The Paradox of Corporate Bankruptcy in a Robust Economy

<p>Since the 1990-91 recession, the economy has been humming along with high productivity, solid growth
and low unemployment. While the recession certainly took its toll on business worldwide, in the
post-recessionary era American business has experienced an unprecedented period of economic prosperity.
Surprisingly, during this period of economic nirvana, numerous firms have experienced dramatic setbacks,
financial distress and, ultimately, bankruptcy. These firms include Marvel Entertainment, G. Heileman
Brewing, Montgomery Ward Holdings, Levitz Furniture, House of Fabrics and scores of other major
enterprises.

</p><p>Unlike personal bankruptcies, which have nearly doubled in number since 1990, the number of corporate
bankruptcies has decreased since the recession years. Yet the decrease has been surprisingly small given
the persistent strength of the post-recession economy. Moreover, the number of large corporate bankruptcies
increased dramatically over the last several years. More public companies filed for bankruptcy in 1999
(145) than in any year since 1986. Furthermore, 20 companies with more than $1 billion in assets filed for
bankruptcy in 1999, which totaled four times as many billion-dollar filers as the previous year.<small>^{<a href="#2" name="2a">2</a>}</small>

</p><p>There are a number of reasons for the financial distress faced by corporate giants in this era of
unprecedented economic well being. The following paragraphs provide a non-exhaustive list of strategic
errors resulting in distress made by firms across a wide range of industries in corporate America.

</p><h3>Expansion Euphoria</h3>

<p>During periods of prosperity, both the bottom line and EBITDA (earnings before interest, depreciation
and amortization) generally grow. Retailers benefit from increased real wages, increased employment and
positive expectations. Manufacturers and service firms take advantage of growing overseas markets,
growing U.S. demand and rapid technological change. Many firms during this period of prosperity use
their positive cash flow to fund internal growth. Firms expand into new geographical markets, expand
product lines and develop infrastructure. These infrastructure changes can be observed in new production
technology, new retail locations, new warehouses, new distribution channels, etc. Prosperity, like adversity,
breeds change. Change, in turn, breeds risk. The risk associated with expansion plans is generally driven
by over-optimism. New stores are opened too rapidly. New territories are entered into without appropriate
market research and new products are developed without understanding the needs of the customer. Hubris
takes hold and analysis takes a back seat. Projections reflecting the existing business are met and exceeded.
Management, being the beneficiary of a robust economy, makes projections of new business activities and
believes that these too can be exceeded.

</p><p>Yet frequently, new projects are long on conceptualization and short on reality testing. Projects are
undertaken with little or no market analysis, and frequently little analysis of the impact on the existing
infrastructure (<i>e.g.,</i> warehouse space, server capacity, management oversight, etc.). Meanwhile, debt levels
increase and coverage ratios fall.

</p><h3>The M&amp;A Curse</h3>

<p>Many firms during the 1990s developed strategic plans involving the acquisition of other players in their
industry. These acquisitions were frequently based on projections far too optimistic to be realistic. Acquirers
assumed that troubled companies could be turned around immediately and that healthy companies would
surpass their present levels of operating capability. Typical of the unreasonable projections and blind faith
in the successful outcome of acquisitions is the situation represented in the following graph of EBITDA
to revenue of a target company.

</p><p>Exhibit 1 demonstrates that, with respect to the ratio of operating cash flow to revenue, the target
company has been performing poorly relative to its industry for the past three years. Moreover, its operating
cash-flow margin ratio has been deteriorating. In spite of this steady deterioration, the projections suggest
that the firm will be brought to industry levels immediately following the acquisition and will keep
improving. While in some situations it may be reasonable to assume a company is brought to industry
standards, in many turnaround situations it is unlikely. More importantly, the likelihood of an immediate
turnaround is typically quite small.

</p><p></p><center><img src="/AM/images/journal/exhib1vc1100.gif" alt="" align="middle" vspace="5" hspace="5"></center>

<p>One of the strategic roadblocks faced by corporations during periods of economic prosperity is the myth
of acquisition growth. Unfortunately, two plus two equals three as often as it equals five. This is due to
what is frequently referred to as the winner's curse. Consider an acquirer willing to purchase a public
company for $50 a share. Suppose it had been previously trading at $40 a share. Following the initial $50
bid, another bidder bids $55 a share. The bidding comes to an end with an uncontested bid of $60 a share.
With this bid, the premium offered for the target is 50 percent over the initial $40 trading price. At $60, no
other firm is willing to offer more, implying that of all possible acquirers, the actual acquirer is the most
optimistic in its evaluation of the target's future cash-flow prospects. Unfortunately for the acquirer, the
odds of the most optimistic assessment of cash flows being a realistic assessment is quite slim. In other
words, the likelihood of overpayment for the target firm is high. Such overpayment potentially results in
dissatisfied shareholders, as well as debt-holders often carrying an unsuitable level of debt. In such a
situation, the firm often finds itself in financial distress. Buyers, whether strategic or opportunistic, face the
risk of overpayment and the winner's curse on each of their acquisitions.

</p><h3>Economic Speculation</h3>

<p>It has been almost a decade since the United States's last recession. As a result, firms making
projections are frequently optimistic in their assessment of both revenues and costs. It is rare that we
encounter, in our practice, a recessionary projection, or even a projection based on an economic slowdown.
This pervasive optimism is particularly surprising given the fact that since the Civil War there has been no
period longer than a decade without a recession. We do not suggest that the past is a guarantor of future
results, but we do suggest caution in developing economic forecasts. A five-year projection often considers
a downside analysis and possibly incorporates either a recessionary forecast or a sensitivity analysis.

</p><h3>Use of OPBP (Other People's Brain Power)</h3>

<p>During the recent period of economic growth, America's consulting industry has reaped significant
rewards. Consulting firms are hired to analyze virtually all aspects of American business. While the hiring
firm typically benefits from the expertise of the consulting firm, the realized results do not always yield the
expected results. In a recent case, a Big Five accounting firm paid more than $180 million because they
staffed a consulting project with inexperienced personnel who were unable to accomplish the project's
objectives. The result: The liquidation of a billion-dollar company. While this project was a turnaround
assignment, it is more typical that a healthy company engages consultants for a variety of important
strategic decisions. These may range from an important technological transformation to the development
of a revised incentive system. Often, the problem stemming from hiring consultants reflects the differences
between the perspectives of principals and agents. The consulting firm is an agent coming in to fix a
problem and quickly departing. It is not there when it becomes evident that the solution is not working, or
that the organizational culture and the consulting fix do not work together. When hiring consultants, it is
important to integrate them into the culture and decision process of the company. Sometimes, the
organization acting as the principal is better off developing the strategy itself and not relegating its
development to a third party. When key decisions are left to others without the consulting firm being an
integral part of the strategic development, it is not uncommon for financial disaster to ensue.

</p><h3>Lack of Customer Focus</h3>

<p>In many bankruptcy cases in which we have been engaged, a key factor driving the financial meltdown
has been the inability to focus on the customers' needs. Consider the situation of a major distributor. Rather
than focus on its customers' needs, it fell into the frequent trap of focusing on price. While its customers
wanted easy access to product, it instead cut margins to attract and maintain customers. Unfortunately, the
operating margins became far too low to support the firm's debt, and the firm soon became insolvent.
Interestingly, this focus on price is particularly commonplace for many high-tech firms. Rather than
concentrate on key customer issues such as waiting time in help lines, technological obsolescence and system
integration, companies focus on price reduction and frequently find themselves driven to reduce prices by the
perception of competitive pressures. As most savvy marketers will readily admit, cutting prices is the last, not
first, resort. In particular, during periods of economic growth, it is easy to get strategically unglued and to shift
the focus from the customer to other seemingly important strategic issues. But without keeping the corporate
eye on the customer, it is easy to drop the ball. Once the ball is dropped, it may well be difficult to recover.

</p><p>For another example, in a recent matter involving a retailer with more than 1,000 stores, the firm
developed an aggressive acquisition strategy. The focus was on growth through acquisitions. As long as the
economy was well oiled, the company felt it could concentrate on external vs. internal growth and
development. As a result, inventory stockpiled and same-store sales stagnated. Since the firm's existing stores
were its core business, the firm was destined to encounter roadblocks. Financial distress and bankruptcy
ensued.

</p><h3>Conclusion</h3>

<p>Most corporations benefit during periods of economic prosperity. Yet there are scores of major
corporate enterprises that find themselves immersed in the web of financial distress. Since the period of
economic prosperity began nearly a decade ago, our firm has witnessed numerous reasons for organizations
filing chapter 7 and 11. While we do not provide an exhaustive list of factors driving firms into bankruptcy,
this article presents a number of commonplace reasons that we have frequently encountered. Unfortunately,
corporate America has learned that a robust economy does not prevent financial distress.

</p><hr>
<h3>Footnotes</h3>

<p>^{<small><a name="1">1</a></small>} The authors are professors at Boston University's School of Management and managing directors of The Michel/Shaked Group. <a href="#1a">Return to article</a>

</p><p>^{<small><a name="2">2</a></small>} <i>The 2000 Bankruptcy Yearbook &amp; Almanac,</i> edited by Christopher McHugh of New Generation Research Inc. <a href="#2a">Return to article</a>