The economy of the living dead?

According to some commentators we've now entered the 'Zombie Economy' phase of the recession. But what does this mean for the engineering sector? E&T flips through a new book on the topic.

In September 2008 the world appeared to be on the brink of financial catastrophe, and trillions of dollars and pounds were committed globally in rescue measures. But is the worst now behind us? Can we look forward to a gradual return to 'business as usual'?

Yet another book on the financial crisis? Not exactly. Mark Thomas's 'The Zombie Economy: Leadership In Times Of Uncertainty' is admirably short and crisp, and comes from a respected management consulting firm. It offers companies at least outline advice on action to take now to remodel their businesses to succeed in the next few difficult years.

Based on an analysis of the 2009 half-year results of over 600 US and UK companies, the Zombie Economy explores the likely scenarios for the remainder of the recession and subsequent recovery, and sets out a series of recommendations to help business leaders steer a course through the next few difficult years.

'Zombie' bank was first coined by a professor of finance, Ed Kane, at Boston College to describe a bank that 'would be put in its grave by its creditors if it weren't for the black magic of government credit support guarantees and loans'. Or as the famous financier George Soros put it, bailing out banks could turn them into zombies. 'Instead of stimulating the economy, they (the banks) will draw the lifeblood, so to speak, of profits away from the real economy in order to keep themselves alive.'

Now the 'zombie' phenomenon, first attributed to banks, extends well beyond the banking sector. According to the author, the crisis has created four types of zombie: zombie banks, zombie governments, zombie companies and zombie consumers.

The author's point is that having banks, companies, governments and consumers all severely constrained in their activities at the same time is something that has not happened before in the working lifetime of anyone in business today. Surely not? Perhaps he means this time the combined effect has been more severe than in previous recessions.

Of course, a return to growth will increase demand for working capital. Zombie banks will struggle to extend additional credit but the prediction is that many companies will run into financial difficulty, leading to contraction in capacity, and in unemployment, which will in turn sustain the downward pressure on demand and prices.

Over-capacity

We are reminded of global capacity in the automotive sector - almost 100 million cars and light trucks, against demand of less than 60 million in 2009. The same issue, we are told, is present to a lesser degree in banking, construction, air transport and wholesale distribution industries and many parts of the retail sector.

PA Consulting recommends taking four key precautions: secure liquidity, create a portfolio of potentially winning businesses, remodel each business to ensure that it can perform strongly in the new world and - subject to the success of the first three steps - take bold action to stake out a massively enhanced market position in the new world.

All good stuff - the kind of advice consultants offer - a framework to be adhered to and monitored in regular intervals. Adequate liquidity has to be a key priority. Companies such as GKN, Rexam and Rio Tinto have all tapped into equity markets recently. Others have refinanced debt; others are facing difficulties obtaining finance from banks have used the bond market. A last resort has been selling prize assets, even by banks.

Calculate your profitability and cash flows the consultants advise, and assess your interest cover and closeness breaching covenants in each scenario.

If you do not have significant headroom, take active steps, however unpalatable, to secure liquidity for the next three years.

You should also carry out a rudimentary form of the same analysis for major customers, key suppliers and other business partners, where their failure would cause your company distress.

Creating a portfolio of winning businesses may sound too optimistic at the present time, but as the authors point out 'in good times, businesses can afford to carry baggage - business units where profits are insufficient to cover the cost of the capital invested in them, products that have a negative economic profit, customers who dilute value.' This is clearly as important as the previous 2 points and in today's climate needs far greater focus than is normally called for.

Times of plenty

'Our experience,' says PA, 'is that even in good times if you separate a business into its constituent parts and analyse the economic profitability of each, you will find that almost half of the capital invested is tied up in value-diluting activities. In bad times this kind of significant cross subsidy is simply unaffordable.'

But these are luxuries that have no place in exceptionally hard times. In good times senior managers may be available to act as trouble-shooters when subsidiaries need strong support. Today consultants or interim executives are likely to be brought in for short-term corrective action.

The first challenge, according to PA, is to separate businesses that will clearly be winners - those with the potential to become winners, but will need some reshaping - from those that have very little in the way of prospects.

The second challenge is to adjust your portfolio and the allocation of capital within it, inline with this assessment. Recent examples of companies that have taken steps on these lines to reshape and resize their portfolios include United Utilities, which sold off non-core businesses in electricity supply and call centre outsourcing to focus on water and sewage services.

Remodelling each business for stronger performance asks the question of how: a fresh value proposition, new efficiency systems to allow more attractive pricing and returns? Or cutbacks? PA quotes American Electric Power will cut $1.2bn from its capital spend this year, and Florida Power and Light $400m and Gazprom 'is taking a hard look at its $25m investment programme'.

Cutbacks

The simplest change to make is to 'defer any project not immediately necessary and where the payback will be longer than one year. In the short term, project culls can make a significant difference to profitability and even more so to cash flow.'

Cost and capital reductions have had to be adopted by many companies. Measures have ranged from a light-touch approach to major surgery, for example reduced travel and expenses, controlling discretionary spending, de-stocking, hiring freezes, head-count reductions, outsourcing back-office functions and relocations and closures.

Tactical moves such as the above will help preserve profitability and possibly cash in the short term, but must never be counterproductive and risk weakening future success.

New customer propositions, the authors claim, 'are not hard to find in a world where buyers are beginning to make different trade-offs between price and quality, price and risk, and price and time, and where conspicuous consumption is out of fashion, at least temporarily.'

In this fast-changing world companies need to be alert to new gaps, opportunities and challenges. For a well-placed company, the authors say, 'the zombie economy can offer rich pickings'. They list three:

1. Insolvencies and restructurings create distracted companies, at least temporarily, that may have to shrink - either way, market share may be easier to take;

2. Falling asset prices and fire sales create opportunities for acquisitions with sound long-term economics even though, as we know, over the cycle most acquisitions destroy value;

3. Changes in customer buying behaviour create opportunities to exploit new market niches, or even significant segments, with new propositions and business models.

The recession is difficult enough for most companies and the fight for survival and some profitability is in many cases as much as they hope for. For the strong and the bold there are clearly opportunities to be grasped.

PA's four immediate recommended actions for business leaders are:

1. Make sure your top team understands the nature of this crisis;

2. Rapidly diagnose your own position and that of others in your industry;

3. Test your current plans against a range of possible scenarios;

4. Make sure you have the type of team-working you will need.

'The Zombie Economy' offers a clear and comprehensive framework that should be welcomed as a refresher by businesses of every size. Large companies must overcome the stigma of being too flat-footed to move fast enough to seize opportunities, while smaller businesses, which can be fast and flexible, should have access to the necessary finance. Liquidity, as the authors show, has to be the first priority to save us from the zombie malaise.

'The Zombie Economy: Leadership In Times Of Uncertainty' by Mark Thomas is published by PA Consulting Group, £12.99.

This article was reproduced with the kind permission of Engineering & technology Magazine.