Business turnarounds - troubleshooting performance problems (3/3)

In our last post we looked at our two most fruitful areas of analysis when an under-performing company has issues with sales (or gross profit) growth. In this post, we look at the two areas of investigation that we find most useful for companies with profitability problems.

Again, the most useful analyses are the ones that are rarely done. Board packs, management KPIs and performance measures often track return on sales and total profit by line and by customer group. These analyses ordinarily have value, but don't add to what the Board already knows, and so do not provide insights to a performance problem that the Board has to date been unable to address.

The analyses we find most useful are related to lifetime profits:

1. Analysis of profit contribution of assets over their lifetime
2. Analysis of profit contribution of customers over their lifetime.

Profitability analysis of asset usage

Capital constraint is a critical issue in turnarounds. However, profitability numbers in Board KPIs often either ignore asset usage or treat amortisation uniformly for each product line, not distinguishing asset-intensive versus asset-light customers.

Accounting for each customer group’s asset usage often highlights major cash sinks. It can overturn previously held understanding of customer profitability and often reveals where companies have historically focused time and resource on what turn out to be loss-making or value-destroying customers.

Example – gaming machine operator turnaround

Profitability had declined for five consecutive years in a highly capital intensive sector, resulting in low return on investment and ultimately covenant breach.

The business had focused on maintaining high machine rents, by targeting sales on high end managed pubs and by rapid and continuous new product introductions. The business deprioritised lower end free trade customers that required lower rates of introduction and paid correspondingly lower rents.

Using a simplistic assumption for machine depreciation, managed houses appeared profitable, free houses unprofitable.



Correct accounting for machine asset depreciation showed the historic focus on managed pubs to be value-destroying.



The business consequently renegotiated its managed pub contracts to reflect the accurate understanding of cost structure, grew profitability and has successfully refinanced.

Customer acquisition cost and lifetime value

Management accounts and monthly KPIs can hide the true cost of acquiring customers, and the payback over the customers’ lifetimes. This can be particularly true for larger deals or new services where the customer contributions appear large, but the time and cost taken to acquire these customers can make them loss-making over their lifetime. This is further exacerbated when accounting for a high time value of money in distressed situations: a large initial sales cost outlay and delayed incoming cash flows can generate large negative net present values and heavy cash requirements for some major prospective customers or ambitious new services.

Example – telecoms reseller turnaround

A corporate telecoms reseller had operated at low scale and with heavy losses for several years, and faced closure by its financing parent.

The business perceived greatest potential from large corporate customers and focused sales efforts on these accounts.

Analysis of customer lifetime and acquisition cost arising from low hit rate, resulted in the conclusion that the business was incorrectly focused on loss-making large corporates and under-investing in sales to highly-profitable SMEs





The business refocused onto SMEs and subsequently achieved trade exit in excess of £150m.


So, there we have it, four rarely-used but commonly insightful analyses to perform on struggling businesses, when the usual KPIs and Board packs have not given any productive clues to the causes of decline.

Given the recent trend for debt holders to delay taking control of breached or distressed companies, we believe that management and equity now has greater breathing space to diagnose financial issues. And we believe that a rigorous understanding of such issues is value-adding for everyone involved.


Copyright Latitude 2009. All rights reserved.

Latitude Partners Ltd
19 Bulstrode Street, London W1U 2JN
www.latitude.co.uk

For the full text of this series email steve@latitude.co.uk