In this article, Profit Planning Group's Al Bates illustrates how top companies across sectors were able to deliver strong profit results relative to their peers during the recession. He explains the four profit drivers that often are the differences between typical and high-profit firms, and with that data, he shows what typical companies can do to recession-proof their firms.
The so-called Great Recession created a unique set of financial challenges for distributors. In many lines of trade, sales didn't just decline, they fell precipitously. Overall, profits sank to the lowest point since distributor financial benchmarking was established in the 1970s.
Despite the challenges, a large number of firms continued to generate strong profits. A few even produced exceptional results. Understanding how they did that is essential for future financial planning for any distribution firm.
The Scope of the Problem
The Profit Planning Group maintains the largest data base on distributor financial performance in North America. For the 2008-2009 time period the firm collected information on distributors in 46 different lines of trade.
Not surprisingly, 40 of the 46 business categories experienced a sales decline in 2009 versus 2008. What is surprising is the six that did not. These were all in consumer-based product lines where continued purchasing is not discretionary.
For those industries not shielded by purchasing necessity, the results were closer to a depression than a recession. For firms serving the construction industries, sales were down more than 22 percent. Industrial supplies didn't fare much better, with declines slightly greater than 21 percent.
Profits, of course, fell as well. The aggregate results for all 46 lines of trade from 2005 to 2009 are presented in Exhibit 1. The exhibit uses return on assets (profit before taxes as a percent of total assets). Return on assets (ROA) is the best way to evaluate profit performance as it measures profit against the totality of the investment in the business. As can be seen, ROA performance peaked in 2006 and declined to 6 percent in 2009.
Experience suggests that 5 percent is something of a minimum point for acceptable financial performance. Below that level, the advisability of reinvesting in the business is called into question. The 6 percent level in 2009 provided limited breathing room.
A little more than a third of the industries fell below the 5 percent base line. Of that group, one industry operated right at breakeven, and two experienced aggregate losses for the year. At the other extreme, six industries exceeded a 10 percent ROA, which is considered outstanding industry-wide performance.
Holding the Line
As disquieting as the profit results were, the fact that things weren't worse is nothing short of astounding. Sales declines in the 20 percent range should not just impact profit, they should decimate it. In 2009 it seems that when the going got tough the tough really did get going.
Exhibit 2 presents a representative response to the economic challenges. It is extremely important to note that distribution firms come in all sales sizes with various levels of gross margin, expenses and profit. The exhibit is not meant to be an amalgam of the 46 industries. Such an amalgam is only possible at the return on investment level, not at the detailed income statement level.
Instead, Exhibit 2 represents a mid-size, mid-margin firm that serves as a proxy for what happened across many industries. The sorts of changes shown in Exhibit 2 were seen in many distribution sectors. The numbers were different by line of trade, but the pattern was similar.
The firm in Exhibit 2 experienced a 20 percent sales decline so it is illustrative of distributors serving both construction and industrial customers. Absent any actions by management, a 20 percent sales decline would have pushed the firm well below its breakeven point.
It is worth mentioning that in a more "typical" recession sales would have fallen somewhere around 5 percent. With that modest decline management probably would have made only minor changes to keep the business structure intact. In essence the firm would have ridden out the storm.
With such a sizeable sales decline, however, fine-tuning and waiting for better days was simply not an option. In general, distributors took three specific actions:
Gross Margin – Despite strong pricing pressures, a very modest improvement in the gross margin percentage was achieved. In a down market this is exemplary performance.
Payroll Expenses – Overall payroll expenses (including bonuses) were cut by about 10 percent while sales fell by 20 percent. This reflects the inability of firms to match wage reductions to sales reductions. However, it still represented something much closer to sharp pruning of the staff than to making selective reductions.
Other Expenses – If it wasn't people, it was cut almost to the point of matching the sales decline. Nothing was sacred.
All expense cuts were painful. The representative firm did not emerge lean and mean. It emerged anemic and chastened. A lot of infrastructure was jettisoned to save the ship. Rebuilding that infrastructure will undoubtedly prove to be arduous and time consuming.
As noted earlier, profit results vary widely by industry. At the same time, within every industry profit results also vary widely. The most important segment to follow in any industry is the high-profit group. This group represents the top 25 percent of the firms in terms of ROA performance.
It is unfair to suggest this group did not feel the impact of the recession. It is fair to suggest that they managed to maintain outstanding profit results relative to their peers across every industry. In 2008 the high-profit firms generated an ROA that was 2.9 times as high as the typical firm. In 2009, the ratio only fell to 2.8 times. For them, profitability fell from great to very good.
With their stronger financial results, the high-profit firms were able to gain market share by keeping "feet on the street" and not sacrificing training or customer support. They were also positioned to absorb failing competitors.
There are four profit drivers that often explain the differences between typical and high-profit results. In the Great Recession, two were at work and two were not:
Sales Size – The size of the firm had no calculable impact on results. Large firms enjoyed both economies and diseconomies of scale.
Sales Growth – This is almost always a major factor in profit performance. But this time the results were different because everybody experienced large sales declines (excluding those few industries discussed at the beginning). Sales growth did not play a role.
Gross Margin – The high-profit firms enjoyed a higher gross margin in almost every industry.
Expense – Across virtually every industry expenses were lower. Much of the advantage was in payroll and interest.
The last two items on the list were almost exact mirror images. The high-profit firms simultaneously had 4 percent higher margins and 4 percent lower total expenses.
This means for example, that in an industry where the typical gross margin percentage was 25 percent, the high-profit firms were at 26 percent (25 percent multiplied by 1.04). By the same token if total expenses were 20 percent in a specific industry, then the high-profit firms would be at 19.2 percent (20 percent multiplied by 0.96).
Amazingly, something close to the 4 percent variation held true across the vast majority of industries. The high-profit firms were able to parlay small, but meaningful, advantages in margin and expenses into large advantages in ROA.
Nobody is eagerly looking forward to the next recession. However, assuming the current recession does not prove to be a double dip, the countdown clock has already started on the beginning of the next recession. As painful as it might seem, now is a great time to recession-proof the firm in anticipation of next time.
Two sets of actions are required. The first of these involves changing the profit structure of the firm. The second requires rethinking the risk structure of that firm.
The profit structure issues are simple. Everybody needs to copy what the high-profit firms are doing, namely getting control of gross margin and payroll. The laundry list of things to do in these two areas is well beyond the scope of this article. However, the end result is not.
Every firm needs to drive profit to a point where its breakeven sales volume is a full 20 percent below its current sales level. This is almost exactly where the high-profit firms were going into the recession. At the same time, the typical firm had only a 10 percent cushion between its current sales and its breakeven point. For garden-variety recessions that was probably good enough. When the big one hit, that safety factor was completely overcome.
Thinking that there will never be another big one does not seem prudent. Any firm that does not strive to get to a 20 percent cushion is derelict in its planning. The changes in gross margin and payroll required to get there are not large, but they require systematic effort.
Risk is always in the eye of the beholder. Some management teams abhor debt. Such firms would rather grow with internal funds or not grow at all. Historically, their growth rates have been slower than their peers. At the other extreme, some firms appear to relish debt. With heavy debt, these firms almost always grow faster than their peers.
While attitudes toward risk are a personal, philosophical issue, one truism persists in every recession. That truism is that firms die in inverse risk order. The highly-aggressive firms that are leveraged to the hilt are wiped out first. When banks decide to stop lending this reality is magnified.
The prudent firm should make sure its debt-to-equity ratio is under 1.0, its cash-to-current liabilities ratio exceeds 20 percent and that it can operate for 15 days without a single penny of revenue coming in (the defensive interval ratio).
In short, every firm needs to join the high-profit club. It would also be nice to join the low-risk club. Only then will success be guaranteed in any set of economic conditions.