Authored by Ken Mann, Managing Director of SC&H Capital
Originally featured by ABL Advisors on September 23, 2021
Economic Recovery is Strong, but Not Universal
Despite a disruptive, global pandemic that spurred a 34% drop in the S&P to 2,237, an unemployment rate of nearly 15%, and a drastically low labor force participation rate of 60%—consumers still managed to reduce credit card debt and set the stage for robust economic growth.
According to Experian, from Q3 2019 to Q3 2021, credit card balances fell 24%, the first drop in credit card debt in 8 years. Consumers are flush with cash and have the highest savings rate since WWII. Interest rates are at historic lows, and money is easy. The U.S. government injected a massive amount of cash into our economy, and most businesses found Payroll Protection Program (PPP) “loans” to be a generous equity infusion from Uncle Sam. As a result, and in spite of Covid-19 and the surging Delta variant, our consumer-driven economy is humming along with robust GDP growth and commercial borrowers boasting strong balance sheets and healthy backlogs.
After a severe bout of Covid-19 in the spring of 2020, public equity markets have since shown incredible immunity. By September 2021, the S&P had hit more than 52 highs and, even as I write this, it sits at 4,537 — yet another all-time high. Equity prices have remained on a steady upward climb, doubling off the low (March of 2020) faster than after any other correction, even in the face of persistent pandemic-driven uncertainty. During this boom, the S&P 500 has not seen a single drop of 5% or more since November 2020.
Even so, our firm has seen a significant uptick in conversations with distressed companies, and some people, me included, see reasons to think that many businesses will soon face economic turbulence. You might ask, how can this be? What could possibly go wrong that would lead to defaults for some of the businesses with whom you work?
There are latent “boogiemen” creeping about, just waiting to prey on unexpecting businesses. Their names are:
- Reduced liquidity (consumer and corporate)
- Excess corporate debt
- Shortages (labor and materials)
Cue an Emerging Economic Reality Check
Stimulus check savings are gradually being spent down, consumers are falling back into old patterns, and debt is on the rise. In the G.19 report on August 4, the Fed revealed that the highest jump in household debt in 14 years occurred in the second quarter. Consumers are showing a willingness to use credit cards for luxury items, like vacations, dining out, and major home renovations. A Creditcards.com survey found 44% of people were willing to take on debt in the second half of 2021 for non-essential purchases. This all bodes well for the short term; there will be spending… and a lot of it. It goes without saying, we all know what follows periods of rampant spending.
Businesses Be Warned: You Aren’t in the Clear, Yet
Low interest rates and relatively easy money have led to a lot of borrowing over an extended period of time. Now, massive amounts of debt are held by non-financials at incredibly low interest rates. Simultaneously, we are experiencing inflation, some of which is certainly transitory (as the Feds say), and some of which is likely not. According to Forbes, for the last three months, consumer inflation as measured by the CPI has crept up from 5% in May to 5.4% in June and July compared to the previous year.
Economic cycles being what they are, high levels of debt paired with inflation lead to rising interest rates and, you guessed it, an eventual recession. Concurrent with this eventual pressure on interest rates for businesses, consumers will start to feel some other pressures. Stimulus checks will have been spent, rents will be due as the eviction moratorium fades, and credit card debt will creep back up, reducing purchasing power.
Rising rates will cripple those businesses with too much debt and, unfortunately, it may occur the very moment there is less demand for their product. PPP funds have breathed life into businesses, but that life support will vanish by the end of this year. Sure, many businesses will be left with a cash cushion, but it’s finite.
In the meantime, even with healthy backlogs and eager customers, many companies are struggling to capitalize on this surge in demand. They can’t hire enough labor and/or they lack product and face long lead times. This is a shared challenge among nearly every business manager. As reported by the Federal Reserve Economic Data St. Louis Fed, with information sourced by the Organization for Economic Co-operation and Development, by May of 2021 there were approximately 9.2 million unfilled job vacancies in the U.S., up from just over 7 million in February of 2020. With shortages of everything from coffee to cars, computer chips, plywood, shipping containers, and even food ingredients, much of the pent-up demand we are all relying on will go unfulfilled.
These supply chain issues create substantial cashflow challenges for many businesses. For example, a small manufacturer that used to buy raw materials “just in time” with 30-day terms, is now having to buy large quantities of materials, often COD (cash on delivery) or even cash in advance, for orders or work still months out from being completed and billed. By the time this hypothetical business gets, converts, and sells products and collects the related accounts receivable, it may have a cash cycle of five or more months versus the one or two months it is accustomed to. Velocity and cashflow are critical to the health of most businesses.
Additionally, many smaller debt-laden manufacturers do not have the resources to retrofit facilities to operate in a Covid-safe manner, which ultimately deters some workers from coming back. Nor do they have the resources to automate to fill the gaps left by workers unwilling to physically return to work due to associated risks, or worse, that have moved on in the Great Resignation.
The Path Towards Opportunity (and Survival)
For those businesses stuck in this negative paradigm, there is an urgent need to consider one of three strategic plans:
- Acquire debt financing that is flexible enough to get the business through this transitory period.
- Raise or infuse equity to help with the balance sheet and liquidity. The market remains crowded with private equity looking to allocate resources.
- Sell the business to a financially stronger suitor before it hits the cash flow wall or loses customers because it is unable to keep up with orders. Currently, sellers are enjoying historically high valuations.
The good news for these stretched thin companies is that there are knowledgeable, experienced professionals in a position to step in and help. Many asset-based lenders are getting creative and stepping up with increasingly creative and flexible offerings—presumably motivated by their own economic interests and a desire to best serve their borrowers.
Of course, with raging demand and low interest rates, most businesses are well-positioned to thrive for the foreseeable future. They do have the liquidity to deal with these potential challenges and opportunity abounds. These stronger organizations will:
- Invest to further automate, attract quality human capital, keep workers safe, and use technology to make sure the business operates smoothly even when some workers will need to stay home
- Develop multiple sources for product, build safety stock, and move from “just in time” to “just in case” inventory management
- Grab market share by promoting shorter lead times and more stable pricing options, while enjoying the healthy margins they can demand
Proceed With Caution
When we combine past observations with current conversations with management teams expressing frustration and struggles around inflation and shortages, wariness is crucial.
Businesses must be careful about overreacting and stocking up on product(s) at high prices or going too deep into futures contracts. It can be difficult to compete profitably if prices fall and competitors are later buying materials at a substantial discount off what the aggressive hoarder paid. We are seeing construction companies stockpiling certain materials at soaring prices, and agricultural businesses and big fuel consumers stretched in hedging positions facing margin calls or potentially pricing themselves out of competition six to 12 months out.
For those business owners that are considering an exit in the near to medium turn, this is a time to think about when, not if, we are likely to see higher interest—and hence, lower multiples for sellers—and when, not if, the next downturn is likely to come.
The pressing question for these leaders is: How can we best position to sell before that recession?
Lenders and consultants will be well-served to evaluate each company with an eye towards how the management team is responding and preparing for the likely threats ahead, and if their financial statements indicate the wherewithal to thrive through them.
If you have any questions about how to create a path forward and overcome potential challenges, reach out to our Special Situations team.