"A great deal of uncertainty exists in the global economy, making it extremely difficult to know how our customers will respond during the remainder of 2009."
Where have we heard this line before? In this case, it was Caterpillar CEO James Owens, a former CFO and economist, explaining in April why the company cut annual profit estimates in half as it reported its first loss in 16 years. But Owens is hardly alone. Executives at companies from wine and spirits purveyor Brown-Forman Corp. to prison-builder Corrections Corp. of America have been invoking the "u" word with alarming regularity in earnings calls. There are few signs that that will change any time soon, even as the recession passes the 18-month mark.
Forecasting, never an activity companies felt particularly confident about, has now become nearly impossible. Processes that once resulted in mildly imperfect visions of the future now produce wildly imperfect ones. "The last 8 to 12 months have created a strong realization among many corporate leaders that whatever planning they may have been doing, they didn't factor in the possibility of the future being dramatically different from the past," says Andrew Blau, co-president of strategy consultancy Global Business Network.
Mark Gottfredson, global head of Bain & Co.'s performance-improvement practice, notes that, "in growth mode, executives can be very focused on their company and their industry. Even if they largely ignore GDP growth or what the government is doing, their forecasts will still be OK." With many once-stable macroeconomic factors now in flux, though, "companies need to look at many more variables," he says, including access to capital, country-specific risks, and structural changes within industries arising from the recession.
To cope, many companies are running the numbers more frequently, with an eye toward capturing different versions of the future. "Customers were doing reforecasts quarterly. Now they're doing them monthly, and augmenting them with a lot of 'what-if' analyses," says Ric Ratkowski, vice president of product marketing for Host Analytics, a budgeting-and-planning (B&P) software provider. A survey by CFO Research Services backs that up: about 80% of finance executives say their departments are spending more time on forecasting revenues and other financial metrics in response to the economic uncertainty, with an equivalent number amping up scenario planning in an effort to gauge the impact of alternate realities.
Host Analytics doubled its business in the past year, says Ratkowski; so has competitor Adaptive Planning, as finance departments automate B&P processes as one step toward creating better forecasts. But as the executives profiled below will tell you, there is no silver-bullet solution. CFOs who hope to emerge from the recession stronger can help their cause by driving improvements in corporate forecasting. To do that, they will need to gather relevant intelligence from far more sources, use it to project a range of possible outcomes, and then create detailed contingency plans for each. It's hard work, but Gottfredson says the potential rewards are substantial. "This is a great time for CFOs — major downturns are when industry decks really get reshuffled."
In Sickness and in Health
You might think a CFO in the health-care field could count on a fairly steady business, with illness being immune to economic cycles. But Tenet Healthcare CFO Biggs Porter has long had to deal with uncertainty, because even in the best of times he faces a paucity of information on potential patient admission levels and the profit they might yield. Tenet's revenues hinge on how many patients choose its hospitals and the types of insurance (if any) those patients carry. Yet statistics on market share for hospital services, the percentage of a population covered by commercial insurance, and the number of patients covered by COBRA (which might indicate an impending loss of insurance) are unavailable or woefully out of date.
On top of all that, current economic conditions mean that "the range of possible outcomes is significantly wider," says Porter, in that people's losing (or fearing they will lose) their insurance can alter their behavior in very different ways. Some accelerate elective surgery before their insurance disappears, for example, while others with high deductibles defer health services to conserve cash. Plus, there are few leading indicators of patients' inability to pay, and thus how much Tenet should reserve for bad debt. There is little correlation, for example, between local unemployment levels and the volume of uninsured patients. Last quarter, both the number of uninsured patients and bad debt accruals declined for Tenet, even as unemployment increased.
To overcome the vast number of unknowns, Porter starts with as much anecdotal evidence as he can glean about patient sentiment from physicians and other hospital staff. He then combines different forecasting methods, including a five-year "top-down" business plan based on broad assumptions and a two-year "bottom-up" plan that pulls together hospital-level projections. Next, he reconciles the two, the idea being that "either one could have bias or inaccuracies and by doing it both ways you can make adjustments to either model."
Porter's team then prepares three different versions of the top-down plan — baseline, high, and low — and creates strategies to cope with each one. "Developing a plan on three different levels is a good idea in any environment," Porter says, "but it is becoming a necessity in this one."
Porter's prism of the future is on point with what Bain recommends to clients. "You can't exactly predict where the economy is going, but you can frame and bound things," says Gottfredson. He says a three-case approach is a wise idea, and suggests a list of nine variables that CFOs should be assessing on at least a qualitative level, including credit availability, the stability of commodity prices, and the adequacy of the government response to economic problems.
Tenet, however, currently regards health-care reform as too much of an outlier to be accurately factored into its forecasting process. "That would be trying to cram too much into one analysis," Porter says. So far, the company has "done only high-level modeling about possible reforms, because so much is unknown."
When Bill Caton took the CFO seat at Navistar in 2006, amid a major accounting restatement, he realized that company culture bred "really good firefighters, but not necessarily fire-preventers." Now Caton says he is becoming known as "Smokey the Bear" for his efforts to push employees at all levels to look for looming disasters. Last year, Caton moved from the CFO spot to the newly created post of chief risk officer, in part to lead an enterprise risk management program that is helping to amplify planning and forecasting activities.
Previously, the $14.7 billion maker of heavy trucks, diesel engines, and other vehicle parts took a siloed approach to risk management, with managers at each major business unit — trucking, engine, and parts — working independently. That led to a wide variety of assumptions about the future, varying degrees of conservatism and optimism among the forecasts, and not much transparency for upper management. "You don't know if people are aggressive in their forecasts or conservative, yet you're letting people make these decisions as individuals," says Caton.
The disparities also led to overproduction. In some instances, he says, "we had forecast that things were going to improve 20% or 30% and then they didn't, which caught us off guard and created a lot of extra inventory." The commercial truck industry has been in a prolonged slump; in fact, Navistar cut its 2009 earnings outlook by about 45% in early June as the slump dragged on longer than expected.
Caton expanded an ERM initiative already under way (to improve internal controls) to encompass an enterprise view of the company's exposure. Now, heads of the business units meet monthly to collaborate on forecasts for sales volumes, production schedules, and inventory management. The different divisions are able to identify common risks and work together to help mitigate them.
"Forecasting isn't just about volume or sales; we need to forecast whether suppliers are going to be in business next year," says Caton. Finance and operations are more intertwined, too, with the purchasing department working more closely with the treasury group to optimize hedging strategies. To help, the company created a "risk committee" made up of employees from each business unit, added new finance hires with some risk-management expertise, and is now planning to roll out a unified ERM system next year.
One of the most promising developments from this approach: a new companywide "supplier watch list" that senior purchasing managers meet weekly to review. Based on intelligence from buyers who have been trained to spot red flags, and on assessments of financial analysts, the list concept has already helped Navistar prevent a business interruption, says Mark Bures, manager of ERM at the company. Late last year, a buyer learned that a trucking-parts supplier that also provided components to the Big Three automakers was trying to delay payments to its own suppliers. That landed the supplier on Navistar's list and led to a full review of its financials. Navistar considered its options and decided in January to choose a new vendor, a process that can take months due to the complexities of plant retooling.
Those proactive steps meant that when the original supplier abruptly shut its doors one Friday in March, Navistar was able to accelerate the switchover. "By Tuesday, we had product from the new supplier, with no shutdown," says Bures. "It was a real success to be able to do that — not to mention we were able to do it at a better price."
What's next at Navistar? Building ERM into the strategic-planning process and creating more accountability for the two-year forecasts each business unit must produce. "This is about showing how you're going to achieve a forecast, the risks you might face, and how you're going to mitigate them," says Caton. "If you're going to throw out some numbers, you're going to be tied to achieving them."
Predictions: E Pluribus Unum
One of the most promising ways to get an accurate forecast is to see how much people will bet on it. This method, often administered online through so-called prediction markets, has famously foretold the results of recent Presidential elections and Super Bowl matchups. Now, some companies are using the concept to help get a window into their corporate futures. "For the things prediction markets are good at, like sales forecasting, they're very good at because it's a type of prediction for which many people in many different places have pieces of the answer, and this is a way to sum up distributed bits of the data," says Andrew Blau of Global Business Network.
Ford Motor Co. has been using prediction markets among internal employees for close to three years to help augment forecasts of sales and other key measures, like the expected popularity of new products. When Ford's cell-phone and iPod dock, Sync, was in development a few years ago, says Bryan Goodman, a technical leader in Ford's research and advanced-engineering department, "there was a lot of uncertainty about what the take rate would be — 10% of customers or 90% of customers?"
When the prediction market suggested it would be closer to the top end, Ford tooled its factories for high volume, to good effect. The system now sells on more than 70% of new vehicles, says Goodman.
One of the key benefits of a market versus a simple survey, says Ford chief economist Ellen Hughes-Cromwick, is that the volume of bets gives a sense of the confidence people have in their forecasts. If everyone is buying shares around a certain value, that would indicate higher market confidence than, say, market participants spreading their dollars across all available values.
Hughes-Cromwick, in collaboration with Prof. Charles Plott of the California Institute of Technology, is currently leading efforts at the National Association for Business Economics to use such markets to augment forecasts of macroeconomic indicators, such as GDP, unemployment, and inflation. So far, a panel of economists has produced fairly accurate results using the market (set up as an auction, in this case) to estimate monthly government figures, and Hughes-Cromwick says the method "is much improved compared with a consensus forecast, which only gives you an average of how much GDP is going to decline."
Another benefit: the anonymous nature of the market can help employees overcome the political pressure they might fall prey to if asked the same question in a meeting or in person. Electronic Arts, for example, has asked employees to bet on the ratings new video games are likely to receive from users and reviewers. The prediction market has turned out estimates that fall within two percentage points of the actual scores, compared with the average eight-point overshoot that in-person polling yielded. That, in turn, has helped the company fix ill-fated games before launching them.
Markets have their limits, of course. Don't look to them for generating new ideas for products, or imagining markets that don't exist, says Blau. They're also not great for predictions of very long-term trends, like what mix of products a company will be selling five years from now. Then again, accurate five-year forecasts seem like a pipe dream these days. Most companies would happily settle for a reasonable view of what the next year will bring.
Alix Stuart is a senior writer at CFO.
Cash Flow Meets the 80/20 Rule
Is there a simple way to forecast cash flow? With treasury teams leaner than ever and nearly every component of cash flow hanging in the balance, it may be time to adopt the 80/20 rule when it comes to cash forecasts. By focusing on the 20% of a company's cash-flow line items that are typically responsible for 80% of the company's results, treasurers can get reasonable results in less time, suggests the consulting firm Treasury Strategies.
Indeed, aiming for perfection when resources are thin can easily result in a lousy forecast, says John Herrick, a principal at Treasury Strategies. Plus, too much detail in a forecast can hamper its usability.
To gain more confidence in forecasts that don't exhaustively probe every component of cash flow, treasurers should compare the results with those obtained from back-of-the-envelope metrics such as cash flow as a percentage of sales. Meanwhile, if a company's cash forecasts have been consistently inaccurate, management should consider requiring business units to submit cash-flow inputs into a common system, and ding those that provide bad information.
"If the folks at the highest levels of the company reinforce the message that sloppy forecasting will not be tolerated," says Herrick, "the forecasting inputs are bound to improve." — DavidMcCann
New on CFO.com: The CFO Prediction Market
Finance chiefs in need of accurate, timely information on the direction of economic indicators, financial markets, or even the likely date that U.S. firms will be required to adopt international accounting standards can now turn to the CFO Prediction Market for answers. This new feature of our Website lets CFOs and other executives "bet" on various economic and financial outcomes that are critical components of accurate business forecasts. What will the price of oil be a month from now? Will Congress pass a bill this year creating a cap-and-trade market for carbon emissions? Where are Treasury yields headed? Executives win prizes for betting on the right outcomes, but, more important, by tapping the wisdom of a crowd of executives, the Prediction Market produces data that any finance department will find indispensable in forecasting. Sign up at www.cfo.com/predictionmarket.