Hope For Inflation, Prepare For Deflation

After months during which the risk of inflation has dominated discussion, the D word—deflation—has resurfaced. Forecasting the odds of something as rare as sustained deflation is chancy at best, but its consequences would be so lethal that executives must prepare their businesses and balance sheets for the possibility, however remote, of a downward spiral.

Conventional wisdom is that in a deflationary period, the highest priority is controlling debt, as price contraction makes fixed debt payments heavier in real terms. Chief financial officers should therefore cut dividends, hoard cash and pay down debt. Unfortunately, if all executives take this route, a deflationary spiral is unavoidable. Parsimony kills demand, prices fall, wages eventually drop as revenue crumbles, spending tightens again and prices drop further—making debts still more burdensome.

Happily, there are individually prudent choices that aren't suicidal when taken en masse.

For a company to survive in a deflationary period, its products must be superior in quality, not just price—or be perceived that way, says Don Rissmiller , chief economist at Strategas Research Partners. Those with uncompetitive cost structures, excessive leverage or inferior products are not bailed out by ambient economic growth. They go bankrupt instead.

A realistic goal for companies is to protect market leadership as weak players wither. Product lines that are also-rans in their markets should be divested.

Consider Germany's Siemens AG. The group should further increase its focus on its energy business, particularly the fast-growing fossil-fuel power and renewable-energy units. The segment has expanded revenue at an impressive 15% compound annual growth rate since 2006 and earned profit margins in the low teens in 2009, well up from 2008 and 2007. Efforts should be made to sell or spin off divisions that are sub-scale or not reaching target margins now. An IPO or sale of the lighting unit fits the bill. Siemens also should take another shot at selling its underinvested hearing-aid division.

Consumer goods companies would be wise to emulate the U.K.'s Reckitt Benckiser PLC, which paid top dollar this year for SSL International PLC, gaining brands like Durex and Dr. Scholl's—quality names that supplement the existing portfolio. Germany's cash-rich Nivea skin cream producer Beiersdorf /zigman2/quotes/210479173/delayed DE:BEI -0.24% AG should shop for premium brands before competitive pressure on its current portfolio intensifies further.

Everyone, even the best-run firms, will feel pain from deflation, but deflation need not be a global phenomenon. Accordingly, companies need to gain access to countries where prices are more likely to be stable, counsels Paul Ashworth , senior U.S. economist at Capital Economics. In practical terms, this means those with sturdy growth and without heavy debts.

Firms everywhere already are looking to the likes of China and Brazil. The threat of deflation gives them reason to redouble their efforts.

Robert Armstrong and Alessandro Pasetti

Will Anyone Take Skype's Call?

Skype SA hopes to create a splash in a tepid market for initial public offerings. If it succeeds, it will no doubt prompt other venture and private-equity backed technology, media and telecommunications businesses to come to market.

Last week's IPO filing comes just seven months after a group led by Silver Lake Partners acquired a 65% stake in Skype from eBay /zigman2/quotes/204653455/composite EBAY +0.16% Inc. in a transaction valued at $2.7 billion, or 14.6 times 2009 earnings before interest, taxes, depreciation and amortization, or Ebitda, of $185 million. For the first six months of 2010, Skype generated revenue of $406 million and adjusted Ebitda of $116 million.

Skype's top line and Ebitda have grown in line with the growth in paying users. What kind of valuation does that growth beget?

In its favor, Skype has enjoyed strong growth in recent years. Average monthly users have grown between 30% and 40% annually. But just 6.5% of Skype's users are paying users, and the proportion of those who pat has fallen consistently from 8.8% at the end of 2007. The rest simply use Skype's free software to call others who likewise have it installed.

Then look at Google /zigman2/quotes/205453964/composite GOOG -3.05% Inc. It, too, has seen Ebitda rise at a 20%-plus rate over the last few quarters, yet it trades at just 12 times trailing Ebitda.

Assuming Skype bags a multiple similar to Google, the company would be valued at $2.8 billion based on a 2010 Ebitda run rate of $232 million (twice its adjusted first-half Ebitda)—no gain for Silver Lake and the company's other backers, after the IPO fees.

To beat that, Skype needs a compelling growth story.

The bulk of Skype's current revenue, around 86%, is generated from the SkypeOut service, which enables users to make calls from Skype to traditional landline or wireless networks. In order to boost the multiple Skype receives, Silver Lake will argue the potential from new revenue sources such as advertising, SkypeIn (which allows users to receive calls from landline and wireless networks), Skype Access (which allows users to use Skype credits to access compatible Wi-Fi networks) and Skype for Business.

But it will face a skeptical audience. Despite a number of successful IPOs this year, it remains a buyer's market.

So, while Skype can dial up investors, it's not clear if they'll take the call.

Sameer Bhatia

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