The Paradox of Corporate Bankruptcy in a Robust Economy
Since the 1990-91 recession, the economy has been humming along with high productivity, solid growth and low unemployment. While the recession certainly took its toll on business worldwide, in the post-recessionary era American business has experienced an unprecedented period of economic prosperity. Surprisingly, during this period of economic nirvana, numerous firms have experienced dramatic setbacks, financial distress and, ultimately, bankruptcy. These firms include Marvel Entertainment, G. Heileman Brewing, Montgomery Ward Holdings, Levitz Furniture, House of Fabrics and scores of other major enterprises.
Unlike personal bankruptcies, which have nearly doubled in number since 1990, the number of corporate bankruptcies has decreased since the recession years. Yet the decrease has been surprisingly small given the persistent strength of the post-recession economy. Moreover, the number of large corporate bankruptcies increased dramatically over the last several years. More public companies filed for bankruptcy in 1999 (145) than in any year since 1986. Furthermore, 20 companies with more than $1 billion in assets filed for bankruptcy in 1999, which totaled four times as many billion-dollar filers as the previous year.2
There are a number of reasons for the financial distress faced by corporate giants in this era of unprecedented economic well being. The following paragraphs provide a non-exhaustive list of strategic errors resulting in distress made by firms across a wide range of industries in corporate America.
During periods of prosperity, both the bottom line and EBITDA (earnings before interest, depreciation and amortization) generally grow. Retailers benefit from increased real wages, increased employment and positive expectations. Manufacturers and service firms take advantage of growing overseas markets, growing U.S. demand and rapid technological change. Many firms during this period of prosperity use their positive cash flow to fund internal growth. Firms expand into new geographical markets, expand product lines and develop infrastructure. These infrastructure changes can be observed in new production technology, new retail locations, new warehouses, new distribution channels, etc. Prosperity, like adversity, breeds change. Change, in turn, breeds risk. The risk associated with expansion plans is generally driven by over-optimism. New stores are opened too rapidly. New territories are entered into without appropriate market research and new products are developed without understanding the needs of the customer. Hubris takes hold and analysis takes a back seat. Projections reflecting the existing business are met and exceeded. Management, being the beneficiary of a robust economy, makes projections of new business activities and believes that these too can be exceeded.
Yet frequently, new projects are long on conceptualization and short on reality testing. Projects are undertaken with little or no market analysis, and frequently little analysis of the impact on the existing infrastructure (e.g., warehouse space, server capacity, management oversight, etc.). Meanwhile, debt levels increase and coverage ratios fall.
The M&A Curse
Many firms during the 1990s developed strategic plans involving the acquisition of other players in their industry. These acquisitions were frequently based on projections far too optimistic to be realistic. Acquirers assumed that troubled companies could be turned around immediately and that healthy companies would surpass their present levels of operating capability. Typical of the unreasonable projections and blind faith in the successful outcome of acquisitions is the situation represented in the following graph of EBITDA to revenue of a target company.
Exhibit 1 demonstrates that, with respect to the ratio of operating cash flow to revenue, the target company has been performing poorly relative to its industry for the past three years. Moreover, its operating cash-flow margin ratio has been deteriorating. In spite of this steady deterioration, the projections suggest that the firm will be brought to industry levels immediately following the acquisition and will keep improving. While in some situations it may be reasonable to assume a company is brought to industry standards, in many turnaround situations it is unlikely. More importantly, the likelihood of an immediate turnaround is typically quite small.
One of the strategic roadblocks faced by corporations during periods of economic prosperity is the myth of acquisition growth. Unfortunately, two plus two equals three as often as it equals five. This is due to what is frequently referred to as the winner's curse. Consider an acquirer willing to purchase a public company for $50 a share. Suppose it had been previously trading at $40 a share. Following the initial $50 bid, another bidder bids $55 a share. The bidding comes to an end with an uncontested bid of $60 a share. With this bid, the premium offered for the target is 50 percent over the initial $40 trading price. At $60, no other firm is willing to offer more, implying that of all possible acquirers, the actual acquirer is the most optimistic in its evaluation of the target's future cash-flow prospects. Unfortunately for the acquirer, the odds of the most optimistic assessment of cash flows being a realistic assessment is quite slim. In other words, the likelihood of overpayment for the target firm is high. Such overpayment potentially results in dissatisfied shareholders, as well as debt-holders often carrying an unsuitable level of debt. In such a situation, the firm often finds itself in financial distress. Buyers, whether strategic or opportunistic, face the risk of overpayment and the winner's curse on each of their acquisitions.
It has been almost a decade since the United States's last recession. As a result, firms making projections are frequently optimistic in their assessment of both revenues and costs. It is rare that we encounter, in our practice, a recessionary projection, or even a projection based on an economic slowdown. This pervasive optimism is particularly surprising given the fact that since the Civil War there has been no period longer than a decade without a recession. We do not suggest that the past is a guarantor of future results, but we do suggest caution in developing economic forecasts. A five-year projection often considers a downside analysis and possibly incorporates either a recessionary forecast or a sensitivity analysis.
Use of OPBP (Other People's Brain Power)
During the recent period of economic growth, America's consulting industry has reaped significant rewards. Consulting firms are hired to analyze virtually all aspects of American business. While the hiring firm typically benefits from the expertise of the consulting firm, the realized results do not always yield the expected results. In a recent case, a Big Five accounting firm paid more than $180 million because they staffed a consulting project with inexperienced personnel who were unable to accomplish the project's objectives. The result: The liquidation of a billion-dollar company. While this project was a turnaround assignment, it is more typical that a healthy company engages consultants for a variety of important strategic decisions. These may range from an important technological transformation to the development of a revised incentive system. Often, the problem stemming from hiring consultants reflects the differences between the perspectives of principals and agents. The consulting firm is an agent coming in to fix a problem and quickly departing. It is not there when it becomes evident that the solution is not working, or that the organizational culture and the consulting fix do not work together. When hiring consultants, it is important to integrate them into the culture and decision process of the company. Sometimes, the organization acting as the principal is better off developing the strategy itself and not relegating its development to a third party. When key decisions are left to others without the consulting firm being an integral part of the strategic development, it is not uncommon for financial disaster to ensue.
Lack of Customer Focus
In many bankruptcy cases in which we have been engaged, a key factor driving the financial meltdown has been the inability to focus on the customers' needs. Consider the situation of a major distributor. Rather than focus on its customers' needs, it fell into the frequent trap of focusing on price. While its customers wanted easy access to product, it instead cut margins to attract and maintain customers. Unfortunately, the operating margins became far too low to support the firm's debt, and the firm soon became insolvent. Interestingly, this focus on price is particularly commonplace for many high-tech firms. Rather than concentrate on key customer issues such as waiting time in help lines, technological obsolescence and system integration, companies focus on price reduction and frequently find themselves driven to reduce prices by the perception of competitive pressures. As most savvy marketers will readily admit, cutting prices is the last, not first, resort. In particular, during periods of economic growth, it is easy to get strategically unglued and to shift the focus from the customer to other seemingly important strategic issues. But without keeping the corporate eye on the customer, it is easy to drop the ball. Once the ball is dropped, it may well be difficult to recover.
For another example, in a recent matter involving a retailer with more than 1,000 stores, the firm developed an aggressive acquisition strategy. The focus was on growth through acquisitions. As long as the economy was well oiled, the company felt it could concentrate on external vs. internal growth and development. As a result, inventory stockpiled and same-store sales stagnated. Since the firm's existing stores were its core business, the firm was destined to encounter roadblocks. Financial distress and bankruptcy ensued.
Most corporations benefit during periods of economic prosperity. Yet there are scores of major corporate enterprises that find themselves immersed in the web of financial distress. Since the period of economic prosperity began nearly a decade ago, our firm has witnessed numerous reasons for organizations filing chapter 7 and 11. While we do not provide an exhaustive list of factors driving firms into bankruptcy, this article presents a number of commonplace reasons that we have frequently encountered. Unfortunately, corporate America has learned that a robust economy does not prevent financial distress.