Sustainable strategies for a world of economic shocks: we live in a time of sudden and severe economic and geopolitical shocks. Senior finance executives can lead the creation of a business cycle-savvy management structure and culture that ensures rapid response to avert potential risks.
For many companies, the answer is a resounding "no!" That's the conclusion reached following five years of research conducted as part of the "Master Cyclist" project at the University of California-Irvine. This study of more than 300 companies indicates that a surprisingly large number of top management teams are indeed "Reactive Cyclists," meaning they lack even the most basic business cycle and financial market literacy to succeed when times get tough.
In contrast, at least some companies have true "Master Cyclists" at their helms. These executives exhibit a superior command of the set of strategies, tactics and forecasting tools needed to manage the business cycle, the related stock market and interest rate cycles and the pervasive "macroeconomic shocks" of the 21st century business world.
The set of strategies and tactics that have emerged from the Master Cyclist project--and that have proven to be most useful to manage economic turbulence--are those illustrated in The Master Cyclist Management Wheel, in the box below. These "battle-tested" strategies and tactics encompass virtually every major decision-making area of the modern corporation. They cover the key functional areas of marketing and pricing, production and inventory control and human resource management. Additionally, for financial executives, they also target the all-important areas of capital expenditures, risk management tools and the tactical timing of strategic acquisitions and divestitures.
Reactive Approach Sours Cisco's Results
Consider, for example, a brilliant but nonetheless "Reactive Cyclist" CEO like John Chambers of Cisco Systems Inc. He and his executive team failed to read numerous signs that the March 2001 recession was on its way--from a doubling of oil prices and a flattening yield curve in 1999 to a collapsing stock market and dramatically rising interest rates in 2000. Chambers also presided over a company that, by its very organizational design, lacked many macroeconomic variables in its business cycle forecasting models.
As one of Cisco's top executives put it: "The economy is too complex to get anything meaningful out of such broad numbers as GDP or interest rates." Given that, it's unsurprising that in 2001 Cisco got caught flatfooted and had to write off over $2 billion in excess inventory while laying off more than 8,000 people.
In contrast, consider these words of a "Master Cyclist" CEO like Johnson & Johnson's former CEO Ralph Larsen: "We saw this recession coming three years ago. It was obvious the booming economic cycle couldn't continue. We tightened our belts. We focused on cash flow."
In anticipation of that 2001 recession, J & J, under Larsen's leadership, boldly cut its capital expenditures by over $100 million dollars at the height of the economic boom in 2000--the first decrease in seven years. As J & J significantly built up its cash reserves, the company saw double-digit growth in both revenues and earnings.
These positive indicators, coupled with a "sector rotation" by investors into defensive sectors like health and medical care stocks as the bear market took hold, helped give J & J's stock a double-digit boost in both 2000 and 2001--and allowed Larsen in 2002 to turn over the CEO reins with his head held high.
Lowe's Strategic Behavior: 'Know Thy Sector'
The starkly contrasting strategic behaviors of Lowe's Companies Inc. versus The Home Depot Inc. over the course of events leading into and out of the 2001 recession provides a shining example of how a highly business cycle-literate, "big picture" executive will often trump a consummate but "little picture" supply chain manager in the area of capital expenditures strategy.
Lowe's meteoric rise to power began during the last gasp of the economic expansion of 2000. CEO Robert Tillman firmly believed that the time was ripe to make Lowe's a national player on the home improvement scene. As he cleverly articulated: "When the economic climate changes, the world's best retailers look for opportunity."
So what "opportunities" did Tillman see that archrival Home Depot didn't? Tillman clearly believed that the economy would peak in 2000--a correct but very contrarian view at the time. But Tillman also foresaw a multi-stage industry adjustment process that would greatly benefit his business once the recession hit.
This process would first involve a recession, in which home remodeling and repairs would increase as new home sales sagged. The next stage, as the Federal Reserve lowered interest rates, would further fuel home remodeling as consumers refinanced their homes and used the drawn-out equity funds for even more expensive remodeling. Finally, lower interest rates would then spur a new housing boom for the next growth leg up for Lowe's stores.
Tillman's highly sophisticated business-cycle literate analysis didn't stop there, however. Lowe's was also counting on playing an important macroeconomic demographic card. Tillman observed in the company's 2000 Annual Report his blueprint for overtaking Home Depot: "The home-improvement market is expected to grow over 4 percent annually for the next four years, as baby boomers trade up, remodel, and generally improve their homes and [Generation] X'ers buy and move into their first homes and prepare for the family to follow."
On this basis of this Master Cyclist logic, in 1999 Lowe's embarked on a strategy to open almost 300 new stores by the end of 2001. For many companies in cyclical industries, this kind of aggressive capital expansion gambit on the eve of a recession would be tantamount to financial suicide--a sure-fire way to create a cash-flow squeeze during a time of falling demand.
However, what Tillman clearly understood was the particular sector he was operating in and how that sector would be affected not just by the business cycle but also by the highly related interest rate cycle and other factors such as the changing demographics.
Here is how the economic adjustment process that Tillman envisioned actually unfolded: Interest rates did indeed continue rising, and housing starts dropped in 2000, to be expected when leading into recession. While this temporarily squeezed Lowe's, by the latter half of 2000, the Fed finally began lowering the discount rate, and 30-year fixed mortgage rates followed--just as Tillman had anticipated.
At that point, Lowe's' business began to boom. By the first quarter of 2001, profits were a very respectable $149 million. By the third quarter, 2002 net income increased to almost $500 million--even as Lowe's began to grab an ever bigger slice of market from Home Depot. By 2003, the news was even better, with the company gobbling up more and more market share from Home Depot and hitting its eighth straight quarter of profitability.
During much of this period of Lowe's' ascendancy, archrival and market leader Home Depot adopted a classically defensive Reactive Cyclist posture, particularly under the stewardship of CEO Robert Nardelli, a former top General Electric Co. executive, appointed in December 2000. Under Nardelli's stewardship, Home Depot focused its efforts inward, on ruthless cost-cutting measures--rather than outward, on an aggressive capital expansion like Lowe's.
Home Depot boosted its inventory turnover rate, improved its broader supply-chain management and squeezed its suppliers for discounts during the soft economic times. The result of this "little picture" supply chain management focus was to lose the home improvement high ground to a very tough and surging competitor with an outward focus and strong business cycle orientation.
Strategic Risk Management
One important risk management area involves the hedging of general business cycle risk. This is typically accomplished by using tools such as business unit and geographical diversification. A second area involves hedging--and often opportunistically leveraging--the more specific risks associated with movements in commodity and oil prices, interest rates and exchange rates. This is usually done using various "financial derivatives" such as call options and futures.
A third major source of risk that can jolt even the healthiest of business cycle expansions into a recession includes a wide variety of so-called "exogenous" shocks. Such random external shocks to the economy range from war and terrorism, drought, disease and pandemics to earthquakes and tsunamis. Grim though this observation may be, the onset of such shocks nonetheless often creates opportunities for the executive team to develop new products or markets or simply to retarget old markets.
Southwest Airlines' Tactical Hedging
Southwest Airlines Co. offers an excellent example of the critical difference between hedging to neutralize risk versus tactically leveraging such risk to enhance profitability. From this perspective, much of Southwest's success--entailing more than 30 consecutive years of profitability--stems from a value proposition that features a low-budget, no-reserved-seats approach, a ticketless travel system that keeps its "back office" costs low, charismatic CEOs and a unique organizational culture renowned for its humor and high employee morale.
That said, Southwest Airlines also relies heavily on business cycle and energy price forecasting to manage all phases of its business. The company's own internal model incorporates not only various aspects of global supply and demand, monetary aggregates and exchange rates but also assessments of geopolitical risk. This forecasting model has proven to be particularly useful in Southwest's fuel cost hedging tactics--with fuel costs constituting about 15 percent of a revenue dollar for most airlines, second only to the cost of labor.
Almost all airline companies strategically hedge their fuel costs. However, most typically hedge less than half--and often well less than half--of their fuel needs, and do so simply to neutralize some energy price risk. In contrast, Southwest frequently, opportunistically and tactically departs from this industry practice when its forecasting models tell it to do so.
A particularly profitable case in point occurred in early 2000; Southwest's executive team opted for a close-to-100 percent fuel hedge for the third and fourth quarters, based upon an internal forecast of a significant shortage of crude oil. As oil prices soared above $30, Southwest used a complex array of financial derivatives to save over $110 million in fuel costs and saw its earnings increase for the year by more than 30 percent--almost three times the industry average.
In the second half of 2004, when oil prices soared over the $50-per-barrel mark, Southwest, likewise, had a full 80 percent of its fuel costs hedged at a price of $24 per barrel. This was in sharp contrast to the so-called "legacy carriers," including Continental, which had a 45 percent hedge at $36; Northwest, which had a 25 percent hedge at from $34 to $41; and Delta, which was completely unhedged.
Caesar's Grounds Its Marketing Campaign
Casino kingpin Caesar's Entertainment and the credit-scoring maven Fair Isaac Corp. illustrate several other key aspects of risk management in an age of macroeconomic shocks and uncertainty involving nimbly tightening the supply chain and changing one's capital expenditure programs, advertising messages and product markets in response to economic events.
Even before becoming part of the Harrah's Entertainment Inc. empire in 2005, Caesar's was one of the world's largest gaming companies. Headquartered in Las Vegas, it runs about 30 resorts around the world--including notable brands such as Caesar's Palace, Bally's and Paris Las Vegas--and generates close to $5 billion in revenues annually.
The company's rapid response to the events of 9/11 illustrates how Caesar's executive team immediately grasped the consequences of 9/11 for the gaming industry--and then reacted swiftly and decisively. For starters, the company immediately canceled a major $500 million capital expenditure--the building of a new 900-suite tower at its premier Caesar's Palace Resort in Las Vegas.
Within a week of the attack, the company also laid off 5 percent of its work force and cut hours for many more. To squeeze its supply chain and creditors, the company then leveraged its large size and time of extreme uncertainty to renegotiate many of its financial covenants.
By far, the most interesting and subtle response to 9/11 came when the company quickly and tactically shifted its marketing emphasis. Rather than continue to advertise heavily to its traditional customer core--air travelers flying in from all over the nation and the globe--Caesar's quickly refocused on the large Southern California and other nearby regional markets that were within easy driving distance.
As a result of these proactive measures, the company was not only able to cut its losses in the short run. By the fourth quarter of 2001, Caesar's was able to actually increase its revenues over the fourth quarter of 2000.
Fair Isaac Expands in A Post-9/11 World
Fair Isaac is one of the leaders in so-called "credit scoring systems." These very complex, statistics-based forecasting systems are used to evaluate the risk profiles of people like you and me when we apply for credit cards, mortgages and other kinds of loans. Its customers range from major credit card companies and commercial lenders to insurers, retailers and cable and phone companies.
Fair Isaac's activities illustrate an astute strategic expansion of the company's product mix and a tactical shift in its marketing message in response to the U.S. Congress' passage of the Patriot Act, in response to the 9/11 attacks.
The Patriot Act was designed both to detect actual terrorists as well as to reveal any money-laundering efforts on behalf of the terrorist network. Under its far-reaching dictates, entities ranging from banks, insurance companies and stockbrokers to casinos, pawnshops and travel agents must collect information on customers whenever they open accounts. More importantly, these entities must verify that these customers are who they say they are and determine if their names appear on any terrorist watch lists.
These and a host of other new, post-9/11 regulatory requirements immediately created a huge new market of companies and financial institutions seeking to cost-effectively deal with a potentially onerous regulatory burden. By doing so, the Act gave Fair Isaac a golden opportunity to build a Patriot Act-compliant "war time" solution that could be added to its suite of existing, peacetime software credit scoring and fraud-screening modules.
Expanding its product line was not Fair Isaac's only tactical move in response to 9/11, however. Fair Isaac also markets its "risk manager for government" software with a heavy antiterrorist message. As the company's website touts, this system has "applications in port and airport security, identification authorization, bioterrorism, and even military tactics."
As a final business-cycle management benefit, by targeting the government sector more heavily following 9/11, Fair Isaac's executive team has found a far less cyclical--and highly lucrative--revenue stream that contributes to a more stable earnings flow. In large part because of these new products, it was able to increase revenues by more than 60 percent in 2003, just two years after 9/11.
The Importance of Business Cycle Literacy
So, what do Lowe's, Caesar's, Southwest Airlines and Fair Isaac have in common? They are each exemplary of successful business cycle and risk management. Each indicates a leading company that possesses a high degree of business cycle literacy and economic sophistication, and each is a company with a decidedly outward-looking "business cycle orientation."
As to what make a business cycle-literate executive tick, the research indicates that the best Master Cyclists will understand such things as: how fiscal and monetary policy work; how Federal Reserve interest rate policies will affect such things as foreign investment flows, long-term interest rates and currency values; what the critical relationships are among productivity, growth and inflation; what the differences are among leading, lagging and coincident indicators; and why oil price shocks, Fed rate hikes, a falling stock market and a flattening yield curve all provide strong, albeit imperfect, signals of recession.
The good news for financial executives is that within any given company, it is the financial executive team that is most likely to exhibit the highest degree of business cycle and financial market literacy. Indeed, because of the critical role that financial markets play in the daily life of financial executives, most have learned--either formally or informally--about the complex relationships between the business cycle and related stock market and interest rate cycles, and how macroeconomic shocks such as war and soaring oil prices can affect the bottom line.
The bad news, however--and one of the most important of the research findings--is that even having a highly business cycle-literate financial executive team does not mean that the broader organization of which it is part will strategically and tactically behave in a business cycle-sensitive fashion. One very big problem here is the "functional silo" nature and compartmentalization of most corporations, combined with the lack of knowledge transfer across departments.
In other words, even if the financial executives in charge of functions such as capital finance, M & A and capital expenditures are adept at reading the economic tea leaves and minimizing capital costs over the course of the business cycle, it does not follow at all that the marketing, human resources or production teams will exhibit the same degree of business cycle management sensitivity and savvy.
Viewed from this perspective, the financial executive team has both the strongest capabilities and the greatest responsibility to help cultivate a much more business cycle-sensitive management structure and culture throughout the organization. This, in turn, means that financial executives must build better relationships and links with every other functional and strategic area on the Master Cyclist Management Wheel. The ultimate goal in this process should be to:
* Build a highly flexible and integrated organization with a strong business cycle orientation;
* Arm that organization with the strategies, tactics and forecasting tools to succeed; and
* Cultivate an organizational structure and culture that facilitates and ensures a rapid response to key economic events.
Peter Navarro is a business professor at the University of California-Irvine and author of The Well-Timed Strategy: Managing the Business Cycle for Competitive Advantage (Wharton School Publishing, 2006). His weekly economic and strategy newsletter may be viewed at www.peternavarro.com.
RELATED ARTICLE: takeaways
* An extensive study finds that a surprising number of top management teams lack even the most basic business cycle and market literacy.
* "Master Cyclist" skills include financial disciplines in areas like capital expenditures, risk management and tactical timing of strategic acquisitions and spinoffs.
* Companies like Lowe's, Southwest Airlines, Caesar's Entertainment and Fair Isaac have demonstrated proactive measures to grow their respective businesses.
* Of all company executives, it is the financial team that is most likely to show the highest degree of literacy in critical business and financial market skills.
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|Article Type:||Cover story|
|Date:||Apr 1, 2006|
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