Understanding Distress in a Growth Company

Speaker: David Johnson September 24, 2013

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Agenda

• Overview • Speaker Biography • Limits on Growth • Warning Signs • Illustrative Scenario • Key Takeaways • Appendix

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Overview

• Many people incorrectly associate distress and turnaround situations with slow-growth or declining businesses. While companies fitting that profile do often find themselves in distress, high-growth companies do as well.

• Growth is not a cure-all for companies, and in fact it can often prove to be incredibly damaging to a company’s viability if not pursued via a well-considered strategy that takes into account the inherent limitations to growth that all companies face.

• In this presentation we will review the limits to growth that companies face, warning signs of a flawed growth strategy, an illustrative scenario of a company that achieved impressive revenue growth at high cost, and lessons learned.

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David Johnson • David Johnson is a founding partner of ACM Partners. His

advisory experience spans North America and ranges from pre-revenue startups to Fortune 500 companies.

• An active member of the Chicago business community, David currently serves on the board of directors of Gateway Foundation, a nonprofit organization focused on providing substance abuse treatment. Additionally, he is an active member in several professional associations.

• David’s writing has appeared in several industry publications, and he has lectured at the University of Chicago, Northwestern University, the University of Wisconsin-Madison, the University of Illinois-Chicago and Loyola University Chicago.

• David earned his MBA from the University of Chicago. His undergraduate studies were completed at Fairleigh Dickinson University.

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Understanding Limits to Growth

• Management teams often do not appreciate the fact that there are inherent limits to growth that every organization faces. A successful growth strategy will recognize these limitations and focus on maximizing profitable growth that will not endanger the viability of the enterprise.

• Sustainable Growth Rate: This is a measure of the maximum growth rate a company can achieve absent external funding:

– [Return on Equity] * (1 – [Dividend Payout Ratio] – For Example, a company with a Return on Equity of 14.0% and a dividend payout ratio

of 50.0% has a maximum sustainable growth rate of 7.0% (.14 * (1-.50)) = 0.07

• Companies that obtain external funding can often grow beyond their sustainable growth rate, but the terms on which capital providers offer additional capital will often act as a check against a reckless pursuit of growth.

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Warning Signs

1) Declining Profitability. An inability to maintain pricing with customers or hold down the growth of operating expenses can often result in companies being less profitable at higher levels of revenue.

2) Worsening Payment Terms. Savvy customers often will recognize a company’s desire to grow rapidly and use that focus to negotiate payment terms strongly in their favor.

3) Rising Inventory Levels. In an effort to avoid the possibility of missed revenue opportunities, many growth companies will permit their inventory levels to rise, ignoring the cash flow implications of this tactic.

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Warning Signs (Cont.)

4) Deteriorating Supplier Relationships. As liquidity worsens, companies will often seek to “stretch” their suppliers. Absent a sound communication strategy and a plan to return to normal terms, this is only a short-term fix.

5) Tensions with Capital Providers. Both equity investors and lenders are generally happy to support growth companies, up to a point. Increasing losses and a failure to manage liquidity pressures often result in capital providers insisting on a change in strategy.

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Growth to Distress Cycle

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Management Commits to a

Growth Strategy

Focus on Growth Leads to Margin

Compression

Customers Negotiate

Better Terms, Weakening Cash Flow

Sales Expenses Balloon

Investors / Lenders

Demand an End to Cash

Burn

ILLUSTRATIVE SCENARIO

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Hypothetical Scenario

In the following pages we will discuss a hypothetical growth company and examine the measures by which its strategy might be deemed successful or problematic.

• Company XYZ was a good but unexciting business. A family-owned food processor, the company produced private label snacks that were sold in supermarkets throughout the Midwest.

• Until the recently, the 50 year old company was content to service a small number of customers, and look to maximize profitability while minimizing debt. As a family-owned company, Company XYZ was under no external pressure to grow, and its strategy created a low pressure, collegial environment that both the founding family and employees highly valued.

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Hypothetical Scenario (Cont.)

• With the retirement of the second generation of family leadership, change finally came to Company XYZ. Siblings Thomas and Melissa, the grandchildren of the company founder, were appointed CEO and CMO, respectively.

• Thomas and Melissa, in contrast to their parents, had spent considerable time working outside Company XYZ. Thomas had been a consultant and investment banker, and Melissa had served in brand management roles at a multinational consumer products company.

• With full control of the company their grandparents had established, Thomas and Melissa set to work to aggressively grow the business, with a goal of doubling sales in five years.

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Hypothetical Scenario (Cont.)

• The changes necessary to achieve this rate of growth were disruptive, and as a result many of Company XYZ’s long-time employees sadly left the company.

• However, the new executives persevered, and managed to achieve their goal of doubling sales in their first five years of control.

• Shortly after company party celebrating the rapid growth of the past five years Thomas received a call from Company XYZ’s senior lender. Bill, the long-standing relationship manager at the Trusted Imperial Bank charged with the Company XYZ account, advised Thomas that Company XYZ was in default of several loan covenants, and that a meeting between representatives of the bank and the company’s management must be scheduled immediately to discuss options.

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Hypothetical Scenario (Cont.)

• In preparation for this critical meeting, Thomas and Melissa sought the advise of turnaround and performance improvement consultant to review the financial performance of Company XYZ and advise over the course of negotiations with the Trusted Imperial Bank.

• After turning over their data to the consultant, Thomas and Melissa, still dazed from the harsh tone of the bank, asked themselves how they could have gotten to this point. They had doubled the size of the company! Surely Company XYZ was a stronger company as a result…

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Management of Company XYZ was successful in doubling sales over a 5-year period, an impressive rate of growth for a formerly staid family-owned company.

Robust Sales Growth

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-

5,000,000

10,000,000

15,000,000

20,000,000

25,000,000

30,000,000

35,000,000

40,000,000

45,000,000

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Sale

s ($

)

Company XYZ(Sales)

A lack of pricing discipline and inability to restrain the growth in fixed expenses resulted in declining profitability during the growth years.

Declining Profitability Measures

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-8.0%

-4.0%

0.0%

4.0%

8.0%

12.0%

34.0%

36.0%

38.0%

40.0%

42.0%

44.0%

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

EBIT

DA

Mar

gin

%

Gro

ss M

argi

n %

Company XYZ(Profitability)

Failure to carefully manage working capital led to a worrying increase in the amount of cash tied up in operations, and a disturbing increase in the company’s cash conversion cycle.

Negative Working Capital Trends

16

80.0

100.0

120.0

140.0

160.0

-

4,000,000

8,000,000

12,000,000

16,000,000

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cas

h C

onve

rsio

n C

ycle

Net

Wor

king

Cap

ital

Company XYZ(Net Working Capital)

The combination of declining profitability and increasing working capital resulted in plummeting cash flow, with a 5-year cumulative cash burn of over $12 million.

Unsustainable Cash Burn

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(14,000,000)

(12,000,000)

(10,000,000)

(8,000,000)

(6,000,000)

(4,000,000)

(2,000,000)

-

2,000,000

(6,000,000)

(5,000,000)

(4,000,000)

(3,000,000)

(2,000,000)

(1,000,000)

-

1,000,000Year 1 Year 2 Year 3 Year 4 Year 5

Cum

ulat

ive

Cas

h Fl

ow

Appr

oxim

ate

Cas

h Fl

ow

Company XYZ(Cash Flow)

A Flawed Strategy

• Company XYZ succeeded in doubling sales in a five year span but in doing so put itself in a precarious financial position.

• Due to a lack of pricing discipline, Gross Margin declined by 5.5 percentage points during the growth years, from 42.5% to 37.0%.

• Lack of management focus on the cost structure allowed Selling Expense to grow from 12.0% of sales to 15.0% and General and Administrative Expense to increase from $4 million the year prior to the launch of the growth plan to $11.5 million in the final year of the growth plan.

• The end result of five years of impressive growth was a company weakened in nearly every aspect of its finances (profitability, break-even point, cash flow, payment terms, etc.).

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KEY TAKEAWAYS

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Key Takeaways

Understanding Limits

• Companies can severely harm their long term prospects by pursuing imprudent growth strategies.

• Management teams and key stakeholders must understand not only the income statement impacts of a growth strategy, but the crucial balance sheet and cash flow implications.

Trade-offs to Growth

• Small and midsize companies especially struggle to focus on multiple issues simultaneously. Management teams should understand the challenges that growth companies routinely face as they look to develop sustainable growth strategies.

• Companies that seek to grow at a rate faster then their finances will allow eventually face considerable pushback from worried lenders, suppliers and eventually even customers.

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About ACM Partners

• ACM Partners is a boutique financial advisory firm providing due diligence, performance improvement, restructuring and turnaround services.

• David Johnson can be contacted at: – Email: david@acm-partners.com – Ph: 312-505-7238

• For more information visit: www.acm-partners.com.

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APPENDIX

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In spite of rapid growth, a failure to invest in the systems necessary to support expansion initiatives resulted in declining profitability and an even more pronounced decline in liquidity. The company was eventually recapitalized by a distressed investment firm after filing for chapter 11 bankruptcy.

Case Study # 1

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0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

160.0

180.0

Year 1 Year 2 Year 3

EBIT

DA

Mar

gin

%

Com

mon

Siz

e Sa

les

(Yea

r 1 =

100

)

Restaurant Company

Advertising-driven growth was accompanied by a collapse in profitability as operating expenses ballooned and sales discipline deteriorated. Despite a near 30-year operating history and proven ability to grow in a difficult market, management was forced to file for a chapter 7 bankruptcy (liquidation).

Case Study # 2

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-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

0.0

50.0

100.0

150.0

200.0

250.0

300.0

Year 1 Year 2 Year 3

EBIT

DA

Mar

gin

%

Com

mon

Siz

e Sa

les

(Yea

r 1 =

100

)

Home Remodeling Company