STRATEGIC MANAGEMENT

I spent twenty-two years in corporate development with one firm, from 1976 through 1998. During
that time, my employer was a broadly diversified manufacturing company, covering agricultural,
industrial, and specialty chemicals, as well as defense, oilfield, food, airline, railroad, municipal,
packaging, construction, and power transmission equipment. Prior to WWII, the company had been a
focused specialty machinery manufacturer, but a succession of acquisitions into the early 1960s
resulted in a rather unwieldy array of increasingly commodity businesses. In 1972, a new CEO was
installed to regain control.

During my tenure, I witnessed three distinct phases of strategic management at the company.
Initially, the company was living by EPS growth, along with most other US corporations. The
chairman ran a tight financial ship, but he adhered to the corporate norms of the time. I remember
reading a strategic plan for construction equipment which projected a huge expansion and
tremendous earnings increases while ROI remained sub par. This was the mindset that the Senior
VP of Corporate Development set out to change. He brought in Callard & Madden (CMA) to provide
expertise on strategic financial measurement, specifically their Cash Flow ROI (CFROI) measure and
associated business valuation model. I was part of a team that implemented the CMA technology in
house. By 1979, we were able to demonstrate that the company’s mix of investments and incentives
was substantially off the mark. The CEO and President lined up behind a new value-oriented

During the next few years, the company made substantial changes to its business portfolio while
business planning at all levels became much more focused. We closed or divested numerous
business units, including the entire power transmission group. We realigned strategic investment
priorities to higher CFROI businesses, although to his credit the chairman avoided exorbitantly priced
acquisitions. He also maintained tight control over budgets, capital spending, and working capital,
with the assistance of a capable and disciplined financial staff. Senior managers generally knew what
was expected of them.

The strategic investment shift and tight operating controls led to a huge buildup of cash. In 1984 the
company did a Dutch auction share repurchase but the cash buildup continued amidst further
divestitures and shutdowns. Finally, in 1986 the company did a massive recapitalization, taking on
about $2 billion in debt while paying out large cash dividends to shareholders. This recap effectively
constrained the company to a very narrow focus on debt repayment during the next few years. I was
heavily involved in the projections that supported the recap as well as corporate financial plans during
subsequent years. We all worshipped at the altar of cash generation. A sign in the CFO’s office read
“Cash is King!”

Financial engineering as a value-creation strategy obviously worked in spades. But in paying down
the recap debt, the company benefited from several distinct factors. First, the economy remained
robust during the late 1980s; some later corporate recaps weren’t so fortunate. Second, two
businesses were minting money during this period, defense equipment and gold mining; a portion of
the gold company was IPO’d during this time, producing more cash. Third, the company was able to
repatriate a substantial sum from its overfunded pension plan. By 1991, the recap debt was reduced
to a manageable level. Also, a new CEO was installed. He was interested in a strategic shift toward
profitable growth via organic expansion and acquisitions, because he believed that the company’s
leading market positions in a number of businesses would support it and because the two money
machines, defense and gold, were in a declining phase with no resurgence in sight. There were
plenty of examples of diversified companies that had grown profitably, GE of course, but also
Emerson, ITW, Danaher, Con Agra, even Tyco before they went astray. So the chairman
commissioned Corporate Development, in tandem with McKinsey, to map out a profitable growth
As an aside, it is important to mention a massive accounting experiment which took place in the
company during the 1980s. Because of the success of CFROI and valuation at the strategic level,
the finance department overhauled the company’s management accounting system with an elaborate
system of current cost adjustments, mainly to fixed assets but also to inventory. The objective was to
create an operational version of CFROI-type adjustments. In principle, this made a lot of sense
because high inflation had created huge disparities in historical book assets which distorted business
results long after inflation subsided. The company even had a current-cost version of EVA, called net
contribution, which predated the Stern-Stewart blitz. Like EVA, net contribution adjusted profit with a
capital charge, but it incorporated current cost capital employed to approximate replacement value
and thereby to level the playing field between businesses with widely varying capital intensities and
vintages. These current-cost concepts played well in the accounting community. The company was
even the subject of a Harvard Business School case.

Nevertheless, operating managers didn’t embrace current cost, particularly in chemicals where the
system highlighted overblown estimates of profitability and future cash generating capability.
Chemical managers countered that current cost assets didn’t reflect modern replacement technology
and therefore painted an erroneous picture of their prospects. In any event, a lot of time and effort
was spent producing inflation adjusted results, and a lot more time was spent arguing about their
relevance rather than focusing on the real issues of the businesses. Because top management had
never been totally supportive either, the current cost system was discredited and doomed. In 1992,
the new CEO scrapped it. The lesson from this experiment is that financial measures, however
logical and well developed, are irrelevant if they are not fully embraced by senior management and if
they are not tied to the financial statements delivered to investors.

Starting in 1992, the CEO initiated a huge investment program, consisting of both acquisitions and
internal investments throughout the diverse industry segments. In total, about $3 billion was spent
during his ten-year tenure. Also during this period, the defense business and the remainder of the
gold company were divested because of perceived low growth prospects and strategic declines.
Unfortunately, the new growth strategy didn’t pan out. In hindsight, a lot of costly chemical
investments were ill-conceived. Moreover, managers’ feet weren’t held to the fire. Bonus targets
were not set on an increasing value basis and seemingly logical explanations were accepted for
mediocre performance. Machinery investments were generally more focused and less costly, and
although they weren’t all unqualified successes, the company did build a very strong position in
subsea oilfield equipment. Throughout this period, earnings remained flat with numerous large write-
offs, relations with Wall Street soured, and the stock price languished. For years, Wall Street and
various consultants clamored for a breakup of the company, but top management resisted. Finally,
when the CEO contemplated retirement, the company was split into two public companies, chemicals
and machinery, both of which have been improving. Interestingly, the chemical company, burdened
with extensive debt and environmental liabilities, has focused primarily on cost reduction and cash
flow, and its share price has responded favorably.

To reiterate, most of the CEO’s strategic chemical investments were failures. His very first
acquisition, in flame retardants, was overpriced, was based on faulty market assumptions, was poorly
managed, and was divested after a few years. Other chemical expansions ended up in mothballs
because the company didn’t have a low cost position and global competitors reacted aggressively. In
many of these cases, the CEO was the principal champion of the proposed investment. The most
absurd example was a lithium chemical plant built at 14,000 feet in the Argentinean Andes which
involved novel technology and which required both construction and operating labor to be flown in!
Shortly after the plant was built, lower cost competitors emerged and it became clear that its market
justification was flawed. Thereafter it became the caricature of a white elephant and new
downstream plants were also abandoned. Additionally, the company built an agricultural chemical
plant, again based on novel technology, that never operated anywhere near specifications.
It’s hard to understand how the company went so far astray, even for those of us who were there.
One former executive said “The strategy could have been fine; profitable growth is, virtually by
definition, a good strategy. That leaves execution as the issue.” The CEO was an intelligent guy with
all the right experience and credentials. Under his stewardship, however, the company lost its
successful value focus of the 1980s. Some say that his zeal to grow clouded his judgment, that he
got poor guidance from certain executives, and that he didn’t brook dissent. I personally found him
puzzlingly single-minded and dismissive of analysis. In any event, financial analysis and operational
accountability were downgraded. Investment decisions, although supported by valuation, were
largely ad hoc with extended paybacks. Big bets were made in commodity businesses based on
faulty market assumptions. There was nothing approaching a profitable growth system. Moreover,
for ten years the board appeared to be asleep. This kind of performance would never have been
tolerated at GE or Emerson.

With all the attention lately to corporate collapses, like Enron, Worldcom, and Tyco, we lose sight of
the fact that many corporations simply underperform for a variety of reasons. There is no
malfeasance, only sustained poor decision making based on fundamental market misperceptions.
CEOs are rewarded with outsized salaries and bonuses regardless of their performance vis-à-vis
shareholders, with the support or at least acquiescence of their boards. Pundits complain about the
Wall Street focus of public companies. But real problems arise when CEOs are allowed to ignore
shareholder interests over substantial periods. The best companies are able to reward shareholders,
and all other stakeholders, with consistent profitable growth.

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