The Other R Word, and We Don’t Mean Revenue
As talk of recession creeps back into the news, our clients have been asking our views on whether we see one on the horizon and how it could affect our industry overall as well as their individual business goals now and in the future. Many factors could impact the US and global economy, including sudden events outside our control and normal business cycles, but we do have data and historic trends that may offer some insight on how to best prepare for those natural ebbs and flows, especially if you’re thinking about selling or buying. We’ve been fielding a lot of questions lately, and this is the best advice we can offer based on our research and review of economic data.
Will a possible recession negatively affect the value of my business if I want to sell this year or next?
From the perspective of current enterprise value, a recession might be a factor in a transaction, but the prospect that a mild to modest economic downturn would be the reason to kill a deal completely is more perception than reality. Transaction elements like payment structure and agreement terms and conditions may be affected, but not the foundational value of the business.
A recession can affect the appetite of certain types of buyers who may not want to take on additional perceived risk during economic uncertainty. But looming recession fears don’t reduce the current worth of a business, simply because its current value is mostly predicated on the financial performance over the past 3-5 years, as well as recent profit trends of the business. Incidentally, the shutdown year (2020) does not weigh heavily unless the business has not significantly recovered. It’s more vital to assess how the business rebounded in 2021 and 2022 as a comparison to the financial metrics of 2019 and just before, and the likelihood that similar financial performance will continue in the foreseeable future. This is largely a financial exercise of planning for increases and/or decreases in revenue and modeling cost structure scenarios and the transaction on a buyer profit and loss proforma.
In our view, based on reviewing the financial trends of more than 230 companies in the chauffeured and motorcoach sectors—particularly their financial performance in 2021, 2022, and so far of 2023 compared to 2019—we are confident that client demand will continue at or above 2022 metrics unless there is a catastrophic global economic event.
“History tells us that there is an economic downturn every 7-8 years, so let’s assume that trend will continue. Basically, recessions are expected and are ‘baked in’ to the value equations ...” – Ken LucciOur position is that even a moderate recession will NOT significantly impact the profitability outcome of financially healthy companies in 2023, and therefore, will not negatively impact the enterprise value. We base this on supply and demand specific to our industry in the post-pandemic operating climate. Specifically, demand has largely roared back across our industry in a climate where roughly half the operators survived. Of those that remain in business, we estimate most are operating about 40 percent fewer fleet vehicles compared to 2019. So based on the return of significant demand and much lower industry vehicle and driver capacity in most areas of the country, we believe that financially strong and savvy operators can withstand even a moderate recession. We are quite confident that if operators do not significantly grow their overhead expenses, most will continue to prosper at the same levels as 2022.
Could a recession in 2023 diminish the long-term value of my business if I want to sell in a few years?
History tells us that there is an economic downturn every 7-8 years, so let’s assume that trend will continue. Basically, recessions are expected and are “baked in” to the value equations that determine the worth of a business. Typically, moderate recessions should not negatively impact the long-term value of an otherwise financially healthy company or prospects for a successful transaction even if there is short-term mild drop in revenue, growth is stifled for a quarter or two, or there is a temporary dip in profits.
However, businesses that are not financially healthy, do not have sufficient working capital, or have excessively high debt could be in for rough road ahead. In these cases, if revenue falls drastically and cash flow turns negative for a longer period, the business could be put in peril or even fail. If revenue falls but the business can reduce costs and shed assets to raise cash and lower debt, it may be able to pull through.
How can I effectively navigate my company through a recession?
- Manage Financial Metrics on a Granular Basis MONTHLY: Operators who manage their businesses using monthly profit and loss statements (P&L), and know their cost structure, can make expense adjustments faster and more effectively should it be necessary.
- Conserve Cash and Create Substantial Liquid Capital: We advise our clients to keep expenses low and know their profit margins so they can project positive monthly cash flow. If recession fears loom, it is wise to shed unproductive assets and create a savings account of cash to bridge in case cash flow goes negative for a few months.
- Keep Long-Term Debt Low: Operators should work to keep total long-term debt at a level that is less than 30 percent of total annual revenue in the worst case, and preferably all that debt is associated with fleet assets that they could shed to generate cash. It is very important to also have a debt-to-fleet equity ratio above 50 percent; i.e., if you sold off vehicles, you could pocket half the money.
- Do Financial Stress Tests Now: This involves owners working with their CPA, CFO, and/or bookkeepers to run “what if” scenarios. For example, what if your largest client stops traveling? What if total revenue drops by 10 percent? What happens if you lose several big clients at once? What would you do to assure sustainability?
- Create an Annual P&L Budget: We recommend every business have an annual P&L budget (including several forecasts with decreases in revenue) that is dynamic and updated with actual results every month. Assuming you have a budget, it is an easy exercise to project what would happen to overall profitability if revenue increased or decreased by certain percentages.
- Check Performance During the Last Recession: Nothing predicts the future like examining patterns of the past. Break out all P&L statements and tax returns and review your reservation system reports from those periods. Chances are you will glean vital information that will help you in the event of another similar recession.
- Manage Your Costs and Lower Overhead Expenses: We have all been forced to do much more with less these past few years. Our advice is to granularly manage direct costs, keep overhead low, and maintain current pricing. Resist the urge to return to bloated operations or lower prices. Overall, most companies are more profitable with lower overhead now than pre-pandemic, so keep it up.
- Cost of Capital: Interest rates on loans and leases will likely be higher, so those additional costs need to be considered as you ponder buying vehicles. Hourly and transfer rates need to be adjusted to account for higher costs of borrowing and other potential direct cost increases such as fuel and insurance.
- Variable Interest Rates Might Rise: It may be wise to look at the terms of any lines of credit and the current interest rate of any outstanding loans if they are variable interest based versus fixed interest. This includes loans like EIDL that are tied to increases in the prime lending rate.
- Lower Short-Term Demand From Select Segments: We encourage every operator to review the trip patterns of their major existing clients and even ask them if they anticipate any change in use ahead. Some segments like tech or financial may slow corporate travel or curtail spending, while other segments may be unaffected like weddings, groups and meetings planned well in advance, or necessary executive travel. Keeping an eye on client use trends and proactively engaging them on how things are going will allow you to plan and forecast much more accurately than not asking or living in a vacuum.
Our advice is not to listen exclusively to gloom and doom and instead keep abreast of what is actually happening in your organization and the clients your company serves daily. Based on what we know today, we are confident that financially healthy companies can weather even a moderate recession if one does materialize anytime soon. After reviewing 230 companies, we can safely say that the new normal has been good to this industry so far. Despite being bumped and bruised, most operators have emerged more profitably with lower cost infrastructures. Many operators serve specific client groups that will still have strong demand even during a recession, so our advice is to keep calm, manage your costs, keep overhead low, and watch your profits. Sufficient profit (and cash flow) can carry you through anything. Profit is the new progress! [CD0523]
Ken Lucci is a consultant to the chauffeured transportation and hospitality Industries. He can be reached at Klucci@drivingyourincome.com.