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Archive for January 18th, 2008

Recession 101

Marvin A. Davis is a member of Gerbsman Partners Board of Intellectual Capital and the author of the book Take No Prisoners: A No Holds-Barred Approach to Corporate Excellence.

In the last few weeks I have read numerous articles in the press both predicting and debunking notions of a possible recession looming in our future. Washington is in heavy denial because no one wants a recession in an election year. Alan Greenspan has stated that there is a strong possibility of one. Like an impending storm, it is better to batten down the hatches before it hits rather then when one is in the middle of a nor’easter. So what’s the real story and what can one do to prepare for it?

I am in the business of fixing troubled companies and in a somewhat unique position to predict economic downturns.

After a long period of relative quiet, my phone has begun to ring at an ever increasing rate, a sure sign of trouble a-brewing. Besides this empirical indication of impending problems let me enumerate what I think the reasons that we are facing economic woes.

  • The subprime mortgage loan meltdown: Unless you live in a cave with no outside communications, you are aware of the problems in the subprime lending market and mortgage backed securities area. The write downs are in the billions if not trillion of dollars and are affecting lenders worldwide. Lenders are being forced to reexamine lending practices not only to questionable mortgage holders but to all their clients including businesses. In other words, they are ratcheting down their risk profiles. This means that even though the prime rate is low, it will become more and more difficult to obtain a business loan. The bank will require more security in the form collateral, more guarantees and tighter covenants. They will be seeking more “creditworthy” companies in their loan portfolio. Thus if you are in an industry which is considered “questionable” even though your company is doing well, it may be difficult to get a loan. This conservatism will certainly slow growth and place certain businesses in peril.
  • Over the last decade there has been a great deal of low priced liquidity in the marketplace. Thus lenders have been chasing borrowers in an attempt to put cash to work. This has led to a glut of corporate sales to hedge funds and others. These sales have been at high multiples of earnings and have put large amounts of debt of the acquired companies. If the acquired company was slow in meeting its objectives even more cheap debt was added to the balance sheet in the hopes that time would solve the problem. With the current tightening of credit, there will be no more easy money and if interest rates begin to rise, as I feel they eventually will, many companies will fall under the weight of their debt.
  • The price of oil is having a dramatic effect on all sectors of our economy. It permeates the cost of almost everything the consumer purchases. We know about the cost of heating oil and gasoline which impacts out pocketbooks directly, but since gasoline and diesel fuel impacts transportation costs these costs are passed on to us in purchase price. Petrochemicals are used in plastics and virtually every other sector of the economy. It is not widely known but fuel in the form of gasoline and heating oil is not part of the CRP (Consumer Price Index), so when we calculate inflation based on the rise in the CRP, it is distorted downward.

What this means is that middle class Americans now have less discretionary income, which them leads to a reduction in spending by the consumer and a slowing of the economy.

  • The cost of our military actions abroad, whether you agree with them or not, have drained cash from the U.S. economy which will never be replaced. We have financed this effort through deficit spending and borrowing from others which in turn has weakened the dollar dramatically, causing the price of imported goods to slowly rise. This impact has not fully worked its way through the supply chain but will soon be obvious.

Since low cost imported goods have offset, in part, the effect of inflation in the energy and materials sector, we can expect to see that moderating effect soon disappear and real inflation begin in earnest.

The only good part of this is that an opportunity now exists for companies to begin exporting relatively cheap U.S. goods to foreign markets, unless our offshore friends constrict trade business to prevent that from happening.

What all this means is that we have an inflationary pressure cooker which is about to pop, tightening of credit by the banks, less ability by the consumer to spend due to lack of discretionary income, and an outflow of each which will keep the dollar weak. And like Harold Hill in “The Music Man” says, it’s a word that begins with “R” and ends with “N” and spells Recession.

Now you ask, what can companies do to prepare for an event like a recession should it occur and in view of the current conditions?

1) Prepare a plan: Look at the business and gauge what a downturn in business would do and how you would offset a reduction in overhead. Prepare “what if” scenarios.

2) Look for new markets and new marketing techniques to offset a drop in your traditional customer base. Look at international markets in view of the weak U.S. dollar.

3) Reexamine your banking relationship and your covenants. Have a second lending relationship waiting in the wings in case of a possible lender dysfunction.

4) Pay down loans if you can. The companies which survive inflationary periods are those which are debt free.

5) Dispose on non-performing assets to raise cash and get back to your core business.

As I stated in the beginning of this article, it is difficult to batten down the hatches while the storm is underway. Prepare now. Most of what I have suggested is wise policy even if the worst doesn’t happen.

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