaming up with a well-resourced partner. In a addition, since targets' earnings and prospects are lower and fewer bidders are viable, valuation expectations typically fall in these environments. During the Great Recession, well-capitalized companies that aggressively consolidated the market saw outsized shareholder returns in the following decade.
Companies that are well-prepared heading into the next recession and use their resources wisely to invest in the long term will emerge stronger and create superior value for shareholders. There may be a silver lining to the downturn after all.