A Mercer

Commentary

Bring on the Recession

It's the best time to strengthen your strategic position

Many senior managers, especially in North America, have little or no experience

steering their firms through a recession. So when the next recession arrives,

they’re likely to react instinctively and hunker down with fixed cuts across

the board. If you’re lucky, that’s what your competitors will do.

Smart managers, by contrast, use recessions as a time to trade up. They “cut 2

and invest 1,” cutting selectively and investing to build their next business

design. Economic downturns offer a unique opportunity to accelerate that

transition and dramatically improve your relative strategic position.

© Copyright 2001, Mercer Management Consulting, Inc. All rights reserved.

 A recession is always under way somewhere around the globe. If the next one should
arrive in your backyard, are you ready? Your financial house must be in order, of
course. But to be really prepared, you must know what your business design should
be after the downturn ends. If you know where you want to go and how to get there,
a recession is by far the best time to improve your relative strategic position.

The first challenge managers face in a recession is uncertainty. No one knows how long
the downturn will last, how deep it will be, or how quickly the strategic landscape will
shift in the interim. (Since the end of World War II, U.S. recessions have lasted from
6 to 16 months, with real output falling from 0.5% to 2% versus a normal 3% to 4.5%
increase per year.) When a recession strikes, managers must quickly address the tough
conditions it brings. They must also prepare for the rebound, which could arrive in
6 months.

But because most managers have little experience steering their firms through a
recession, they instinctively reach for the lever marked “10% across-the-board cut”
and hunker down. They order layoffs, hoard cash, delay product development, and
wait for tough times to end. They address the recession, but they don’t prepare for
the rebound. If you are lucky, that’s what your competitors will do.

Great business leaders, by contrast, use recessions to capture the strategic high ground.
In the 1990-91 downturn, for example, Michael Dell perfected his company’s telephone
ordering and demand-pull production system. At Intel, CEO Andy Grove accelerated
investments in cutting-edge plant and equipment and launched the “Intel Inside”
brand-building campaign. Both companies then powered out of the recession and
have since captured the bulk of the profits earned in their respective industries.

Exhibit 1 Recessions occur frequently in the global economy

1980 1985 1990 1995 2000

U.S.
U.K.
Germany
Switzerland
Japan
East Asia
Source: U.S. Federal Reserve; National Bureau of Economic Research. Annual data for U.K., Germany, Switzerland, Japan, and East Asia.

The key lesson: Start preparing now. Plan to accelerate your transition to your next
business design. Before you’re boxed in by deteriorating economic conditions, act on
several fronts.

Become indispensable to your best customers.

Before you pick up the hatchet, assess your customers. Identify the long-term
profitability of serving each market segment. Should a recession hit, your best
customers typically provide an even greater share of your profits, while your worst
customers typically become value destroyers. So cull your portfolio of customers
and cut out your weakest market segments. At the same time, redesign your value
propositions to better serve your most profitable customers. Focus especially on
opportunities to improve their economics. Then, make sure to deliver what you
promise. Every customer contact is a “moment of truth” that should affirm your
value proposition and build a consistent customer experience.
2
Exhibit 2 Not all customer segments are equally profitable

Profit In good times... ...or bad

Profit
0 0

Customer Customer

Singapore airlines targeted Market-Value/Sales

its most reliable customer 2.50 Singapore
segments and created the Airlines Ltd.
most consistently successful
airline in Asia. 2.00 Cathay Pacific
Airways Ltd.
1.50
Thai Airways
International
1.00
China Airlines
0.50 Japan Airlines
Co. Ltd.
0.00 Korean Air
'94 '95 '96 '97 '98 '99
Source: Compustat, Mercer analysis.

Singapore Airlines provides a classic example. A customer audit identified the

company’s most profitable customers, in good times and bad, as full-fare business
and first-class travelers on transcontinental routes. The company responded by
culling its customer base and focusing intently on serving these customers. It shifted
capacity from short-haul to long-haul routes and “up-scaled” its value proposition.
It invested $300 million in seat comfort, entertainment systems, meals, flight
attendant training, and other improvements to first- and business-class service.
Because of these moves, Singapore Airlines maintained its unbroken record of
profitability right through the East Asian recession that followed the 1997 currency
crisis. Its business has been far more successful than that of other Asian airlines,
as indicated by its much higher market-value-to-sales ratio.

If your customers are companies, treat them in much the same way. Identify your best
customers and kill them with kindness. Ease payment terms or lend staff to help solve
their most pressing problems. Adjust your offer. Perhaps a customer would like to
outsource a costly non-core function. Use a recession to expand your relationships,
tighten your control, and reinforce your status as the supplier of choice. Businesses,
however, often consolidate in a downturn. So do one thing right away: Identify the
potential winners in those mergers, and strengthen your position with those firms.

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 Be sure to assess your customers for long-term profitability. Your best customers
today might not be the best during or after a recession. Certain credit card companies
such as Capital One, for example, reap high profits from customers who carry a
substantial balance from month to month. Will a downturn push many of these
customers into default? Should a credit card provider offer help by easing payment
terms? Such companies must protect themselves against losses during a recession
and emerge with the best possible portfolio of customers.

A final reason to focus on your customers first: They are your key to long-term
success. To build a business design that will be viable after a recession, know your
customers’ priorities and where they are heading. DoCoMo, a subsidiary of NTT in
Japan, acquired a deep understanding of what customers wanted when it created and
nurtured its i-mode wireless Internet service. DoCoMo recognized a vast untapped
market in teenagers who wanted chat, e-mail, and simple information services.
It put together a value proposition that spoke to teenagers’ priorities––fashion
and inexpensive entertainment, not cutting-edge technology. Even though launched
in the midst of Japan’s prolonged economic slump, DoCoMo has been hugely
successful. It created $250 billion in market value in Japan and is using this value to
buy stakes in companies abroad.

Exhibit 3 Recessions are nothing like the Great Depression of the 1930s. The economy continues
Recessions do not shut to function, unemployment rises just a few percentage points above normal, and
the door to growth, bold, exciting ventures take off. Even in Japan’s stagnant economy, NTT DoCoMo
as NTT DoCoMo shows
could launch its popular i-mode wireless Internet service and create over $250 billion
in market value.

i-mode Subscribers
14

12

10
In millions

0
Feb-99 Jun-99 Oct-99 Feb-00 Jun-00 Sep-00

Market Value

$300 NTT

$250
In billions

$200

$150
SBC
$100

$50 AT&T

Qwest
$0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Source: Compustat, company press releases, Hambrecht & Quist.

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 Let “cut 2, invest 1” be your guiding principle.

Cut 2: Once you know the customers you intend to serve and the value propositions
you intend to offer, focus on costs. But avoid the traditional across-the-board cut.
If you trim the wrong 10%, you could destroy 100% of the firm’s value proposition.
If Singapore Airlines had cut expenditures on customer service instead of spending
more, it would have undermined its entire recession-ready business design. Eliminate
expenditures that support customers and value propositions you intend to abandon,
and ask whether the customers you intend to serve must pay for a particular item.

Recessions put a premium on efficiency. So use your cost engineering skills to

cut overhead and to tighten up on inventories and receivables. As most companies
already operate lean production systems, you will probably need to take more
significant steps to get your costs in line. Now could be the time to install a
digital production-control system. Beyond that, approach your suppliers.
Explore opportunities to restructure the supply chain to lower everyone’s costs.
And the best time to get your house in order is before the economy turns down.

In 1998, when times were good, a large European building materials supplier decided
to protect itself against potential economic threats by engineering a more flexible
cost structure. It resolved to reduce fixed costs by at least 10%, lower its fixed-cost-
to-revenue ratio, and outsource non-core functions. The company did not impose
an across-the-board cut. Instead, it took a measured approach, using internal and
external benchmarking and its understanding of the 15 European markets it serves.
In four months, it identified reductions equal to 14% of total fixed costs. The cuts
were differentiated by country and function and ranged from sales force and capacity
consolidations to outsourcing support services. The company realized these savings
by the end of 1999, making it well positioned to weather an economic downturn.

Exhibit 4
1. How sound are my finances?
Quickly size up your
Can I improve my:
situation by asking
- Fixed vs. variable cost mix?
four critical questions
- Level of working capital?
- Debt levels, credit status, and cash reserves?

2. What is my position in the industry. Am I #1 or #2?

3. How resilient are my relationships with customers and suppliers?

- How loyal are my customers and suppliers?
- How exposed are my customers and suppliers?
- Which customers or suppliers might consolidate?

4. How vulnerable are my competitors?

Controlling inventories and receivables is critical. Both are expensive to carry.

Inventories lose value. And receivables might never get paid. So sharpen up
your production and logistics management skills. You should be able to accelerate
the payables-inventory-receivables cycle, slash inventories and receivables, and
reduce your working capital needs.

Be sure to consider digital demand-pull production systems. This technology is now

well-proven, and even small-scale systems can have a rapid payback. Weyerhaueser
installed such a system in 1995 at its custom-door-building plant in Marshfield,
Wisconsin. Using a Choiceboard® system, configuring and ordering products went
from a cumbersome three-week process to a 15-minute session on the Web. The
integrated digital production system then cut manufacturing time in half, slashed
inventories, and delivered nearly all orders on time. In addition to cutting working
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A recession-ready business design
Now is the time to recalibrate your business design to
prepare for the next recession. Review the standard
playbook. Examine the latest digital options. Do what
you must now, and be prepared to act quickly should
the economy worsen.
It's actually easier to reconfigure your company in a
slowdown. You're not growing at breakneck speed.
You've got your employees' undivided attention, and they
understand that the company must adjust to the new
environment. Your competitors, in addition, may be
“hunkering down.”
If you make the right moves, you should rebound from a
downturn sooner, stronger, and with a markedly improved
strategic position.

Business Design Element From the Standard Playbook From the Digital Playbook

Customer Selection / Value Proposition Map out the critical battleground:
What high-value customer opportunity Which of your high-value customers––
am I targeting with what unique and and which of your competitors’––can
differentiated customer proposition? be cherry-picked in a recession?
How can you best compete for this
business? Think beyond your current
value proposition, and consider new
finance and service offers. Can you sell
these customers more, perhaps as part
of an expanded product bundle?
For many customers, the Internet is
now a critical part of a supplier’s
value proposition. They quickly access
information about a company and its
products. They can configure and place
an order, track its status, and process the
transaction electronically. They get
technical support and communicate with
other customers on a whole range of
issues. Identify the capabilities that your
high-profit customers value and provide
them before your competitors do.

Value Capture / Profit Model
What profit model will I harness to
capture value from this customer?
Recessions raise the importance
of earning a profit today, with little
or no capital outlays. So know
where such opportunities lie. In
telecommunications, prepaid calling
cards and wireless service provide
an example. While telecom is
enormously capital-intensive, prepaid
offerings are “lighter than air.” They
don’t absorb much capital, they carry
little or no credit risk, and they are
cash-positive almost immediately.
Demand for prepaid products also
rises in recessions, as customers
shun long-term commitments.
Customer priorities shift quickly in a
downturn. Customers buy less, and
they buy different products. Digital
information systems let you catch these
swings as they happen, not 30 days
later. So make sure you are getting the
real-time information you need. New
business intelligence systems, such as
online experimentation and margin
engineering, go one step further.
They use the information in your
digital systems to accelerate your
response to shifts in customer
priorities. It’s not too late to get
such systems in place.

Strategic Control “Hunker down” managers typically
How will I build sustainability into cut “discretionary” strategic-control
my business design? investments, such as brand-building
and new product development.
If you are lucky, this is what your
competitors will do. It creates
opportunities for you to buy critical
plant and equipment, to build brand
equity, or even to establish your
technology as the industry standard.
Digital initiatives are especially
attractive for establishing unique,
high-value relationships with
customers. Use a recession to get
closer to your customers and create
barriers to displacement. Build an
online customer community. Provide
information and applications on your
Web site that your customers value.
Help customers tie into your digital
ordering and transaction-processing
systems. Your goal is to create a
distinctive and compelling value
proposition that keeps your
customers loyal.

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Business Design Element From the Standard Playbook From the Digital Playbook

Scope of Operations / Value Chain
What scope of activities and assets
is required?
You will often want to reduce your
scope of operations if a recession hits.
Today’s marginal businesses and non-
critical cost centers typically become
huge value destroyers. So to prepare
for a recession, sell or outsource these
assets before the economy turns
down. You can then go into the
recession with a strong balance sheet,
well-positioned to advance your
strategic agenda.
There is nothing good about holding
inventories or receivables in a recession.
Dell has shown how a digital ordering
and demand-pull production system
can essentially eliminate inventories
and receivables. The story is old, but
it’s still hugely relevant. Take Oracle.
It installed such a system in 1998. By
2000, it had cut $1 billion out of its cost
structure and had raised its operating
margin from 16% to 36%. Oracle is a
great innovator. But the critical lesson
here is that Oracle did nothing new.
It emulated the smart moves developed
by the digital pioneers.

Organizational Systems
What organizational and technical
capabilities do I need to execute my
business design?
With talent, as with other aspects
of your business, the rule in recessions
is cut 2, invest 1. Cut staff that make
marginal contributions to your value
proposition. Be sure to trade up.
Great talent is always more available
in recessions. Then lay out your
strategic agenda. Your staff needs a
sense of direction in these uncertain
times and should be eager to follow
your lead.
The right digital moves can
dramatically improve your staff’s
ability to contribute––especially staff
that’s underemployed in a recession.
Take Hewlett-Packard, which
reversed its security-centric internal
information policy in the 1990-91
downturn. It gave employees access
to everything not explicitly restricted
and created company-wide networks
for sharing problems and solutions.
Many underemployed workers found
ways to add value, Hewlett-Packard
became a font of innovation, and by
1995 went from seventh to second in
global computer sales.

capital, the speed and reliability the new system provides have become critical components
in Weyerhaueser’s value proposition. Its doors now command a premium price, unit
volume has doubled, and return on assets has reached 27%.

If your company has sophisticated digital systems in place, you might find little fat to
cut in your production process. You must then take a broader view of your expense
structure. Approach key suppliers and ask what could be done to get your costs down.
Could they use your expertise in cost engineering? If you outsource a function, could
they do the work more efficiently? Cisco, for example, uses contract manufacturers to
build and ship directly to its customers fully 60% of all units produced. If a supplier
needs to get bigger to capture an economy of scale, could a loan or long-term contract
help finance a needed acquisition? The more you rely on outside suppliers, the more
you must look beyond your own organization to get your costs in line.

But remember, cost-cutting alone is no formula for victory. Mercer Management

Consulting analyzed the strategies and performance of 800 companies in numerous
industries during the period 1987-1992, which included the last recession, and identified
120 “cost-cutters.” Of those firms, only one in three achieved profitable revenue growth
during the five years that followed. To set the stage for growth, cuts must be selective
and based on an understanding of where value within the company resides, both now
and in the future. To capture that growth, you must invest as well as cut.

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Invest 1: Recessions make the impossible dramatically possible. If you know what
your company needs to succeed tomorrow, a recession is the best time to buy or build
those assets. It’s easier to move upstream or downstream, develop a killer product,
or acquire a critical customer-service capability. Talent unavailable today gets freed
up in a downturn, and your current employees also have an added incentive to
upgrade their skill sets.

Most valuable are moves that strengthen your competitive position, such as those
made by Intel and Dell in the 1990-91 downturn. These companies understood the
rewards as well as the risks. They knew where they were going, saw a clear path to
get there, and had the fortitude to move forward. Andy Grove, Intel’s CEO at the
time, summed it up: “For us to have the opportunities that we have today and not
bet on them, I don’t want to lose that way.”

Intel and Dell had a solid strategic position going into the last recession. But firms
in far weaker positions can also get stronger. Take Hongkong Telecom. In October
1997, the company faced an uncertain future. The deregulation of its core long-
distance telephone business meant that competition would soon drive prices to
unattractive levels. Then the Hang Seng Index crashed and the East Asian recession
arrived in Hong Kong. HKT already had targeted several adjacent and potentially
more profitable businesses to enter. Thanks to the downturn, it could go shopping
for assets when prices were right.

In January 1998, Hongkong Telecom acquired Pacific Link Telecommunications, a

competing wireless operator. It relaunched the business in May as a low-end offering
for the growing price-sensitive customer segment—and to complement the firm’s
existing high-end wireless service. HKT also acquired Star Internet, the number
two provider in the market, in 1998. Both acquisitions expanded the firm’s customer
base and strengthened its strategic control over profit streams in rapidly growing
businesses. Because it could make these moves in a recession, the company sharply
improved its prospects at bargain-basement prices.

Accelerate the digital transition.

The digital business revolution has paused for a moment. The dot-com bubble
has burst. Traditional firms are awash with scattered, sub-scale, and overlapping
e-business initiatives that have yet to add value. Many managers at these large
corporations have taken this as a sign to relax and cut back. If a recession hits,
the “hunker down” mentality would further slow their digital transition.

So no matter where you stand in the digital business revolution, the next few quarters
will provide unique opportunities. Talent and other resources should be relatively
abundant and your competitors inattentive.

If you’re just beginning the shift to digital business, now is the time to catch up.
Cisco, Dell, Cemex, and a handful of other digital pioneers achieved productivity
and profitability gains that have placed them far ahead of their competitors.
Their techniques have been well developed, so you don’t have to reinvent the wheel
to digitize. Just be sure to manage the process in a business-like fashion. Focus on
your most pressing business issues, not the technology. Be sure to measure progress
as you would with any investment—with a market-value yardstick.

This is precisely what many large corporations have not done. While dot-com
hysteria raged in the financial markets, these companies each spawned hundreds of
e-business initiatives. Most cost between $.5 million and $5 million—a small sum
8
 when compared to the average IPO. But most of these intrapreneurial ventures are
still alive and kicking and requesting more capital. In the aggregate, they probably
represent more wasted investment than the far more visible dot-com fiasco. It’s now
time to bring order out of this chaos. Assess what you need, define what you’ve got,
then draw up a plan. Cut 2, invest 1. And by the end of the slowdown, have sound
digital business designs in place.

If you already have a solid digital infrastructure, business intelligence systems are the
most promising new opportunity. They analyze the enormous flows of data, and move
your business from judgment-driven to information-driven decisions. These systems
are especially attractive in recessions. They can generate significant returns from
small incremental investments. They also are especially good at responding to
shifting customer priorities—and customer priorities shift quickly in a downturn.

A regional supermarket chain added margin engineering—one such business

intelligence system—to its existing digital infrastructure. It took a few years and
several million dollars to build. But the company can now predict the impact of price
changes and promotions on storewide profitability. To maximize profits, it raised
some prices and lowered others. Sometimes it captured profits not primarily on the
item in question, but on items purchased in tandem. The payback has been dramatic.
By the third year of operation, the investment yielded over $100 million in additional
gross margin. The company also added a system to predict the profit impact of floor-
space allocations and changes in the variety of brands or package sizes, which further
contributes to storewide profitability.

Crayola used another business intelligence system, scientific online experimentation,

to significantly improve the performance of its Web site. Customer response to Web-
marketing initiatives is notoriously poor. The judgment that marketing professionals
have developed in other media—on matters such as when to quote a price or offer a
discount—is of little use. So Crayola used online experimentation to guide its

Exhibit 5 Business intelligence systems: The next step in digital business design

Business intelligence systems analyze customer responses quickly and inexpensively. In an economic downturn, they help
you adjust to your customers’ rapidly shifting priorities. Online experimentation, one such system, can dramatically raise
e-customer response rates. In the offer below, note that the most effective treatments are far from intuitive.

Base Price Parent

Mention Promotion Company Association
0.208%
Change in
click-through 0.144%
0.110%
rate 0.081%
base = 0.218%
0.029%

Base price Base price No Current No set 60-day Strong No

mentioned not promotion promotion up fee, first trial association association
mentioned month free

4X higher click-through rate

from improved e-mail script

9
marketing decisions. It tested and optimized e-mail solicitations, banner ads, and
Web site value propositions. The best treatments were nearly four times as effective
in converting shoppers into buyers, nearly doubled revenues per buyer, and added
significant profit.

Secure financing.

Funds are still plentiful. But once a recession starts, the spigot might be suddenly
shut off, as was the case during the last recession’s “credit crunch.” So line up your
financing now, and minimize working capital by allocating it only to the most
important projects.

Hutchison Whampoa, a conglomerate based in Hong Kong, issued $2 billion in

bonds during July 1997, three months before the stock market crash. Demand for
the offer was far higher than the target amount, and the average cost of the loan is
substantially lower than most other deals of comparable size and duration today.
Because of the subsequent financial crisis and credit crunch, Hutchison was among
the few companies in the region with enough cash to take advantage of cheaper
land and assets. It invested the capital in wireless services and equipment, hotels,
and ports in several countries.

Get the story out.

Executing these strategies isn’t enough. You must also make sure that the people
who matter understand what you’re doing and why. Market your message internally:
Tell your employees your firm’s recession-ready strategy—a strategy based on the
realities of the marketplace. If you are shifting your business design, show how you
will realign incentive structures and reporting systems. This helps maintain loyalty
and morale, and increases the acceptance of cuts and new strategic initiatives.

And get your story out to lenders and investors. If they are informed, they will have
a better basis for making decisions that can support you and your business.

Great managers embrace recessions because of the opportunities they present.

They appreciate the competitive risk of not investing when the moment is right.
Timing, therefore, is important. So make the right moves during this pre-recession
period. You will then be prepared not just to weather a recession, but to emerge in a
far stronger strategic position. L

This commentary was prepared by Robert G. Atkins and Adrian J. Slywotzky,

senior partners of Mercer Management Consulting. Slywotzky is co-author of
How Digital Is Your Business? (Crown Business, 2000).

Robert G. Atkins, Boston, 781-674-3559, bob.atkins@mercermc.com

Adrian J. Slywotzky, Boston, 781-674-3850, adrian.slywotzky@mercermc.com

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About Mercer As one of the world’s premier corporate strategy firms, Mercer Management
Management Consulting Consulting helps leading enterprises achieve sustained shareholder value growth
through the development and implementation of innovative business designs.
Mercer’s proprietary business design techniques, combined with its specialized
industry knowledge and global reach, enable companies to anticipate changes in
customer priorities and the competitive environment, and then design their
businesses to seize opportunities created by those changes. The firm serves
clients from 23 offices in the Americas, Europe, and Asia.

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