The global pandemic taught businesses how unforeseen economic
disturbances can annul business-as-usual strategies. Current economic forecasts (or the uncertainty of it) are no less serious.

Most econometric models have recently raised the probability of a recession significantly. This includes major US Banks and IMF, who predict that US might narrowly avoid a recession with slow economic growth in 2022 and 2023. CEOs have also displayed their concern around the uncertainty in economic climate and the impending danger of recession.

Persistently high inflation rates, pose significant risk to the economy, especially during an economic downturn. The current inflation rate is the highest that US has seen in 42 years. To fight this, the Fed has raised interest rates rapidly and has signaled more hikes to come. If the future interest rate hikes are aggressive (amplitude or pace), it might have a catalytic effect on the looming recession.
The possibility of an economic “soft landing” seems slim especially as the inflation is partially driven by factors out of US control e.g., the Russia-Ukraine war and China’s zero covid policy which is causing supply shortages.

Given this uncertainty, businesses should prepare themselves proactively.

1. Falling demand: Businesses have started to see falling demand for their products and services. Banks are facing lower demand for loans with issuance of mortgages at its lowest since 2000. Asset Managers have seen a drop in AUMs. This falling demand has intensified the already stiff competition in industries such as financial services.
2. Increasing cost pressure: The persistently high inflation rate has created significant cost pressure draining the bottom-line of businesses. Blackrock’s year-to-date net income has shrunk by 22% while JP Morgan’s has shrunk by 13%2 Businesses are caught in a deadlock as they are forced to increase price to sustain margins, but price increments may hamper customer relationships, thereby hurting sales.

It is difficult to balance short-term survival with long-term health in times of uncertainty. As the cost of borrowing goes up, firms have less cash for its operations. In order to survive in the short-term, firms are forced to defer long-term initiatives, capex investments, product launches, etc. Adding to this problem is the fact that firms often apply across-the-board spend cuts to tackle these challenges.

Insufficient preparation often leads to businesses reacting defensively, by rushing into deep across-the-board cuts. These measures typically
include:
• Layoffs and reduction in employee benefits: This is the most popular yet risky way of cost reduction. In a tight labor market, any lost talent is hard and expensive to fill.
• Additionally, prospective and retained employees may lose confidence due to concerns over job security. Customers and business partners also view such actions as a distress signal, affecting long-term relations. Both are likely to get easily poached in such an economic environment.
• Scaling back marketing investments: Cashflow concerns may leave firms with little choice but to scale back on marketing. During volatile times, marketers often also find it difficult to leverage historic campaign data to allocate spend in the right ecosystems and the right touchpoints.
• Paring down product/service quality: In an attempt to maintain margins, some firms try to ration their cost of production/servicing by trading off quality. This can have unintended consequences depending on the impact of quality reduction on customers, suppliers, partners, etc.
• Reducing technology, innovation and research efforts: In most cases, these investments are in pursuit of long-term success. Businesses, while on survival mode, put actions with no immediate result on the back burner.
The problem with such a knee-jerk reaction is that once conditions improve, businesses are unlikely to be able to capitalize on growth opportunities.
Deep cuts in operational costs often have lasting effects, such as:
• Low customer satisfaction
• Low employee morale and weak confidence in the employer
• Hampered business relationships (customers, suppliers, partners)
• Lag in innovation and technology

The best way to prepare for times of economic uncertainty and risk of unprecedented stagflation, is to reassess the profitability and prospects of each business line.
The attractiveness of businesses can change dramatically in such an environment e.g., labor intensive businesses may be hard and expensive to operate in a tight labor market. Similarly, the attractiveness of interest rate sensitive businesses can change dramatically. On the flip side, business lines that have been digitalized more significantly than the competition may have an opportunity to win market share in this environment. Similarly, geography plays a more significant role in determining the attractiveness of a business. Even within the US, there is a wide variance in the labor and real estate costs across state boundaries. The strength of the US$ vs. the Euro has fundamentally changed the attractiveness of businesses reliant on cross-border trade.
The secret to success in such an environment is to dissect and refresh the strategies for individual business lines and focus the overall portfolio of businesses across the firm.

The first step towards focusing your business portfolio is to assess the ‘true’ scope, health and prospects of individual businesses, and then decide the best go-forward plan.
Firms that focused their portfolio of businesses early have emerged successfully through past recessions. A study on performance of 4,700 public companies during the recession of 1980, 1990 and 2000 found that 9% of them not only recovered in the following three years —they flourished! They outperformed competitors by at least 10% in sales and profits growth. Let’s look at the reasons that made them stand apart:

Individual business lines must be re-assessed in today’s environment for financial performance, competitive strength, and business sustainability. All available strategic options must be evaluated to compare the opportunities and their feasibility (see Exhibit 3). While most firms tend to focus on growth or operational costs, exit/restructuring/pivoting options should also be evaluated. We recommend a data-driven approach to determining the ‘true’ strengths, weaknesses, and opportunities.

Exhibit 4 outlines a data driven approach to assessing the business’ financial performance, competitive strength, operating model and long-term health.

Given all the changes in the environment, we recommend reconstructing the P&L, of the business lines in question, from first principles. Methodologies and assumptions made a few years ago may not be valid anymore.
1. Standalone Profitability
Many a times, there is confusion regarding cost allocations across business lines. Methodologies that were appropriate or convenient during a different business lifecycle stage or economic cycle, may be misleading today. Thus, they deserve a second look in this environment. Margins need to be dissected for individual customer segments, offerings/services, geographies, to uncover the hidden gems of profitable growth. This enables leaders reallocate future investments towards the most profitable segments.
2. Pricing Flexibility
All pricing needs to be revisited in inflationary times, especially with a tight labor market. While costs are guaranteed to go up, individual business lines may or may not have the power to (re)set prices in the market. Customer contracts need to be evaluated for pricing flexibility. Value added services and operating models should be evaluated to uncover opportunities to maintain profitability as you ride through stagflation. The true cost of each business line, on a standalone basis, provides good insight into potential pricing thresholds.
3. Cash Flow Realignment
Availability of cash and corporate budgets to finance day-to-day operations versus long term growth initiatives is likely to be different going forward. While assessing cashflow projections, it is important to stress test it for potential shocks that may occur. These include changes in credit/payment terms with suppliers/customers, pricing terms and discounts with customers, sudden drop in demand, increased cost of borrowing, etc. A realigned understanding of cashflow is pivotal in assessing the viability of future strategic options, as most of them (growing, evolving, restructuring, etc.) are likely to require a different mix of financial investments and returns.
4. Operational Efficiency

Assessing the business line’s operational efficiency (through indicators like return on assets, asset turnover ratio, receivables turnover, etc.) for its scalability, flexibility, consistency, wastefulness, reliability etc. informs leaders of the room available to bolster margins in tough economic times, the need for re-engineering, opportunities for digital deflation, restructuring operations etc.
.

Evaluating the competitive strength of a business not only indicates potential for future growth, but also helps determine the root cause for any untapped opportunities to date.
Firstly, the relevant set of competitors, substitutes and likely new entrants needs to be identified. Thereafter, the business must be compared across a variety of factors, as outlined in Exhibit 5.

Prioritizing factors that are most influential in the customer’s purchasing decision and factors that are most easily achievable can help score some easy wins. Additionally, quirks, whitespace, and loopholes in the market, emerging trends likely to present new opportunities, and a review of the industry’s fundamentals can help quickly define the path to success

Strength and maturity of an operating model determines the ability of businesses to translate their strategic intent into operational capabilities.
A diagnosis of the business’ operating model, specifically maturity levels, gaps, and improvement opportunities is needed. This includes detailed assessment of the service delivery model, functional process, talent base, technology, performance insights, data and governance e.g., one needs to assess whether the current operating model can adapt to the current environment, or if it needs restructuring or a pivot to a new model.

Assessing long-term health of a business line involves multitude of assumptions, estimations and projections. In today’s environment of rapid industry disruption and low switching costs, understanding of long-term prospects of a business unit is pivotal while devising it’s go-forward plan. A market that seemed attractive five years back, may have new entrants, new strategies, new technologies, new customer priorities etc. that may have completely changed its attractiveness.
Key attributes of long-term health are:
• Growth in demand: It is determined by the growth in existing customer segments as well as the potential for expansion into new customer segments. Customer satisfaction level across key dimensions for different customer segments plays a vital role here.
• Criticality of the business line: The firm overall might have critical dependence on certain business lines. Alternately, business lines may be dependent or synergistic with each other. Understanding those interdependencies between business lines and measuring the impact of go-forward strategy of a particular unit on other units is important.
• Client satisfaction levels: Client satisfaction scores (CSAT scores, NPS, customer feedback) although a softer measure, is a strong predictor of long-term health and growth prospects.
• Growth drivers and inhibitors: Assessing potential growth drivers and roadblocks depicts a clear picture of the unit’s ability to create sustainable business outcome. This demands strong understanding of intrinsic strengths and weaknesses as well as market outlook.
• Innovation and improvement efforts: Evaluating the track record of innovation to date and planned (inflight) investments can help leaders better understand if the business line can be more competitive in the future. Such innovation efforts can be far beyond technology. For example, they may include developing a more competitive value proposition, improving service delivery, enhancing talent, or new offerings.

The economic climate is becoming increasingly uncertain with cautionary signals of recession, along with inflationary pressure, fluctuating currencies, and uncontrollable impact of geopolitical events. Making deep spend cuts across the board does not work well in such an environment. Firms need to proactively take this opportunity to refocus their future investments on high value, high potential business lines. Business assumptions and designs from a different lifecycle stage or economic environment may not be relevant anymore. The economics and attractiveness of any business line may be radically different today due to factors such as high labor costs, rising interest rates, changing customer priorities, loss of knowledge resident in attracting talent, and rapidly increased digitalization efforts of the competition and customers during the pandemic.
Thus, focusing the portfolio of businesses requires carefully (re)assessing the health of individual businesses to devise the best go-forward strategy to adapt and win in today’s evolving environment.
Businesses that prepared for such crisis in the past, by shedding lost causes and doubling down on winning business lines, navigated such economic uncertainty most successfully.

1. 1 The New York Times, June 28th, 2022: “Uncomfortably High: What economists say about the chance of recession”
2. Pensions & Investments article, July 14th, 2022
3. Harvard Business Review: “How to survive a recession and thrive afterward”