As of this writing, the COVID-19 lockdown continues to escalate, and it is unknown the extent to which it may be escalated to manage the impact of the virus. In addition, the collapse of oil prices – normally an economic event of material consequence – is hard to detect amid the virus-caused slowdown in the worldwide economy, unprecedented in modern times.
The immediate future is uncertain, and yet we must plan and execute to keep our Solution Provider businesses moving ahead, and continue to serve our shareholders, business partners, customers and employees and their families as well as possible.
This newsletter suggests methods to plan and execute successfully in the current circumstances which are drawn from our experiences managing through previous recessions, and our current, daily, and often urgent work with clients and members.
This newsletter has four main sections:
To aid you in finding the precise information you would like, we provide a more detailed Table of Contents below.
For those not interested in the first two sections on the likely economic planning context for Solution Providers, go straight to “Actions to Maximize Revenue, Profit and Safety” and read that section.
For those with very little time to read, go directly to the “Start of Recession Checklist of the Best-in-Class”. See also the two “Recommendations for Driving Revenue in a Recession” tables.
The first thing we need to do is understand the likely trajectory of the business economy for which we are planning. The situation is unprecedented, but as we survey the available macro-economic analyses, we see that three scenarios seem to be commonly identified by the various experts:
It is beyond the scope of this document and our abilities to predict which of these might be most likely to occur, but we will pick Scenario B as our planning scenario, for reasons we’ll shortly explain.
We are not experts in the field of economics outside of the Solution Provider industry. The situation is unprecedented in modern times, but there are perhaps some clues that can give us a sense of context.
In most recessions, the fact that a recession is occurring is often uncertain in its early stages, as is its ultimate depth and duration. In fact, for this reason, the U.S. Bureau of Economic Analysis, which is officially chartered with declaring recessions in the United States, purposefully doesn’t do so until two or three quarters after the recession has begun (and thus possibly after the recovery has begun).
In contrast, in this case – as with the September 11, 2001 attacks – the trigger of today’s economic slowdown is obvious.
Also, in parallel with the September 11 attacks, at least some of the slowdown is wisely mandated by governments. In the case of September 11, the U.S. federal government ordered the skies to literally be emptied; within an hour all non-military air traffic was grounded. The impact on the finances of the commercial airline industry was immediate and material.
Similarly, today governments worldwide have ordered what is in effect a “grounding” of much of the commerce that cannot be conducted in the virtual world. As much physical world productivity continues as possible, of course:
Regardless, the economic impact will be substantial.
There is no lack of opinion in the news, but to provide some expert context, here is Goldman Sachs’ opinion of what may happen macro-economically, as of March 20, 2020. They reportedly expect Q1-20 U.S. GDP to drop by 6% from Q4-19 and then by another 24% in Q2-20 from Q1-20. Here is their prediction expressed monthly:
Figure 1 - Source: Goldman Sachs 3/20/20 projection for recession impact, for via the Daily Mail (UK)1
To quote the Daily Mail: “That would be more than double the largest quarterly drop in (U.S.) GDP on record, which is a 10 percent decline in the first quarter of 1958 during the 'Eisenhower Recession.'”
This is just in the United States. Similar lockdowns are wisely being enacted – with concomitant economic slowdowns – in many if not most countries around the world.
Regardless of this difficult picture, we know two things. First, the situation often turns out to be not as bad as it at first seems. Second, we will survive, and many will thrive. Let’s talk about how.
We outlined three scenarios at the start of this newsletter:
We’re going to focus on Scenario B. Many of the actions we suggest in this newsletter are applicable to Scenario A and Scenario B. However, Scenario A, with its short-term nature, requires the least planning, and Scenario C, by its extreme nature, makes it impossible to fully address.
We also believe Scenario B is the most likely outcome, though we are hoping and praying for Scenario A.
While we all hope for Scenario A or something better, we would be wise to be planning for Scenario B.
In late 2018 and early 2019, many Solution Providers were worried about a recession occurring in 2019. In March 2019, we published a 12-page advisory, in which we outlined the strategies used by those Managed Services Providers (MSPs) and Product-Centric firms (VARs and Resellers) who had most successfully navigated previous economic downturns of various magnitudes. Later in the year, we built on that in our Service Leadership Index® (S-L Index™) Annual Solution Provider Industry Profitability Report™, in a section called “Recession Contingency Planning.” We’ll leverage both resources in this discussion.
Because the Service Leadership Index has uniquely benchmarked the largest population of Solution Providers in the most detail, for the longest time (every quarter for nearly 15 years) in the industry, we can share the most accurate view of what happened to Solution Providers in the “Great Recession” of 2008-09. In addition, we have successfully managed our own Solution Providers firms through previous recessions.
It is a possibility the depth of even the “Great Recession” will turn out to have been shallower than the one resulting from our current situation, but it does offer a fact-based view which is instructive to us today.
Here, we look at the impact of past recessions on three Solution Provider Predominant Business Models™ (PBMs™)2:
Although we don’t include them in the charts below, we will comment on the impact of recessions on Project Services companies, whose predominant Revenue stream is from implementations of infrastructure (such as data center builds, large scale roll-outs, and so on), and the most successful navigation strategies of those companies.
In the recessions of 2001 and 2008-09, P-C firms’ Revenue dropped quickly (within two quarters), on average declining about 45%.
Customers can curtail capital spending – on IT and any other capital investment area – very quickly. To remain intact, a customer order for product must generally fulfill one or both of these conditions:
Obviously, the Revenue of P-C firms doesn’t drop to zero, so there must be a fair bit of business which meets one or both conditions.
One area that P-C (and other) firms should pay attention to is the immediate infrastructure changes needed to accommodate the shift in customer workload patterns brought on by a recession. The obvious example in today’s situation is the rapid deployment of “Work From Home” infrastructures.
We will address successful coping strategies for P-C firms during recessions in a few moments.
The SMB-focused Managed Services business has only weathered one recession (2008-09) just as they were gathering steam. Therefore, we don’t have multiple data points to inform what will happen to SMB MSPs in today’s situation, but we can guess.
In past recessions, Mid-Market and Enterprise MSPs Revenue dropped about 30% over the first one to three quarters. One might ask, “Managed Services is by definition, contracted recurring Revenue, how can it decline so much?”
Regardless of which size customer they focus on, three things occur which impact MSP’s contracted recurring Revenue during economic downturns:
These factors, along with a drop in IT capital spending by their customers, mean that MSPs generally experience a 30% drop in Revenue within the first three quarters of the start of a recession.
We will address successful coping strategies for MSP firms during recessions in a few moments.
In past recessions, these firms have fared fairly well, dropping only about 10% in Revenue in the first three quarters. This lesser downturn is a result of three factors:
That said, empirically, the Private Cloud business model is one of the most difficult and risky of all Solution Provider business models, and we do not recommend that those Solution Providers who do not have a Private Cloud business, or whose Private Cloud business isn’t healthy, increase their investment in this area.
We will address successful coping strategies for Private Cloud firms during recessions in a few moments.
Unfortunately, of all the PBMs, Infra-Project Services firms experience the greatest financial challenges during downturns, for a simple reason.
As with Product-Centric firms, Infra-Projects firms rely on customers making capital investments which, as we have noted, customers are capable of quickly shutting down.
From there, the economic journeys of Product-Centric and Infra-PS firms during recessions, diverge:
As a result, during downturns, Infra-Project Services firms typically experience substantially more financial stress than do the other PBMs.5
This can be seen in the chart below, comparing the change in profitability of Product-Centric firms and Infra-Project Services firms, during and coming out of the recession of 2008-09.
Figure 2 - Recession and post-recession profitability of Product-Centric and Infra-Project Services firms
Compared to Q1-08 (our “Index” quarter, meaning that quarter’s result =1.0), in Q4-08, the point at which the recession was in full swing, we see that the Median Product-Centric firm (P-C) had an Adjusted Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) Percentage of 0.2 times what it was in Q1-08 (the first quarter of the recession and itself already down from the strong economy of 2007). Meaning that in actual Adjusted EBITDA % in P-C firms, the result in Q1-08 was 4.5%, then in Q3-08 it was a mere 0.8%.
This is certainly a sharp fall-off in profitability, and one should keep in mind that this thin Q3-08 profit percentage was against a 45% Revenue decline, which means profit dollars were very thin indeed.
Now look at the Infra-Project Services firms: In Q3-08 they had dropped even further than Product-Centric firms, into negative profit territory with 0.3 x the profit percentage they had had in Q1-08. In financial terms, they had gone from 9.3% Adjusted EBITDA % in Q1-08 to -2.6% in Q3-08.
As hard as this deceleration was on Product-Centric firms, it was more difficult for Infra-Project Services firms. Why did the Infra-PS firms drop this hard?
This chart serves to illustrate another useful relationship between Product-Centric and Infra-PS firms:
Generally, this “sonic boom” effect of Infra-PS firms doing better (and worse) one or two quarters after the Product-Centric companies has been consistent over the decades. This is because customers buy equipment, and then need it installed. Often – and to the surprise or bewilderment of the Product-Centric firms who have their own Project Services teams – the Infra-PS firms are installing equipment the customer bought from the Product-Centric firms.
As often as not, it takes the customer, and the project team they have engaged, several months after the equipment is shipped to actually pick it up and put it in place. Customers are invoiced for equipment when it ships; they are invoiced for projects when the project is done (or perhaps at best when phases of the project are done). Thus, project Revenue frequently lags equipment Revenue by a quarter or two.
Another factor made clear by the chart is that – although the 2010-12 time period was officially a recovery, it was a weak one. While the Product-Centric firms did trend weakly upward, the Infra-PS firms trended downward, again because of their tendency to hold on to COGS, that is, hold on to technical people in the face of uncertain demand.
We will address successful coping strategies for Infra-Project Services firms during recessions in a few moments.
Generally speaking, since its advent in the mid-1950’s, businesses have turned to increased computer usage in boom times to accommodate and capitalize on growth, and in bad times to increase automation, usually to reduce COGS and/or SG&A expenses.
Despite the ubiquity of IT in today’s business, government and personal activities, we believe this downturn will fuel continued investment in IT. The initial effects of this, of course, can be seen in the urgent orders of laptops and tablets being placed by customers who are ill-prepared for the “Work From Home” mandate. Likewise, no doubt, personal, commercial and government networks are being rapidly upgraded to accommodate a massive shift in data and voice traffic patterns. Probably the volume of workload being transferred to the public and private cloud providers will go up, perhaps substantially, so that customers don’t need to be responsible for their own data centers in the midst of rapid change.
At the same time, we fervently hope the following piece of data isn’t relevant:
Thus, while we expect Solution Providers to have worse financial results in the next few quarters than they would have had, if the boom had continued, we do expect both they and the IT industry as a whole to recover, and perhaps recover faster than the general economy.
We can start by examining the Revenue and profit recovery of Solution Providers in the U.S. after the 2008-09 recession. This chart (Figure 3) shows the growth in Revenue since 2009 – the last year of that recession – of the Solution Providers in three PBMs: Product-Centric, MSPs (Infra-MS), and Private Cloud providers (Infra-SS).
Figure 3 shows these Revenue trajectories:
Figure 3 - Revenue growth of the average Solution Provider in each of three PBMs, since the last recession
Figure 4 shows the change in profit (Adjusted EBITDA percent) of the same three PBMs during the same time period. This is a somewhat dizzying chart – which reflects the real volatility of bottom line profits.
Figure 4 - Change in Adjusted EBITDA % of the average Product-Centric and MSP firm since 2009.
We outlined three scenarios at the start of this newsletter:
In this section, we’re going to focus on Scenario B. Many of the actions we suggest in this newsletter are applicable to Scenario A and Scenario B. However, Scenario A, with its short term nature, requires the least planning, and Scenario C, by its extreme nature, makes it impossible to fully address.
We also believe Scenario B is the most likely outcome, though we are hoping and praying for Scenario A.
The charts that follow show two planning cases:
These are shown for two PBMs: Product-Centric and MSPs (Infra-MS). Figure 5 shows our Revenue projections.
Figure 5 - Revenue projections for P-C and MSPs firms in a "Scenario B" recession (dotted lines)
For Product-Centric firms:
The blue dashed line shows what we project Revenue to do in a recession, for Product-Centric firms pursuing all customer sizes.
The green dashed line shows what we project Revenue to do in a recession for MSPs pursuing all customer sizes, including SMB.
Figure 6 shows our Adjusted EBITDA percent projections, for both “Bust” (Scenario B) and “Boom” cases, for Product-Centric and MSP firms.6
Figure 6 - Adjusted EBITDA projections for MSPs and Product-Centric firms in a Scenario B recession (dotted lines)
In Figures 7 and 8, we show the Revenue and Profit dollar projections for a Scenario B recession for the average P-C and MSP firms.
The reason we are showing dollars instead of percentages or degree of change, is that it can sometimes be hard to relate percentages and indexed numbers to management’s perception and understanding of the reality of the situation. We don’t wish to belabor the unpleasant here, but instead to make clear the challenges management will need to face.
Figure 7 shows the Revenue of the average P-C and MSP firms, in a Scenario B recession and recovery.
Figure 7 - Revenue of the average P-C and MSP firms, in a Scenario B recession (dotted lines)
The solid blue line shows what the Revenue of the average P-C firm ($48.6mm in 2018) would be in 2028 after 10 years of economic expansion (2019-28).
The dashed blue line shows the Revenue trajectory of that same average P-C firm since a recession has hit in 2020.
The green lines show the same for the average Infra-MS (MSP) firm, whose Revenue was $5.9mm in 2018.
In 2028 with no recession:
In 2028 with a recession:
Figure 8 - Adjusted EBITDA dollars of the average P-C and MSP firms, in a Scenario B recession (dotted lines)
On this chart, we run the risk of creating “assumption-stacking errors” by applying the Median Adjusted EBITDA % Projections to the Median Revenue Change Projections. That said, the exercise merits coming to conclusions.
In 2028 with no recession:
In 2028 with recession:
Projecting the future is a risky business, and we may very well be wrong. We hope, as we’re sure you do, that we are too pessimistic in our discussion today, but that you find our thought process useful in advancing yours.
Most effectively navigating the turbulent waters ahead requires three steps:
We’re going to give you the details on these, but first, here are the strategies common to those Solution Providers in all business models who fare best in recessions.
As the recession starts to take hold, Best-in-Class management teams exhibit these behaviors:
If you get nothing more from this newsletter, pay attention to this checklist.
Unfortunately, it looks like, because of the steep drop in Revenue that many of your customers are going to experience, it is likely that you, too, will experience a rapid reduction in Revenue generation, and therefore profit dollars.8
In the face of this, you must quickly determine three things as best you can:
These together will help you understand the degree of safety you do or do not have, and the speed, depth and nature of the actions you must take.
The spreadsheet below shows an example of one Solution Provider’s actual calculation of their February 2020 Balance Sheet and Income Statement (labeled Case 1) in a format we provided them, and then our response to it (Case 2).
Those of you who subscribe to our S-L Index benchmarking or have implemented our Normalized Solution Provider Chart of Accounts™ (NSPCoA™)9, will recognize the row labels as being set to that standard. Those of you who do not, you can likely interpolate quickly to your own Chart of Accounts.
Column D: In both examples, column D, labeled “Today” is this Solution Provider’s:
This is because the most accurate Balance Sheet can be pulled daily, while the most accurate Income Statement is last month’s. This is close enough for our purposes.
Column E: In both examples, column E is the percent by which they (in Case 1) and we (in Case 2) are adjusting the value in column D for the risk presented by the current economic situation. A positive value in column E, means a reduction of the value column D by that amount. Thus, a column E value of 40% means the value in column D will be reduced by 40%: $100 in column D x (less) 40% in column E = $60 = column F.10
Column F: This is the risk-adjusted number.
As noted in the title of this subsection, the objective here is to determine how long the company’s liquid assets (essentially cash on hand and collectable Accounts Receivable) can pay for the company’s essential expenses (payroll and other unavoidable fixed expenses).
The assumption here (as discussed in the second section of this newsletter) is that the Revenue of virtually all Solution Providers (MSPs, VARs, and other business models alike) will materially decline in the near term, and probably for some period of time.
The follow-on assumption is that many Solution Providers will go into negative cash flow, that is, will start to lose money, possibly as soon as this month.
It is imperative that you know, with reasonable accuracy,
whether or not this is true for your company, as soon as possible.
Once you have determined that you are likely to be losing money (though we hope not), it is also imperative that you know how many months of cash coverage you have under these conditions.
How many months will your available cash cover the bottom-line losses, if Revenue continues at a depressed level, continues to decline or, improbably but these days possibly, stops altogether?
That is the purpose of this subsection.
To orient you to the more detailed spreadsheet of our examples, let’s first look at a simple version, shown in Figure 9, below.
Figure 9 - Simple version of a risk-adjusted "Months of Cash" calculation
The above example is fairly merciful: even though the bottom line goes negative, there’s enough cash on hand after our likely liabilities and expenses, to cover those losses for 9.7 months, as long as the risk-adjusted level of Revenue keeps coming in and our costs stay where they are.
As stressful as running nine months of losses would be to this fictional management team, in real life, unfortunately, things are often not even as easy as this.
Figure 10 below shows the initial attempt by an actual Solution Provider management team, to perform the risk-adjusted “Months of Cash” calculation.
In the column titled “S-L Notes to Readers” we provide the comments we gave as we advised them on revising the spreadsheet to better reflect the likely situation and restore bottom line profit under those conditions.
(Please forgive the tiny font; a larger version of this is provided in the Appendix, in landscape format.)
Case 1: Created by Solution Provider
Figure 10 – Initial attempt by a real Solution Provider to create a risk-adjusted “Months of Cash #2” calculation
In the second to last row, “Months of Safety #1”, we see that this management team calculated that, prior to the downturn, they had enough cash and collectable A/R to cover 1.7 months’ worth of Service Payroll and SG&A costs if no further Revenue came in the door. They further calculated that, after the downturn, despite now losing -$160,000 at the bottom line, they still had 1.5 months of cash coverage without any future Revenue.
In the last row, “Months of Safety #2”, we see that they calculated, before the downturn, because they were generating positive Net Income, they essentially had cash to last forever (as long as those conditions persisted).
We see that they calculated the post-downturn “Months of Safety #2” at 8.6 months. This may be enough time for a recovery to start to take hold and a return to a positive bottom line for the Solution Provider.
Wisely, they were anxious about suddenly losing -$160,000 a month and about what had appeared to be a seemingly reassuring calculation that they could withstand that loss for nearly nine months.
As they reviewed this with us, we saw right away that these conclusions were, indeed, likely to be false. As you can see from our comments in the “S-L Notes to Readers” column, our suggestions to them were to instead assume:
In recessionary times, when Revenue is going to decline from current levels, the wise management team:
The age-old wisdom applies: “Prove the profit model, then grow.”
This is because plans to return to profitability by growing most often do not come to fruition. Most often, unfortunately, either the hoped-for growth doesn’t come soon enough and/or expense ratios do not improve as Revenue rises. No, the winning move is to reduce costs, generally across the board. Better to ensure saving some value in the company and some jobs, than to risk losing all.
Figure 11 shows the revised “Months of Safety #2” suggestions which bring the company immediately to profitability, albeit by a thin margin.
Case 2: Service Leadership’s Revision
Figure 11 - Revised risk-adjusted "Months of Safety #2" calculation with suggested assumptions
You can read our suggestions in the “Notes to S-L Readers” column and as described above.
Their primary challenge will be to reduce payroll in Services, Sales and Marketing and General and Administration, by 25%.
Compared to many types of businesses, Solution Providers have a large proportion of their total cost in employees – people. As a result, while in good-to-great times, we can employ many people and often have a hard time filling new positions, in recessions we cannot have as many people, and positions are often easier to fill. Thus, it is to payroll – people – that we must turn to reduce costs to a survivable level.
As we discussed earlier in more detail, understandably, Solution Provider owners and executives are reluctant to terminate employees. At a high level, here are our suggestions for how to do so, for this company:
How easy will it be for them to reduce payroll by 25% in each department? Based on the Revenue mix of this Solution Provider, we know their PBM is Infrastructure-Technical Services, and their February Net Income of 2.8% ($39k on Revenue of $13.65mm) puts them squarely on average performance for that PBM.
To address the greatest proportion of our reading audience, we’re going to look at the Service Leadership Index cost ratios of the Median Product-Centric (not Infra-Technical Services) firm and the Best-in-Class ones, to get a sense for this company’s opportunity to improve.
|2019 Cost Factor||Median||Best-in-Class||Median Is|
|Services Gross Margin %||27.4%||44.2%||Lower by 38.0%|
|Sales & Marketing % of Rev||7.2%||5.3%||Higher by 35.8%|
|General & Admin % of Rev||11.1%||13.9%||Lower by 20.1%|
Services Gross Margin %: As we can see, the Median firm in this PBM has a Services Gross Margin % that is 38% lower than that of the Best-in-Class. This means that their Services COGS (1 – 27.4% = 72.6%) is 30% higher per Service dollar than Best-in-Class (1 – 44.2% = 55.8%). As a result, leaving potential factors such as geographic coverage, maintaining vendor certifications, efficiency and quality of delivery and utilization management, the average firm could cut their Service payroll by about 23% (that is, right in line with the 25% reduction the spreadsheet requires) and have about the same payroll cost as the Best-in-Class in their business model.
The factors we “left aside” are real, but they often become more attainable, if no less unpleasant, when faced with losses at the bottom line.
Sales and Marketing Cost: As we can see, the Median firm in this PBM has Sales and Marketing cost as a percent of Revenue % of about 35% more that of the Best-in-Class. That means that they could cut 35% of their Sales and Marketing payroll and have about the same payroll cost as the Best-in-Class in their PBM. In both Median and Bottom-Quartile Product-Centric firms, there is often quite a bit of low productivity sales cost. This is now both the bad news (it exists) and good news (it can be reduced with limited negative impact on the firm).
General and Administrative Cost: As we can see, the average firm in this PBM has General and Administrative cost as a percent of Revenue that is 20.1% lower than that of the Best-in-Class. Meaning, they would have to add payroll to this team to get to the Best-in-Class number. This is true of the average Product-Centric firm: their overall Gross Margin is so thin that they attain profitability partly by under-funding General and Administrative costs in comparison to the Best-in-Class, who have materially higher overall Gross Margin. Obviously, in today’s situation we do not want to increase payroll in this area.
For the benefit of our readers who are MSPs, here are the same cost ratios for the Infra-MS (MSP) Predominant Business Model:
|2019 Cost Factor||Median||Best-in-Class||Median Is|
|Services Gross Margin %||44.7%||51.8%||Lower by 13.7%|
|Sales & Marketing % of Rev||6.5%||5.1%||Higher by 27.5%|
|General & Admin % of Rev||23.1%||21.8%||Higher by 6.0%|
The performance ratios are different from Product-Centric, but the method for bringing them in line is the same.
If there is a sense that we are perhaps “brushing away” real world challenges of cutting headcount to arrive at a number, the fact is, in restoring a company to profitability, this is the end of the management decision-making spectrum that you need to err on. You need to be thoughtful, but as leaders, if you are to save the most shareholder value and the most jobs, you need to “face the pain” and go through it. The sooner and more complete, the less painful and the sooner you can create safety for the shareholders, the remaining employees and your customers.
In the case of our real-life Solution Provider, we need to get to a 25% reduction in total payroll. The spreadsheet has us doing this by cutting 25% in each department, but if we look at their Income Statement (and not that of the Median P-C firm) where are the opportunities to do so?
|Cost Factor||Our Solution Provider||Best-in-Class||Our SP Is|
|Services Gross Margin %||41.0%||44.2%||Lower by 7.2%|
|Sales & Marketing % of Rev||9.9%||5.3%||Higher by 88.5%|
|General & Admin % of Rev||21.5%||13.9%||Higher by 55.0%|
As it happens, this firm, although Median in profit performance, actually runs a Services group which nearly attains Best-in-Class Gross Margin (for Product-Centric firms). There is only a 7% cost opportunity in this department.11 Do we need to take it?
Perhaps not, since the costs in Sales and Marketing are 88% high and the costs in General & Administrative are 55% high. Can such reductions in these two departments meeting our overall goal of 25%?
From their S-L Index benchmarking, we know that in Q4-19, this firm had:
Without going into the payroll cost detail, we can see from the headcount numbers that the SG&A departments cannot be cut much at all. Which means that the majority of cost must be taken out of the Service department.
If Service is running at almost Best-in-Class labor efficiency (though, see footnote below), why do we need to look there for reduced costs? Unfortunately, it’s this simple:
If we cannot trim headcount enough to meet our goal of 25% payroll cost reduction, what are our options? Probably we are looking at pay cuts, possibly eliminating incentives, but more likely reducing overall compensation packages. Generally, management is in a better position to absorb these reductions than is staff, but in this case, all will probably need some level of sacrifice.
There are some cost components in all three departments that are not headcount-related, and these should be examined and reduced as much as possible. But because most of Solution Provider firms’ cost is in payroll, unfortunately this is where we usually end up turning when Gross Margin is severely lacking.
Of course, we can and should try to sell our way to generating more Gross Margin – more on this in a moment – but we know the Best-in-Class in these situations count on cost reductions first because it’s safer.
The same approach must be taken with every cost line in the company; the spreadsheet tells us we are dealing with a 26% drop in total Gross Margin dollars, and we must get to bottom line profitability.
We’ll make one last note about our real-life Solution Providers’ mid-epidemic Income Statement. The sharp-eyed reader will have noticed that we pared costs enough to increase our marketing budget by 25%. To the extent customers and prospects are spending money, we want them to know about us!
Before we move on to driving Revenue in a downturn, it will be helpful to take a deeper look at how to safely guesstimate your near-term Revenue numbers by using a quick spreadsheet we created for another Solution Provider, this one a $25mm MSP.
Figure 12, below, shows the spreadsheet that we quickly worked up in a 50-minute phone call.
They had not had time to put much thought into what any client other than their largest – which they had budgeted to contribute nearly 10% of their Revenue in 2020 – would cut in the downturn. This particular client is in Hospitality (hotels), a sector which we already know is being badly hurt.
The executives of that client informed the Solution Provider of their intent to cut really all of their planned 2020 Product purchases. That is recognized on the spreadsheet as a large part of the $1.5mm drop in Product Resale Revenue.
During our call:
In total, we estimated that Product Resale would drop about $1.5mm and Services would drop about $955,000 from their 2020 budgeted numbers.
Figure 12 - Quick "Before and After" Income Statement with Per-Client Revenue Risk Adjustment Detail
Further, we reduced their Product GM% from 30.5% to 27.0% to account for likely discount pressure. We kept the Services Gross Margin at 40%. However, since this was on $955,000 less Revenue, clearly, Services costs would need to be cut a proportionate amount to maintain that 40% GM, which of course would then produce 9.5% fewer Gross Margin dollars.
The management team of this firm is quite capable, and maintaining 40% Services GM may well be possible, if difficult.
Overall, we quickly projected a 15.1% decrease in Gross Margin dollars for the year, as compared to their budget. For lack of time on the call, we didn’t get to guesstimating reductions in Sales, Marketing, General & Administrative costs, and so they remain as they were in their budget. The CEO was relieved that the bottom line had only dropped from 7.5% to 2.5% (though obviously concerned that Net Income dollars will drop by about 71%).
Unfortunately, despite this apparent “good” news, we believe that Revenue will be impacted to a greater degree than shown here, and reductions in SG&A cost will be required to still deliver a bottom-line profit.
Be that as it may, in 50 minutes we were able to provide a revised planning framework which will be useful to this team in short order.
In normal (good to great) economic times, the traditional rule of thumb of having six months of cash to cover all your expenses assuming 100% of Revenue stops, seems rather old fashioned and unlikely to be ever needed.
In “normal” recession times, it still seems somewhat overly-conservative – surely 100% of Revenue will not stop, so to speak, on a dime.
Yet, in the case of this epidemic, it unfortunately seems like we might get as close to that doomsday scenario as we might ever see in our lifetimes.
Let’s now turn to a more pleasant – if equally challenging – subject: Keeping as much of your current Revenue as possible and driving new Revenue.
What do we know about the selling environment? We know:
We can already see changes in customer buying patterns, and in likely requirements:
Small and mid-sized customers will exhibit the same changes in buying behavior and requirements.
In Enterprise and Mid-Market customers, where management more often (though not always) has professional management experience, outsourcing more – including outsourcing IT – is a well-accepted survival tactic during downturns.
Outsourcing allows them to shift the burden of execution to the provider, so the client can focus on their core business. It also allows them to shift the financial risk of meeting uncertain and probably variable, IT support consumption levels to the provider.
It remains to be seen how many small-business decision-makers will come to the same conclusion.
In addition, prospects who currently have Solution Provider relationships will, more often than usual, find their current provider to be unable to meet their needs, either because their needs have changed, or because the provider is struggling financially. They will search for a new provider, giving you the opportunity for a “conquest” sale.
From our 2019 Annual Solution Provider Industry Profitability Report, here are our summary recommendations for driving Revenue (as well as managing other factors) during a recession. Where appropriate, they are segmented by PBM.
|T&M-Centric (Infra-TS)||Project Services-
|Finance||Have cash in the bank to cover all expenses for 3-6 months. Be prepared for employees to have personal financial difficulties, and for an upsurge in client slow-pays and no-pays. Tighten collections and shorten DSO. Crank up your credit-checking before taking on a new customer or significant deal. In exchange for discounts, collect more up front. Secure your line of credit and understand your covenants. Delay all but essential capital investment and expense commitments. Reduce incentive pay by half or more (except for Sales), but do not cut base pay unless critical. Keep Sales’ incentives and consider boosting but be sure to drop low productivity reps from payroll. Cut R&D and “science projects” exploring or developing new offerings.|
|Staffing||Cut staffing levels hard across the board. Those who do, fare best in terms of morale and retention of best employees and customers. Those who are more timid then must perform multiple cuts which do greater damage to morale and customer relationships. Only keep those you would hire again if you were starting a new company. Your smartest employees and customers will be watching for bold decisions.|
|Keep pre-sales and make billable (dual purpose). See text at right, also.||Focus on keeping your high performers at all skill levels, with special emphasis on keeping the high performers who are lower skilled and at lower wages. These will save your company. Only keep higher skilled (more costly) technical people if they are good at getting new business and at being billable themselves.|
|Offerings||Focus on the lower-cost end of your current chosen vendors’ wares. Pick a single, cheaper second vendor for each part of your tech stack. Don’t skimp on project budgets; cutting corners costs more. Block time for Service, works. If MS isn’t profitable, don’t add or expand contracts.||You will win some customers coming off of MSP contracts. Keep billable rate at 2.5 x Taxable Wages of your techs. Sell block time which states you will proactively burn it on preventative maintenance and management.||Assume fewer and smaller contracts, especially at first. Later in recession, downsized clients will outsource more projects. Don’t skimp on project budgets; cutting corners costs more. Block time works. If MS isn’t profitable, don’t add or expand contracts.||Do not negotiate different recession deals with each client.
Create a single “recession special” or “deferred maintenance” package at about 70% of your current SLA and price, with on-site and projects billed via block time.
Hold or increase GM%, even though lower dollars.
Write terms that automatically retire the “deferred maintenance” package and restore the pre-recession one after 1 year, but be prepared to wait 2 years.
|Assume fewer and smaller contracts, especially at first. Later in recession, downsized clients will outsource more projects. Don’t skimp on project budgets; cutting corners costs more. Agile works.|
Figure 13 - Recommendations for driving Revenue in a recession, by business model.
|Strategy Area||All Predominant Business Models|
|Clients||Grade existing clients as follows: “A” = on your tech stack, your fullest offer and your best win/win pricing, “B” = close on all, “C” = not close but GM% exceeds your SG&A %, “D” = not close and GM% doesn’t exceed your SG&A %. Actions: “A” = keep, “B” = raise to “A” when possible, “C” = keep but try to get more in line and act on them when D’s are all gone, “D” = terminate when you win a new “A” or “B”, or right away if really hemorrhaging.|
|Marketing||Focus hard on messaging that you enable your clients to: manage costs and risks, drive new Revenue, keep their own customers happy. With some of the savings from other cuts, judiciously increase marketing spend, especially Thought Leadership Marketing (C-level speaking, publishing); become the locally recognized expert on saving money, driving Revenue and keeping customers happy using great IT. Also focus on maintaining and extending the value of the customers current IT assets, as opposed to only promoting acquiring new assets. Those who market effectively into the face of a downturn, do better soonest, but make sure each marketing strategy produces results early, otherwise cut and spend on other ones.|
|Sales||CEOs: Get out and meet most important existing customers and especially new prospects, a lot. Lead by example. CFOs or Finance execs: Get out and meet all the other existing customers. Sales management: Create a “war-room” atmosphere and nurture every material opportunity. Learn to pre-qualify more accurately and get management and/or pre-sales on phone calls sooner with pre-qualified; if the phone call goes well, get them out face-to-face with the prospects sooner, too. Assume some of your competition will fall apart, so keep an eye on their best accounts and best Salespeople. Make clear that losses of deals or accounts, are due to client/prospect not fitting your needs and/or going out of business. Celebrate wins and renewals loudly. Cut your bottom 30% of Sales reps; move their accounts to productive existing reps. Pay your best hunters to hunt more and shift their existing accounts to lower cost farmers.|
|Service||Make sure account losses are due to clients’ business difficulties, not your service levels. Highlight great customer service and lead generation by Service people, especially your lower cost people. Highlight examples of good Sales/Service collaboration. Cut 15% to 30% of your most costly people and shift their work to remaining folks. Reassure Service people – who are analytic types and therefore perhaps tend to be overly pessimistic – that recessions do end and that the company has reserves and is executing its plan. Fewer busier people will thrive sooner and are easier to manage than more, less busy people.|
Figure 14 - Recommendations for driving Revenue in a recession, for all business models
Some additional detail for Product-Centric firms:
Together these actions can help mitigate Revenue attrition and secure client relationships, helping to sustain profitability and promoting a more rapid recovery.
Some additional details for Managed Services Providers:
The question often comes up, “Are there better and worse vertical markets to be in, during a downturn?
The answer is, “Yes, sort of.”
There are two factors here:
Why is the second bullet true? Because those Solution Providers who are successfully vertically focused, have the vertical knowledge to most compellingly convince decision-makers they can help them drive Revenue, reduce cost and reduce risk.
These Solution Providers tend to take market share – such market as there is – from the generalist Solution Providers who currently serve them. They are also more likely to be compelling when approaching prospects who, prior to the downturn, had their own IT departments but who now wish to instead outsource.
That does not necessarily mean, for a vertically focused Solution Provider who is short on Gross Margin dollars, that they should not take on a willing new customer in another vertical, if survival mandates it.
Here is a short list of verticals who tend to stay better, or worse, in recessions. Remember, these are broad statements, not guarantees.
No doubt there will be exceptions to these.
To try to anticipate what Mergers & Acquisition (M&A) might do during this downturn, let’s first recap our planning scenarios:
As previously noted, we are hoping for Scenario A and planning for Scenario B.
How would M&A activity, pricing and terms change in each of those?
Clearly, M&A is pausing right now. Everyone is too busy trying to implement the most effective, most stable form of operations and ascertain which customers are going to be able to pay.
To the extent Buyers might have time to consider transactions, and Sellers might have time to contemplate them, what we’re seeing so far is “same price, terms more favorable to Buyer”, meaning, the re-appearance of earn-outs. Possibly heavy ones: 50% of the valuation tied to an earn-out for example, where a week before, the Buyer wasn’t requiring any earn-out. Will the Seller accept? Who knows?
This will perhaps apply for the next few weeks or months.
From there, those Solution Providers with the most robust financials, most determined management teams, largest sources of funding, least-impacted work forces and who have the most customers who have these attributes, will do the best.
Those who lack one or more of those attributes, are going to suffer more. Probably there will be an increasing number of distressed companies up for sale.
As we know, the party with the least time pressure, has the upper hand in any negotiation. To the extent that there are Buyers – and with the Private Equity groups in the arena, likely there will be – then one presumes that deals will get done, on prices and terms more favorable to the Buyer. They would be more favorable to the Buyer because:
Assuming the Buyers would want to buy, this would imply lower prices and more contingent earn-outs.
What happens next depends on which economic scenario we are looking at: “V-shaped”, “U-shaped”, or “all bets are off”.
|Scenario||Deal Price and Terms
– Until Recovery
|Deal Prices and Terms
– During Recovery
|“V” Shaped Recovery||Moderate Shift in Both, Towards Buyer||Rapid Rebound, Probably to Pre-COVID-19 Levels||“Pause” then quick to very quick recovery.|
|“U” Shaped Recovery||Heavy Shift in Both, Towards Buyer||Slow Rebound, Possibly to Pre- COVID-19 Levels||Flurry of Distressed Sales, Then Lower Volume as Stronger Potential Sellers Hold Out for Better Pricing/Terms|
|“All Bets Are Off” Recovery||Heavy Shift in Both, Towards Buyer||Slower Rebound, Perhaps Not to Pre- COVID-19 Levels||Long Cadence of Distressed Sales with Volume Mounting, Few Prime Assets on Market|
It’s an unfortunate situation, to be sure. To the extent that one might have viewed the participation of Private Equity in the market as a negative thing (we do not), certainly now their presence in the community has to be seen as a good thing – they may make up the largest population of Buyers for willing Sellers.
Even among Private Equity groups, many will be less aggressive Buyers during this time. This may be because they lack funds and borrowing power, because they’re focused on making sure their current portfolio companies survive (or are selling them), or because their strategy has them backing off during recessions.
However, there will no doubt be Private Equity groups – and other private and public Buyers – whose approach is to be more aggressive during downturns.
As you no doubt know, leaders have successfully led through adversity, throughout the course of human history. The same will be true during these challenging times.
There is no lack leadership advice available; we urge you to seek out that which resonates most with you.
However, if we may offer in closing, these suggestions:
Lastly, for you and for those around you, remember, family comes first, second and third in priority.
Figure 10 – Initial attempt by a real Solution Provider to create a risk-adjusted “Months of Cash #2” calculation.
Figure 11 - Revised risk-adjusted "Months of Safety #2" calculation with suggested assumptions.
|Definition||Synonyms, More Information|
|Best-in-Class (or top quartile)||When referring to EBITDA, this is the EBITDA % required to get into the top quartile of EBITDA% in the specified PBM, according to the Service Leadership Index®. When referring to other metrics, this is the average of the metric for those in the top quartile of EBITDA %.|
|DSO||Days Sales Outstanding|
|EBITDA||Earnings Before Interest, Taxes, Depreciation and Amortization||The closest approximation to the amount of free cash flow produced by a company; that is, profit. Adjusted such that owner compensation for the role they perform in the company is paid at fair market compensation from the Income Statement, not the Balance Sheet, to produce the most accurate and comparable measure of profitability.|
|Adjusted EBITDA||To best normalize for the effects of tax strategies, we adjust EBITDA to reflect fair market owner compensation coming from the income statement rather than the balance sheet. The amount of adjustment is based in PBM and Revenue size, and is known to our benchmarking subscribers. This adjustment is often used by those valuing companies, and it also lets the owner(s) in the company how much they would have in passive income from the company if they hired non-owner executives to do their jobs.|
|GM||Gross Margin||Revenue minus the cost to the Solution Provider of that which is being sold (Cost of Goods Sold or COGS). Explicitly does not include Sales, Marketing or General and Administrative costs.|
|Line of Business||An over-arching practice as defined not by the technology being used or customer set being served but by the specific billable utilization pattern which must be optimized to produce the greatest profit at the highest service quality.|
|Median||When referring to EBITDA, this is the Adjusted EBITDA % which separates those in the top half of EBITDA% attainment in the specified PBM™, from those in the bottom half. When referring to other metrics in the Service Leadership Index, this is the average of the metric for those who are not in the top or bottom quartiles of EBITDA%.|
|MSP||Managed Services Provider||A Solution Provider for whom Managed Services is the predominant Line of Business. Specifically, at least 40% of total Revenue comes from Services, and of those Services, Managed Services is the largest Revenue by at least 10%.|
|Normalized Solution Provider Chart of Accounts™ (NSPCoA™)||The standardized categorization of Solution Provider Revenues and costs promulgated by Service Leadership to offer not just the optimal benchmark comparability, but more importantly also to provide Solution Provider management with the best transparency into the financial performance of their business.|
|Operational Maturity Level™ (OML™)||Operational efficiency and effectiveness.||The measurable degree of efficiency and effectiveness of the management and operational practices of a Solution Provider in their PBM, which correlates strongly to profitability, growth, scale and service quality.|
|Predominant Business Model™ (PBM™)||That Line of Business which predominates the partner's Revenue mix.||The PBM of the Solution Provider determines the drivers of its executives' decision making, the business model's capacity for profit and growth performance, and the specific Operational Maturity Level Traits (that is, best practices) which will be most effective in improving the business. For more information about PBMs, click here.|
|Applications - Project Services PBM, A-PS||The Line of Business of developing and/or configuring and customizing commercial or custom applications.|
|Managed Services PBM, Infra-Managed Services, Infra-MS, I-MS||A Solution Provider for whom Managed Services is the predominant Line of Business.|
|Product-Centric PBM, P-C||A Solution Provider for whom resale of equipment, software and others' cloud services is the predominant Line of Business.|
|Professional (Project) Services PBM, Infra-Project Services, Infra-Projects, Infra-PS||A Solution Provider for whom implementation of infrastructure is the predominant Line of Business.|
|Infrastructure - Shared Services PBM, Infra-Shared Services, I-SS, private cloud||A Solution Provider for whom self-delivered cloud services is the predominant Line of Business.|
|Infrastructure - Technical Services PBM, Infra-TS T&M-Centric||A Solution Provider for whom hourly-billed (break/fix) support is the predominant Line of Business.|
|Service Factory™||A euphemism for the process, tools and people who comprise the Pre-Sales Support and Service Delivery functions in the Solution Provider organization. Used to emphasize the programmatic or intentional way in which it can be best managed to produce high performance for all stakeholders. Can refer to a specific practice or location, or to the entire functional area within the company.|
|SG&A||Sales, General and Administrative|
|S-L Index™||Service Leadership Index®||Quarterly financial and operational benchmark of Solution Providers worldwide conducted by Service Leadership, Inc.|
|S-L Index Annual Solution Provider Industry Profitability Report™||Contains a wealth of information about the financial health, viability and trends of Solution Providers within each specific business model in the industry. Click here to learn more.|
|SLIQ™||Service Leadership's proprietary Operational Maturity Level™ progression app for SP owner/executives.|
|SMB||Small and Medium Business||There is no precise definition but refers generally to end customer companies with under 100 users. A second useful qualifier for “SMB” is a customer who, after they sign the Managed Services agreement, has no more IT people on staff. This account can be managed using an “SMB” account management model. Any account, no matter what size, who after signing the Managed Services agreement, still has one or more remaining IT people, will not be successfully managed using an “SMB” account management model.|
|Solution Provider||A company which provides IT services and solutions to end customers, sometimes also reselling products provided by vendors.||Channel Partner, Partner, Dealer, etc.|
|T&M||Time and Materials|
Service Leadership is dedicated to providing total profit solutions for IT Solution and Service Providers, directly and through industry consultants and global technology vendors. The company publishes the leading vendor-neutral, Solution Provider financial and operational benchmark: Service Leadership Index®. This includes private diagnostic benchmarks for individual Solution Providers and their business coaches and consultants. The company also publishes SLIQ™, the exclusive web application for partner owners and executives to drive financial improvements by confidentially assessing and driving their Operational Maturity Level™.
Service Leadership offers advanced peer groups for Solution Providers of all sizes and business models, and individual management consulting engagements for Solution Providers from US$15mm to US$3bb in size worldwide. In addition, Service Leadership provides global IT vendors with advanced partner enablement assets, partner ROI models, management consulting and advanced peer groups, as well as executive and industry best practices education and speaking. Please visit www.service-leadership.com for more information.
Notice: All materials published (electronically or print) by Service Leadership are proprietary and subject to trademark and copyright protections, regardless of where and how it is sourced. The terms and concepts of SLIQ™, Service Leadership Index®, (S-L Index™), Predominant Business Model™ (PBM™), Operational Maturity Level™ (OML™), Normalized Solution Provider Charts of Accounts™ (NSPCoA™), Total Cost of Managed Services™ (TCMS™) and Service Factory™ are proprietary to Service Leadership, Inc. All Rights Reserved.
2 That Line of Business (LOB), such as Product Resale, Managed Services, Project Services, etc., which predominates the partner's Revenue mix. This in turn determines the Solution Provider executives' decision making, the business model's capacity for profit and growth performance, and the specific Operational Maturity Level™ (OML™) Traits (that is, best practices) which will be most effective in improving the business. See on our website, https://www.service-leadership.com/trial/?tool=findmypbm at no cost for more information.
3 This presumes that the vendors they rely on are ramping up production capacity as the recession recedes. Whether vendors will have the factory capacity to do this quickly as this virus-induced recession recedes, is unclear.
4 If an Infra-Project Services firm is high in OML, they have successfully standardized (greatly simplified) the technology stack they will implement thus enabling them to document their delivery and control processes, and develop proprietary project delivery automation, which together materially reduce the loss of intellectual property – and the impact on ability to execute projects – resulting from terminating technical people. Lower OML firms will not have done these things, and will not have this advantage.
5 Likewise, the same is true of the Project Services practices of firms in the Product-Centric, MSP and the other PBMs.
6 Note: These projections were made in early 2019, when 2018 S-L Index figures were in, but 2019 and beyond were projections. We now know 2019 came in at 9.6% Adjusted EBITDA for MSPs and 2.8% for P-C firms.
7 More on these later.
8 For those of you who have skipped ahead to here, we discuss the possible depth and duration of the drop in Figures 5, 6, 7 and 8.
9 The NSPCoA is available here at no cost, although for your interest only, as this would not be the time to actually reengineer your Chart of Accounts.
10 Conversely, a negative percentage in column E results in an increase in column F over column D: $100 in column D x -20% in column E = $120 in column F.
11 In fact, for Infra-Technical Services firms, Best-in-Class Services Gross Margin in 2019 was 53.8%, which means this firm actually has an opportunity of about 22% in Service cost, not 7%.
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