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Thorn in your side

December 2007 - Insolvency & Restructuring. Legal Developments by KPMG LLP.

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Underperforming business units depress enterprise values and consume cash that could be better used elsewhere, but it is easy to waste resources on ineffective fixes. Roger Bayly, a Partner in KPMG’s UK Restructuring practice discusses how to spot these problem areas and how to decide what to do.

Every company has a thorn in its side - an aspect of the business that depresses profits and weighs on value. The problem might be a division that stubbornly continues to under perform, a product line that has failed to live up to expectations or a floundering overseas operation. Equally, it could be a factory where the performance metrics are way out of line with those expected by the whole business, or even a large contract where the revenues generated are outweighed by the costs. Whatever the scenario, it is vital to take action. Underperforming units consume cash that could be better used elsewhere in the business or returned to shareholders. In fact, they destroy value. It is not necessarily hard to spot these problem areas. Meagre operating margins or disappointing cash generation as a percentage of EBITDA are typical signs. When directors meet, it is often these issues that crop up again and again as the management team strives to find a solution.

Internal and external factors

In the longer term, that tendency to focus on poorly performing units can, in itself, undermine shareholder value as not only cash, but also a considerable amount of management energy is channelled towards the problem. Attempts by management to turn round a particular aspect of a business very often end in failure. There are manifold reasons for this – some internal, some external. For instance, management teams that are successful at growing a business do not always have the appropriate skill set or mindset to grow profit through restructuring the cost base. On the other hand, the problem area could be coping with external issues, such as seismic changes in the market. In a sector where traditional television sales are falling as consumers flock to buy sets with plasma and LCD screens, manufacturers of cathode ray tubes have had to move quickly to adapt to the changing economic conditions in order to avoid a dangerous shrinkage of market share. In these situations, certain companies prove more agile than others, and there are always casualties that cannot successfully manage the transition.

Holding or folding

 Regardless of the cause of the problem, the question facing the parent company is when to hold, when to twist and when to fold. It is possible to burn huge amounts of cash attempting to turn around divisions that are either beyond saving or in a situation where the returns are unlikely to justify the investment. We often find that management look at the possible options of how to fix the business, rather than thinking laterally. They often neglect the value of time in assessing options that can have a significant cash cost to stakeholders. The difficult truth is that, in some cases, the least value-destructive way to deal with an underperforming division is sale, closure or significant surgery rather than investment in the current model. This can be a hard decision for business owners to take. We are frequently called in after a company has tried and failed to solve a problem, often by attempting to sell the business. What we are able to do is provide companies with objective advice on the value and risk of their options along with the skills required to execute the changes needed. Expert third-party advice can inject objectivity into the process of dealing with problem areas of a business, helping those involved assess the available options, from investing in recovery through to selling or shutting down. This will include discussions on whether it is worth spending money and time on a recovery plan, and if it is, agreeing a timescale for payback. Third-party advisors will also take an impartial view on what to do if recovery isn’t an option. However, there is more involved than simply running a ruler over the balance sheet. The objective is to exit the value-destructive parts of the business without harming those elements that are value-creative.

Considering the consequences

This all sounds like a simple enough equation – you sell those parts of the business that aren’t performing well and retain the rest. However, in the real world, this type of judgement call can require a considerable amount of thought. Many people don’t consider the consequences of closing a business. You have to take the time to think about the reactions of and other stakeholders, including customers or suppliers, and arguably most importantly, the reputational damage that closure might cause. You should also prepare for failure. For instance, selling a business requires finding a buyer and, in certain markets, this may not be possible. You must always have a fall-back plan.

Pressure from shareholders

One group of stakeholders that will be watching the process very closely will be the shareholders. It is the responsibility of the management to identify problem areas. But shareholder groups ought to be putting pressure on companies to resolve those issues. Over the past few years, there has been a significant rise in investor activism, a trend characterised by shareholders, whether public or private, taking a more focused interest in the companies in which they have invested. When problems are identified, many investors will now apply pressure to bring about change, while others will simply take their cash elsewhere.

Again, this illustrates the absolute importance of comprehensively dealing with and removing any corporate thorns in the side. Fail to deal with any glitches like this and you could not only undermine company performance, you also run the risk of losing investor support. Now is the time to act.

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