The Day After

The financial crisis has led to seismic shifts in the ways companies do business. But with the recovery come new opportunities for those smart enough—and bold enough—to seize them. more

It may be premature to call the greatest economic downturn since the Great Depression “over.” As summer turned to fall, however, there was a collective exhalation as many realized the worst of the recession was now behind us. But as we emerge now from our financial bunkers, it is to a landscape changed. We asked five Tuck faculty members for their insight into what lessons can be drawn from this bruising chapter in our financial history—who were the winners and losers, who was successful in responding to the downturn, and what we can all learn as breaks in the clouds begin to appear.

Vijay Govindarajan: The Innovation Imperative
When the last recession hit after the dot-com bust, General Motors scoured its divisions to cut costs. The obvious choice was the Chevy Volt, a costly and complicated project that seemed light-years away from paying dividends. At around the same time, struggling Apple Computer doubled-down on a risky new venture—a handheld device that would store and play music files. We all know how this turns out. GM is now bankrupt, struggling to make up ground in the hybrid and electric car markets, and Apple has changed life as we know it with the iPod and iPhone.

The financial crisis has led to seismic shifts in the ways companies do business. But with the recovery come new opportunities for those smart enough—and bold enough—to seize them.

There’s a clear moral to the contrasting fortunes of these two companies, says Vijay Govindarajan, Earl C. Daum 1924 Professor of International Business and Professor in Residence and Chief Innovation Consultant at General Electric. Companies that skimp on innovation during a recession will be left behind when the economy eventually recovers. “Most companies are hunkering down, focusing on cost reduction,” he says. “If that is all you do, then you are history.” Govindarajan has been researching recessions of the last 100 years and has come to two inescapable conclusions. First, the expansion that follows a recession is always more robust and lasts longer than the downturn that preceded it. Second, recession always changes the business landscape, a situation Govindarajan calls the “reset.”

In the current recession, he’s identified three factors that all companies had better prepare for if they don’t want to be counted out when the economy turns. The first is the current low reputation of business across the board. The second is the fact that growth for the next decade will come not from the United States and Europe but from emerging markets in the developing world, especially the BRIC countries of Brazil, Russia, India, and China. Last, he says, is government that has “moved next door to business. Government is now a lender, an investor, a partner, a regulator; they are everything.”


The only way that companies can prepare for these seismic shifts, he says, is through innovation. One way for companies to cut through the low reputation of business, for example, is with exciting new products that can capture the imagination of the public and attract top talent. Likewise, it’ll take fundamentally different products to compete in countries like India and China, where per capita income is a fraction of that in the United States.

Of course, innovation costs money—which has been in undeniably short supply. To maximize resources, Govindarajan recommends companies first close down any innovation projects that clearly aren’t going to yield fruit, thereby freeing up cash for those that will. Another strategy is to concentrate most innovation energy on “adjacency innovations,” going after low-cost, low-risk tweaks to existing projects that might allow you to capture another 20 or 30 percent of a market you already own. There is no substitute, however, for the kinds of breakthrough innovations that can really change the game when the economy comes roaring back, and he recommends companies spend at least 20 percent of their R&D budget on those initiatives.

If there is a silver lining, says Govindarajan, it’s that in addition to requiring innovation to compete in the “reset” world, a recession might actually create the conditions in which innovations can thrive. “Innovation is only needed when there is scarcity,” he argues. “That’s when you have to apply your brain.”

Paul Argenti: Authenticity Above All
Paul Argenti starts every one of the talks he’s given over the last decade by reminding the audience how little most people trust big business. Nevertheless, the numbers in a recent poll were still shocking—across the world, 62 percent of people trusted business less than they did a year before; in the United States, the number was 77 percent. “There really is an overwhelming negativity in the air,” says Argenti, a professor of corporate communication at Tuck and editor of Corporate Reputation Review. While the banks and financial companies that directly precipitated the financial crisis have been hardest hit, that negativity has rippled out to health care, insurance, and even consumer products and technology.

Given such strong headwinds, finding a way to talk positively to restore consumer confidence is more important than ever. Most companies, however, have been afraid to talk much at all. “Things have gotten eerily quiet,” says Argenti. “That’s very, very dangerous. The reason [the public] doesn’t trust them is that they aren’t out there talking.” Worse, many are living up to the negative impression, cutting back on community efforts and tossing aside employee benefits to cut costs and please shareholders.

Argenti recently completed a survey of companies’ communications strategies in dealing with the downturn, which ran in the Financial Times earlier in the fall. He says the companies willing to address problems, real or perceived, head-on are the ones winning back confidence. As an example, he cites financial-services firm JPMorgan Chase & Co., which has set up a new Web site called The Way Forward that acknowledges consumer fears at the same time as it reassures them with an appeal to its bedrock values of responsible investing. “It’s a pretty powerful back-to-values form of communication,” says Argenti. In addition, the company has kept up efforts in the community and maintained bonuses and benefits for employees. And JPMorgan’s Jamie Dimon has been one of the most visible CEOs in the past few months, actively collaborating with Washington in setting the terms of the bailout plan.

But it’s not enough to just talk with consumers, cautions Argenti. Just as important is to be authentic and transparent in those communications. He cites a recent ad by General Motors that acknowledged its Chapter 11 filing, even as it concludes saying, “the only chapter we’re interested in is Chapter 1.” “That’s a stark contrast to what [oil company] BP did when they were in all kinds of trouble, running ads about the environment,” says Argenti. Despite the recent focus on environmental and social responsibility, Argenti contends that the way a company runs its business—especially the way it treats employees—resonates far more with customers. “It’s not about giving to UNICEF,” he says. “It’s about not trading employees off your own profits.”

The ring of authenticity is even more important now in the new era of social media, when it is so easy for consumers to find their own information to test the veracity of companies’ claims. Argenti faults Volkswagen, for instance, for trying to get out of having to fix a design flaw in their seatbelts by saying customers were using them incorrectly—a stance that blew up in the company’s face online. By contrast, computer-maker Dell has created its own social-networking community where consumers can not only talk to one another but also offer advice to management. “It’s almost like consumers are saying, ‘Look, we don’t trust you guys, so we are going to talk amongst ourselves and tell you what we think you should do.’” It’s the wise company that takes the advice.

Kusum Ailawadi: Survival of the Brand
Anyone who has ever reached for the supermarket label instead of the premium brand knows that consumers have changed their buying habits. The question, however, is how they’ve changed them and how companies should react. According to Kusum Ailawadi, Charles Jordan 1911, TU’12 Professor of Marketing, too few companies make understanding consumer behavior a priority, which leads to unfounded assumptions and flawed strategies in retooling their operations for the downturn. “Researchers link companies’ actions during economic cycles to their market value and infer optimal strategies in a recession,” she says, “but I think we should start by understanding what consumers do in a recession.”

To answer that question, Ailawadi and her co-authors embarked on a two-and-a-half-year study of consumer behavior, tracking every grocery purchase of a panel of households from 2006 to mid-2008 (as the recession was beginning, but gas prices were already affecting disposable income). For every dollar per gallon increase in gas price, the average household in their study reduced monthly consumption by almost 10 percent and monthly expenditures by just less than 5 percent—this despite grocery prices trending upward and consumers eating out less. Perhaps more interesting for companies is exactly how these households reduced expenditure. As gas prices rose, they shifted purchases away from traditional supermarkets and drug stores. Mass merchants like Wal-Mart and Target gained share but only at their “super” stores. Club warehouses such as Costco and Sam’s Club saw only a marginal share increase, perhaps due to cash-strapped consumers not willing to make the bigger investment required to buy in bulk.

One important finding for packaged-goods producers is that the death of brands—and the subsequent rise of store brands— is somewhat exaggerated. While consumers in Ailawadi’s study did shift away from regular-priced brand-name goods, the largest gains were made not by private labels but rather by brand-name goods sold on promotion. In other words, while some consumers are only sensitive to costs and buy store brands, there are plenty of others who are loathe to give up their favorite brands, provided they can get them at a discount. “I’m not suggesting we shouldn’t worry about store brands,” says Ailawadi, “but consumers are not running to store brands in droves. If national brands are able to provide promotions they will retain customers through these troubled times.”

Of course, that means those brands might need to cut into their own profit margins, but Ailawadi argues the cost is worth it. Likewise, other researchers have found that companies who cut advertising during a downturn tend to suffer more in the long run than those that take a hit on profitability during a recession but continue to support their brands. “Speaking of brands, for years people have said, ‘don’t promote because it hurts brand equity,’” she says. “I would say that fear is overrated—companies need to stem the possibly long-term loss of consumers to store brands. And promotions can do this. Recall that Procter & Gamble wanted to cut promotions drastically in the ‘90s but retreated from the move in the face of sustained and significant market-share losses.”

What Ailawadi does, however, worry may dilute brand equity is initiatives by manufacturers to offer lower-tier versions of their brands—such as Bounty Basic or Tide Basic—to stave off consumer flight to private labels. Among consumers loyal to national brands, Ailawadi found, higher-tier brands gained share at the expense of lower-tier brands as gas prices went up. It is as if consumers said if they were going to pay for national brands then they wanted the best. “‘Basic’ versions of well-known brands have to be priced very low to effectively compete with store brands. Unless manufacturers can really separate these products from their core brands by selling them in different retail outlets, etcetera, they could end up doing damage to the core brands while still not profitably competing with store brands,” she says. And if a company is going to remain competitive when the clouds lift and the economy improves, a vibrant brand may be the most important asset it has.

Katharina Lewellen: Financing Matters?
For years, those who earn a living researching corporations have sparred over a seemingly cut-and-dried question: How much does financing really matter? On one side, business watchers argue that access to credit markets is essential for companies looking to start new projects or expand into new areas of business. On the other, they contend that credit markets work so well that a company can always get a loan or issue stock for liquidity. In other words, if a company doesn’t have cash on hand, it’s because it doesn’t have investment opportunities—not the other way around.

“This is a huge question in corporate financing,” explains Katharina Lewellen, assistant professor of business administration. “People have been arguing this for decades.” The current financial crisis, however, has added serious fuel to the fire for those who say financing does matter. The shutoff of the credit spigot has been sudden and dramatic. Syndicated lending, the most common form of lending whereby an investment bank such as Goldman Sachs takes on smaller banks as partners for an investment, was down nearly 50 percent between the third and fourth quarters of 2008. Meanwhile, research done since the crisis has shown that companies that were cash-poor before the recession have fared worse in the past year, showing larger stock price declines than those with more liquidity. The same study was done during the recession after 9/11, implying that it was the lack of lending, and not just the recession that caused the declines.

Of course, this remains an open question. It’s possible, says Lewellen, that companies without a lot of cash were suffering from demand shock before the recession—that is, consumers didn’t want to buy their products even in the boom times, leading to even worse performance during the recession. “It’s sort of a cleansing effect,” says Lewellen. “The recession gets rid of firms that weren’t meant to be around.”

The more important question, at least for CFOs, is what to do now. If financing really does matter, and companies are cut off from credit, then hoarding cash might seem like a wise move. “But I am not sure that is the right thing to do,” says Lewellen. Not only are there costs associated with holding excess financial capacity, but there may also be opportunities to invest precisely because the economy is down and competitors are against the ropes. Companies might do well to hire right now while so much talent is floating around unclaimed, for example, or increase marketing to try to capture more market share. “That is what European car companies are doing,” says Lewellen, “investing in the U.S. precisely because U.S. car companies are in trouble.”

In the end, it may depend on the industry. Makers of essential goods that customers can’t go without, such as milk or toothpaste, might get through the recession without stockpiling cash. On the other hand, manufacturers of large durable goods—cars, tractors—might hedge their bets a bit more in favor of more liquidity. “Not only how much debt they have but also what kind of debt and whether they can restructure it easily,” says Lewellen. “These are the kinds of companies that should be cautious when they plan the right side of their balance sheets.

Matthew Slaughter: Gaining Leverage
Private equity has long been the boogeyman of corporate finance says Matthew Slaughter, Signal Companies’ Professor of Management and associate dean for the MBA program. To many observers, the thought of private equity firms using leveraged buyouts to take companies off public exchanges and into less-regulated private territory seemed inherently destabilizing. “Many said these firms borrow a lot of money, and that their borrowing would somehow create trouble,” says Slaughter. So it’s ironic, he continues, that private equity firms not only had little to do with the capital-markets crisis—which involved mainly large commercial and investment banks—but they have also taken a harder hit than almost anyone.

“The crisis has dealt many private equity firms a one-two punch,” says Slaughter. On the one hand, they’ve taken a blow from the drying up of capital markets, upon which they depend to help finance transactions. On the other, many of their portfolio companies have suffered decreased profitability. Private-equity firms, after all, exist to buy companies and improve performance through changes such as new product mixes and new managerial strategy, and then re-sell these companies at a profit, often through public offerings on stock exchanges. With overall IPO and M&A activity down sharply amidst the crisis, private equity firms are largely holding onto portfolio companies and improving their performance as best they can.

If there is a silver lining to the crisis, it’s that the buyout purgatory has forced firms to spend more time on the companies currently in their portfolios—for example, by bringing in top managerial talent to make them better. At the same time, in some ways, the recession may help make private equity firms stronger by weeding out firms who were less successful at improving the companies they took over. “Some observers,” says Slaughter, “argued that the industry grew kind of easy during the credit boom. Now private equity firms that didn’t have a history of managerial talent may struggle a lot more.”

For the private equity firms that do survive into the upturn in the economy, they may find attractive companies attainable at a discount—and that companies may be more open to outsiders coming in to inject capital and improve profitability through a buyout. Like many economists, Slaughter also has his sights set overseas. Many countries outside the United States and Europe have weathered the recession better, leaving pools of capital that private equity firms may be able to tap. And developing countries may provide investment opportunities, with growing companies that could benefit from new management expertise. “The largest investment firms like The Carlyle Group and Blackstone have long been overseas,” says Slaughter. “Smaller scale private equity companies would benefit from thinking globally.”

Fall 2009