In an economic downturn, decision-making is distilled in to a clear-cut choice: Do you go on the offensive, aggressively pursuing growth, or do you become defensive, protecting your revenues and profit margins? In A.T. Kearney’s experience, the decision is determined by a firm’s competitive position and ability to counteract income-statement and balance-sheet stresses caused by the downturn. Imagine then that you’ve just won the coin toss. Should you receive or kick off?
Look at any of the grim economic news – consumer confidence and manufacturing indexes are at 25-year lows, major stock indexes declined by more than 30 percent, storied companies such as Lehman Brothers, Bear Stearns and AIG have succumbed to the credit crunch – and it’s easy to see that the world is in a significant recession. Governments around the world are scrambling to save the financial system, led by the United States, which has stepped in with roughly $8 trillion in bailouts, stimuli and other guarantees—an investment worth half the size of the entire U.S. economy.
Lessons learned from the last recession, the dotcom bust of 2001 and 2002, provide hope for survival and some guidance for success. They show that while the impact of economic downturns is wide-ranging across industries and companies, it seldom creates a level playing field: in a downturn, some companies clearly outperform others (see Figure 1). For example, the semiconductor industry was at the epicenter of the technology-led recession, with the S&P 500 Semiconductor Stock Index declining more than 80 percent over 2 years. Yet Nvidia and Microchip Technologies were two companies that thrived even in the face of a dramatic drop in overall computer chip sales. Similarly, in retail, while thousands of stores closed across the United States in 2001, and companies such as Kmart and Ames filed for bankruptcy, retailers such as JCPenney and Kohl’s outperformed the competition.
Figure 1. Winners And Losers In The Semiconductor and Retail Industries During the 2001 Recession (2000-2003)
Given that there are such opportunities to outperform even during severe downturns, in 2009 most CEO’s are facing this crucial question: How do we approach those decisions that will allow us to outsmart our competitors?
The choice: Offense or Defense?
Severe economic downturns cause numerous stresses on income statements and balance sheets, led by declining revenues and margins, productivity problems and cash shortages, among others. The current downturn certainly has its own unique DNA, with credit contraction, bank failures, rapid declines in housing values and low consumer confidence impacting nearly every aspect of business. Given this challenge, CEOs looking to the future face a difficult question: Should they go on the offensive, taking advantage of the downturn to buy struggling competitors, or are they better off playing defense, hunkering down and protecting existing revenues and operating margins?
The question does not have a simple answer. The right choice between defense and offense may differ for each particular problem. In some cases, offensive strategies such as pursuing revenue growth in a key market segment or strategic investment in a particular business unit may be the right choices; in others, aggressive protection of revenues, profit margins and the balance sheet may be the correct choice (see Figure 2).
Figure 2. Offense and Defense – CEO Strategy Checklist During A Downturn
With limited resources available during times of economic distress, the key question is which option to pick and how to plan the execution.
Going on the offensive is a restricted option
Several factors determine a company’s ability to go on the offensive during downturns. First and foremost is the ability of the core business to withstand the stresses created by the downturn. For example, countercyclical revenue streams can allow a company to withstand a downturn in one product category if it is successful in another; strong innovations can help to maintain pricing power; sufficient variability in cost structure can help protect margins, and a sound capital structure can give a company the financial flexibility to acquire competitors. Companies that developed these traits in boom times are generally in the best position to take the offensive. In fact, A.T. Kearney’s experience with Fortune 500 companies indicates that such traits are the foundation of a successful strategy for going on the offensive. Moreover, these traits have been in place for some time before the economic downturn and the related headwinds began.
In some cases, luck or timing can have a significant impact on the ability to get aggressive on go on the offence. Consider this: What if Microsoft had succeeded in buying Yahoo! in February, 2008 for $45 billion, a premium of 62 percent at the time? By the end of the year, Yahoo’s stock had fallen an additional 50 percent, leaving Microsoft in a much better position. On the other hand, what if Royal Bank of Scotland’s $100 billion purchase of ABN Amro in 2007 had not gone through? How ironic that at one point in late 2008, $100 billion was more than the market capitalization of Citibank, Morgan Stanley, Goldman Sachs, Bear Stearns and Barclays combined. Had RBS preserved its $100 billion, perhaps the British taxpayers who now own 60 percent of RBS would not have had to bail them out.
In other cases however, the ability to go on the offensive is purely a result of prudent business strategies put in place prior to the downturn. Before the recession hit, Kohl’s focus on a low-cost structure, a unique merchandising philosophy, lean staffing levels and sophisticated management of information systems led to growth that significantly outpaced the retail industry (see Figure 3). When the downturn began, Kohl’s was strongly posiitoned for an offensive strategy. While other competitors, such as Ames and Kmart, were declaring bankruptcy, Kohl’s step-by-step expansion included organic growth and a series of acquisitions. Eventually, Kohl’s emerged from the downturn with 50 percent more retail space and access to numerous new major metropolitan areas.
Figure 3: Kohl’s Goes On Offense And Successfully Outpaces Industry Throughout The 2001 Downturn
Kohl’s Continues its methodical, step-by-step expansion strategy throughout the downturn:
- 137 new store openings, with the total square feet of selling space increasing 46% to 34.5 million ft.²
- 40% growth in number of employees
- Acquisition of existing locations from Bradlee Stores and Caldor Stores as an entry strategy into new markets
- New market entry into major metropolitan areas such as Houston, Phoenix, Boston, Los Angeles etc
In the semiconductor industry, Nvidia provides another example of how a successful pre-recession business strategy enabled the company to go on the offensive. Before the downturn, the semiconductor company had invested in engineering discipline to pioneer a previously unheard-of six-month product development cycle. The move gave it a competitive advantage by maintaining the pricing power on its products throughout the 2001-2002 technology-led recession. Meanwhile, Nvidia’s archrival, ATI Technologies, struggled to fund research and development to compete with Nvidia’s sustained and consistent release of new products. In the end, Nvidia overcame the recessionary headwinds to increase sales by 160 percent from 2001-2003, and maintained its gross margins at over 30 percent. As a result of its strong position, Nvidia was able to acquire weaker competitors to further solidify its market position.
Going on the offensive, however, is not for everyone. While the success stories of pursuing growth during downturns appear seductive, in A.T. Kearney’s experience, companies with a weak competitive position going into a downturn have little possibility of forming an offense strategy. For example, while Nvidia was able to grow throughout the downturn, another semiconductor company, Micron Technology, a leading provider of advanced semiconductor solutions, felt a severe negative impact. In fact, as shown in Figure 4, the management team was facing a 97 percent decline in year-over-year gross profits. In such situations, it is more appropriate to focus on survival and play defense rather than take an offensive posture. Micron learned this the hard way in mid 2002, when its attempt to go on offense by acquiring South Korea’s Hynix Semiconductor for $3 billion in stock was rebuffed by Hynix’s board, which saw Micron’s stock as overvalued.
Figure 4: Micron Technology: Not In A Position To Go On Offense
A Solid defense: Protecting the core business
Companies facing significant income statement or balance sheet stresses during a downturn will find that its best strategy is to protect its core business by strengthening its defenses. Such a strategy can protect revenue streams and profit margins, or preserve the balance sheet. For example, revenues and margins can be protected with targeted or segmented pricing incentives, strategic sourcing or SGA reduction; balance sheet strength can be preserved by restructuring assets or managing working capital more effectively.
At first glance, defensive actions such as cost-cutting and asset restructuring might sound like weaker strategic alternatives compared to offensive moves such as acquiring a struggling competitor. However, our analysis indicates that a well-executed defense can in fact present an opportunity to clean house in the short term, and prepare the company for potentially significant growth down the road. A.T. Kearney’s client experience in operations strategy and cost transformation highlights two priorities a CEO needs to have to ensure a successful defense during a downturn: 1) Be aggressive with cost-transformation initiatives, in order to step ahead of the downturn, 2) Prepare the business to go on the offensive at the end of the recession
1. Aggressive targeting of costs
To be successful in the short-term and create longer-term strategic advantages, companies have to look beyond the “low hanging fruit” for cost transformation and develop an all encompassing strategy. Instead of simply targeting headcount or divesting assets, CEO’s should seek a comprehensive set of changes that can drive success both sooner and later.
Consider the example of a global power company whose business in 2001 was affected by the California energy crisis, Enron bankruptcy, devaluation of South American currencies, and a U.S. recession, all at the same time. To ensure its survival, the company went beyond the basics. A Cost-Cutting Office was created to better capture the benefits of scale in procurement, and to launch a global audit process for controlling costs. It also created a Turnaround Office to identify underperforming businesses and submit “fix, sell or abandon” recommendations and a Restructuring Office to cut capital expenditures and realign the parent company capital structure. Finally, it conducted a strategic review to re-organize the business into more sensible business units. The benefits of such an all-encompassing strategy were wide-ranging, and included a reduction in debt, the sale of underperforming businesses, an improvement in fleet utilization and most importantly, the redeployment of talent developed from these restructuring efforts to manage complex, everyday business issues.
It is also critical for CEO’s to ensure that their defensive strategy hits the company’s cost structures aggressively enough to outpace declines in revenues due to worsening economic conditions. A critical step, one often recommended by A.T. Kearney, is to have a clear understanding of “strategic” versus “non-strategic costs.” A good example can be picked from the 2001 downturn and its impact on the advertising industry. Omnicom and Interpublic Group, leaders in the advertising industry, had revenues of $6.2 billion and $5.7 billion. Omnicom was in a comparatively stronger competitive position due to a strong countercyclical portfolio of businesses. As part of its strategy, Omnicom did go on the offensive by undertaking several key strategic investments, including upgrading its bench strength by hiring top-notch, creative executives from competing agencies. On the defense, Omnicom aggressively targeted non-strategic costs related to office and real estate expenses. The company not only grew its countercyclical business during the downturn, but it also created a longer-term competitive advantage by eliminating unnecessary, non-strategic costs.
Interpublic, on the other hand, was in a relatively weaker position, as it was integrating a large acquisition and struggling to grow revenues. Its major defensive strategy was a $650 million restructuring initiative that targeted headcount reduction, real estate lease terminations and the sale of non-core assets. But the overall plan lacked the aggressiveness necessary to outpace the decline in revenues due to the downturn. The results were evident as operating expenses exceeded revenue throughout the downturn, and profitability suffered (see Figure 5).
Figure 5: Aggressive Cost Reduction Is Critical to Outpace A Decline in Revenues During A Downturn
Finally, aggressiveness also relates to the velocity of action necessary to implement cost-cutting initiatives. Severe economic downturns create a need for long-term realignment in the way companies do business. The speed with which CEO’s respond determines how fast they emerge from the downturn. For example, semiconductor company Broadcom’s struggles during and after the 2001-2002 recession were due in a large part to their reluctance to deal swiftly with cost structure problems. Although the technology downturn took hold in 2001, serious restructuring did not begin until November 2002, by which time the company had already suffered through seven quarterly losses.
2. A strong defense means preparing to take the offensive
While the short-term objective for CEOs may be to halt the decline in revenue or margins, the best defense prepares the company to go on the offense when the downturn ends. The strategy adopted by the executive team at JCPenney during the 2001 economic downturn is an outstanding example of such an approach.
As shown in Figure 6, JCPenney sputtered into the economic downturn following a history of several years of declining profitability and operating margins at levels below most of its competitors. JCPenney had missed the “retail wave” of the 1990s because of a host of problems, including poor merchandise selection, an unproven marketing message, and a decentralized operating model. Furthermore, management’s lack of faith in its retail assets led it to use the company’s capital to diversify into the drugstore business with the purchase of Eckerd, which became a drag on profits. Under the leadership of a new management team, a five-year turnaround strategy was launched to turn the ship. The early initiatives were classic defensive moves: staff reductions, the closing of unprofitable stores, the introduction of more effective inventory management, and the eventual sale of non-core assets, such as Eckerd.
Figure 6. JCPenney’s Defense Strategy Led To A Remarkable Turnaround
However, JCPenney’s defensive strategy also focused on the creation of long-term strategic advantages that would eventually enable the company to go on the offensive. The company invested in a new distribution system to decrease long-term transportation costs in the supply chain, a costly move but one that was critical to its long-term growth. After almost 100 years of decentralized store management, JCPenney transformed itself into a centralized company that included a unified marketing message, more targeted merchandising, updated technology, new store layouts and improved store operations. All these initiatives, coupled with a renewed focus on consumer preferences led to a remarkable transformation in the years following the recession.
The lesson for CEO’s who choose the defensive option for withstanding an economic downturn is crucial: Be aggressive with the turnaround plan but also ensure that any plan for remaining on the defensive includes details for switching strategies and going on the offensive once the downturn shows signs of coming to an end.
Putting the plan in place
There are significant opportunities to improve competitive position during a downturn, regardless of the strategy chosen. On the one hand, companies that go on the offensive can either continue to follow their existing growth strategy or leverage their strong competitive positions to adopt even more aggressive strategies, such as acquiring weaker competitors at a discount. On the other hand, an aggressive, well-executed turnaround plan can create a sustainable advantage for a company and potentially position it to outperform even its stronger competitors by the end of the downturn.
No one knows how deep and long the current recession will be. Competitors could fail, creating unforeseen opportunities, consumer confidence could sink even further, or the balance sheet could be in worse state than previously thought. CEO’s are hearing about the choices and challenges of this environment from every direction—the board of directors, Wall Street, regulators, the media and others. Meeting these challenges requires any CEO to answer this important question: Do I choose to receive the ball and start with the offense or do I kick off and put my defense on the field?