In 1980, Maytag was a high-end, niche manufacturer of clothes washers, dryers, and dishwashers. The company grew by acquisition through the mid-1980s, becoming a full-line manufacturer of major appliances. Late in the decade, Maytag added overseas acquisitions for international growth. While that strategy helped diversify the corporation’s product lines, the overseas businesses did not meet its internal profitability standards. Maytag subsequently sold off its poorly performing European and Australian operations. Maytag used the proceeds to pay down debt and strengthen its balance sheet, reinvest in its core North American business, and initiate a share repurchase program. Maytag once again performed as a high-margin producer with strong synergies among its laundry, dishwashing, cooking, and refrigeration lines.
In the 1960s and 1970s, International Harvester was in the farm equipment, construction equipment, truck, and gas and solar turbine businesses. It paid a high percentage of profits in dividends and earned less than its cost of capital in most years. In the early 1980s, the combination of a strike, high interest rates, and a recession nearly bankrupted the company. After a five-year, multistage restructuring of bank and insurance-company debt, the company closed a dozen plants and sold its farm equipment, construction equipment, and solar turbine businesses. Renamed Navistar, it now focuses on becoming a world-class competitor in trucks and diesel engines.
In 1988, USG had a conservative balance sheet and an established market leadership position selling essential building materials. It used excess cash to diversify into other building-related products. A hostile takeover attempt put the company in play, and management responded with a leveraged recapitalization. The combination of high leverage and a poor housing market in the early 1990s forced USG to default on several loans and to undergo a complex financial restructuring that eventually led to a prepackaged bankruptcy. Fortunately, despite its balance-sheet problems, the company had an underlying business worth saving. It has regained an investment-grade credit rating and developed a less hierarchical corporate culture that is entrepreneurial and team oriented.
Forstmann, a manufacturer of high-quality woolen fabrics for the garment industry, filed for Chapter 11 protection in September 1995 and emerged from bankruptcy in July 1997. At the time, its major problems were an unfocused sales strategy and capital-expenditure program, compounded by a lack of product-profitability analysis and cost controls, poor inventory management, and high leverage. A new CEO and his team turned Forstmann around by communicating with all the stakeholders, reorganizing management, developing a more focused business strategy, rationalizing products, reducing overhead, and setting up systems for cash-flow management, cost analysis, quality control, and customer service. However, after failing to react quickly enough to a sharp decline in market demand, the company filed for Chapter 11 protection again in July 1999. A Canadian competitor purchased its assets under bankruptcy court proceedings in November 1999.
By the time a new CEO assumed control of this family-owned company in 1981, it was nearly bankrupt. Production facilities and trucks were in poor shape. Customers were undersupplied, morale was low, and employee turnover was high. There were few internal controls. The company was in real danger of losing its Pepsi-Cola franchise, the foundation of its value. The new CEO and chief operating officer (COO) built a solid management team and restored production, sales, distribution, financial management, and data processing. As a result, case volume has increased two and a half times and profitability has quadrupled.
The net worth of the family-owned Sampson Paint Company eroded from about $6 million in 1970 to near zero in 1980. The big culprits were inappropriate pricing, poor marketing, inadequate financial controls, high overhead and manufacturing costs, and a lack of product and customer profitability analysis. Sampson Paint needed a new owner with management experience and fresh insight. With financing from an asset-based lender and the previous owners, turnaround specialist Frank Genovese restored the company to profitability by reducing overhead; rationalizing and repricing the product line; and establishing a marketing strategy, operating procedures, and financial reporting and controls.
Ames Department Stores, Inc., is the fourth-largest discounter and the largest regional discounter in the United States. The company was forced to declare bankruptcy after it sustained heavy financial losses from an ill-advised acquisition. Ames also lost sight of its core customer, a major strategic mistake. A new CEO and his team turned the company around by reconnecting with Ames’ core customer base and establishing a market niche that allows Ames stores to coexist with the larger Wal-Mart and K-Mart stores.
When turnaround specialist Timothy Finley became CEO of this upscale men’s clothier in 1990, he discovered that heavy debt from a leveraged buyout (LBO) was the company’s biggest problem. But there were also other operating and marketing problems. To avoid bankruptcy, Finley persuaded the bondholders to accept equity. Ensuring Jos. A. Bank’s profitability over the longer term required reinforcing its commitment to its target customer and redefining the company’s merchandising, sourcing, selling, store-design, and store-location strategies.
Edison Brothers was a low-end, private-brand operator of mall-based stores with a retailing strategy based on price points. It overexpanded and suffered from a glut of stores and a shift in consumer tastes toward more expensive, name-brand merchandise. The company filed for Chapter 11 protection in 1995 and reemerged in 1997, making creditors whole. Despite efforts to improve merchandising and systems, the company faced heavy competition from better-known stores after emerging from bankruptcy and filed for Chapter 11 protection again in March 1999. This case study charts the course of a failing retailing strategy and the role of intercreditor issues. It also demonstrates that building the company’s value, even during a bankruptcy, ultimately helps creditors receive a high percentage of their claims.
Forzani, the largest retailer of sporting goods in Canada, had an opportunistic development strategy. As a result, it had too many retailing concepts under too many trade names. The company stumbled when it simultaneously tried to expand nationwide and improve its information systems and business processes. With the help of a new CFO and head of retailing, the Forzani Group stemmed the tide of failure. The new management astutely managed cash flow, negotiated with suppliers, landlords, and other key constituents, consolidated store trade names, and reengineered the merchandise mix and store design. It also introduced incentive compensation for salespeople, improved information systems, reduced overhead, and increased the company’s focus on key performance indicators.
Musicland is the largest specialty retailer of prerecorded music in the United States. Between 1993 and 1996, after paying down debt from an LBO, the company substantially increased its leverage to finance the continuing expansion of its store network. In 1994, cash flow available to service debt obligations began to decline because of competition from discount stores and flat industry sales. By closing stores and negotiating with vendors, landlords, and lenders, the company narrowly avoided bankruptcy. Its financial performance rebounded sharply in 1997 with a pickup in overall music sales. In 2000 Musicland was acquired by Best Buy Co.
After decades of steady growth, this privately-owned auto parts wholesaler and retailer demonstrated an overconfidence that mushroomed into financial problems. Red Rooster did not pay enough attention to profit margins, and its financial controls were weak. Plus, its employee compensation was well above industry standards. Management turned the company around by basing performance measures and employee compensation on gross profit rather than sales and reducing headcount through attrition and job redesign. The company has also improved information and inventory management systems, and it has begun sharing a great deal more information among employees.
Computervision, a market leader in CAD/CAM (computer-aided design/computer-aided manufacturing) products in the early 1980s, ran into financial difficulty for two reasons: Its competition overtook it technologically, and it was overleveraged after a hostile takeover and LBO. Parametric Technology Corporation, a younger, more nimble competitor that purchased Computervision, turned out to be its savior.
GenRad, a Boston-area high-technology company, was handicapped by having an engineering culture rather than a business culture. Therefore, it diversified away from its strengths and lost its leadership position in test equipment. After a period of losses, a new CEO was hired. He simplified management, listened to the customer, and defined core businesses. The CEO also sold unproductive assets and shifted the business from test equipment to diagnostic services.
Kollmorgen, a producer of motion-control and electro-optical equipment for industrial and military applications, lost money for several years. It depleted much of its equity through overdiversification. A decline in government defense spending and the expense of fending off a hostile takeover attempt were also major factors. A new management team turned the company around by selling off businesses that did not fit within its core competencies. The team used the proceeds to rebuild the company’s balance sheet, and it began investing in new businesses to strengthen Kollmorgen’s core business segments. The company was acquired by Danaher Corporation in 2000.
Cadillac Fairview, based in Toronto, is one of North America’s largest fully integrated commercial real-estate operating companies. It was taken private through an LBO in 1987. To succeed, the LBO required continued growth in cash flow and property values. That didn’t happen because the Canadian real-estate market was depressed between 1989 and 1995. Since reorganization under the Canadian Companies’ Creditors Arrangement Act (CCAA) in 1995, Cadillac Fairview has pursued a strategy that limits growth to what can be financed through internally generated funds and debt financing allowable under its capital-structure policies.
Burlington Motor Carriers filed for Chapter 11 protection six years after its LBO because of poor operating margins and overexpansion. New owners with experience in the trucking business purchased the company from bankruptcy and reduced its overhead, invested in state-of-the-art information systems, and strengthened relationships with high-volume customers.
Before its turnaround between 1991 and 1994, the Fairmont Hotel Management Company was reluctant to offer discounts from its top-tier prices for fear of compromising its market image. Recognizing the need to increase occupancy, a new management team allowed average daily rates for hotel rooms to drop while increasing occupancy and revenue per available room, restoring profitability. This case study illustrates the importance of customer- and product-profitability analysis as well as understanding a business’ key performance indicators.
The staff of this independent, not-for-profit hospital will do whatever it takes to help the institution survive and fulfill its mission of serving the needy in a low-income neighborhood. The hospital has had to make continuous cost reductions during the past decade—a volatile time in the health care industry—while maintaining its quality of service. It also has had to increase its income by developing new products and services. Essentially, this means that St. Luke’s is continually turning itself around, reinventing its strategies to survive in a highly competitive health-care environment while staying true to its mission.
Microserv was started in 1985 to provide computer equipment repair services to corporate clients. Since then, the information technology business has evolved considerably. Not surprisingly, the competitive requirements for service providers have also become much more daunting. The founder and the original management team were computer repair experts with few financial, marketing, and general management skills. After sorting out cash-flow, capital-spending, and borrowing problems, a new management team redirected Microserv’s marketing strategy. Instead of focusing on direct selling to corporate customers, the company began to build partnerships with large original equipment manufacturers (OEMs), independent service organizations, value-added resellers, and other information-technology organizations. To spur the company’s growth and to prepare for the future, the CEO hired a management team capable of running a much larger organization.
In all the companies we studied, the CFO played a vital role in turning the company around by contributing to strategic development, not to mention its financing and controls. Working with the CEO and line management, the CFO needs to develop an understanding of and consensus on the company’s business model by which the company delivers a product and earns a profit. The CFO and CEO must also develop a “balanced scorecard” of financial and nonfinancial key performance indicators (KPIs) that take the company’s pulse on a regular basis.
In this and many other respects, the CFO performs a vital function in keeping the company healthy. But as the corporate scorekeeper and an important member of the strategic planning team, the CFO is also in a position to spot early warning signs of possible financial difficulty. These include a change in corporate strategy, rapid growth, an increase in leverage, loss of market share, and deterioration in key performance indicators. When the company runs into problems, despite the CFO’s best efforts, the CFO must sound the alarm. And, if the CFO is up to the challenge and can work with new management, the CFO will be one of the key players spearheading the turnaround.
The CEO of Microserv has worked with several CFOs with varying abilities. This has led him to conclude that a CFO cannot function well without understanding the business thoroughly. The CFO also must demonstrate a detailed knowledge of costs in order to manage margins effectively. In Microserv’s business, that translates to an understanding of all the direct and indirect costs of the complex computer-parts business so that he can create profitable pricing proposals.
CFOs and CEOs also need to anticipate market shifts, which should seldom come as a surprise. In reality, however, companies often fail to spot a market change. For example, Computervision rejected a proposal to develop three-dimensional modeling capabilities. This short-sightedness was one of the factors that nearly drove the company into bankruptcy.
Although we identified very few cases of outright inept management—and those were in small, privately held companies—most financial problems were still caused, at least in part, by management error. Furthermore, the study uncovered similarities in both the causes of and remedies for financial difficulty that extended across all industry groups. Companies that got into trouble had poor business plans, lost focus, overdiversified, took on too much debt, tried to grow too fast, or had problems with acquisitions. Examples include Burlington Motors and Musicland, both of which allowed growth to leapfrog profitability, and Maytag and Kollmorgen, whose acquisitions were derailed, in part, by corporate culture issues and by poorly performing acquired companies.
If you’re the CFO of a thriving company, you may think your company would never make these mistakes. But no company can afford to be smug because all of the case-study companies started out as sound, profitable, dynamic organizations. Every sound company should be aware of its potential Achilles’ heels and understand the warning signs.
For example, Edison Brothers’ strategy to sell off-brand, low-price-point apparel to a fashion-conscious young market was a good one for a number of years. But it stopped working as customers moved up to name-brand merchandise, and the company was too slow to react. Similarly, Ames Department Stores lost sight of its core customer base.
Other companies had a slightly different problem with their market strategy—the inability to focus in areas of competitive advantage. For example, Kollmorgen, which makes electro-optical equipment and weapons-positioning systems, made the mistake of overdiversifying, and it then had to reestablish its focus on its core businesses. The company concluded that companies without a strong focus on their customers and competitive advantage risk being knocked out of the market by competitors that do. To underscore this point, when USG pursued its building-materials conglomerate strategy, even the appearance of being unfocused subjected the company to takeover threats from investors, who saw an opportunity to profit from breaking it up.
Overleveraging was another major stumbling block in our study group. More specifically, none of the companies that became overleveraged performed stress tests to determine how much debt they could handle in adverse conditions. Cadillac-Fairview, Jos. A. Bank, Musicland, and USG, among others, survived the turnaround process largely because their underlying businesses were fundamentally strong, despite their balance-sheet problems.
During the crisis period in a turnaround situation, the finance function often must run the business, negotiating with creditors, collecting receivables, trimming inventories, controlling capital expenditures, and monitoring cash. Musicland is an excellent example of a proactive finance function. Its strong accounting and reporting system was critical in helping management determine what actions to take during the turnaround. Before deciding to reduce costs in a particular category, management could “drill down” to analyze subcomponents and distinguish necessary from unnecessary costs. This exercise helped management estimate whether cutting certain costs would hurt the business or incur additional risks.
Of course, finance’s role does not end once the company is out of immediate danger. For the CFO and other members of management who are directly involved, saving the company means conflict, stress, and long hours. Turnarounds demand perseverance and difficult decisions, such as eliminating jobs and operations. Plus, management usually does not have the luxury of time. It must act decisively to cut staff and close stores or facilities, as Ames Department Stores, Computervision, and Edison Brothers all clearly demonstrate. Because a turnaround is more than a full-time job, some companies, such as Jos. A. Bank and USG, divided their management staffs, assigning some to handle turnaround issues and others to dispatch day-to-day business matters.
After a company emerges from restructuring, it needs to reestablish its financial and management credibility. The finance function takes the lead in gaining access to the capital markets. CFOs have a major hand in telling the company’s story to shareholders, institutional investors and analysts, and particularly in explaining why a similar situation will not develop again.
Companies that are restructuring also need to rebuild management credibility, and one way to do that is to supplement management expertise with specialized advisers. Cadillac Fairview and Musicland both retained lawyers, investment bankers, and financial advisers with restructuring experience. In addition to providing advice, these professionals also bolstered management credibility. Credibility is vital to a company in crisis; in fact, many of the case-study companies, notably Forzani and Musicland, found that good long-term working relationships with bankers, vendors, and landlords helped their turnaround efforts. This was especially important when company management needed to negotiate immediate solutions with its creditors.
Despite the best efforts of senior management, however, there are bound to be changes in the management team during a turnaround. Typically, either a consultant specializing in turnarounds or a seasoned manager with turnaround experience helps the company make the changes necessary for its survival. These changes are understandable given leadership and management requirements that must evolve along with the company. One of the reasons companies get into trouble is that they do not recognize this requirement early enough. Many entrepreneurs are not capable of managing the companies they started once the business reaches a new stage of development.
This is yet another powerful argument for the CFO’s stewardship role. The onus is on the CFO to warn the CEO of any strategic or leadership blind spots. It is perhaps the CFO’s most important responsibility.
Companies that are headed for trouble exhibit a number of early warning signs that every CFO needs to recognize, and, if necessary, to compel his CEO to recognize. Denis Hickey, in a 1991 article in the Commercial Lending Review, observed that troubled companies often begin their decline before their financial statements reveal problems. One of the most important indicators is the presence of imbalances—that is, an undue emphasis on one functional area, such as sales. High lifestyles among managers are another sign, and, along with that, a lack of values, such as a get-rich-quick rather than a long-term-building philosophy.
“Follower” attitudes can lead to insufficient creativity in product development and in other areas that affect margins, and this is often accompanied by an entrenched management that lacks the energy and adaptability to face new challenges. Two other signs are a lack of strategic plans and product-profitability reporting and harmful relationships, such as bad hiring decisions or acquisitions/mergers that distract management.
As for the more tangible indicators, one common signal of impending problems is a combination of a decline in sales profitability and a decrease in asset efficiency (receivable or inventory turnover). For example, Forzani, the Canadian sporting-goods retailer in our study, experienced increased inventory and decreased margins at the same time. Eight other companies saw declining margins or sustained cash drains.
Wes Treleaven, a partner with Deloitte & Touche in Toronto, highlights six common attributes of underperformers:
Weak management
Poor board governance processes
Badly planned or executed expansion
Lack of accurate and timely management information
Inadequate interdepartmental communication
Inability to effect change
Treleaven believes a decline in a company’s cash position is the most important early warning sign. He recalls a large company that did a 45-day rolling cash-flow forecast—but failed to realize that it would run out of cash in four months. This example demonstrates the need to understand where the company’s cash comes from and how it is used. Management must have a reliable system to forecast receipts and disbursements —day by day and over the next year—and know how to react if the cash position starts to deviate from the forecast.
Gerald Ryles, the CEO of Microserv, couldn’t agree more. Essentially, he says, “Operating cash flow determines whether the company survives.” The income statement, balance sheet, and statement of cash flows in a company’s annual report are accounting based, but the bills are paid from operating cash flow. Therefore, a company that does not consistently generate enough cash to operate effectively is headed for a fall.
On a different front, a change in a previously reliable business strategy, while not necessarily bad, is still a potential trouble sign. For example, among our case-study companies, GenRad and Kollmorgen strayed from their primary businesses, and Ames Department Stores drifted similarly from its core customer base. Maytag decided it needed critical mass to avoid a hostile takeover and made international acquisitions that it was not equipped to absorb.
Market shifts, such as the change in the health care service environment that affected St. Luke’s Hospital, are also early warning signs, but they are not always easy to identify. Finally, high leverage is always an early warning sign of financial difficulty, even though highly leveraged companies sometimes succeed.
David Steadman, president of Atlantic Management Associates, Inc., a company that specializes in turnarounds, points out two other early warning signs: loss of market share and difficulty in signing up new customers. Of course, continued and expanding business from existing customers is important, but, he notes, longstanding customers sometimes have a remarkable tolerance for suffering, so they should not be the only barometer of success.
Seymour Jones, a former Coopers & Lybrand partner now on the faculty of the Stern School, New York University, finds that nearly every troubled company has some degree of inventory mismanagement. Most companies hold on to inventory far too long, he observes. Commercial finance companies lend 80 to 85 percent on receivables but only 50 percent on inventory, he reports, because that might be all they can get in liquidation. Even without accounting for obsolescence, Jones estimates that it costs a company 20 to 30 cents on the dollar to hold seasonal inventory until the same time next year. Instead, companies are better off selling at a discount and getting the cash.
In a similar vein, Jeff Goodman, president of Best Practices, Inc. a turnaround consulting firm, reports that one company he worked with had not paid enough attention to the balance sheet and was running out of cash. It had 96 days of accounts receivable, and its inventory turnover was two and a half times per year, compared with an industry average of between eight and nine. Reducing inventory and receivables to a normal industry level fixed the cash shortage and eliminated the need for external financing. These situations crop up, he believes, because developing companies often get addicted to revenue growth that masks underlying weaknesses—until that growth starts to plateau.
Both experts believe that many failing companies exhibit some early evidence of poor controls and fraud. One important clue is the use of profit-driven bonuses as a form of management compensation. Fraud is often behind awarding high management bonuses after the business starts to go bad, when underlying problems may be masked through methods like misvaluation of inventory. Other factors include the presence of only a few decision makers at the top, weak controls, a poor relationship with auditors, and one-person accounting departments.
Goodman adds that troubled companies often lack financial metrics tied to the company’s financial objectives. A company needs to have a full range of key performance indicators in place so it can judge whether it is operating profitably and building shareholder value. In a healthy company, such metrics are used regularly to monitor performance in every area. For example, Navistar, a case-study company, went through the important process of establishing new capital budgeting disciplines as part of its turnaround efforts. Before then, the company had not recognized the importance of earning more than the cost of capital and of slowing down growth so that it could be properly financed.
Other case-study companies also discovered through the turnaround process that they had kept their eye on the wrong ball in terms of financial metrics. For example, Fairmont Hotel Management found that in a high-fixed-cost business, generating additional revenue is more productive than focusing on cutting costs. Red Rooster, the auto-parts retailer, learned that it is not sales but profits that pay the bills. As the company reevaluated its performance measures, it began to use industry operating data for benchmarking. Management also began to share information more openly with employees on performance measures and financials and to allow employee participation.
The importance of metrics, and the lack of them in an ailing company, underscores the role of the finance function as the linchpin of the company. To illustrate, Goodman says that one of the clear signs of trouble in a company is an ill-defined finance function, along with a lack of financial metrics. In a company that is faltering, the finance function does not assume joint ownership of the key performance indicators or responsibility for achieving them. Although other warning signs should never be ignored, for CFOs and other financial executives, it’s especially important to recognize what has gone awry in your own backyard.