Value Creation in a Downturn

Overview

Value creation is a mandate for leadership teams regardless of industry or company size. This mandate is both an economic necessity and a nod to the element of stewardship inherent in leading an organization: good leaders improve the companies they lead and work to ensure that they leave them financially stronger, in a more robust strategic position, and more valuable at the end of their tenure than at the beginning. The challenge for every leader is that the optimal mix and weighting of value creation levers changes over time, sometimes due to idiosyncratic factors, and sometimes due to sudden, exogenous shocks.

The impact of COVID-19 has been a severe negative shock to global growth prospects. Even worse, research suggests that below-trend growth could persist for years. There will of course be exceptions, and some quite notable, but for many companies and in some cases whole industries, the prospects for year-over-year revenue growth in 2020 are decidedly bleak. In some cases, the prospects for 2021, even accounting for the lower bar of comparison, are daunting. For many companies, pursuit of a growth-oriented value creation strategy in this environment is no longer viable.

Growth is a proven engine of value creation, and over the last decade it has been the lever on which leadership teams and capital providers have focused their efforts. But there are many ways to increase the value of a company, and as companies grapple with a radically altered business landscape, now is the time for leadership teams to reacquaint themselves with equally proven, though at times less sexy, value creation drivers.

While there are many value creation drivers, in looking to recast a strategy there are certain characteristics that should be sought out:

• Actionable. Focus on measures that leadership can influence.
• Scope of Impact. Focus on measures that will deliver a considerable impact to company performance when optimized.
• Scalable. Focus on measures that scale.

The fact that COVID-19 acted as the catalyst for the end of the most recent expansionary phase serves to obscure the reality that systemic weaknesses have been steadily building throughout the long expansionary phase that the U.S. and global economy enjoyed from the end of the global financial crisis to February of 2020. Middle market companies that respond to the shifting zeitgeist with a focus on pivoting to value creation drivers other than growth will be setting the stage for compelling value creation in the years to come.

Unit Economics

Generally, companies on a robust growth path will experience a steady decline in gross margins. There is no hard and fast business rule that dictates this trend, but companies and their leadership teams must understand the implications of their own strategy, and a strategy that seeks to maximize revenue growth is a strategy that, at the margin, will tend to be associated with gross margin erosion (absent technology driven network effects other structural idiosyncrasies).

The impact of flat or declining revenue can be offset, in part or in whole, by improving unit economics. When gross margin ([Revenue] – [Cost of Goods Sold] / [Revenue]) is rising, a company enjoys an increasing level of incremental benefit (profit) from each sale. Despite this fundamental benefit, it is organizationally very challenging to focus simultaneously on executing a successful growth strategy and driving persistent gross margin expansion.

Working Capital

Working capital management should appear high on any list of organizational value creation drivers. The impact of optimizing working capital does not appear on the income statement, but savvy leadership teams and capital providers understand that by offering the prospect of increases in both cash flow and capital efficiency, working capital is an attractive value creation driver at all points in the economic cycle.

Net Working Capital, or the net amount of capital used in the normal operations of a business, is calculated as the sum of total Current Assets (excluding cash and equivalents) less the sum of total Current Liabilities. Since any increase in Current Assets represents a use of cash, and any increase in Current Liabilities represents a source of cash, the goal is to reduce Accounts Receivable, Inventory, and Other Current Assets while increasing Accounts Payable and Other Current Liabilities. Working capital improvements cannot be accomplished in a vacuum, as the parties on the other sides of these initiatives are often important stakeholders for a company, but nevertheless, the basic arithmetic remains unchanged.

Analytic Insights

Mastering the implications of their own data remains perhaps the greatest untapped source of competitive advantage available to every company. Data is ubiquitous but as a result of that ubiquity it carries with it a low signal-to-noise ratio. Leadership teams must champion efforts, and ultimately structured processes, to generate insights that will point to opportunities for improvement. Once generated, insights should be regarded as maps to untapped pockets of value creation.

Conclusion

Growth cures many ills, but expansionary phases, whether at the macro or micro level, contain within themselves the seeds of their own dissolution. At the level of individual companies, long growth phases are often associated with sub-optimal levels of profitability, as the mandate to grow consumes the time and attention of leadership teams, and the discipline necessary to improve underlying operational efficiency becomes an early casualty of a company’s narrative of growth as the dominant value creation driver.

In the face of the massive economic disruptions arising from COVID-19, middle market companies and their leadership teams will find any growth oriented strategy severely tested. The end of positive momentum for revenue growth, even over an extended period, does not presage an end to value creation. Rather, in an economic environment that will prove hostile to the growth ambitions of many companies, middle market leadership teams must reset both strategy and operations in order to maximize a different set of actionable value creation drivers.

About the Author

David Johnson (@TurnaroundDavid) is Founder and Managing Partner of Abraxas Group, a boutique advisory firm focused on providing transformational leadership to middle market companies in transition.  Over the course of his career David has served as financial advisor and interim executive to dozens of middle market companies.  David is also a recognized thought leader on the topics of business transformation, change management, interim leadership, restructuring, turnaround, and value creation.  He can be contacted at: david@abraxasgp.com.