September 27, 2009

Unlocking Value in Saudi Companies - Managing the Cash Crunch and Positioning for Growth

Better management of working capital could unlock 10-15 billion SAR in cash per year.

Robust economic growth in the past five years allowed many Saudi companies to be lax in managing growth. Many chased sales at any cost, ignoring critical aspects of cash flow and balance sheet management, while taking on debt from multiple sources. Liquidity issues bubbled beneath the surface while the economy was booming, rising to the top when the recession hit. A Booz & Company analysis of 75 listed Saudi companies revealed that many mismanaged their working capital, overshot in adding fixed assets, and are now struggling to manage their short-term obligations, exacerbated by the current lack of liquidity.

Saudi companies must now take immediate tactical action to free up cash, while building sustainable cash positions for the long term. They will have to tear down the walls between strategy, operations, and finance and foster an environment of cooperation, with a fresh look at the way information is shared and decisions are made within the company. “Those that use the downturn as an opportunity to better manage their business can look forward to a more robust competitive advantage in the long term,” explained Ahmed Youssef, a principal at Booz & Company.

“Perpertual Growth" Derailed 

Prior to the downturn, Saudi companies believed that their biggest risk was losing out if they did not keep pace with the economy’s rapid expansion. Demand for goods and services skyrocketed and the stock market surged, whetting investors’ appetites for public offerings, while lenders competed for a greater share of the growing market for corporate loans. In response, companies undertook bold expansionary policies to capture their share and banks loosened their terms to finance these aggressive plans. Shareholders came to expect quick, high rates of return and continuous dividend payouts from their equity. When the downturn hit, however, it became clear how unsustainable these practices are.

“Lack of attention to cash flow and balance sheet considerations limits a company’s ability to take advantage of strategic opportunities. During economic trouble, financial mismanagement can threaten a company’s ability to meet even basic obligations,” said Peter Vayanos, a partner at Booz & Company.

The credit crisis has brought these issues to the fore and Saudi’s businesses are in general being challenged in three main areas: working capital management, asset utilization, and capital utilization.

High Levels of Working Capital
Saudi companies have traditionally not focused on generating cash from operations. They have therefore kept high levels of inventory and receivables compared to global benchmarks. Although part of this issue is structural in nature given the procurement practices in the country, there is still room for improvement.

The current liquidity crunch demonstrates how hazardous this practice can be. “Inventory and receivables for the companies we analyzed reached 40 billion SAR at the end of fiscal year 2008; although high payable levels dampened the negative financial impact of high inventory and receivable levels, companies’ working capital remained high compared to benchmarks across most industries,” commented Youssef. Bringing working capital back down to industry averages could unlock 10 to15 billion SAR in cash per year.

Overshooting on Fixed Asset Investments
During the economic boom, Saudi companies aggressively built up their asset base to meet demand. “Between 2004 and 2008, the Saudi companies we analyzed almost tripled their total asset base, to a total of more than 250 billion SAR by the end of 2008. The grew fixed assets much faster then GDP growth” said Vayanos. The assets were intended to generate additional sales in line with expectations of perpetual growth. “Now that growth has moderated and declined, it’s clear these companies overshot demand. It will take much more time for new fixed assets to pay for themselves,” he added.

Suboptimal Capital Structures
Saudi listed companies’ average debt-to-equity ratio of around 50 percent may appear adequate. However, cash flow from operations and investment activities was negative for more than half (53 percent) of the companies analyzed. Prior to the crisis, those companies easily tapped liquidity from banks to cover this gap. Without a developed debt market, many companies reverted to easily accessible short-term loans to finance their growth—including financing investments in long-term assets.

Today banks are stricter about issuing or renewing loans. “Companies have an unhealthy proportion of short-term liabilities to long-term assets: 60 percent of the analyzed companies have a mismatch between the mix of their current and long-term assets, and that of their current and long-term liabilities,” explained Youssef. Companies could be dangerously exposed if banks put additional pressure on them to pay short-term debt. An analysis of companies’ cash ratios shows that more than 20 percent have a cash ratio of less than 0.1 as of the end of fiscal year 2008, making them highly vulnerable.

Companies moreover have furthered their cash crunch by paying their shareholders dividends despite the circumstances, and had to raise additional debt for them.

Immediate Action: Urgent Repairs to the House 

Managing the top line in isolation from cash flow and balance sheet considerations is unsustainable. Companies need to fix their house in the short term by quickly and tactically addressing these three challenges.

Working Capital Management
Improve accounts receivables: Companies could transform some accounts receivables into cash by changing what they measure, looking at their receivables from the point of order. They should also change how they measure them. Companies then should take immediate action during every stage in the receivable chain.

Overhaul inventory management: Saudi and GCC companies have not managed inventory levels well. Companies may consider reducing inventory levels by selling obsolete inventory, even at a book loss: In many industries, almost half of the inventory cost is related to its storage, handling, and insurance.

Increase accountability for cash flow: “While chasing growth, many Saudi companies tied the incentives of their managers to growth and profitability indicators, prompting them to turn a blind eye to cash flow measures and balance sheet measures,” explained Vayanos. Companies should ensure that incentive schemes reward growth and performance measures related to cash flow and the balance sheet.

Asset Utilization
Improve asset utilization: Companies should consider deferring large capital investments and maintenance capital, as well as selling or leasing out underutilized assets, where possible. Managers must avoid falling into the trap of sunk costs and should not hesitate to stop or delay current projects or shut down plants if necessary. They should evaluate opportunities to improve sales through better targeting, pricing structures, or a more proactive sales approach.

Rationalize the portfolio: Selling idle or underutilized non-core investments can generate significant cash for value-adding operations, despite a loss of that specific investment. 

Capital Utilization
Suspend or reduce dividends: Companies should suspend or reduce dividend payments to save cash and help restore the health of their balance sheet. Investors are more likely now than ever to understand the importance of keeping cash in the company, given the turbulent times.

Ease debt burdens: Banks realize they stand a greater chance of recovering loans by working with companies to restructure their debt. Companies should be transparent with the banks and commit to a clear action plan to address challenges. They could also explore hybrid capital instruments to address short-term needs.

The Long-term View: Rebuilding the Foundations 

After taking immediate action, executives need to lay the groundwork for a more strategic approach to managing financials. “The current market respite means ample opportunity for Saudi companies to take measure of their current situation, invest in the right capabilities, and establish a blueprint for future growth,” stated Youssef.

Most Saudi businesses are governed by a patchwork of independent individuals, departments, and business units. Strategy, operations, and finance are often uncoordinated, operating in silos: a recipe for unstable growth. Removing these silos and fostering cooperation will clarify decision rights and make sure information flows where it needs to. Ensuring that strategy decisions are subjected to rigorous due diligence and risk assessments will also help companies steer clear of financial distress.

Finance unit’s traditional role in Saudi companies has been mainly focused on historical accounting. Moving forward Finance unit’s should design a clear financial strategy, taking into account the company’s operational capabilities and overall growth strategy, and aligning its capital structure, cash management, and shareholder distributions. Finance becomes a business partner to the CEO and the board of directors. As an example, strategically reviewing banking relationships can yield opportunities to build closer relationships by consolidating activities under a select few and finding ways to reduce business finance transactions costs. On the equity side, finance executives could help reset shareholders’ expectations by communicating goals for total shareholder returns over a five- to 10-year period. “This may be tougher in Saudi Arabia, where most investors are individuals, than elsewhere,” said Vayanos. Building better awareness will help keep shareholders from punishing companies for short-term strategic shifts.

Saudi companies should also focus on improving productivity and instituting the right management incentives to maintain a high level of productivity. They should not be shy in making significant changes to their operating model to ensure a radical and sustainable change in cost position. Successful companies will emerge from the downturn with a more competitive and sustainable cost structure than their competitors.