Five ways companies can prepare for Europe’s “lost decade”

The future of the euro zone is more secure than a year ago – the likelihood of a Greek exit has decreased, and in Germany, Europe’s economic stronghold during the crisis, business expectations are beginning to brighten.

But research by Ernst & Young and the McKinsey Global Institute suggests that companies operating in the region shouldn’t let down their guard.

“Rather than preparing for a quick return to a ‘normal’ situation with continuous growth, five years into the crisis companies should prepare for a ‘lost decade’, one marked by continued struggles over growth and lingering high levels of unemployment,” Mark Otty, E&Y’s area managing partner in Europe, the Middle East, India and Africa, wrote in the company’s latest euro-zone forecast.

Companies doing business in Europe face several challenges: Ernst & Young expects the euro-zone economy to stagnate in 2013 and to grow no more than 1.6% per year during the rest of the decade. Demand for goods is expected to remain slow as Europeans continue to save and lower household debt. Government austerity measures will probably compound weak consumer spending. And the supply of credit for companies remains limited.

The depth of the euro-zone gloom is reflected in the reluctance of companies to invest in the region. From 2007 to 2011, private investments in the 27 EU countries declined an unprecedented €350 billion (more than $450 billion), according to the McKinsey Global Institute. At the same time, listed European companies had accumulated €750 million (nearly $1 trillion) in excess cash by 2011, one of the highest amounts in two decades.

Increased private investment would provide the European economy a vital boost, but McKinsey Global Institute and E&Y suggested a recovery may take some time.

In the meantime, companies doing business in Europe have to deal with the situation. E&Y and the McKinsey Global Institute offer advice on how companies can be prudent without missing out on opportunities:

1. Don’t discard risky projects without analysis and review. Mid-level managers, who make routine investment decisions, are often very risk averse. As a result, attractive projects may not even make it to the proposal stage. To shift a company’s risk profile, senior managers could encourage mid-level managers to analyse options and review those that are risky but have high potential returns.

2. Don’t overcompensate for risk. Managers may add an arbitrary and unnecessary risk premium to the cost of capital of worthwhile investments to compensate for risk. That can lead to missed investment opportunities. Instead, managers should incorporate risk assumptions into cash flow projections of the investment using scenario analysis. That would help calculate the risk by the probability of each scenario. 

3. Dig into the details. McKinsey research has determined that about 80% of the variation in large companies’ top-line revenue growth goes back to growth in sub-industry segments and revenue gained through mergers and acquisitions. For example, upgrading the bandwidth of fixed and mobile networks is critical to meet increasing needs by European firms and households. To deliver desired levels of data speeds in the EU, €230 billion to €290 billion in investments are needed over the next decade in the fixed network alone.

4. Look for opportunities to drive capital productivity. Companies can find opportunities in Europe across a range of investment sizes to achieve savings of more than 30% and increase the return on invested capital by up to 4%, according to McKinsey. To drive capital productivity, companies should focus on continuous improvement, develop a customised tool kit that helps managers extract maximum value from capital projects and assemble a project team with superior execution skills.

5. Drive growth through exports. Companies doing business in Europe will have to look for markets outside of the euro zone to drive growth through exports. Economic growth has slowed in many developing markets, but rapidly rising numbers of consumers are expected to boost domestic demand for goods and services from around the world in countries such as China, India, Nigeria, Indonesia, and Turkey. Exports from the euro zone to rapid-growth markets increased nearly fourfold in the past decade and are expected to pass intra-euro zone trade, which currently constitutes about 60% of European exports, by about 2030. Oxford Economics projects that by 2020, exports from Europe to Africa and the Middle East will be about 50% larger than exports from Europe to the US.

Related CGMA Magazine content:

“Is Your Company Prepared for the Rise of the Asian Consumer?”: If your company does business overseas, you are about to feel the rapidly rising influence of the Asian consumer. Is your company prepared for this economic shift?

“Concerns About Europe, Global Economy Drive Down Economic Optimism”: Revenue and profit projections dropped sharply in the second quarter, according to a global CGMA survey of finance executives. Those and several measures of economic sentiment led to a decline in optimism worldwide.

“Top Five Emerging Markets Capture Foreign Investors’ Attention”: Western Europe and North America are still attractive to foreign investors, but not as attractive as the top five emerging market hot spots. Even lesser-known emerging economies are gaining ground.

“Foreign Investors Not Scared of Europe, But More Selective”: The ongoing euro-zone crisis hasn’t scared foreign investors away from Europe, but it has made them more selective, according to Ernst & Young research.

—Sabine Vollmer (svollmer@aicpa.org) is a CGMA Magazine senior editor.