Strategy in a "Structural Break" - Richard Rumelt

• Strategy is a cohesive response to a challenge. The most important element is a coherent viewpoint about the forces at work, not a plan.
• Leverage lies at the heart of most crisis. The current crisis is about kickback from leverage in two places: households and financial services. Leverage spreads the pain in ever-widening waves.
• US houshold debt started rising in the early 1980s and its growth accelerated in 2001. Leverage among the five largest broker-dealers rose dramatically after 2004, when the SEC exempted these firms from the long standing 12 to 1 leverage ratio limit. From 1990 to 2007 the whole financial services sector expanded 2.5 times faster than overall GDP, and its profits rose from their 1947-96 average of 0.75 percent of GDP to 2.5 percent in 2007. Then falling home prices led to an unanticipated rise in foreclosure rates and a drop in the value of mortgage backed securities. US consumer spending continued at a high level through the first half of 2008 but by the third quarter had dropped at a 3.1 percent annualized rate. Recession had arrived.
• Structural break : Moment in time-series data when trends and the patterns of associations among variables change.
• The first order of the day is to survive any downturns but the second is to benefit from new patterns.
• In several industry sectors, the most recent structural break occurred in the 1980s, with the development of microprocessors, which lead to cheaper computing, personal and desktop computers, and the rise of a new kind of s/w industry. These innovations begat the Internet and e-commerce.
• Many aspects of structural changes will depend upon the government's policy response. Today, nuclear power, infrastructure repair, and fiber to the home are on the list of possible stimuli.
• The wrong way forward in a structural break during hard times is to try more of the same.
• Another pattern that may generate diminished or negative returns is the complexity of our business and management systems.
• In structural breaks, cutting costs isnt enough. Things have to be done differently, and on two levels: reducing the complexity of corporate structures and transforming business models.

Lessons from the Crisis: Lowell Bryan & Richard Rumelt

Management Lessons:

• Smooth Sailing fallacy: The fallacy is the idea that you can predict disaster risk by looking at the bumps and wiggles in current results. Competent management always looks deeper than the numbers, deeper than the current numbers.
• This focus on meter readings rather than on a deeper understanding of the forces at work is what gets one into trouble. The Fed for eg, managed its policies around the Consumer Price Index (CPI). The CPI doesnt really measure inflation, it measures a bundle of prices. It doesnt measure wages, it doesnt measure asset prices. Of course if they took their eyes off the meter reading, they'd realize that they were creating a giant credit/asset bubble.

Policy response:

• We dont know whether the response is going to be effective or not. There's one of two outcomes for this: One is that the quick fix will work but not fix the fundamentals. In that case we wont have a foundation for good sound growth. The other result is, no matter what we do we'll have a deep recession, which will give us time to actually fix the problems. We will get leverage down to good levels.
• The real economy boils down to what work people do. We are now in a structural break and that mix of work being done has to change. The worst policy is to prop up people in jobs that are no longer necessary.

Corporate Strategy:

• What would be interesting coming out of this economic shock is that all the industry structures and rules and value chains and customer segments in industry after industry are in flux. And no one's yet figured out how to make money at it. That's the opportunity !
• Pinning these structural shifts down and seeing the second order effects - the second wave in each one of them - is the strategists job. The money is made in the second order effect. The money is made on the rebound from that inital proposition.

M&A strategy in a downturn

• Organic growth is hard to come by and profit margins are constantly under pressure.
• A carefully designed M&A transaction can accelerate growth by providing access to new markets, customer segments, technologies, human resources, and economies of scale.
• Indian M&A volumes have dropped from USD 42 bn in 2007 to USD 33bn in 2008 and just USD 3.7 bn in Q1 2009. Global volumes are down to USD 427 bn in Q1 2009 from USD 2498 bn in 2008 and USD 4058 bn in 2007.
• Reasons range from a shift in focus from growth to survival, higher risk aversion, poor or no availability of capital, reduced PE appetite etc.
• However, valuations are modest and an increasing no. of companies are looking to consolidate by divesting non-core/non-performing assets.
• Further, market uncertainty has resulted in a widening of the bid/ask spread, where bridging the gap between buyer and seller expectations has made deal closures difficult.
• With lower leveraging opportunities, promotoer contribution has become important. This will significantly reduce highly leveraged buyouts. Max debt levels are likely to be between 2.5-3 x EBITDA (post acquisition) vis a vis levels of 4-5 x EBITDA, structured through multiple levels of senior, subordinate, quasi, and unsecured debt instruments.
• Some solutions that can be considered include cashless transactions via the share swap and asset swap route, delayed payment schemes, "earn out" strategies, upside sharing, and minority sales.
• Also, SWFs who continue to be more optimistic can be considered a source.
• Global research has shown that downturn mergers generate about 15% more value (total shareholder return) as compared to bottomline transactions.

Strat Talk

"To be world class, Indian companies have to focus, they can't be in 25 businesses" - Michael Porter, 2004

"If you think, standardisation is wonderful in a manufacturing process, when you start to standardise mindsets then innovation and thinking dies" - Gary Hamel, 2006

"Before the crisis struck, your company's indicators of success were increasing earnings per share and growing revenues ... The most critical metric now is cash" - Ram Charan, 2009