COVER STORY - Ready, whatever the weather.

By June 1996 the recession had technically been over for several years – but
the country was in the grip of a malaise, with economists and taxi drivers
bemoaning the lack of a “feel-good factor”. The Conservative government was
rumbling toward near-certain defeat within the year, and insolvency experts
were, well, not exactly salivating over the prospect of another 1990s recession,
but certainly they were anticipating it. While the experts were still noting
that the recovery was “patchy”, some were expecting a pick-up in insolvency work
as early as 1997-98. Bankers were also looking ahead, in part by calling in
so-called “business recovery” specialists to help spot and work with problem
borrowers before they turned into basket cases.

This, perhaps, marks the defining aspect of the coming economic
dip/slowdown/recession. Businesses and their professional advisers and financial
backers were still raw from the lashings of the last recession when they were
starting to think about the next one. The “R” word has rarely been off the
business pages all decade. The result is that British businesses are probably
facing the prospect of a late-1990s downturn in better shape than they have
entered any other recession.

Indeed, it is partly because businesses have long been on the lookout for
this coming slump that it may be avoided altogether. One of the oddest
statistics to be published recently came from the credit information group
Experian. In November, it announced that average profit margins in the UK had
risen in more than half of the industrial sectors surveyed. Overall, margins
rose from 8.1% to 8.95% in the second quarter of 1998, soaring to a level unseen
since 1989 – not exactly a sign of worsening times. Return on capital rose to
more than 15%, compared with just over 11.5% two years earlier, while return on
shareholders’ funds topped 26%. Interest cover was more than 5.4 times.

Peter Brooker, author of the Experian Corporate Health Check, explained that
companies have been taking action to combat the expected economic crunch. “The
slowdown in the economy has been forecast for a long time, and many companies
have taken steps to improve their profitability,” he noted. The result has been
factory closures, job losses, and the scaling down and scrapping of investment
plans. Growth has suffered, output has been flat, export orders have been
getting more and more difficult to find – but profit margins have largely been
safeguarded. “The fact that profitability is still rising indicates that a
recession is less likely than previously thought,” Brooker concluded.

Against this uncharacteristically rosy background, large swathes of
manufacturing industry were already well into recession. The Confederation of
British Industry was warning in early November that small and medium-sized
manufacturers were hitting the worst point in their economic cycle since the
recession of the early 1990s. Orders, exports, confidence, output and jobs were
all falling. The outlook was even worse – although the rate of fall was expected
to slow. As sterling’s strength waned and interest rates started to head south,
however, the pain began to ease.

By the end of November, UK manufacturers were “bullish”, according to
Deloitte & Touche. “Activity levels for UK manufacturers of all sizes
improved and, for the larger manufacturers, operating profit margins and bottom
line profits bounced back from 1996-97 levels,” reported David Fletcher, head of
Deloitte’s Manufacturing Group. Real productivity improvements and “a high
degree of pricing discipline” – part of a strategy that entailed greater focus
on customers – were largely responsible. “The steps taken by many of these
businesses in 1997-98 to recognise the importance both of customers and of
effective cost reduction, cannot fail to help them weather these problems,” he
said.

By January, the CBI was saying, “Glimmer of hope as decline looks set to
slow.” In February, “Confidence weak, but improving.” Analysis published in
January by PA Consulting Group suggested that no more than about a quarter of
redundancies would arise as a result of companies “shedding staff because they
believe they are expendable” – a typical demand-starved recession, in other
words. Rather, PA expected that the majority of lay-offs would result from ”
structural business changes”.

Michael Fletcher, a consultant at PA, said “it is more likely that executives
will lose their jobs because of where they’ve been rather than how they’ve
performed.” Fletcher noted that, unlike the headlong charge into the last
recession as the excesses of the 1980s were burned off, companies now are much
leaner and relatively more efficient. “We are finding that the changes now being
made involve cutting back or eliminating entire business units,” Fletcher added.
Globalisation is a key driving force; world-scale acquisitions and mergers are
resulting in the kinds of economies of scale that enable substantial reductions
in overheads.

An analysis carried out by advertising agency Ogilvy & Mather at the end
of last year offered “a challenge to conventional thinking on recession”. Its
conclusions were distressing – “the fluttering of the Thai baht will transform
into a gale of uncertainty that will rip through the British economy and into
marketing departments across the country,” warned the report Come the Fall.
While it foresaw at that time a “very real risk” of recession, factors such as
the millennium bug and the introduction of the euro were “likely to increase
uncertainty within the value chain for most UK businesses.”

The O&M report argued that the recession would be very different in
nature from any we have seen before. Most notable was the fact that consumers
were not overly burdened with debt. However, the recession, it was said, was
likely to be passed “from business to business, rather than from consumer to
business”. It identified three types of strategy that companies might adopt in
the face of such an economic onslaught: – the Brute strategy, in which a company
seizes the opportunity of recession to radically restructure the market through
increased pressure on competitors – the Bull strategy, which involves sticking
to long-term plans – the Bear; an attempt to stay in the market by protecting
against, or removing, risk.

A Brute strategy is characterised by risk-taking, and has the aim of
permanently changing the market. Price wars may feature – not just to buy market
share but to seriously damage weak competitors – as may acquisitions and even
product launches. In the last recession, Grand Metropolitan launched Haagen-Dazs
ice cream, creating a new premium-priced sub-sector, with sales surging from
$10m in 1990 to $140m in four years. The late US retailer Sam Walton is cited as
a typical Bull strategist: “I was asked what I thought about the recession,”
said the Wal-Mart founder. “I thought about it and decided not to participate.”
O&M describe the Bull as risk-neutral, sticking with long-term strategy.

There is a danger of intransigence leading to late, over-reaction, but
successful bulls will take small risks to surprise competitors. Product
development is typical, such as the Guardian newspaper’s tabloid section (which
was launched in 1992).

A Bear strategy is characterised by tight financial management, decisive
reactions and quick decision-making. It is risk-averse and likely to be found in
mature industries. The aim of a Bear is to “stay in the game profitably”, ”
focusing on what works and cancelling what doesn’t”. As an example of a Bear in
action, O&M quote British Airways boss Robert Ayling: “We can’t afford to
have growth that is unjustified. Every route must pay for itself. If it can’t,
it goes.” The airline slashed its Far East route capacity within two months of
the Asian collapse.

The need to be sensitive to the circumstances in individual markets – rather
than adopting an across-the-board strategy – is highlighted by the experience of
Coca-Cola. Faced with economic blight in the Far East a year ago, the company
jacked up its ad spend programme. Faced with similarly bad times in Russia, the
marketing plan was slashed. The difference? Coca-Cola had a strong lead over
Pepsi in Asia, a region that was still seen as having excellent long-term
potential. In Russia, Coke was a long way behind its rival: “Playing catch-up in
an economy declining at over 20% was not a viable option,” the report notes. ”
One company. Two markets. Two recessions. Two strategies. Coke’s behaviour
underlines the point that there is no one experience of recession and therefore
there is no one correct strategic response.”

Perhaps what is most interesting in the O&M analysis, however, is that –
whatever strategic response is ultimately adopted by companies as they face
their own particular circumstances – in each case the business managers are
actually doing something – rather than just watching their customers not walk in
through the shop door. In each case, businesses analyse their and their
competitors’ strengths and weaknesses, seeking to turn problems into some kind
of opportunity. Bruce Gregory of the Business Regeneration Group at
PricewaterhouseCoopers warned in February that businesses are increasingly
having to deal with an era of deflation. “After so many years of inflation,
management may be slow to recognise the magnitude of the change that faces them,
” he said. “The deflationary trend means lower costs of materials and, as
interest rates fall, lower costs of capital. This means higher shareholder value
– but only if the company can protect margins or achieve growth.”

His analysis suggests that the likes of steel, oil and basic chemicals
industries would be “deflation losers”, while high-tech areas such as telecoms,
pharmaceuticals and IT would be “deflation winners”, best able to maintain
margins and achieve growth. Like the O&M study, PwC’s guide, Defending
Shareholder Value in an Era of Deflation, emphasised the opportunity to take
action at a time when RPI has all but become RIP: – exploit a critical asset
that is in short supply; skilled staff is one good example, especially in the
consultancy industry(!) – develop intellectual property; patent protection can
support product pricing – differentiate through product performance/design –
compensate price declines with volume growth; as in the mobile phone industry –
achieve cost reductions; strip out costs even faster than product prices are
falling.

Niches, cost-leadership, restructuring industry capacity, innovation – all
are ways that businesses have been trying to continue to create shareholder
value. Paul Baker from KPMG Consulting argued recently that businesses were
taking a much more sophisticated approach to the feared downturn. “The
traditional thinking is that businesses retrench and cut back on investment when
there is a downturn in the economy,” he said at the Alternative Business
Solutions conference in November. “However, this will not be the case on this
occasion, because businesses are beginning to recognise that, by streamlining
the supply chain, they can achieve cost savings that will help them survive the
slowdown.”

Part of this strategy is to embrace e-commerce. “In lean times, organisations
necessarily focus on how they can reduce costs and this can be done by
eliminating inefficiencies in the supply chain using electronic commerce,” he
said. Baker noted that companies were discovering ways of taking costs out of
their businesses “without damaging their ability to provide excellent customer
service or their operational effectiveness.” By increasing the speed at which
orders can be processed, costs can be reduced, and inventories run down,
reducing warehousing costs and working capital.

Better, more efficient order processing can also increase customer loyalty,
Baker argued: “It is now recognised by most companies that the cost of making a
sale to a new customer far outweighs the cost of making a repeat sale.” Hence,
if companies can generate more revenue out of the existing client base, then
they can save the costs that would otherwise be incurred chasing new business.
The added bonus is that e-commerce should make companies more responsive and
more flexible – “not necessarily leaner in terms of headcount,” Baker added. He
cautions that many companies have become fixated with the Internet as a means of
trying to emulate Amazon.com’s success – but it is the business-to-business
aspects, particularly procurement and supply chain management, where e-commerce
can really pay off.

A survey by KPMG Consulting showed that 30% of businesses were already using
e-commerce for transactions with suppliers; this figure is expected to rise to
70% within three years. If it is possible to summarise the state of British
industry as it heads into a – perhaps illusory – recession, it is “ready for the
worst, and seizing the advantage”. The scars of the recession of the early 1990s
have been slow to heal. The pain inflicted on families and businesses has been
seared into the memory of managers throughout the UK.

The problem may well be that the next generation of managers will think all
recessions are like this one. And if the young bucks ignore the lessons learned
by today’s business leaders, then the recession of 2005 may leave them with egg
on their face.

LESSONS FROM THE YIELD CURVE

Since September 1997, Financial Director has been publishing data on
the UK yield curve. This information is essential for corporate treasuries,
given that it shows the relationship between short, medium and long-term
interest rates at any moment in time.

It is also useful for FDs who are not concerned with treasury issues, since
the yield curve – and, in particular, the way it changes over time – says much
about the state of the economy. An upward-sloping yield curve suggests that the
economy is burning along, with short-term interest rates boosting demand while
higher long-term rates reflect inflationary worries. A downward sloping curve
suggests that the monetary brakes are being applied and that economic activity
will slow. If it is flat, the yield curve is likely to be in transition from one
phase to another. (It is also likely to be frustrating treasury dealers who find
themselves unable to make a turn out of borrowing short and lending long, or
vice versa.)

Various economists over the years have endeavoured to demonstrate a link
between the yield curve and the future state of the economy. In the United
States, Arturo Estrella and Frederic S Mishkin, of the Federal Reserve Bank of
New York, found that the shape of the US yield curve was a reasonably good
leading indicator of recession*. Their 1996 research showed that when the yield
curve is sloping upwards and 10-year Treasury notes yield 1.21% more than
three-month Treasury bills, then there is a 5% probability of recession within
the next four quarters. If short-term rates are 2.4% higher than long-term
rates, then there is a 90% chance of recession within a year.

It’s dangerous to apply US research results to the UK economy, given the
different structure of household and corporate debt, but the broad lessons
should still be relevant. In May 1997, UK 10-year rates were about 0.80% higher
than short-term rates. Under the US model, that would suggest that there was a
10% probability of recession by mid-1998. Back then, the economy was chugging
along on the back of the Labour victory. Within three months, however, the yield
curve was starting to flatten out as short-term rates were hiked up, raising the
recession risk to 25% (again, assuming the US model is directly applicable).

By September 1998 the curve was sharply downward-sloping: there was,
theoretically, an 85% chance of recession. But as bank base rates have fallen,
the yield curve has flattened out. By mid-March, the difference between 10-year
and 3-month rates was just 0.35%. Recession may not be avoidable, but the odds
of it happening within the next year may have fallen to just one-in-three.

* The Yield Curve as a Predictor of US Recessions, Current Issues in
Economics & Finance, June 1996.
www.ny.frb.org

WE HAVE BEEN HERE BEFORE This magazine was born in the
Thatcher boom shortly after the Conservatives’ second consecutive election
victory. The recession of the 1990s was for us, as for many of our
thirty-something readers, our first real downturn. Within a year of the
stockmarket crash of 1987 it was apparent the good times were not going to last
forever. It was not yet apparent, however, that the recession was going to be as
bad as it turned out to be. In September 1988 we were optimistically saying, ”
The good news is that the inclement weather is only expected to last for between
a year and 18 months.”

But what was promised to be a saucer-shaped recession – short and shallow –
turned into a bear-in-a-china-shop catastrophe. We got it spectacularly wrong in
aligning ourselves with the experts who said that construction would be one of
the sectors that “not only (is) expected to lose the least ground, but (will)
even show some solid growth over the next year or two, and possibly longer
(because it is) linked to the liberalisation of Europe’s markets (in 1992) which
could spawn a boom in tourism and business travel, building and the transport of
goods.”

More than three years later, FDs were not yet convinced whether 1992 would be
better than 1991. “With the loss of consumer confidence, the slump in house
values and uncertainty over the election, I feel that Norman Lamont’s
expectations of a consumer-led recovery are probably so much poppycock,” we were
told in January 1992 by Alan Penson, then FD at design business Clarke Hooper.

Meanwhile, the Abbey National’s group financial controller Oliver O’Shea
expected house repossessions to be as bad in 1992 as in 1991. If there was a
sunny side to the last recession, we argued in January 1993 that it helped bring
the FD to the fore. “Glamorous may be the wrong word for (the FDs’) jobs but
they are now seen as weighty rather than dull and they are the ones (at
analysts’ meetings) fielding all the difficult questions about cash flow and
debt. FDs have come into their own.”

BZW analyst Bill Curry said: “The City prefers strong FDs. It is very
concerned if a chief executive dominates and the FD keeps quiet during the whole
of a presentation.” Wimpey construction group’s FD, Roger Wood, explained in
1993 that FDs were having to spend between 10% and 30% of their time on their
relations with analysts and institutional investors. “When times are tough, FDs
have to spend more time preparing their ground because it is harder to get the
right message across.” Robert Shrager, who joined Dixons as the corporate
finance director in 1988, said that FDs were also spending a lot more time with
their bankers:

“The whole relationship between companies and their banks has become more
important. In the aggressive days of the 1980s, FDs could pick and choose
between banks and margins got pulled down. Not now.” With recession, of course,
comes a slowdown in the job market. One FD commented that this was not only
frustrating for him personally, but probably was not good for companies: “In a
recession people tend to hold onto their jobs,” said David Kay at Lionheart. ”
It has stopped the flow of financial management and I don’t think that’s good.
It stops new people coming into companies with new thinking.”

During the early 1990s Financial Director ran a series of articles
under the heading “Diary of a recession”. In it, “Pete di Nero”, a nom de plume
for the managing director and FD of a small consumer goods company, talked about
his struggle to survive. “I usually work out a business plan that requires just
a little extra cash to work,” he wrote in February 1992. “This of course
contains a good deal of wishful thinking, but that’s par for the course. I’ve
done it time and time again and it’s never failed. But things are changing now
…” Di Nero wrote of his distress at learning that his request for more funding
had been passed to his bank’s regional office. “That was bad news because the
regional office knows nothing about our business … But this is bank policy: It
keeps the regional guys ‘objective’, it says.”