The New Normal

April 20, 2009: Many prognosticators offer opinions on the future as the economic turbulence shakes out, but few provide tangible strategies for successfully running small businesses in these changing economic times. Here are our forecasts of major trends and a few ideas of how to win, survive and thrive in the “New Normal”.

ER’s fundamental methodology requires establishing key operating and market drivers of profitability; in this case, the key driver will be the behavior of the consumer, the 600-pound gorilla in the U.S. economy accounting for 70 percent of gross national product. Understanding how your products or services reach consumers will become increasingly important.

Here are some facts, forecasts and ideas to take into account:

The Consumer

• Lead by consumers, the nation has taken on significantly more debt. Household debt as a percent of GDP grew from 60 percent in the early 90s to roughly 100 percent today, an increase of $5.5 trillion. Total household debt, approximately $14 trillion, has remained flat for the past year.


• As the economy begins to recover, the savings rate will increase and the consumer will begin a sustained period of deleveraging.


• Debt in the financial sector has increased more dramatically despite the fact that the majority of large bank loans have been securitized. Banks are deleveraging and the securitization market is anemic.


• Commercial real estate loans will be the next shoe to drop, further impacting the securitization market, regional banks and insurance companies.


• Banks and credit card companies have been and will continue reducing lines of credit on cards and home equity loans. Some predict this might amount to trillions of dollars.


• Pending hearings and legislation to restrict bank charges and practices associated with credit cards will result in further and possibly significant contraction of this source of credit. If returns are limited, banks will simply adjust their risk profile.


• Underwriting criteria for regional and national banks will tighten. Regional and community banks with modest exposure to commercial real estate will gain market share with privately held businesses needing inventory and receivable financing. Finance companies that survive will become more significant for middle market companies and private equity firms.


• The percentage of home ownership is 6 to 7 percent higher than historical norms.


• Recovery in new home construction will be longer than previous recessions. Home improvement expenditures will remain steady and exceed growth in the overall economy.


• New home construction and the auto industry represent a significant proportion of the economy. Suppliers in these sectors will fail if they are not right-sizing in anticipation of a slow recovery.


• If you are a third or fourth tier supplier, understanding how your product gets to market will enable better forecasting and inventory control. Train your salespeople to retrieve channel intelligence. Selling a similar part to BMW and Chrysler likely will lead to differing outcomes. It is surprising how much market information is available if you look.


• Value shopping will make specialty retailing particularly challenging. Guard against concentration and be vigilant in credit monitoring. Smaller companies dealing with distributors, agents, and retailers should consider factoring. A good factor has credit monitoring capabilities that can justify the additional cost for some companies.


• Downsize product lines for residential and commercial construction markets. Recovery will be slow and sporadic.


• Companies must deleverage, too. Manage working capital by trimming unprofitable customers and product lines. Are you organized to know?


• Private equity firms will divest portfolio companies at an increasing rate as many are overleveraged. This presents opportunities to strategic buyers.

Inflation

• The Fed’s balance sheet has more than doubled in the last year, and the administration is forecasting $9 trillion in deficits over the next eight years. While deflation continues to be a concern, it is hard to imagine that infusions of this magnitude will not eventually cause serious inflation. Regardless of one’s political or economic outlook, there are numerous steps one should consider.


• Interest rates will rise and the economy will grow more slowly with the government consuming so much of the credit markets. Treasury rates will be dependent on the willingness of China and other trading partners to buy the nation’s debt.


• Worldwide inflation will further destabilize Mexico and make manufacturing there increasing more difficult. The trend to outsource to Asia will continue.


• States and local governments with large budget deficits requiring higher taxes will continue to lose population and businesses. The southeast and southwest will be major benefactors.


• More talented people will postpone retirement for financial reasons, providing additional sources of skilled and reliable labor. Many outsourcing firms will emerge by taking advantage of this resource.


• Watch the yield curve on treasuries and the spread on corporate debt. Both are good indicators of the direction of interest rates.


• Manufacturing information systems must flag increases from suppliers and the impact on cost of sales. Tracking gross margin at the company division level is not adequate. Product line and customer profitability monitoring are essential to maintain the vitality of earnings and managing working capital.


• Interest rates are now at historic lows. Optimize your capital structure now, i.e. less short-term variable debt.


• Keep your organization performance-oriented with a reasonable percentage of compensation in bonuses/incentives. View employees as your most valuable resource. Turnover is extremely expensive and doesn’t show up on most P&L’s. Track it. If it’s high, get some help and fix it.


• Credit policies are monitored by the accounting department, but the policy’s efficacy is dependent on the sales force. The most important variable in managing working capital is setting a firm expectation of the payment terms when the sale is made. Stick to them.


• Service businesses often do not track their burn rate as many systems charge staff salaries to both cost of sales and overhead depending on whether they are billable or not.


• Know your burn rate and monitor the relationship of total expenses to salaries. Businesses that have utilization of 80 percent and spend 60 cents for every dollar of salaries can break even at a 2.0 multiplier of salaries. Pricing often gravitates to this level in difficult times.


• Utilization is the heart beat of a service business. Measure it weekly. The expense-to-salaries ratio is the blood pressure. It won’t kill you in the short range, but over time it can be deadly. Monitor it at least quarterly and watch for trends.