Cash versus margin — The uneasy trade-off

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Contents

Introduction 3 Cash and margin trade-offs in working capital 4

Strategic considerations when balancing cash and margin 5

In conclusion: Keep striving for balance 7

Cash versus Margin — The Uneasy Trade-Off 3

Introduction

Cash has always been king, but the recent downturn has strengthened its throne. On top of traditional concerns like margin pressure, low demand, and shrinking revenue, the “great recession” added a credit crunch to the mix. As a result, U.S. businesses, especially chemical companies, needed a laser-like focus on liquidity to weather the storm.

It is a widely held belief that the cash crunch hit chemical manufacturers particularly hard due to three reasons. First, the years leading up to the recession featured cheap and readily available money from creditors, and few chemical manufacturers invested in building robust cash management practices. Second, many chemical manufacturers had been preoccupied with quarterly earnings to meet analysts’ expectations, and the balance sheet (where cash resides) took a back seat to the income statement. Third, increased volatility of raw material prices — coupled with low ability for chemical manufacturers to pass on this volatility to customers in a market of shrinking demand — strained operating cash flows. When the recession hit, liquidity quickly became the immediate priority.

While it is fair to expect businesses to shift focus away from cash and liquidity when the economy and credit markets improve, there is good reason to sustain good cash management practices. Studies have shown that measures accounting for both earnings and liquidity (such as economic margin or cash flow return on investments) are the best long-term predictors of stock price, not just revenue-focused measures like earnings per share. Companies must therefore balance their focus between both margin and cash to sustain long-term enterprise value and stock price.

One of the key drivers for operational cash requirements is working capital. As cash management practices withered in a highly volatile raw material market, many chemical manufacturers saw a significant increase in working capital levels. Thus, when the recession hit, working capital reduction became a clear source for cash.

However, many have experienced that lowering working capital requires striking the right balance between cash and margin; this is especially true for chemical manufacturers. The following examples show how cash and margin are often at odds with each other in the three core components of working capital: product inventory, supplier payables, and customer receivables.

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Product inventoryBusinesses — and especially chemical manufacturers — constantly try to find the right inventory levels that will serve customer needs for products. While maintaining a high inventory is heavy on the balance sheet, losing a sale when you don’t have a product in stock directly affects revenue, a clear conflict between cash and margin.

This issue played out distinctly in the chemical markets, as inventories were built up to suit high demand levels of 2007 across specialty and commodity companies (see Exhibit 1). When demand fell, chemical companies reacted to growing inventory levels in two ways. Some lowered prices to destock inventory and sustain market share to prioritize cash over margin. Others attempted to protect margin by maintaining prices, which led to high inventory levels. However, the credit crunch had the final say and forced these companies to destock at lower prices and eventually prioritize cash over margin. In addition, destocking efforts appeared to be adhoc, as inventory levels started to climb back up in early 2009

Many chemical manufacturers segment customers by profitability with the intent of aligning customer service levels to customer type — for instance, strategic versus non-strategic. However, few companies take the cost of

Cash and margin trade-offs in working capital

inventory into account when measuring the profitability of customer segments. By reducing inventory availability for non-strategic customers, chemical manufacturers should see small losses in margin in return for substantial reductions in inventory of both raw materials and finished goods — all while keeping the most strategic customers happy and ridding the balance sheet of excess inventory.

Supplier payables Most purchasing organizations focus their efforts on achieving price and savings targets and will often accept inferior payment terms if the price is right. This lopsided focus on margin can lead to strain on the balance sheet, especially when cash becomes tight. In reality, purchasing organizations should have a dual mandate to both lower purchase price and also extend terms and reduce raw material inventory.

Customer receivablesThe story in receivables management is largely a flip of the trade-off in payables. Expecting a customer to pay quickly without providing any price discount incentive is a difficult request even when times are good; in tough times when the customer has the upper hand, it is virtually impossible.

Exhibit 1 — Inventory levels across the industry indicate destocking from 2007 levels through the end of 2008, with inventory levels increasing in 2009. Source - DTT Chemical group financial database of 231 companies across commodities, specialties and integrated. Financial data source is from Capital IQ

Inventory Days

85.0

75.0

65.0

55.0

45.0

35.0

25.0

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Commodity Integrated Specialty

Inventory Destocking

Cash versus margin — The uneasy trade-off 5

If growing both cash and margin together is a tall order, how can chemical manufacturers manage this trade-off and optimize both income statement and balance sheet performance? The answer is neither easy nor perfect. However, some key strategic considerations can help companies balance these objectives consistently.

How much cash do we need?Before taking any action, it is prudent to align management with the fundamental trade-off between cash and margin. One way to do this is by asking, “How much cash is needed?” The answer will depend on the business’ current needs. The need for cash may be absolute — for instance, staving off creditors to keep the business solvent. Other times, the need for cash may depend on strategic priorities, such as funding a large-scale capital investment or maximizing cash-flow return on investment. By framing the need for cash, management can decide how aggressively to pursue the trade-off between cash and margin.

Can we recover price cuts later? During a downturn, some chemical manufacturers make the strategic decision to focus on cash by offering steep price discounts in exchange for compressed payment terms — with the intention of quickly recovering these margins through price increases during the upturn. However, the success of this strategy depends largely on a company’s ability to increase future prices without losing

Strategic considerations when balancing cash and margin

customers. Companies should closely assess price elasticity of products and consider the historical record of customer responses to price increases when making a decision on this trade-off.

This consideration is paramount for the chemical sector, as most chemical companies have found it difficult to pass on price increases to consumers. Further, as the Middle East increases its chemical manufacturing capacities, cost competition will further challenge price increases, making it especially difficult to recover prices that are typically discounted to improve customer payment terms and working capital. This is particularly true for commodities that have seen the greatest price decline and also have higher price elasticity relative to specialties (see Exhibit 2)

What are our rights? Some countries regulate payment and collection terms as a way to stimulate monetary flow and limit bankruptcy risks. Being aware of such regulations allows companies to improve terms without offering price discounts as incentives. A good example is the French LME law (“Loi de Modernisation de l’économie”). This law, which went into effect in 2009, mandates specific payment terms of 45 days end-of-month or 60 days from invoicing date. Updating payment terms that significantly deviate from these regulations is an easy way to generate cash, as customers and vendors are often quick to comply

Exhibit 2: Eroding gross margins across the chemical sectors indicates weakness in the ability to pass on price increases Source - DTT Chemical group financial database of 231 companies across commodities, specialties and integrated. Financial data source is from Capital IQ

Gross Margin

35%

30%

25%

20%

15%

10%

5%

0%1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Commodity Integrated Specialty

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with regulations. It also allows companies to distance themselves from the potential negative fallout such a change in terms might generate without the law to justify it.

What’s the most bang for our buck? Businesses must take a comprehensive view of working capital management, managing the entire portfolio of payables, receivables, and inventory. Not all levers are created equal. For instance, the impact on margin is typically less when compressing payables versus extending receivables. Such comparisons in trade-offs can be made only if companies tackle working capital in a comprehensive and cross-functional manner. Chemical manufacturers that choose to parse out working capital components individually will likely experience suboptimal results.

What are the possible synergies? Another advantage to treating working capital as a portfolio is the possible synergies between areas, especially customer payables and inventory management. Companies traditionally compress payment terms by giving away price discounts to customers. Yet improving service levels through better inventory management practices — such as providing greater finished goods inventory availability — may also entice customers to accept shorter payable times. This is especially true because service level expectations in the chemical industry are primarily driven by product availability and technical service. The result is a win-win, making the customer happy while lowering internal costs, all without taking a hit to margins.

What are the priorities of our value-chain partners?Chemical manufacturers should also consider the priorities of suppliers and customers when determining which working capital lever to pull. If your value chain partners are also feeling liquidity constraints, it may be difficult to negotiate more favorable terms. For instance, a cash-strapped customer may require steep price discounts for nominal improvements in payment terms, or may reject compressed terms entirely, as was seen with most chemical suppliers to the automotive industry over the course of the downturn.

In such situations, chemical manufacturers may want to focus on internal improvements in the near term, such as improving efficiency and compliance of the payables/receivables process, or reducing inventory without deteriorating service levels. Then as the priorities of customers and suppliers change, companies can shift focus to external levers that require negotiation or collaboration with customers and suppliers.

However, it should be noted that while internal levers may generate cash without much margin trade-off, these internal improvements are typically small when compared to external levers such as compressing payment terms or aligning inventory service levels to customer segmentation.

What are we measuring? Developing sustainable discipline in concurrent cash and margin management starts with focusing on the right metrics. In most cases, managers in manufacturing are measured solely on P&L performance, with little emphasis on balance sheet and cash management. As a result, managers often carry high inventory and offer customer-friendly terms to drive sales, earn market share, and meet revenue targets without considering the impact on the balance sheet. Instead of this exclusive focus on margin, chemical manufacturers should measure performance on a total “cost-to-serve” basis, which includes cost of capital and other balance sheet considerations.

Finally, most of the above strategic considerations can optimize the cash-margin trade-off within the constraints of a company’s operating model. However, companies could broaden their aperture and consider ideas that would challenge their current business and operating model. Examples of such ideas include “make versus buy” strategies and operating network optimization, especially in the context of the expanding manufacturing and supply chain footprints in emerging markets. While these expansions will grow revenues and therefore margins to gain enterprise value, companies will also run the risk of diluting these gains if working capital and cash requirements to service new markets are not managed structurally by revisiting the operating model. Optimizing cash and margin through changes in operating models are typically longer term opportunities with higher payback periods. Such operating model changes are typically suited for execution when the economy expands in 2010 and beyond (as expected by many global economic monitoring units) and typically can produce a step improvement in shareholder value.

Cash versus margin — The uneasy trade-off 7

Most economists expect continued easing of credits markets and improved availability of capital in the near future. Yet despite this projected recovery, the need to balance cash and margin must remain an ongoing priority. The tendency for many chemical manufacturers will be to swing full-tilt toward a focus on margins and de-emphasize working capital metrics as the recovery continues. However, it is only by continuing to find the right balance between margin and cash that chemical manufacturers can drive shareholder value over the long term.

In conclusion: Keep striving for balance

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ContactsTim HanleyVice Chairman and U.S Process & Industrial Products LeaderDeloitte & Touche LLPthanley@deloitte.com

Tom MarriottNational Managing Director - Consumer & Industrial Products Deloitte Consulting LLPtmarriott@deloitte.com

Raj NagarajanSenior Manager – Consumer & Industrial Products / RestructuringDeloitte Consulting LLPrnagarajan@deloitte.com