Once again there are rumblings and warnings of a fresh financial crisis along the lines of 2008. Banks are supposedly better regulated now, and have generally lower corporate lending levels. Potential banking fallout should therefore be less dramatic than that witnessed in the period following 2008. However, this will not stop a number of banks starting reviews of their already heavily-scrutinised credit portfolios.
If we examine the causes of corporate distress, it is surprising that economic downturn is so often cited as the core reason. Economic cyclicality is a fact of life in all but the most tightly controlled economic systems – of which there are very few. The root cause of the difficulty in which corporates find themselves is management – planning for and responding to economic volatility is just one aspect of this.
My intention here is to examine the generic issues around corporate distress and then in subsequent blogs, by drawing on a number of real-life case studies, examine the key reasons corporates get into distress, the key signs that should have been identified and the lessons for the future.
The Failure Process
John Argenti, talks about the three common stages of failure:
By simple extension:
Fundamental defect = bad management
Fundamental symptom = Lack of sustainable free cash flow
Bad management is the common link in all distress situations:
A company only goes down the road its directors lead it
The consequence is this:
- All failed companies exhibit bad management
- Well managed companies will succeed
- Badly managed companies can survive – but only in a minority of cases and with a large measure of good fortune and luck
- Well managed companies that fail because of bad luck are a myth
Often, we are blind to the failings of corporate leaders because companies ‘market the management’: the management will have gorged themselves on the latest text books, attended seminars and courses, brought in the consultants, and undertaken slick stakeholder presentations that are overflowing with traditional and contemporary jargon. These companies lose perspective: rather than focus on themselves and what they need to analyse, plan and implement to succeed they become more concerned with telling the outside world what they think it wants to hear. Ask Warren Buffet what his corporate strategy is and he will tell you that he doesn’t have a formal plan – because of the danger that the plan itself becomes the overriding issue in making business decisions. Buffet’s strategy, in effect, is to remain flexible in order to take advantage of market opportunities. Look at his recent investments into Heinz and Kraft – businesses that fit very neatly into the BCG Matrix as ‘cash cows’.
Withbad management cemented into the corporate’s foundations, it is inevitable that mistakes will be made. The problem can be exacerbated because managers are often unwilling / unable to recognise their mistakes and take ownership of them, or when they do it is too late to take remedial action. They are frequently the last to acknowledge the symptoms that have become all too apparent to investors, bankers, analysts, suppliers and customers. In nearly all circumstances where mistakes have proven to be terminal, the management’s response has been reactive rather than proactive – stemming from the delusional belief in their own ability and, in some cases, greatness (even invincibility!).
Research into corporate distress, and my own experience working in corporate recoveries and as a ‘seasoned analyst’, points to the following as the most common mistakes:
|MISTAKE||GUILTY EXAMPLES – Entities or industry sectors who have experienced some element of distress|
|Fundamentally flawed corporate strategy. Much of what follows can be considered an element of this – ‘numbers follow strategy’||Euro Disney (France)
|Unbalanced board of directors – lacking in appropriate skill sets, nationality, age, gender||Marks & Spencer (UK)
Co-Operative Bank (UK)
|Failure to plan for and respond to macro factors – economic, political, regulatory, social||Alitalia (Italy)
Anglo Irish Bank (Ireland)
Lehman Brothers (US)
Steel and commodity sectors
Real estate sector
|Failure to innovate and respond to technological changes||Nokia (Finland)
|Failure to understand the nature and impact of competitive forces||Marks & Spencer (UK)
Dick Smith (Australia)
Consumer retail sector
|Failure to diversify||Kodak (US)|
Royal Numico (Netherlands)
|Poor acquisitions / investments||RBS (UK)
Royal Numico (Netherlands)
|Overtrading and a management focus on revenue growth and profitability rather than cash flow||Aero Inventory (UK)|
|Over leveraging the company when credit is readily available||Abengoa (Spain)
Real estate sector
|Lack of liquidity planning||Northern Rock (UK)|
|Exposure to fraud – both external and internal||Parmalat (Italy)
Bernard L. Madoff Investment Securities (US)
Barings Bank (UK)
Adelphia Communications (US)
|Lack of effective corporate governance||AIG (US)
Barings Bank (UK)
The above list is by no means exclusive and it would be interesting to hear from readers with other examples of fundamental mistakes being made by specific organisations.
It is only after the mistakes have been made that the symptoms become apparent and analysts will look to identify these as early as possible.
Early warning signs fall into two broad categories:
- Business / operational signs – for example loss of customer confidence, delay in the publication or provision of information, loss of key personnel, loss of a major supplier or customer
- Financial – for example general deterioration in key ratios, increasing foreign exchange losses, financial forecasts based upon assumptions that have little basis in reality
We will look at specific warning signs later when considering individual cases – particularly as it is often a combination of several different signs building up over time rather than individual items. However, the constant in distressed situations is inadequate cash flow – and in particular Sustainable Free Cash Flow.
The one sector where cash flow impacts are slightly different is banking where we talk about liquidity rather than cash flow per se. We will see this at a later stage when analysing one of the bank failure case studies.
My next blog will look at the case of British Home Stores (BHS).