Wednesday, 13 July 2022

The current inflationary cycle is impacting industries very differently.

Australian retailers have continued to perform strongly, announcing 10.4% year-on-year growth to May 2022. Meanwhile, the construction industry was hit hard and early, with low-margin fixed-price contracts quickly underwater in the face of delays and 20-30% increases in input costs – all before wage inflation and interest rate hikes have been fully realised. 

CFOs are under pressure to make decisions in highly ambiguous and rapidly changing conditions, while balancing the need for growth and margins. A key part of the CFO role in this environment is ensuring their organisation is clear on its margin drivers and highlighting various financial outcomes under different inflation, interest rate and wage increase scenarios.   

In our experience working closely with executive teams, we have identified critical focus areas for CFOs in times of rapid change and an unclear outlook. 

CFO’s key focus areas: 

  • Insightful scenario modelling. The unpredictability of the current environment means it is more important than ever that CFOs model how different scenarios could impact business performance. It is also essential that the whole executive team fully understands their business model and the margin drivers that underpin growth, conservative and adverse scenarios. This is not just an exercise for the finance team. 
  • Avoiding blanket cost cutting. These efforts are too blunt and often temporary as costs quickly creep back in if activity is not actually stopped. Sustainable and strategic cost reductions will come from transitioning resources and focus away from legacy businesses and redirecting them to future growth. 
  • Organic growth and margin improvement. Capital markets have changed dramatically in the last quarter, with a significantly reduced appetite to fund mergers and acquisitions (M&A) activity. In response, budgets and forecasts should prioritise organic growth and margin improvement. 
  • Rapid and opportunistic M&A. An accelerated shift from debt-fuelled M&A to opportunistic, financially distressed transactions is predicted over the next year. This requires a change in mindset and immediate preparation to get comfortable with making rapid decisions on imperfect diligence.  

Insightful scenario modelling 

No matter how experienced, no one knows how the current market cycle will play out. 20 years ago when we last faced similar inflationary pressures, market and geopolitical factors were very different. It is essential for CFOs and executive teams to understand how their business model performs under various scenarios.  

Scenario modelling needs to include the cashflow impacts of interest rate increases, wage inflation and increased input costs. The insights from this exercise will help facilitate a more rapid response to market changes when they occur. For example, interest rates moving from 2% to 4% may not seem significant but modelling the impact of borrowing costs doubling may tell a different story. 

Given the unpredictability of the current environment, strategic investment and growth decisions should be made utilising conservative scenarios. Now is the time effective CFOs focus and preserve cash and liquid assets to cover unforeseen challenges, delays or even growth unique opportunities.  

Avoiding blanket cost cutting  

The last time the market presented similar inflationary pressures, many organisations were ineffective at managing financial data, cost control and margins. For this reason, the simple answer for CFOs was to undertake a blanket cost out exercise (e.g. 10-20% across the entire organisation) to galvanise focus and address margin erosion. Blanket cost out measures are far too blunt for the complexity we now face. In a low growth market with challenging workforce issues and talent shortages, these generic approaches will likely lead to disengagement and erosion of growth opportunities, allowing competitors easy entry. 

Today’s businesses have far greater access to data, enabling a better understanding of their performance, cost attribution and margins. Efficiency and margin improvement in this environment will come from. decisions on transitioning resources and focus away from legacy businesses and redirecting them to future growth areas. These decisions require sound business insights driven by effective use of data and financial information.   

A recent client in the entertainment sector achieved this by winding back legacy operations that were losing money and deemed non-core for future growth. Challenging the viability and winding back these legacy operations contributed to $40 million of in-year savings and enabled critical investment in future growth opportunities.  

Organic growth and margin improvement 

Since 2020, much corporate growth has come from M&A. The aggregate value of deals over $50 million increased from $32.8 billion in 2020 to $130.5 billion in 2021. With the price of debt increasing rapidly and capital markets drying up, this trend looks unsustainable.  

CFOs and executives may increasingly need to focus inwards to promote organic growth and drive profit through innovation and ‘sweating their assets’ more effectively. This includes consolidating acquisitions made over the last few years to ensure that the benefits articulated in the investment thesis genuinely come to fruition.  

A recent client in the education sector achieved this through removing barriers and simplifying their student intake process, resulting in projected growth of 17% in the student base. Universities traditionally have a highly complex sales funnel working in siloed functions, so a cross-functional project team focusing on student attraction was formed to improve all aspects of the student journey. These initiatives resulted in record numbers of search results, applications, and ultimately enrolments, enabling the organisation to position for organic growth in future periods.  

Rapid and opportunistic M&A 

While M&A activity has been riding high, corporate insolvencies over the last two years have occurred at around 50% of pre-pandemic levels.  In the last two years, financially distressed transactions have been relatively non-existent. 

The key difference between M&A and financially distressed transactions is timeframe. In a financially distressed transaction, interested parties have days and weeks to bid and close transactions rather than months to undertake thorough due diligence. The successful bidders are those that can move the fastest to transact and take on risk.  

Proactively preparing for opportunities now will save time and increase the likelihood of success in future acquisitions. This growth will be opportunistic but can have incredible value considering buyers won’t have to pay the multiples the market has seen recently. 

A recent client in the waste management sector acquired a competitor out of receivership.  The process was highly complex and required the acquiring company to act quickly on imperfect information to put themselves in the best position to acquire the competitor. They succeeded in this through having prior knowledge of the situation and, at the right time, taking advantage of the emerging opportunity through this insight and speed of decision making. 

How to succeed 

In an economic landscape with constantly shifting goal posts, CFOs have a key role in enabling leadership to make financially informed decisions. To thrive in this environment, they must ruthlessly prioritise and not lose sight of the future. Redirecting energy from legacy or non-core activities, prioritising organic growth and being prepared to strike at strategic acquisition opportunities will allow organisations and their CFOs to adapt, thrive and win.