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 strategy. 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 strategy. 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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