how to approach 2012
by Rick Anderson, Chairman and CEO, Moss Adams LLP
Will late 2011’s mini-momentum continue into 2012? It’s a question everyone seems to be asking. But the answer is far from certain. The economic body blow of the past three years has left a big bruise, and there are simply too many variables in play to say for sure that the healing process will move swiftly.
On the one hand, the nation’s gloomy jobs picture seems to be brightening, and a host of economic indicators—including manufacturing activity, small-business formation, transaction velocity, and consumer confidence—appear to be improving. On the other hand, worries about the euro zone, lingering concerns over US federal and state deficits, and an intensely divisive election cycle make it unclear whether the momentum will continue, much less gather steam.
To be sure, there will be tremendous financial opportunity in some sectors. Others will face onerous structural and cyclical challenges. This inequity is always the case, even during relatively prosperous times.
The good news, though, even for those facing a still-difficult road ahead, is that the financial pressures of the past few years have pushed businesses across the board to redouble their efforts on strong fundamentals, including better strategic and operational planning and increased efficiencies. As a result, many companies are now both healthier and better prepared to weather uncertainty.
With that in mind, let’s look sector by sector and see where the opportunities and challenges lie.
International: Will Sovereign Debt Hurt Growth?
The euro zone in particular—and the global economy in general—is perhaps the biggest variable right now. Bob Bunting, former CEO of Moss Adams, former president of the International Federation of Accountants, and currently chair of the Moss Adams International Services Group, has been on almost every continent during the past year and is deeply connected with public- and private-sector leaders all over the world. Like many observers, he entered 2011 worried about global business activity. But he now feels that the past 12 months were a bottoming-out period. He also sees modest growth—not in Europe but in Asia and the United States—for 2012.
The big problem as we start the new year, though, is sovereign debt. The inability of certain European countries to roll over sovereign debt may force them to restrict activity, and this could cause a major recession around the world—anytime there’s a default, capital dries up and banks won’t lend to one another or to businesses.
This is something Bunting is watching very carefully, but he isn’t totally pessimistic. He reports that clients with global business interests are doing really good risk analysis and working very hard to lock up any lending commitments they need.
He’s also encouraged by the way global companies are investing in sustainable business practices. The main reason for these investments is reduced operating costs; in other words, this isn’t just the result of a touchy-feely green impulse. Yes, sustainability enhances reputation, but at the end of the day it’s about the bottom line. That’s why a consortium of 40 major retailers is working to iron out a common approach to greening supply chains. If they can do this right, it will increase their profits, wherever they operate.
Bunting believes that 2012 will see a good deal more of this proactive environmental activity everywhere in the world.
Financial Services: A Cautious Outlook
Over the past three years, John Hancock, national chair of the Moss Adams Financial Services practice, has seen financial institutions clean up nonperforming loans and other distressed assets carried on their balance sheets. Dealing with internal issues involving these assets, sufficiency of liquidity funding, capital adequacy, and regulatory matters has forced bank managers to look inwardly to resolve problems.
Unfortunately, this means they haven’t had an intense focus on the business of generating new lending relationships, and with continued tightness in the credit markets, Hancock doesn’t think 2012 will represent much of an improvement over 2011 for the industry.
Still, he believes these issues are slowly being remedied and that bankers are again looking, albeit carefully, to expand their customer relationships. The financial institution failure rate will subside, and banks will look for ways to become more efficient and cost-effective and pay more attention to risk-based pricing strategies.
But it will take some time before a more robust rebound occurs and financial institutions achieve more than modest profitability. The reasons? Interest-rate margins remain thin, the cost of regulatory compliance has escalated, and uncertainty persists regarding the implementation and writing of new regulations.
Hancock cites this uncertainty in the industry as a key reason for borrowers to pay extra attention to their lending relationships. Companies need to actively communicate and partner with their bankers more than ever right now. Proactively offering important business documentation, communicating frequently about company activities, and making the creditor-borrower relationship as open as possible is crucial to maintaining and solidifying banking relationships.
Health Care: Accepting Change
Chris Rivard, national chair of the Moss Adams Health Care Group, has advised a wide range of clients during a time of sweeping transformation in the industry. He believes we’ll see a continuation of the move from fee-for-service to a system that increasingly rewards high-quality, efficient care. Individual reform efforts are kicking in, and health care exchanges in most states are being established. The employer-based commercial insurance establishment will adjust to this new paradigm as collaboration and integration continue at a very brisk pace. In terms of overall reform efforts, Rivard believes that by the end of 2012 we’ll be close to the point of no return.
None of this, he stresses, is dependent on the survival of the Affordable Care Act or any other piece of health care legislation. Rather, it’s a function of the environment and the economic realities of health care, both today and in the future.
Looking ahead, Rivard lists a number of factors that will continue to make it difficult for providers to survive in the wake of 2012 without making significant changes in the way they conduct business. The average age of the population will increase for example, as will the average occurrence of chronic disease. The shortage of primary care physicians will worsen, and more people will be insured under government-sponsored health plans (Medicare and Medicaid). What’s more, reimbursement under these plans will erode further, and the cost per day for a hospital stay will increase.
Given all these changes, providers across the continuum will clearly have to make tough choices in the coming year. How to proceed?
The first step is understanding that success for any health care provider depends on accepting change. It means taking an honest look at your organization and assessing your strengths and weaknesses. Every provider has a role in this evolving health care world, but it may not be the role they’ve played historically or even the one they most want to play. Adaptability will be key.
People will argue whether reform is occurring the “right” way or the most effective way. But as a country, Rivard concludes, we’ll emerge from this with a more efficient, higher-quality health care system.
Technology: Keep the Capital Flowing
Like Bob Bunting, Taft Kortus, a partner in the Moss Adams Technology & Life Sciences practice, is wary of a global recession arising from Europe’s sovereign debt crisis. What would accompany a recession? The answer, he says, is easy: deteriorating capital markets—the technology industry’s lifeblood.
But he also has reason for optimism, pointing out that innovation, which persisted during the downturn of 2008–2009, will continue. In fact, many of the technology companies Kortus advises are heads-down on new products and services and driving ahead to the future. He cites new, next-generation breakthroughs in cloud computing and software as a service as examples.
Overall he believes things will happen more quickly in 2012. There simply won’t be as much hesitation. The technology sector, while not immune to economic cycles, is just wired differently.
But it all comes back to maintaining stability in the capital markets. This has to come from policy makers, regulators and, hopefully, from economic conditions. If we can achieve this, he says, we’ll be able to feed and fund innovation, allowing the technology sector to thrive.
Manufacturing: Signs of Life
Activity is picking up, say Kris Dunning and Corinne Baughman, national chair of and partner in, respectively, the Moss Adams Manufacturing & Distribution Group. Despite uncertain global demand, sales in Canada are forecasted to grow strongly, private equity firms have lots of money for strategic acquisitions, and costs in China are rising, making US manufacturers more competitive—especially in California.
Companies are making some investments in productivity, looking to get more output with existing resources. However, despite the ramp-up in hours, they’re still hesitant to hire permanent workers, and they don’t anticipate adding much to their workforces in 2012. That said, some companies have carried excess capacity in positions critical to their business, giving them the ability to increase output as sales increase.
But Dunning and Baughman also remind us that this is an election year, which breeds even greater uncertainty when it comes to taxes and economic policy. What’s more, many customers remain skittish, credit availability is still tough, banks continue to look critically at risk, and cash flow and liquidity pressures persist.
Dunning and Baughman point out that the manufacturing companies that have done well over the past three years are those that have aggressively managed cash and inventory. Cash hoarding has also contributed to survival and success, and this approach will still have merit in 2012. Big investments may not be possible, or even advisable, but small ones can pay off. There’s also an opportunity for international sales, despite the problems abroad. As John Hancock mentioned above, working closely with banks is an absolute must.
The other thing to watch is the flurry of manufacturing company owners taking advantage of favorable estate tax provisions before the year ends and less beneficial rules return.
When push comes to shove, though, Dunning and Baughman believe 2013 will be a better year for manufacturers than 2012, noting that we’re still not on a solid and sustainable growth path in this sector.
Transactions: The Three Cs
Luc Arsenault, who leads the Moss Adams Transaction Services practice, says the European debt crisis had a major impact on middle-market M&A activity toward the end of 2011 because it created additional risks and uncertainty. But he still expects to see a continuing increase in deal activity in 2012, similar to the increase we experienced from 2010 to 2011. Nonetheless, according to Arsenault, 2012 will be another year that flashes proceed with caution.
The upside in 2012 will come from a variety of potentially positive economic news, including strong new jobs data. This will signal to the market that consumer confidence is back on track. Confidence is, after all, one of the three Cs (along with cash and credit) required for a sustainable deal environment. The cash is present, and the credit is available, but it’s still restricted to strong businesses. An easing of credit would go a long way toward improving deal flow.
Arsenault strongly believes that to prosper in the near future, the country needs to get the deficit and debt under control. It took approximately 200 years for the United States to accumulate $1 trillion in debt. Since then we’ve been adding approximately $1 trillion in new debt annually. Arsenault thinks the failure of the so-called deficit supercommittee last year could result in additional market uncertainties and hence a negative impact on deal flow.
But he reminds us that deficit reduction is a double-edged sword: While overall it fosters confidence, at least in the short term it can negatively affect certain sectors that rely on government spending. Potential cuts to the defense budget, for example, could impact the aerospace industry, a sector that was very active in middle-market M&A activity in 2011.
For additional perspective, Arsenault contacted Dave DiFranco, a principal at Blue Point Capital Partners, one of the largest private equity firms serving the middle market. Like Arsenault, DiFranco forecasts a better year ahead. He thinks valuations are improving, and he sees lots of buyers that want to put capital to work. Last year saw a mix of private equity deals as well as entrepreneurs and business owners doing deals. In 2012 he thinks the blend will be different.
DiFranco is still uncertain about Europe for 2012. But he feels better about the United States, projecting a flat to slightly up economy, although he’s braced for an unanticipated negative. And amid the lack of clarity and uncertainty, DiFranco doesn’t think China will let its economy land hard.
The watchwords for 2012? Revenue and talent. The next 12 months, both Arsenault and DiFranco agree, will put a premium on both.
Real Estate: Laying the Groundwork
The property markets, as we all know, have been battered since the financial meltdown in 2008, with multifamily housing being the only well-healed sector. So is 2012 finally the year we see a significant move in the other direction for the other sectors?
Greg Martin, national chair of the Moss Adams Real Estate practice, emphasizes that jobs are critical to any rebound in the commercial and residential real estate sectors. The markets where job stability and growth take hold are the ones that will see improved rents, sales, and investment prospects.
In the meantime, Martin notes, companies are making bare-bones real estate decisions, and they’ll demand shorter commitments and more flexibility going forward. The US rate of home ownership will also stay soft as recession-weary Americans stick to renting.
Martin points out, however, that even though home prices fell nationally in 2011, a consensus of home builders and industry analysts anticipates prices stabilizing in early 2012, with an uptrend to follow. The leading job centers, such as San Francisco–Silicon Valley, are already seeing price stabilization, gains, and new construction. There are other niche opportunities throughout the West.
Martin believes that while real estate firms have gone through significant pain over the past two years, many of them are now lean, focused organizations, ready for new opportunity, especially as access to capital increases. Firms that have survived prior downturns know that better times are ahead, and they’re acting where they see real prospects, especially in the residential multifamily segment.
Being ready for opportunity is crucial, Martin emphasizes. Companies that haven’t fully reevaluated their real estate strategies must take action, especially as the economy begins improving. Real estate firms should also line up access to financing, particularly if they can gain access to the lower-cost sources now emerging. And if they haven’t done so already, apartment developers and investors should move quickly to take part in the renter-dominated housing market.
Construction: Fundamentals (Still) Matter
Shovel-ready programs from Washington, DC, really did very little for the construction industry in 2011, according to Elaine Ervin, who leads the Construction practice at Moss Adams. Why? Long lead times. She points out that it takes 18–24 months with architects, engineers, and banks before you can ultimately break ground on a project. Plus, we’re probably not going to see a lot more of these programs in 2012, because they’re just not effective as currently configured and deployed and because of politics and fiscal realities.
There are, however, some growth sectors Ervin is optimistic about for the next 12 months. Construction for multifamily housing, health care, and higher education are good examples. Marine contracting, which includes dredging, will also be a bright spot. But construction for commercial office buildings and condominiums will still be slow. There continues to be much inventory to be absorbed in both sectors.
The bottom line? It’s going to continue to be a long dig for construction in 2012. The markets just aren’t going to recover quickly over the next 12 months.
In tactical terms, though, Ervin believes that the good contractors—those who pay attention to the details and manage their cash flow—can ride out this rough patch. They have to know where their cash is and where their obligations are, both today and in the future. They also must find ways to put more money in their pockets, and one of the best methods is to take advantage of every available tax credit—from R&D credits they may be surprised to learn they could qualify for to energy credits many construction businesses end up leaving on the table.
If they can do these things well, Ervin thinks they can turn the corner in 2013 when, hopefully, the markets will improve. In the meantime, she cautions, business will be slow, margins will be tight, and profits will be slim at best.
Food Processing and Agriculture: Keeping the Momentum Going
Is there an industry that’s been fairly stable and relatively profitable through the downturn? Yes, says Bryan Powell, who leads the Food Processing & Agriculture Group at Moss Adams. After all, he adds, people still have to eat.
Consumers have traded down, he acknowledges. They don’t go out to eat as much, or they choose chicken over steak. But he sees 2012 being essentially a repeat of 2011. Which means it may be a great time to expand or upgrade processing facilities. Most business owners have deferred technological advancements over the past few years. Now, with interest rates low and accelerated depreciation options, their return on investment is much quicker. Technology affords throughput efficiencies that help reduce costs.
So is there a cloud to the silver lining? Everyone’s keeping an eye on Europe as the biggest concern, but Europe aside, the biggest downside will be increased input costs to produce products. So for the dairy farmer that means the cost of feed. For the French fry producer it’s the cost of potatoes. For beverage makers it’s sugar equivalents. And for the growers it’s the cost of fertilizers. Input costs, Powell believes, are likely to continue along at a steady incline.
Regardless, the biggest thing companies can do is to really improve working capital by restructuring their balance sheets to maximize their position. This will help create a reservoir of funds if an opportunity comes their way and a rainy-day fund if times get really tough.
It pays to be prudent, Powell says, noting that all the tax write-offs available for facility upgrades might have given businesses a false sense of security. Companies have become used to writing off everything when they buy it and aren’t yet seeing the tax bite when they don’t have depreciation.
But that’s about to change. Bonus depreciation shrinks from 100 percent to 50 percent in 2012. And absent any new legislation, in 2013 it’s scheduled to sunset completely, along with the so-called Bush-era tax cuts. Add in the looming provisions of health care reform, and there’s no way for businesses not to get pinched.
It’s a useful reminder, Powell says, that everybody should have a scalable, detailed financial forecast that accounts for contingencies like increased input costs, health care, taxes, and compliance-related expenses. In addition, new working capital targets should be set and maintained—something that’s absolutely critical, especially in times like these.
State and Local Tax: Making Careful Choices
It’s no secret that state governments are struggling financially all across the country. And, according to Rob O’Neill, a partner in our State & Local Tax Group, despite the tentative recovery of the past few months, state coffers aren’t being refilled as quickly as one might think. In fact, most states continue to cut programs and look for new sources of revenue.
In O’Neill’s opinion, this means more state audit activity will be focused on bringing in additional revenue and taxpayers. It also means companies doing business in a state, but located outside the state, will be audited more regularly. Furthermore, since a lot of this effort is being contracted out on a contingency- or success-fee basis, the audits will be aggressive and sophisticated.
The upside here is that companies may be able to benefit from the competition between states as they seek to get businesses to relocate, create jobs, and boost tax revenues in their communities. There are many incentives being used in this recruiting effort, from property tax cuts to payroll and income tax reductions to investment tax credits. Taking advantage of these incentive packages is an opportunity for companies as state economic development campaigns heat up.
But companies have to understand where they’re vulnerable, O’Neill stresses, especially in terms of state auditing processes. Knowing this will help management make good decisions. Companies also need to analyze the state incentives out there and make sure they fully grasp all the refund opportunities that surround state tax laws and codes before they make any expansion or relocation decisions. Negotiating the best possible incentive package with a state, he says, can make a tremendous financial difference over the long haul.
Conclusion
As the above comments clearly show, the watchwords as we approach 2012 are patience and scrutiny. For many business sectors, the next 12 months aren’t going to be easy, and, after several years of tough sledding, there’s still no quick fix.
One of the most challenging elements companies will face in 2012 is the regulatory environment. It’s in a great deal of flux, especially as standard setters and government agencies continue to try to hammer out a way to prevent the kind of calamity we saw in 2008, and it’s a certainty that both the number and complexity of rules will increase. This makes compliance with accounting standards and tax regulations especially difficult.
On a more macro level, it’s quite obvious that doing business in the world isn’t getting simpler. Everyone is coping with complexity and uncertainty.
But as we can also see, uncertainty is no reason to despair. Many businesses are finding success by paying renewed attention to business basics: cash flow, risk analysis, due diligence, greater efficiency, and so on. These may not be sexy, but they’re crucial. And they’re things your organization can do right now to help it survive—no matter what the economy does in 2012.
Rick Anderson has been chairman and CEO of Moss Adams since 2004. He has close to 40 years of experience in public accounting, including serving two terms on the board of the Financial Accounting Foundation and several committees for the American Institute of Certified Public Accountants.
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