UK economy: working your way through the downturn transcript

Welcome to this PricewaterhouseCoopers podcast. I’m Gordon Thomas, partner at PricewaterhouseCoopers and with me today are John Hawksworth, Head of PwC Macro Economics, Barry Ross, Head of Corporate Restructuring and Jason Green, a director in Corporate Finance.

With the state of the UK economy still dominating the headlines, our specialists will be assessing its immediate outlook and how this will affect the corporate marketplace and outlining the steps companies need to take to plan for the future.
Turning to you John, just to start, what’s the latest evidence from the global and UK economies and how severe is the UK downturn so far?

Well it’s a pretty mixed picture globally – the US economy is pretty much flat-lining but other parts of the world are doing OK. In your area there were pretty good results for the first quarter, Germany doing pretty well and the BRIC economies are roaring ahead so we’re certainly not looking at a global recession so far, it’s just a slowdown. And that’s also the picture in the UK – it’s pretty mixed. There are some areas of the economy such as the housing market, construction and parts of the city affected by the credit crunch that are suffering a bit. Other areas of the economy that still seem to be growing reasonably well so it’s certainly a slowdown and not a recession so far.

OK. As an individual dealing with clients I am slightly confused because I talk to one client who says they haven’t seen any indication of a recession so far, WPP’s results just looking forward suggests that they are expecting like-for-like revenues to continue growing faster than in 2007. I always thought that advertising was a bit of a bellwether for these things.
It does seem like the shape of the downturn is different this time. Things like advertising not so badly affected. There are kind of two epicentres of the downturn in the credit crunch and the housing market. If you’re not really directly affected by that, you’re probably still doing pretty well so it’s a pretty mixed picture so far.

And Jason, in the debt markets?

I think I’d be inclined to agree with what John said actually in terms of the mixed picture. We keep hearing that the debt markets are closed almost in their entirety but that’s certainly inconsistent with my experience including during the first part of this year and so which are the transactions that can still attract financing? Well I think a few comments I could make: size is clearly important and I think where the debt amount is greater than five or six hundred million pounds I think it’s extremely difficult to do those deals although not impossible. But in what I would call the mid cap which is debt levels up to that sort of quantum then we are still seeing a relatively good deal flow so what are the characteristics of the deals that can attract financing? Well I would probably alight on five and the first one, again to pick up John’s comment about the mixed nature of what we’re seeing at the moment, there are winners and losers and of course banks are desperately trying to identify the winners and avoid the losers. There are those that are not necessarily GDP linked and I think that banks are looking for non-cyclical businesses that could be expected to ride out any downturn and closely associated with that then would be the defensive nature of borrowers that are getting banks to look in to try and identify. Fourthly then, low volatility in cash flows which you would normally expect to see in a business with good contract and revenue visibility and then finally I suppose it has to be said the sector point and clearly not all sectors are affected. We hear a lot about consumer sectors or consumer facing businesses but even in those sectors the banks are mitigating their risks there by running more detailed sensitivities and thinking about what the sensitivity cases are that would take into account even a very nasty downturn for that for that particular borrower.
And Barry, does that line up with your experiences?

In part yes, I think what we’ve seen since the autumn is our order book increase by about 10-15% and that level has remained pretty consistent in terms of activity and I think we’ve seen that really aligned around the sectors that Jason was talking about in terms of people that are aligned to consumer. We’ve also seen some issue with financial services and finally I think the thing that goes across all sectors really is levels of debt just in terms of leverage. Going forward though I think I am certainly a little bit more downbeat. I think the issues around inflation and also around the cost and availability of credit will actually start to have more of an impact across more businesses and there I think it will expand into areas like house building that John mentioned, logistics and transportation and property suppliers and financial services will become harder and I think in all of those, even businesses where there is some growth, there is still going to be a downturn in the levels of growth that they are experiencing and so therefore I think that most businesses will have to change the way they have operated because life will be harder this year than it was last year even if they’ve got some growth.
Turning back to you Jason just for a second, all of this seems to be that debt markets are different, it’s difficult and Barry is saying that organisations are going to have to behave differently so when do we return to normal?

Well firstly I think you’d have to define what normal means and I think the first half of 2007 is a period of time the like of which we are not going to see for a very long time but if we take that our of our definition of normal and think about perhaps during the course of those six when debt markets weren’t quite as frothy, then I think it’s probably at least a year away frankly before we get back to that point and it really depends on the absence of bad news as to when that year starts or indeed whether it has perhaps already started. Again I’d echo one of Barry’s comments in making the distinction between the financial system and the real economy and I think that’s really a big dependency for how long it takes us to return to normal but absent further major sub prime write downs, absent failure of a mono line insurer and other sort of risks that remain in the financial system then certainly in Spring next year I would have thought that we would see a degree of normality return.

Now going back to you John, just at a macro economic level, we’ve seen announcements of government injections of funds into the economy and yet we also see lots of risks of inflation – inflation is already 3% - how do you see those balancing out?

Well yes, the Chancellor has just given away £2.7 billion in income tax cuts so that will help a bit but of course that also…. The Chancellor is putting in money but then the Bank of England is going to be less prepared to cut interest rates because it will feel that the Chancellor is doing that job for it and so with inflation at 3% and rising it does mean that the prospect for interest rate cuts looks a lot worse than it did even three or four weeks ago. We may still get one or two later in the year but they’re going to get less and rather slower than people had hoped and so the cavalry won’t quite come over the hill in terms of interest rates in the way people might have been hoping for, in at least the next three to six months so I think businesses will have to batten down the hatches, deal with the fact that their import costs are going up but they may be finding it difficult to pass those on to the consumers so it will be a difficult time for companies in terms of reacting to that kind of pressure.

Given this background, what should companies do? Turning to you Barry first of all.

I think there are some pretty simple, straightforward things they should do. In fact the most common sense thing to do is to focus more on cash. I tell you it is common sense but frankly in my experience it’s not so much common practice. And I think the thing you need to do there is make sure you’ve got the key performance indicators available to actually monitor what’s actually happening in cash, make sure you’ve got clear ownership for the management of it and make sure your communication strategies are all there. Credit control is not a bad thing and should not actually harm relationships with your suppliers and your customers and it’s essential that your staff know how to manage it and take responsibility for it. So I think that’s the first thing. I think then as well some scenario planning. One of the issues that is facing people now is visibility of what’s actually happening in the marketplace so we are working with a couple of companies at the moment where we are looking at various scenarios they might face in the forthcoming 12-18 months and then working out if that scenario actually emerges what should they do in terms of their operations and HR? What should they do to actually execute around that strategy because that will then give them the opportunity and the agility to move quickly to deliver against that plan and I think that was going to be one of the things that will sort out the winners and losers that Jason was talking about because I’m a great believer that business is a lot around good strategy well executed and therefore this is around having some good tactics in the short term and being able to well execute them. The final thing I would say is making sure that, once you’ve identified the scenarios, work out for your business what is the advance warning indicators that will help you determine which of those strategies is actually emerging.

I would agree with that. I think that what we are finding is that business really need to stress test their business against different scenarios and adopt that kind of problemistic approach because to be honest no-one can be sure whether there will be a recession or not so you might say well ok you have one scenario with a three in four chance which is just a slowdown and a one in four chance of recession and your valuations, if you are doing a project or an acquisition of what you are going to pay for that is actually going to be a weighted average of those different scenarios problemistically. That is the kind of approach we are working with clients on and we think is sensible in this quite difficult environment.

Well picking up the point on valuations, it’s a good point, clearly there are opportunities to buy on the cheap in today’s market and so I think there are a number of private equity houses that perhaps don’t have the stress in their current portfolios and are looking at bolt-ons or new acquisitions that they can do out of their funds believing there is value to be had in today’s market so those that are in that position I think will find there is real value in today’s market and perhaps if the debt funding is done today on a very conservative basis that actually provides the refinancing opportunity in 18 months, two years hence.

And Barry, just picking up Jason’s point about opportunity, how do you see it?

I’d agree with that and echo it really. I’m a great believer that if you get your own house in order and try and be as strong as you can be, that will give you the best opportunity to take advantage of opportunities that come along.

I would also say at a macro level that I think what we are going to see is the UK economy is going to rebalance from domestic demand to exports. The pound has come down 12% over the last year so I think some of these fast growing emerging markets for example, instead of just being places to outsource to will actually be big new markets to sell to and I think that is going to be huge new opportunities looking three to five years ahead for these businesses.

So in summary, a mixed picture for the economy, different by different sectors, a need to focus really firmly on cash and make sure you’ve got plans in place to execute against various scenarios, opportunities to get good value in the transaction market as ever and opportunities in exports with the weakness of the pound and some of the growth economies we see outside of the UK.

John, Barry, Jason thank you very much for your time. I’m sure our listeners will have enjoyed it.

You can find out more information about the current issues affecting the UK economy on our website pwc.co.uk. Thank you very much for listening.