How Should Companies Respond to an Economic Recession?

I. Korean Companies Facing a Recession

Despite widespread financial turmoil coming from the US subprime debacle and soaring global commodity prices, Korean companies performed well in the first half of 2008. However, as the global economy has apparently entered into a recession in the second half of the year, the profitability of Korean companies has become rapidly aggravated. There is sufficient warning that the upcoming crisis may be much more devastating than the financial crisis in 1997 (which at the time primarily affected only the Asian region) due to the fact that Korea is highly dependent upon exports and that the entire global economy is currently mired in similar recessionary difficulties.

Although overall economic conditions have deteriorated, it should be noted that Korea’s capability to overcome recessions has strengthened considerably since its experience with the currency crisis over a decade past. For example, since then, the interest coverage ratio (operating income/interest costs) of Korean manufacturers has risen from 1.2 times to 6.3 times while their debt-to-equity ratio has dropped dramatically from 425% to 96%. In addition, Korea’s soft competitiveness, such as brand recognition, design and technological power, has advanced substantially over the years. For instance, Interbrand’s 2008 100 Best Global Brands List ranked Samsung Electronics 21st with a brand value of US$17.7 billion, while Hyundai Motors was placed 72nd with US$4.8 billion. The list goes on. Among the 2,553 awards presented in 2007 by the top three global design awards (International Forum Design, Red Dot and the International Design Excellence Award), Koreans, mostly firms, received 208. Furthermore, the nu mber of patents Koreans registered in the US increased to 7,264 in 2007 from 1,567 in 1996, ranking the fifth highest in the world. The aforementioned are all testament to the marked improvements Korean companies have made in advancing their capabilities.

Since global competitors are now faced with an unprecedented degree of hardship, the global recession may serve as a new opportunity for Korean companies, equipped with stronger competitiveness now more than ever, to excel internationally. Korean companies must take hold of this opportunity by correctly analyzing their strengths and using smart tactics accordingly. To provide Korean companies with some assistance, Samsung Economic Research Institute (SERI) tried to identify successful factors that assisted companies in overcoming difficulties coming from the 1997 currency crisis. SERI conducted an in-depth analysis on the magnitude of shocks stemming from the crisis and the ability of companies to respond to such shocks. Based on the analysis, SERI then attempted to chart some corporate strategies in dealing with an economic recession.

II. The SERI S-R (Shock-Resilience) Model

To find customized strategies for companies addressing a recession, SERI developed a model called the SERI S-R (Shock-Resilience). To this end, the magnitude of the shocks was measured by the slowdown in a company’s sales revenue growth (demand side) and the increase in its unit-cost rate (cost side). As for a company’s ability to respond to crisis, its resilience was measured with financial flexibility and soft competitiveness. A company’s financial flexibility was represented by its interest coverage ratio while its soft competitiveness was measured by its price-to-book value ratio (PBR).¹

According to the analysis based on the SERI S-R model, changes experienced by the Korean corporate world since the currency crisis had the following characteristics. The model assumes that the currency crisis is representative of an economic recession.

First, two-thirds of the companies that ranked in the top 25% by sales revenue and return on assets immediately before the recession failed to do so after the recession, an extreme change to say the least. Second, the intensity of the shocks that the high-performing group (the top 25% immediately after the recession) suffered from during the recession was similar to or bigger than that of the low-performing group (the lower 75% immediately after the recession). Third, the critical factor that decided the fate of the two groups was mainly the level of resilience they had secured before the recession began. Fourth, among the four groups (i.e., four quartiles) divided by their sales and earnings performance, companies that rose from the lower-performing group to a higher-performing group and companies that fell from a higher-performing group to a lower-performing one exhibited similar resilience. However, the key that determined their fortune was what strategies they put in place to respond to a recession .

III. Customized Strategies for Companies to Overcome a Recession

Generally, companies experience difficulty in generating both profit and growth during a recession, and thus end up focusing on securing cash and cutting costs through restructuring. It is critical to go a step further by breaking with these “one size fits all” strategies and implement ones that fit each company according to their type of resilience. Only through such differentiated strategies can companies secure a competitive advantage post-recession. There are frequent cases where sales and earnings performance among companies with similar resilience strike sharp contrasts from each other. To take a glimpse of this, we need to first divide companies into four groups (placed into the four quadrants described in the chart below) according to their type of resilience and then prescribe optimal anti-recession strategies for each group.

1. Group I - Strengthening of Market Dominance

Companies that have good financial flexibility and soft competitiveness are advised to carry out M&As to solidify market dominance after a recession and to aggressively implement proactive investments in preparation for an incoming boom. A recession can provide many opportunities for such companies to strengthen market dominance through M&As because assets are generally much more cheaper to purchase during such a time. Blue-chip companies that cannot bear a temporary liquidity squeeze are often put up for sale. In addition, based on their strong financial flexibility, some companies in this group had better make investments in soft competitiveness, such as brand power and technology, so as to widen the gap with competitors. For instance, Nippon Steel upgraded its productivity and technological prowess by investing 400 billion yen (70% of its net profit) in R&D from 1996 to 2005, a period when Japan suffered from a prolonged recession. Today, with 1,038 international patents, the company now dwarfs Arcel orMittal, its formidable adversary with only 32, in terms of technological superiority.

2. Group II - Strengthening of Fundamentals

For companies that have strong financial flexibility but weak intangible assets (soft competitiveness), recessions present opportunities to fortify soft competitiveness with less investments compared to investments made during booms. They can enhance brand image with relatively little cost because their competitors tend to focus on belt-tightening during difficult economic times. Investment efficiency would also be high because it costs relatively less to establish global brands or secure core technologies and human resources during a recession. For example, Sungkwang Electronics, which was once a mere original equipment manufacturer (OEM)² for electric rice cookers, unveiled its own brand, “Cuckoo,” in 1998 at a time when it was receiving virtually no orders immediately after the currency crisis. With an investment of 5 billion won in advertising costs over three years, the company became the leader in Korea’s electric pressure rice cooker market after o nly a year and three months. Moreover, companies that belong to this group can secure brand and technology through M&As. A case in point is Lotte Confectionery. The snack manufacturer acquired Guylian (Belgium), a globally-recognized luxury brand for chocolates, for 170 billion won in June 2008.

3. Group III - Prioritizing Survival

Companies that fail to secure financial flexibility or soft competitiveness should solidify a financial foundation that enables them to endure a recession and prepare for the future. The key is in securing cash as soon as possible before recessions become full-blown. For instance, Hutchison Whampoa (Hong Kong) could have made effective investments in wireless telecommunications services, hotels and seaports with the cash it had secured by issuing bonds worth US$2 billion in July 1997, immediately before a financial crisis struck Hong Kong. When it is difficult for companies to survive and grow, they should secure partners through strategic alliances or even mergers. A case in point is the potential merger of General Motors and Chrysler, two of the US’ “Big Three” automakers.

4. Group IV - Securing Profit

Companies in this group can maximize profits by taking advantage of their existing soft competitiveness, such as brand power and core technology, thereby making their services higher value-added. They can make the maximum use of their own intangible assets, introduce new products through existing distribution networks and know-how, or sell existing brand products through new distribution channels. For example, in 1999 AmorePacific released a brand of cosmetics offered only to cosmetics discount stores, which at the time was a brand new method of distribution channel in Korea’s cosmetic industry, thus targeting the new retailing market more aggressively. These companies can also increase licensing income by using their own technologies or brands. This was the case when Hanmi Parmaceutical invested 200 million won to develop technology for polypeptide-type oral formulations. By exporting the technology to Novartis (Switzerland) in April 1997, the company earned US$63 million over the course of a decade.

IV. Strategies of Representative Korean Companies to Overcome Recession: Comparison in Resilience with Global Companies

In a comparison between global companies and leading companies in Korea’s major industries such as electronics, steel and automobiles (as of end-June 2008), it was found that the resilience of Korea’s representative companies almost equaled that of global competitors. Since the analysis used global leading companies as a sample, all except GM were blue-chip companies that belonged to quadrant I in types of resilience. Nevertheless, Korea’s representative companies did not lag behind. As for Samsung Electronics, its interest coverage ratio was second highest following Intel, and its PBR of 1.6 was at a medium level. Posco had an equal or higher position than global competitors in terms of both financial flexibility and soft competitiveness. Hyundai Motors, with its financial flexibility being relatively low, stood in the middle among global competitors.

Moreover, even in terms of financial structure and management performance, Korea’s representative companies did not fall behind their global competitors, even outperforming them in some areas. In particular, they exhibited stable financial structures with debt-to-equity ratios at the lowest levels among all companies compared.

V. Implications

To overcome a recession, it is important for companies to fully understand their capabilities so as to restore confidence. They then need to come up with customized strategies depending on their capabilities. For their part, CEOs need to have insight and see the bigger picture rather than be susceptible to the sway of short-term events. By doing so, they should nurture a climate of dedication. In short, recessions can be overcome effectively only when both a CEO’s insightful commitment and employees’ dedication are combined.

Note

1. Market capitalization/ book value of net assets.
2. OEM is typically a company that uses a component made by another company in its own product, or sells the product of another company under its own brand.
- seriworld.org