The financial crisis obliterated corporate forecasts. Now, CFOs struggle to assess what lies ahead.
by Vincent Ryan/CFO Magazine
Former Federal Reserve chairman Alan Greenspan made plenty of news in October when he admitted before Congress that he had "found a flaw" in his model of financial reality, but another, less-publicized portion of his testimony should resonate with CFOs. The Fed's failure to anticipate the risks and consequences of securitizing and selling mortgages, Greenspan said, was due to poor forecasting.
"We're not smart enough as people," he said. "We just cannot see events that far in advance. There are always a lot of people raising issues, and half the time they're wrong."
Few if any CFOs have the luxury of throwing up their hands and citing human limitations as an excuse for their inability to foresee adversity. Indeed, uttering such words in public would immediately erode any confidence that a board and investors had in a finance chief. Suggest that you agree with Greenspan that forecasts often have no better than a 50-50 chance of being right and the impact on your career may be all too predictable.
And yet Greenspan may be right. For example, in a recent lawsuit filed by chemical maker Huntsman to force a merger with Hexion, Hexion's CEO testified in open court that forecasting raw-materials costs is almost impossible. According to documents supplied by Huntsman in a Securities and Exchange Commission filing, Hexion's method of forecasting raw-materials costs is to arbitrarily prognosticate that they will remain flat, pretty much ensuring the numbers will be wrong. (Hexion declined to comment, due to litigation.)
Meanwhile, forecasts of 2008 revenues and profits have missed the mark substantially at many organizations. That's not remarkable, given that the speed and severity of the third-quarter collapse caught nearly everyone off guard. What is surprising is the degree to which forecasting, a task that few companies have ever felt very confident about, is now so difficult that in a spot survey of 250 Website visitors (see "The Dark Side" at the end of this article), CFO found that 70 percent say they can't forecast more than one quarter out. (Of those, one-quarter said they can't forecast more than two weeks ahead and an equal number said "We're in the dark.")
But abandoning the prediction game is not an option. Companies are now redoubling their forecasting efforts, even though (and perhaps because) the horizon is brimming with unknowns. In a recent CFO Research survey, 41 percent of senior finance executives said they have strengthened scenario-planning procedures in light of the banking crisis. Retail organizations in particular are scrambling to manage inventory and adjust financial projections with the knowledge that holiday retail sales may decline for the first time in more than 10 years.
"Companies need to get the best perspective on what the future looks like so they can make actionable decisions and share information with investors and stakeholders," says Stephen Lis, partner in charge of business-performance services at KPMG.
The credit crisis and the downturn in world economies may offer a useful lesson: forecasting can't be just about number-crunching. Static spreadsheets filled with hundreds of line items that represent best guesses from operations just won't cut it if a company hopes to produce forecasts that aid quicker, fact-based decisions under stress.
Some finance departments are beginning to incorporate methods such as scenario modeling, sensitivity analysis, and contingency planning to help CFOs think through a wide-ranging set of potential situations, thus avoiding a monocular view of what's ahead. They are refreshing forecasts more frequently, homing in on a handful of measures that have a financial effect on the company (so-called driver-based forecasting), and doing more to provide synchronous information flow between finance and operations.
Taking the Long View
Most companies may feel that adapting any of these techniques, or attempting to refine their current approaches to forecasting, is not exactly top-of-mind at the moment. In an environment like this one, "the urgent drives out the important and they operate in panic mode, instead of developing a longer-term, more-rational understanding," says Nick Turner, co-president of Global Business Network, a scenario-planning consultancy and a member of the Monitor Group.
An exception is The Principal Financial Group, a life and health insurer as well as a large administrator of employer-sponsored retirement plans. The Principal has some exposure to mortgage insurers as well as a commercial real estate portfolio, but it has weathered the credit storm by cutting its dividend and suspending stock buybacks. It also employs a comprehensive forecasting process that includes short- and long-term components and incorporates what CFO Terry Lillis calls "stochastic" modeling — generating a host of scenarios that follow a random distribution.
The Principal develops five-quarter, five-year, and 10-year forecasts that have a set of conservative baseline assumptions, such as the equity market growing two percent a quarter. Then it introduces variances to that baseline to understand the magnitude of the effect on operating earnings, sales, and assets under management — the key drivers. The forecasts are now revisited every two weeks. "You get into problems by trying to model too much minutiae," notes Lillis. "Your best models are those that identify four or five key drivers and focus on the interplay between them."
The stochastic element, which emphasizes randomness, enables The Principal to spot potential blowups. The modeling generates a wide distribution of scenarios, which Lillis uses to determine how much capital the company needs to hold in 99 percent of all possible outcomes, from the best to the worst cases of economic performance. Says Lillis, "It helps us deal with tail risk" — those potential futures that are several standard deviations from the mean. The model also projects items such as cash flow from investments versus the surrender of liabilities, critical for a company that uses asset-liability management.
While 10-year (and even five-year) forecasts may appear anachronistic at a time when so many companies say they are "in the dark," some industries demand them. At Bonny Doon Vineyard near Santa Cruz, California, it can take 5 years to go from vine planting to bottling. CFO Lisa Kohrs employs a 10-year forecast of revenues and liabilities, factoring in items such as vineyard labor costs, cellar costs, and eventual selling prices in four different channels. To complicate matters, the business is managed as three different companies affected in different ways by environmental, regulatory, and economic forces. Current projects are as diverse as developing a new 300-acre estate vineyard and building a new tasting room.
Whether companies think long- or short-term, the ability to react quickly to events is really all that CFOs can ask of forecasting, say experts. An all-out drive for pinpoint accuracy, especially in light of current events, can be less helpful. The Principal's forecasters, for example, did not foresee the huge drop in equity indexes this past year. "The value of [forecasting] is directional," Lillis says. "If I say to our finance people that the best estimate of our earnings is not good enough, the question becomes, What can we do about it? What drivers do we have to change? Are they within our control? If so, do we pull the lever?"
Generating timely, reliable financial forecasts that help executive management implement decisions faster requires using true driver-based forecasting — tracking the operational measures (such as hours of temporary labor required and associated labor rates in a manufacturing plant) that have a decided financial effect, says Tony Levy, director of product marketing at software firm Cognos (now owned by IBM). Finance personnel have to think in terms of business factors instead of dry lines on a general ledger. For a telesales organization, for example, the drivers might be dollars per deal or the conversion rate of customers — measures that can be influenced by performance.
At W.W. Grainger, a $6 billion distributor of industrial supplies and equipment that averages 120,000 transactions per day, company operations include more than 600 branches, eighteen distribution centers, and multiple Websites worldwide. Finance personnel are embedded in the company's business units, such as product management, business development, and marketing. The key to Grainger's business is high inventory availability and service levels at walk-in customer sites, as well as next-day delivery from distribution centers. By sitting alongside internal business partners, finance personnel get a much closer view of things like demand, product uptake, the success of new-product introductions, and supply-side trends. "We rely on sales-force input, marketing analytics, and supply-chain feedback that filters through to finance," says Ronald Jadin, Grainger's CFO.
Finance people can also draw a bead on crucial economic factors like inflation. They get the "micro" view on price increases that suppliers may be planning to pass along, and those increases are entered into Grainger's quarterly forecasts to supplement any macro analysis on inflation that Grainger gleans from economists, Jadin says. The quick relay of information also enables Grainger to better manage the price increases suppliers may try to pass on due to rising commodity costs. "We try to get them to hold off passing along inflationary pressure to us," Jadin says, "by limiting price increases to the annual publication of our catalog."
The company's forecasting process also focuses on contingency planning for a downturn. The company plans three to five major actions it might take if the economy were to soften. "The business units commit to it — that strips the emotion out," Jadin says. "If the problem arises, you just execute the plan."
For satellite services provider Hughes Communications, the most material determinant of the company's profitability is consumer uptake of services. Projections of profit and loss, cash flow, and the balance sheet depend heavily on a three-year model of new consumer subscriptions — the only forecast that Hughes updates every month. The forecast is so important that it can affect investment decisions such as whether or not the company should launch its own satellite (a $400 million prospect) or continue to lease transponders from others, says finance chief Grant Barber.
By staying close to call-center orders and new installations, Hughes took preventive action ahead of the economic downturn two months ago. The company gave Internet service consumers the option to pay equipment and installation fees over time instead of all upfront, which Barber says kept new installations from stalling. "We're constantly turning the knobs and making changes to the consumer models," he adds.
This article has been excerpted from CFO magazine.
Vincent Ryan is a senior editor at CFO.
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