Spending into a Headwind

In the middle of the Great Recession, two CFOs gambled on growth.

Through the course of the economic downturn, many finance chiefs have come under pressure to locate as much cash as possible to make up for plummeting sales. For those executives, that’s often meant cutting back on spending for future growth.

Yet for some companies, maintaining a certain level of spending — to stave off hard-charging competition, say, or to keep plans for a crucial merger on course — has been an absolute necessity. The process, however, requires CFOs who are willing to take risks and hold their ground against dividend-hungry shareholders.

Earlier this week at the CFO Rising West conference in Las Vegas, two such finance chiefs — Robert Lloyd of GameStop, a video-game retailer, and Don Jordan of Pelican Products, a maker of protective cases for products ranging in size from an iPad to a Tomahawk missile — spoke of the challenges their companies faced in pursuing growth strategies during the past two years.

Faced with stiffening competition for used video games from the likes of Wal-Mart, Best Buy, and Target, and with plummeting demand for its game consoles, GameStop executives knew the company had to reinvent itself. Indeed, critics often asked company executives how it would avoid the kind of troubles that video chain Blockbuster, which filed for bankruptcy last month, has endured. “For us to succeed, and to succeed in the future, we’ve had to stop thinking like a traditional retailer and start thinking like a technology-focused, multichannel provider of video games,” said Lloyd.

As a result, the company boosted its marketing efforts and worked with game publishers to develop unique content. GameStop began doing such things as offering exclusive game-related armor and weapons if customers reserved orders for future product launches.

The firm also worked with console makers to develop technology that enabled GameStop to offer console add-ons that could only be applied in the store. It invested heavily in making its products available online, and it continued to open stores in markets where it could achieve targeted returns and grab market share from competitors.

The company was able to make such outlays because its typically strong cash flow held up during the recession, according to Lloyd. Indeed, GameStop’s core operating cash flow (cash gross margin less cash operating expense) rose from $634 million in the second quarter of 2008 to $986 million in the third quarter of 2010, according to data supplied by Cash Flow Analytics.

Ironically, the strength of GameStop’s cash flow created Lloyd’s toughest challenge as CFO during the downturn, he said: to explain why the company was spending all that money on capital improvements. “‘Why don’t you just return that cash to shareholders,’” the finance chief recalled investors asking, “‘if you’re feeling that good about the cash?’”

At first, that investor pushback seemed to have some effect. For its 2008 fiscal year ending January 30, GameStop reported $183 million in capital expenditures, mainly spent to open 674 new stores in the United States and internationally, and to invest in information systems. During fiscal 2009, however, with the retailer opening just 388 stores, its capex dropped to $179 million. Nevertheless, the company seems to have returned to its growth mode, projecting capex of about $215 million for fiscal 2010.

For its part, Pelican Products faced the decision of going ahead with the acquisition of its prime competitor, Hardigg Industries, at exactly the point when the U.S. economy was slipping into its biggest downturn since the Great Depression. A large private company that had grown mainly through acquisitions, Pelican had experienced record sales and growth in September 2008 and for much of the following month — a period when due-diligence negotiations for the merger, which would double the size of Pelican, were proceeding apace, according to Jordan.

In the last week of October 2008, however, “the orders just dried up,” Jordan remembered. What’s more, the financing for the merger had not been arranged. “We had a number of banks lined up, and both companies had very strong fundamentals,” he added. “But when October and November came, we had banks dropping out left and right.”

Nevertheless, Pelican was able to seal the $200 million acquisition in December 2008. Besides the diminished bank debt, the deal was financed by a patchwork of stock, warrants, and 14.5% mezzanine borrowing that, Jordan quipped, was almost like “credit-card debt.”

The financing part of the deal “was just nerve-racking,” he said. But the two companies embarked on a rigorous effort at integration that netted them unanticipated cost savings. Pelican executives had thought they would get at least $5 million in cost savings as a result of the deal and that $10 million was in reach. The merger, however, ended up resulting in a cost savings of $25 million, according to Jordan.

In the end, choosing to go ahead with the deal amounted to a big bet on the company’s future. “When we decided to do the acquisition, we said if [Hardigg] ended up in somebody else’s hands, we’d never be the same,” said Jordan. “That was our first decision — and all the rest were secondary decisions.”

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