Here is a brief excerpt from a classic article written by Richard Dobbs, Tomas Karakolev, and Rishi Raj for the McKinsey Quarterly, published by McKinsey & Company. To read the complete article, check out other resources, learn more about the firm, obtain subscription information, and register to receive email alerts, please click here.
To learn more about the McKinsey Quarterly, please click here.
* * *
In a buoyant economy, the next recession seems far off. But managers who prepare during good times can improve their companies’ chances to endure—or thrive in—the eventual downturn.
“Economists,” Nobel laureate Paul Samuelson famously quipped, “have correctly predicted nine of the last five recessions.” Impossible as it is to forecast the timing or depth of the next downturn, executives enjoying today’s upbeat economy should also be preparing for the recession that will inevitably follow. Many weren’t ready for the last one; by our reckoning, nearly 40 percent of leading US industrial companies toppled from the first quartile in their sectors during the 2000–01 recession, and a third of leading US banks met the same fate. At the same time, 15 percent of companies that had not been industry leaders prior to the last recession vaulted into those positions during it.
To understand how to make the most of a recessionary environment, we analyzed the performance before, during, and after the 2000–01 recession of some 1,300 US companies from a broad range of sectors1 and identified which of these companies emerged from it having gained or maintained leadership status.2 For these industry leaders, we analyzed which characteristics they exhibited before the recession that might help explain why they outperformed their peers. Although recessions strike different sectors in different ways and at different times, the postrecession leaders in most of the sectors we explored had characteristics in common. Entering the downturn, they typically maintained lower leverage on their balance sheets, controlled operating costs well, and diversified their product offerings and business geographies. Such fundamentals gave them a greater degree of strategic flexibility, which became even more valuable during the recession (Exhibit 1). And although previous recessions aren’t necessarily a guide to future ones, we believe that flexibility can make a notable difference by allowing managers to take advantage of the opportunities that the next recession might provide.
Balance sheet flexibility
Whatever the position the companies had within their sectors before the downturn, many that emerged from it as leaders expanded their businesses during the recession, both organically (through internal investment) and through inorganic activities such as M&A, alliances, and joint ventures. And although the leaders increased their asset bases through capital expenditures or acquisitions at the same pace as less successful companies did before the recession, the focus of their growth was different: the more successful companies spent less on M&A, on average, and focused more on organic growth. In 1999, for example, leading companies had, on average, capital expenditures that were 8 percent higher and growth through M&A that was 13 percent lower than their less successful counterparts did. During the recession itself, however, better performers leapfrogged the competition by continuing to invest and to grow inorganically: in 2000, companies that emerged in the top quartile spent 15 percent more on capital expenditures and conducted 7 percent more M&A—possibly buying cheaper assets from distressed sellers. In addition, they were able to pay their suppliers faster, probably in an effort to negotiate lower prices and better service.
Arguably, winning companies leveraged the benefits of balance sheet flexibility that they had achieved before the recession. At industrial companies that ultimately emerged as sector leaders, for example, the average net debt-to-equity (D/E) ratio before the recession was roughly half that of their less successful competitors. What’s more, the postrecession leaders also held more cash on their balance sheets prior to the recession than those that weathered it less successfully.
Starbucks was one company that used such tactics to good effect in holding on to its leader status before and after the recession. In 1996 it had a D/E ratio of 8 percent, compared with an average of 14 percent for the restaurant sector, and managers consistently reduced the company’s leverage every year until 1999.3 That year the D/E ratio of Starbucks dropped to only 2 percent, as the industry average hit a high of 31 percent. Managers achieved this target by expanding the proportion of licensed outlets from 7 percent in 1998 to 13 percent in 1999 and 23 percent in 2000. Licensing and international expansion through alliances allowed Starbucks to accelerate its growth during the recession (Exhibit 2). Currently, alliances contribute 14 percent of the company’s revenues but account for 39 percent of its profits.
Executives can build flexibility into a company’s balance sheet by reducing the capital intensity of the business model, for example, or by resisting the urge to use additional debt to finance dividend growth or share buybacks. In our study, as profits grew during the expansion, the companies that emerged as winners refrained from increasing their dividends: their dividend payout ratio gradually decreased from a peak of 40 percent in 1995 to 32 percent in 1999. Then they cut dividend payouts aggressively at the first signs of the recession, reducing the payout ratio to 28 percent in 2000. In contrast, before the recession their less successful counterparts kept dividend payouts roughly stable—at 35 percent in 1995 and 33 percent in 1999—and even increased them to an average of 38 percent in 2000 as the recession began.
* * *
Here is a direct link to the complete article.
Richard Dobbs is a partner in McKinsey’s London office, Tomas Karakolev is a partner in the Prague office, and Rishi Raj is a consultant in the Delhi office.