Betting the Business

I’ve just returned from Europe where I spent part of the summer talking to companies in different European nations. Everywhere I went, the signals are flashing yellow. In Europe, the recovery seems to be coming to a standstill.

A poisonous mix of sluggish output, sovereign debt crisis, fragile banks and lack of political will has created a perverse cycle of lower growth, less than expected tax revenues (despite VAT and income tax hikes), obstinate fiscal deficits, growing public debt, more turmoil in financial markets, stressed banks that refuse to ease lending, further austerity and spending cuts, which further undercut business and consumer confidence, as well as disposable income, which lead to yet lower economic growth and so on. It is as if much of the Eurozone and the UK are dangerously balanced on the edge of another recession…without even having been able to recover to the levels of output seen before it all started in 2008.

Recent data tells a sad story. Industrial production in the 17-nation euro area fell 0.7 percent in June compared to May. GDP has slowed to a meager 0.2 per cent in the second quarter from 0.8 per cent in the previous three months. Even mighty Germany is decelerating fast, with last quarter GDP slowing to a shocking 0.1 percent, and the latest IFO Business Climate Index shows that German businesses have turned much less optimistic.

No question that the coming year will be challenging for European businesses. Many companies have been closely monitoring how the situation is evolving, and are diligently working on contingency plans that deal with possible sinister Eco-Fin scenarios.

The following figure shows the risk matrix used by a European manufacturing company (call it MadeInEU) back at the beginning of 2010 (a few months after the beginning of the Greek debt tragedy). The risk matrix plots the different drivers of risk that matter to MadeInEU. The horizontal axis measures the likelihood of a particular driver of risk happening; the vertical axis measures how a driver influences operations, EBITDA and Cash flows. A heuristic combination of probability and impact helps managers rank the drivers of risk by their relative importance.

The same risk matrix redrawn at the end of June showed a different picture. The most important changes that caught management attention were the significant upgrades in three drivers: (1) Macroeconomy; (2) Access to Capital; (3) Financial Risks (mainly related to the outlook for the Euro).

In just over a year these three drivers have become a priority. Accordingly, MadeInEU is actively managing the risks posed by these drivers, by incorporating risk management actions into the business planning and evaluating the responses to the changes.

While still budgeting that orders will hold up, MadeInEU has made plans for a recession. The company is contemplating adjustments to its portfolio of product lines, and new marketing strategies to build resilience under slackening demand, as well as identifying measures to save costs and protect margins. Competing in a sector where it is quite expensive to switch on and off its production capabilities, MadeInEU is stress testing its plants under severe economic conditions, and thinking through its entire supply chain to cut rigidities and gain flexibility.

Simultaneously, MadeInEU is evaluating the threat posed by a curb in lending by some of its bankers who have started a gradual deleveraging. MadeInEU is accelerating the renegotiation of its credit facilities, diversifying its creditors, preserving cash and implementing a capital light investment strategy.  By doing all of these, MadeInEU is attempting to achieve a stable financial position in a context of extraordinary uncertainty.

As to the risk posed by the event of a collapse of the Euro, it is so tragic that one feels uneasy even discussing the issue. As the Governor of the Bank of England, Mervyn King, so poignantly put it this past week: “There are many risks which we don’t feel that we can sensibly quantify”…”they come under the heading of the unimaginable or the unmentionable”.

MadeInEU has built a good approach to risk management. The process follows a rigorous sequence: the company identifies the relevant risks, and the sources (drivers of the critical risks and the underlying causes), measures the triggers (by determining the relevant indicators), establishes ownership of the risk within the company, then manages the risks by devising the appropriate actions, which requires identifying a degree of risk tolerance and a strategy to deal with the various risks, establishes controls, and finally monitors the execution progress while keeping a close eye on the changes in the drivers of risk. With such a process in place, the management can prioritize the relevant risks, assess their potential impact, and focus on the strategy to manage them effectively.

It would be foolish to think that this is some kind of full protection harness. Non-trivial risks are at times ‘unknowns-unknowns’, and plans can hardly resist reality checks. But in today’s economic and financial environment, EU companies do well in preparing for what nobody wants to happen.