Can This Company Be Saved?
NO SOONER HAD THE INK DRIED ON the pages of its 1986 statements than Cardinal Services' director of accounting laid down his red-stained quill and joined a seminary. Any of us might have chosen to be a cleric over a clerk, given the pitiful results of the company's past two fiscal years. In 1985, Cardinal lost $2.7 million on revenues that, at $23.3 million, were off more than 30% from the previous year. Revenues for fiscal '86 slid even farther, and $2.5 million more went down the drain. Loan covenants were in tatters, long-term debt in default. At the end of '86, Cardinal's receivables totaled a scant $0.4 million, payables $3.4 million. With cash flow like that, it was evident that hundreds of vendors -- never mind an annual debt service of more than $1 million -- didn't stand a prayer of being paid.
Not knowing where to turn for capital or advice, the Sandusky, Ohio, food vendor simply forged ahead, come what may. By mid-'87, the private company had weathered more adversity than Job, owed about as much as Brazil, yet was still doing business as usual -- which consists mainly of coin-dispensing in-house meals to a captive audience of factory-worker gourmands. Miraculously, Cardinal had managed (if that's the word) to stave off receivership, even after its $3.5-million revolver was turned over to the bank's loan-workout department. But miracle or not, this author is quoting long odds against survival.
Cardinal's in extremis condition didn't scare one Gregory R. Kelly, however. "Odds are just odds, part of the game," philosophizes the president and founder of Multi Financial Services Inc. (MFS), a Birmingham, Mich., 21-person consultancy with a specialty in do-or-die turnaround missions. "I think this one has a shot." Thus when MFS was summoned by Cardinal Services Inc. owner and president Edward O. Ries last January, an ad hoc team of games players willingly trekked off to Sandusky to take a crack at halting the slide.
Though it was apparent even to the cleaning crew that the end of the poverty-stricken company couldn't have been more than three months away, don't mistake MFS for fools rushing in where other financial angels feared to tread. MFS works its wonders in ways strange to the rescue industry: for fees, not equity. No wonder Kelly, a 39-year-old onetime car repossessor, can afford to be sanguine about the outcome. "If we don't make it, it doesn't defeat our purpose. The measure will be, did we try as hard as we could?"
Nor were Kelly's unflappable turnaround troops startled to discover that the situation was considerably more desperate than Cardinal's chief executive had admitted -- or, indeed, recognized. "Typically, a client insists that the answer to his problem is more money -- another loan, or a partner who will bring in additional equity," says operations expert Larry L. Walker, MFS's mission leader. Usually, though, the enterprise is so riddled with debt and delinquency that if it gets more money, it loses it even faster than before. "Almost every time," the veteran Walker concludes, "more money is the last thing needed."
Needier than most, this particular client undertook to bring in the additional money on his own. Ries had recently sold a family house, plowing the funds he received into the corporation in an admirable but woefully inadequate attempt to revive its moribund treasury. To create yet more spendables, some taxes owed the federal government and the six states in which Cardinal operated went unpaid. While states have to fight for their due like anyone else, not paying the feds on time exposes a corporation and anything remotely connected to it -- including the personal property of its owners, officers, and directors -- to unannounced visits from lien-wielding Internal Revenue Service agents. To collect overdue withholding (for which a corporation is considered trustee), the feds can butt in ahead of everybody else in the liquidation line -- to the annoyance of no-longer-so-secured lenders, of which Cardinal had several.
Hoping to mollify some suppliers with which Cardinal was sorely behind, Ries and his wife had personally guaranteed promissory notes; to yet others the company had issued checks postdated for as many as 21 months into the future. They all added up to more than $600,000, but inside the corporation, nothing was changed. "Usually the principals aren't even convinced that corrective action is required," observes MFS teammate Jay N. Brown, an erstwhile banker lured to the other side of the cage by Kelly. "When a company has book losses like that, management's first reaction is, it's a volume problem, a temporary downturn; renewed prosperity is just around the corner. Had we gotten in a year ago, maybe there wouldn't be any problems today. But who's going to pay for a couple of people with a portable computer to tell them what to do when things don't look bad? It has to be at the point where you can't pay the bills, when there's no cash available, when there are lawsuits and collections and the bank's on your back and everybody's screaming -- then when someone tells you they have some answers, maybe you'll listen."
In the owner's view, what had tipped his fortunes into decline was a court judgment handed down in May 1986 for $2.3 million from a claim by a former employee. "The huge award scared suppliers and customers, and everybody shortened our terms," Ries explains. "It tore up our cash flow." Sure enough, when Cardinal had to pay its $120,000 share of the settlement that December, it didn't have any cash left.
Brown, however, blamed the mess squarely on internal disarray. "It's only when they can show significant deterioration that there's forcefulness to outsiders' opinions," he has found, and at Cardinal, the pickings were easy. The fact that a number of the company's 1,600 creditors hadn't been paid a dime in over a year was a good opener. Furthermore, he noted in his initial presentation to Ries, "Management hierarchy [is] operating without specific goals, accountabilities and measures. [There are] no management priorities. Elements of business are working at cross purposes . . . e.g., sales vs. operations. . . ." Brown's forceful opinion: "Bankruptcy is knocking hard on door and should be seriously considered."
Now why hadn't Cardinal's attorneys, bankers, or accountants put the brakes on beforehand? Because, offers Kelly, when a businessperson turns to them for advice, they feel compelled to give it -- as narrowly interpreted by their particular discipline. Besides, often they're slow to catch on. Bankers aren't operating experts, and lawyers don't delve into corporate numbers. The way a typical attorney realizes a firm is getting into financial trouble is when his or her own bill isn't paid -- in which instance he not only doesn't help, he bows out.
A bank may indeed suggest that a business needs fixing, but it can't dictate how a company should proceed internally. If a lender exerts such control that it crosses the line between outsider and insider, a court could take away its standing as first secured creditor. And banks can be their own worst enemies. "There are still a lot of lenders out there who, while they see there is a problem," says Brown, "will lend more money, because they don't want the creditors to push the company into Chapter 11." Often, one of the first steps MFS must take in a crisis situation is to get the bank to stop lending.
When contracted, the consulting arms of certified public accounting firms will study a problem business and outline conservative corrective actions. Other than that, however, a CPA firm comes into a small business once a year, usually at the behest of the bank rather than the owner. And that's a month or two after the year is ended, after which it takes perhaps four more months to complete the audit -- several months too late to do anything about the results. It was nearly nine months after Cardinal's books closed that a preliminary audit for fiscal year '85 (ending November 30) was compiled, and in its cover letter dated August 22, 1986, newly hired Arthur Andersen & Co. did indeed issue a warning, noting (less vividly than Brown was to describe it six months later) that "the company may be unable to continue in existence."
So Cardinal kept "running around pissing on fires," as Brown put it. When problems first beset a business, Kelly observes, "management tends to ignore or doesn't see the larger picture. They get caught up in day-to-day decision making, thinking they're addressing those problems, but never really getting at them." Even as its second multimillion-dollar loss was posted, Cardinal management took solace in the fact that it had brought down its cost-of-sales percentage under the previous year's.
The only way management can really know what's happening, Walker insists, "is through people within the organization cranking out meaningful information. The common thread in virtually every financially troubled company is lack of discipline in management. Without fail, that factor is always there in a turnaround situation. It may take different shapes, but it's always there."
The highly leveraged shape Ed Ries's company was to take was cast in November 1982, when Ries Vending Service Inc., a family enterprise then doing about $5 million in annual sales in three cities, purchased Cardinal Services Inc., a big-business-owned enterprise shakily booking more than $20 million. The base price (not including inventory) was $7 million cash -- no bargain in an easy-to-enter industry whose pretax margins were averaging not much more than 2%. Nonetheless, Ries's projections showed proven synergies resulting from the combined operations would lead to better-than-industry margins. "No one puts forth a business plan or a projection that's bad," ex-banker Brown points out wryly. "Typically, sales increase at rate X, expenses increase at somewhat less than X, extend it out to infinity, and get infinite profits."
The anxious seller, Harley Hotels, did nothing to challenge the accuracy of that plan. Harley took a note for $5 million at 11%, assuming a second secured position behind the leveraged buyout's other free-lending ($1.8 million) sponsor, an Ohio bank. So what if, in order to service its total debt, the merged business would probably have to double the industry's gross margins? To lenders that doesn't matter, argues Brown in defense of the leveraging community. "If they can be convinced of a source of repayment -- ideally, a primary source and a secondary source (good collateral values, good fees, and a good interest rate) -- it's a doable deal. Cardinal fell within the risk profile of the business, and the bank clearly believed it was in its best interest to fund it. It felt it was an ongoing business, a big business, and that it could always sell Cardinal to somebody for 40? on the [sales] dollar plus the inventory and cash, and it'd probably come out pretty clean." Chances are that was the reasoning behind the willingness of Cardinal's current lender, Bank One, not only to take out the previous bank and assume the loan, but to extend additional borrowing courtesies as well. Nonetheless, Brown ventures, "I suggest that excessive credit was granted on the deal."
Nor was that the end of it. Harley committed Ries to $1 million more, keeping the sum from weighing down the balance sheet via an interest-free "consulting agreement" whose five installments could be expensed yearly and therefore not show as long-term debt. Its ledger legerdemain likely has gone for naught, however. The lion's share of Harley's $6 million may be destined to disappear, never to be seen again. "It was the old dollar-down-and-assume-a-lot-of-debt routine," says Kelly of his overeager client. "It became a financial burden that shouldn't have been assumed."
Be that as it may, the deeply in hock new owner was suddenly responsible for some 600 employees dispensing chips and soda and similar unstaples as far away as Charleston, S. C. Rising to the challenge, Ries dismantled the stratified corporate setup he had inherited and restructured it more to his liking -- pyramid shaped, with him perched alone at the top. "Big companies tend to become a paper jungle," he complained to a trade journal in January 1986. "We got out of the old 'layered management' philosophies of the past. . . ." Maybe the loosely cemented structure could have worked if everyone actually had done what the man at the top assumed he was doing, but you couldn't make such assumptions at Cardinal. For example, MFS determined that certain invoices were not being put directly into a computer, but were being cultivated into a paper jungle of their own by "a lot of people doing nothing but filing." Nonetheless, Kelly grants in hindsight, "I congratulate Ed for trying. A lot of companies are successful in the early years until they require more than one person to be in charge of all the functions. Then it becomes serious -- and hard. In this case, the company grew too fast, and he lost the ability to grab hold."
At the pyramid's base were 15 independently managed service centers, where the profits were assumed to be generated. Each center was a local business of its own, purchasing goods, supplying and stocking vending machines, and, in some cases, operating cafeterias. Charged around 11% of gross sales for overhead, the centers carried the weight of 22 corporate functionaries and their respective staffs, whose cost far exceeded their apparent value. "There was too much overhead," Brown was able to surmise. "It overwhelmed the profit centers. Cardinal would have needed a hundred centers to support that structure."
At that, the service center managers -- in large part workaday unsophisticates such as route drivers who had been promoted from within and were on straight salary of some $25,000 a year -- were left to wing it. Most were winging it straight into the ground, disdaining even simple financial decisions. To prepare for the slow summer season, for example, managers didn't bother to start cutting back three months ahead as they should have. "Without incentive," Brown understands, "they weren't going to devote their lives to Sandusky." And the worse an installation was performing, the more reluctant a service center manager was to try to fix it. "He was afraid he was going to lose the account," Walker says, "and if he started to lose accounts, he was afraid management was going to get on him. So literally, because of lack of discipline, the company allowed loss accounts to exist."
Every month, headquarters would dutifully pay the invoices and send the managers product-by-product, machine-by-machine computer summaries as thick as sandwiches -- MFS calls such unfocused data "paralysis by analysis" -- to help with future pricing and cost decisions. As losses continued to pile up, at last it struck one of the Sandusky 22 that perhaps the reports not only weren't being interpreted right, but weren't even being opened. To test the unwelcome thought, small bonus checks made out to each service center manager were slipped inside the next month's reports. No check was ever cashed.
Coming into January, when MFS began studying the picture, Cardinal was behind by more than $3 million to vendors, had loans of around $11 million that were or were about to become current, and owed back money on a multitude of other line items. Indeed, in a real sense, even the employees were helping to finance the company: because management failed to keep up insurance payments, health plans lapsed and some workers were hounded directly by hospitals for large medical bills. At the $18-million annualized revenue level toward which Cardinal was rapidly being reduced -- as customers switched to sturdier competitors -- its obligations-to-sales ratio was closing in on an even 1.0. Essentially, each dollar of sales in '87 would belong to someone else in '87. Now how are you supposed to construct positive cash flow out of that?
There wasn't enough time to build sales back up and then synchronize operations to them. (To gain the confidence of creditors in a turnaround, MFS believes, operating cash flow has to get to break-even within 60 days.) An alternative was to generate a cash infusion by selling some successful service centers, but that would mean forgoing future profits after the crisis phase was completed. MFS's dilemma: there wouldn't even be a future if MFS didn't first make sure that the machines in whatever sites remained could be stocked so Cardinal could stay alive just one more day. Filing for court protection was considered, but the owner deemed the process degrading and, having the ultimate say whether MFS liked it or not, declined to throw in the towel.
The tactics of a Chapter 11 were adapted, however. MFS revamped headquarters, dismissing remiss executives and reshuffling what Walker calls the "rocks" -- knowledgeable and enthusiastic management members upon whom, God willing, the new business could be built. Ordinarily, a CEO would be first to go, since he's the one who orchestrated the mess, but in Cardinal's closely held case, Ries retained the reins. "If it was a public company, the stockholders might have been perturbed," Brown reflects. "But it was private, and as the golden rule goes, he who has the gold makes the rule." Walker oversaw operations. Brown took up juggling creditors -- including the IRS, with whom he immediately tried to work out an extended payment plan -- until the service centers could be rehabilitated.
One of the balls lingering precipitously in the air was made of high-bouncing rubber -- the postdated checks and promissory notes Ries had earlier distributed to vendors needing assurance of payment. "There was a surprise," admits Brown. "Rivets are popping all over the place, and you're swimming around in a sea of trouble, trying to find a course to steer through. Suddenly, you're faced with a large number of checks that are going to keep coming in for deposit, which is going to whack the cash, and a bunch of promissory notes that the company is expected to make good on. Meanwhile, we can't even pay sales taxes."
Brown called up the recipients and told them some consultants had just come in with a survival plan. To succeed, unfortunately it dictated that there be no payments for the next 90 days. Don't deposit the checks, the promissory notes will not be honored, there is no money, and I'm telling you the truth, confided Brown, now sitting in the cash manager's seat as de facto chief financial officer -- a position Ries had never established. (Ironically, Cardinal had been stocking its money-changing machines with considerably more coins than were actually needed. The excess -- around $100,000 that could have been plugging such leaks -- might as well have been stored in a cookie jar.)
In April, Brown sent a last-ditch appeal to several hundred unpaid suppliers. For a while, nobody would get any of the $3 million plus by which Cardinal was in arrears. But if the suppliers could see their way to keep the goods coming, the company would take current dollars coming in and apportion them to current invoices. And, Brown was careful to emphasize, all creditors would be equal: Coke and Pepsi wouldn't get their money any sooner than Mom and Pop. Obviously, this would lead to positive cash flow; then the plan was to begin making regular payments toward old debts -- perhaps a payout of 10% a month for 10 months, or to offer a onetime discounted settlement of 75? on the dollar. "In the meantime," the besieged Brown urged, "we request that you hold all questions and telephone calls." He personally signed each letter, giving it that from-the-heart touch.
"It was more strategy than numbers," admits Brown. "My job was to keep everybody calm. The vendors hadn't gotten to the gang-up stage yet, but they were antsy." At any time, a mere handful of disgruntled creditors could have forced Cardinal's hand. "If they decided their chance of receiving anything was zero, they might do something nasty to the company just out of spite," he fretted. When suppliers mentioned liquidation, Brown would cajole them: go ahead, call your lawyer. But remember, only secured creditors will get something. Therefore, it's in everyone else's best interest to go along. As long as there are positive results, the bank is happy; as long as the bank is happy, you should be happy, too, because that means you'll get a payout.
The bank, however, only Looked happy, having so far refrained from action. MFS's go-call-your-lawyer tactic forestalled Bank One as well. People out there know Cardinal's in trouble and are waiting for the fire sale, MFS intimated. If you force us to sell, those guys will be picking up machines on the courthouse steps for a nickel on the dollar. That's going to deteriorate your collateral position seriously. Besides, it will be more rewarding to sell an ongoing business tomorrow than a dead business today. The bank was so touched that it contributed to cash flow by postponing half a month's interest. For its part, Cardinal agreed to dispatch weekly sources-and-uses-of-funds statements plus a recap of what had been accomplished, the upshot of which consisted mainly of here's some bad news, and here's some worse news.
In sternly official correspondence, the bank's workout department had notified Ries in March that it understood he had decided to sell the kit and caboodle and to settle secured accounts. "We wish to have you modify your statement," countered Ries, displaying admirable cheekiness for someone buried under obligations of $5 million. "All strengths and efforts," he informed the bank, "are to keep Cardinal alive."
That prognosis was brightened by the presence of two contending lenders, each of which was haplessly pitted against the other. Because of that situation, an asset that ordinarily would have been liquidated might in this case be spared. For example, as first secured lender, Bank One would be entitled to the money from the sale, but why would Harley sign off and allow that piece of collateral to be released, when it wasn't going to receive anything? And if Harley decided to be the one to pull the plug, it stood to be sued for acting against Cardinal's best interest while the other secured lender, Bank One, was cooperating. It was a standoff made in heaven, and it gave Brown welcome breathing room -- about a week's worth at a time.
Some suppliers agreed to keep goods coming in, but only on a COD basis; some specified strict terms: keep us current within a week, two weeks. "A lot of the reason the creditors were willing to go along is Ed Ries," Brown acknowledges. "He has a very good reputation, and he's well liked and respected, so they'd go that extra mile. Then it was up to us to squeeze more days out of them. Every COD vendor that gave us one week's credit was one more week's cash flow we had right then." If, alarmed by some rumor that Cardinal was about to go under, suppliers called up to cancel the delicate arrangement, Brown would patiently repeat the litany of reassurance he kept next to his phone: the company has taken significant positive steps to improve cash flow. Expenses have been reduced. Internal systems have been streamlined -- computing, accounting, financial. Idle assets are being converted to cash.
Meanwhile, from each round of payments a few checks rebounded (including more than one made out to Multi Financial Services, a creditor on the same chancy terms as everyone else). After payroll and federal-withholding priorities, there wasn't enough money coming in, even on a rationed basis. "You take your chances with bouncing," is Brown's philosophy of crisis, "but at least you get that week's vendor or shipper in the bag." As for the next week, there was nothing for the MFS team to do until the service centers' margins were brought under control. To accomplish that, the managers were instructed to increase prices, reduce costs, cut back personnel, streamline operations, and renegotiate contracts. If an account couldn't be righted with dispatch, there was no alternative but to pull the machines.
Easy for you to say, professor. In the trenches, though, the directives did not go over well. We should go back into the plants and increase prices after we worked so hard to get the accounts? service center managers objected. "Well, you're going to have to, and not two weeks from now, but tomorrow," Walker dictated. Brown would add, to the consternation of some managers, "If we have to ration product, let's not ship it to City A, where they're losing $1.10 for every dollar of sales. Let's send it to City B, where they're making a dime."
The managers were given two targets to aim at on the weekly profit-and-loss statement each was now required to prepare -- and interpret. First, they had to raise gross margin two points from its current average of 50%, mostly by adjusting prices. Second, they had to limit expenses to 38% of sales; as sales went up and down, the manager learned to adjust spending, mainly by controlling labor. The results were calculated each Friday in a two-page flash report. If the manager met the criteria, he achieved what MFS called "threshold profitability management." If he bettered them, he achieved a salary enhancement that MFS called "a reward."
Not that Cardinal hadn't been feeding usable data into its computers all along. Upper management simply hadn't instructed the service centers to perform usable analyses of it. From the number of items that were replaced in each machine every time it was serviced, for example, MFS was able to reschedule the frequency of service to match when the machine would be almost empty. This led to the managers' devising more efficient routes for the trucks, to a concomitant reduction of labor, and to a 50% reduction in inventory required to support field operations within the first 60 days. Within the next 60 days, however, the managers appeared to have learned their lessons too well: it seemed some were purposely over-ordering and stockpiling supplies, hedging against corporate's being unable to pay the invoices.
At press time in late August, the positive cash flow promised by the end of May had yet to materialize -- but then again, it wasn't negative. Indeed, Kelly was able to pronounce with some satisfaction, "It's exactly zero." Cardinal was barely squeaking by, "but we can see the light at the end of the tunnel." He must have unusually good eyesight: sales had not responded to resuscitation, no delinquencies had been paid, and in meetings with loan officers, Brown reported, "those guys weren't smiling." One likely reason: no significant asset had yet been sold.
Still, the mere fact that the company was breathing on its own eight months later was inspiration enough. Now it was time to pin down how many cents on the dollar Bank One, Harley Hotels, the city of Sandusky, and other notes and obligations holders would accept if the settlement could be paid by, say, December 31. "If we continue to do what we're doing, maybe we'll have positive cash flow by then," says Kelly. "There's no point in working if we don't have a goal." And beyond that goal is, somewhere in the vicinity of the last row of the end zone, the possibility of -- dare it be mentioned? -- equity financing. Just as the typical MFS client wants in the first place, only without all this fuss.