Restructuring cure two-dimensional

By Inghie Kwik

JAKARTA (JP): Bernd Waltermann, president of PT Boston Consulting Group wrote an article titled Corporate restructuring toward growth: 'C' curve, which was published on Jan. 6.

Next to the article, Waltermann produced a graph showing the trajectory of 58 U.S. companies that underwent restructuring efforts in the 1990s. The trajectory was plotted along two variables, with profitability on the vertical axis and investment on the horizontal axis.

Successful restructuring efforts were shown to move left (reduced investment), up (increased profitability) then right (increased investment).

Unsuccessful companies, starting from the same point, were shown to increase investment with little improvement in profitability. The total graph depicted the letter "C", hence the title of the article.

On the basis of this graph, Waltermann suggested that Indonesian companies follow the C curve in order to emerge from the crisis with higher profitability and better capital allocation.

The title and the graph of the article were attractive, especially since the article was authored by a senior member of a well-known firm. After careful reading, however, it was clear that the article was statistically misleading, and that the advice provided by Waltermann could be wrong for Indonesian companies to follow.

First of all, for Waltermann to make a general conclusion on a sample of 58 U.S. companies is simply appalling. Take the population of companies undergoing restructuring in the U.S. in the 1990s, and it is reasonably certain that each draw of 58 random samples would provide a different trajectory -- possibly even representing different letters in the alphabet. With several million firms operating in the U.S., how can Waltermann provide any advice merely based on the performance of 58 companies?

From his profession, Waltermann should know that the nature of a company in distress is simply too complex to be depicted along two axes. Restructuring alternatives could not be force-fitted along a two dimensional curve. For distressed companies in Indonesia, if there were any common underlining symptoms, they would be excessive debt to equity ratios and dismal productivity levels, when compared to international standards.

These are not problems that can be solved by simply "doing the C-curve". In fact, in many current cases of distressed Indonesian firms, management does not even have the leverage to think along investment versus profit trade-offs. Their problems are often far more severe than suboptimal portfolio/resource allocation.

Another flaw in Waltermann's article is the underlying assertion that for companies under distress, profitability and investment are mutually exclusive choices.

To provide a simple example, suppose that a widget company is undergoing financial distress because its manual labor simply no longer produces products that are cost/quality competitive with its automated competitors.

The company produces only one variety of widgets, and its market share is rapidly being eroded by its better competitors. Suppose that the only way for this company to maintain its share (and profit) would be to get a bank loan to purchase automated widget machines and replace its manual labor.

Waltermann's article suggested that such a widget company should not increase its capital base (e.g. don't get the loan) but instead find a way to become more profitable before further investment. Yet in this case, profitability and survivability of the company depends on further investment.

This may be a simple example, but if Waltermann has been in Indonesia long enough, he should know that many companies here face similar conditions as this example shows.

Waltermann's article seems to assume that most companies have portfolios of businesses that could be easily purged by management. This is certainly not the case in Indonesia and it is doubtful that this would be the case in the U.S.

There are many companies that produce single products through single business units. These companies do not have the freedom to "clean-up" their portfolios as suggested. Even with companies that do have portfolios, "cleaning-up" by selling assets in Indonesia today is probably one of the worse things to do given the depressed asset values and an illiquid market for assets. Of course, some companies may be forced to do so in order to pay back debt, but this is an entirely different issue.

Finally, the nature of company distress should never be generalized. Of course, as a rule of thumb, the pursuit of profitability before additional investment is always a good thing.

Nevertheless, most restructuring cases are far too complex to follow simple profit/investment trade-off. Problems within distressed companies could stem from a multitude of internal and external factors.

Internally, they could stem from weaknesses in human resources, organization, product development, strategy and marketing. Externally, they could be caused by changing technology, changing demand patterns and macroeconomic shocks.

Suppose a company has an excellent product, but is dying because it simply has no money for a major advertising campaign during a down cycle in the market. Should such a company refuse to increase its capital base and opt for profitability. How?

For most unsuccessful turnarounds, corporate distress follows a spectrum of symptoms that ends with financial disaster. The beginning of distress is normally characterized by a deterioration in product, customer and/or distribution channel profitability.

The next level of distress is a deterioration in productivity marked by increases in labor/material unit cost, increases in sales/marketing expenses and/or increases in finance/administration expenses.

As the company moves closer to financial disaster, its revenue generating capabilities would deteriorate as characterized by falling unit sales by customer, product line or distribution channel. This normally leads to decreasing capacity utilization.

Deterioration in balance sheet structure normally follows. Debt/equity ratios balloon and current ratios collapse. Without a turnaround at this level, a firm would eventually face the inability to pay secondary cash flow commitments such as purchase commitments and fringe benefits.

Finally, the death blow would arrive when the firm was no longer able to pay primary contractual cash flow commitments such as interest payments, taxes, accounts payable and salaries.

Each of the aforementioned symptoms need different solutions and require careful balancing of complex decisions along many important variables. At times, it may even become necessary to increase the capital base (e.g. get a new loan) simply to continue the payroll, especially when the cost of liquidation would be higher than the cost of a going concern, even with additional investment.

Granted, there are times when companies could face a C-curve decision, but this is only one among a myriad of decisions that a distressed company faces. Doing the C curve is certainly not the kind of panacea that Waltermann was trying to portray.

The writer is a businessman with previous experience in consulting and corporate restructuring.