Is there a silver lining? Capitalising on the next economic downturn

Baird argue that with careful planning, industrial companies can emerge from the next downturn stronger and positioned for success.

While softening demand in certain industrial end markets can be challenging, it is also an opportunity to make strategic moves that may be difficult to pursue during periods of rapid economic growth. We believe companies can optimise this opportunity and not let the next recession go to waste.

PREPARING FOR THE NEXT RECESSION

Companies need financial strength and flexibility to capitalise on opportunities that emerge in a soft economic environment. Best-in-class companies are pursuing initiatives to bolster their economic fortitude ahead of the next downturn.

Capital Structure 

Ample liquidity and a strong balance sheet are critical to capitalising on the next downturn. Sophisticated companies are developing recessionary scenarios to quantify the likely fall in EBITDA based on how they performed in the last recession, end market exposure and cost structure. Companies that feel exposed should endeavour to deleverage by staying disciplined on capital expenditures, selling non-core assets and preserving cash. Many companies are also re-examining their debt securities to ensure they have the most flexible terms possible, and some are considering raising equity to shore up balance sheets.

Variable Cost Structure 

Since the Great Recession, many companies have migrated more costs from fixed to variable to mitigate the bottom-line impact from a drop in revenue. They have done this by automating manufacturing, outsourcing non-core functions like certain design, maintenance, IT, HR, legal and finance operations, and reducing large fixed costs like excess manufacturing footprints. 

Portfolio Realignment 

Many businesses have diversified their end markets and entered new, less cyclical markets. They have achieved this by divesting or spinning-off highly cyclical business and acquiring assets serving noncyclical end markets such as food & beverage and medical & pharmaceutical. Several companies are exploiting secular trends within their markets, in areas like electrification, automation and IIoT (industrial internet of things), which may mitigate recessionary headwinds.

Business Model Innovation 

While many companies are innovative in new product development, it is less common to see aggressive, strategic business model innovation. Companies at the forefront of model innovation know improving quality of revenue can enhance their resilience to market weakness. For example, they are investing in recurring revenue streams like aftermarket service and spare parts, subscription software and equipment leasing. They are also working to increase differentiation and customer loyalty to preserve pricing in a failing-volume environment.

Recession Plan 

It is imperative that every management team has a recession plan that identifies and prioritises actions to mitigate economic weakness. This enables them to react quickly and realign their businesses to preserve capital and shift resources to key strategic functions. In the last recession, companies that took immediate actions like reducing retirement contributions, giving workers unpaid time off and making headcount reductions shored up their profitability and were better able to navigate the environment than ill-prepared businesses.

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PRIORITISING STRATEGIC INVESTMENTS

Companies that prepare for a recession will be flexible enough to direct resources to initiatives that will generate strong ROIs when the economy strengthens. They may achieve even greater long-term market share expansion if their competitors are not as diligent.

Double Down on Research & Development

Many companies have made the mistake of slowing R&D investment during recessions. During the Great Recession, businesses that could afford and had the strategic vision to continue new product development programs captured significant market share from competitors when demand re-emerged.

Implement Operational Initiatives

It can be challenging to divert time and resources to operational initiatives in a strong environment where customer requirements are high. A downturn provides an opportunity to tackle initiatives such as enterprise resource planning (ERP) or customer relationship management (CRM) implementations, workforce training, lean manufacturing programs, supply chain rationalisation or facility consolidations.

Pursue Strategic Acquisitions

Recessions are a unique opportunity for companies with strong balance sheets to capitalise on weaker competitors and drive industry consolidation. The psychology of entrepreneurs often evolves during a recession as they are faced with circumstances like layoffs, reducing incomes and dealing with unhappy constituents. Continued independence is often less appealing than teaming up with a well-resourced partner. In addition, since targets' earnings and prospects are lower and fewer bidders are viable, valuation expectations typically fall in these environments. During the Great Recession, well-capitalised companies that aggressively consolidated the market saw outsized shareholder returns in the following decade.

Companies that are well-prepared heading into the next recession and use their resources wisely to invest in the long term will emerge stronger and create superior value for shareholders. There may be a silver lining to the downturn after all.

Joel Cohen and Joe Packee are co-heads at Baird Global Industrial Investment Banking.

Baird has a long and successful heritage of advising public and private companies and financial sponsors in the Industrial and Industrial Technology sectors. Baird’s Industrial team provides an extensive range of equity and debt capital markets and M&A advisory services to middle-market Industrial companies. Our global team ranks as one of the leading Industrial M&A advisors among all investment banks.