Tracking Down Value by John McGrath Chief Executive, Diageo PLC In recent years shareholder value has become an axiom of contemporary business without which any senior executive walks naked into the boardroom. However, while particular theories of shareholder value stride boldly ahead, good practice in this field is encountered less frequently. Nowadays, the crucial question for shareholders is not whether a company believes in shareholder value - or claims to - but whether it acts to translate its words into deeds. My own introduction to shareholder value as a practical tool dates back to my time at International Distillers & Vintners in February 1993. At that time, lDV's marketing and investment expenditure was severely squeezed and we had to prioritize scarce resources, Value-based management was the answer. In other words, my first foray into share-holder value was motivated not by a desire to improve the share price but by short-term pressure to optimize resources. I felt strongly at the time that value-based management was a powerful tool, which, at its simplest level, unified the profit and loss account with the balance sheet and allowed managers to make judgements that could transform a company. There are several proprietary metrics - and one or two non-proprietary ones - that enable companies to measure shareholder value. Diageo, along with such companies as Siemens and Tate & Lyle in Europe and Coca-Cola and Monsanto in the US, chose the approach of Stern Stewart, the consulting firm that invented EVA®. EVA, or Economic Value Added, is represented by operating profits after tax, less a charge on the total invested capital. But it is also a complete management system that changes priorities and behavior to focus on value. It is both the measure of a company's true profitability and a strategy for creating corporate and shareholder wealth. The simplest application of EVA lies in analysis. For instance, connoisseurs of aged Scotch whisky know how beguiling this renowned drink can be. In marketing terms it may sell well. But does it create value? Analyzing the real cost of holding such a long-term inventory of product as we did in the pre-Diageo IDV days - proved to be an illuminating exercise. The costs of maturing Scotch whisky, sherry and port tied up capital in such a way that, in one particular case, the return on it was inadequate - the process sometimes destroyed value, even though Scotch, premium priced, tends to generate good returns. By contrast, our analysis
highlighted drinks such as vodka and liqueurs that could be sold within weeks of distillation - the real value creators for the company. Conventional wisdom took a body blow from this innovative picture of what generated value and what didn't. As a consequence, we switched funds from the lower value-added brands to the higher ones and diverted our advertising expenditure accordingly. This incident, which occurred in the period before I became chief executive of Grand Metropolitan in 1996, convinced me that we understood value-based management and were ready to move on to the next stage of its implementation. We needed to extend the discipline of economic profit throughout the Organization while finding an executive compensation scheme that was consistent with value-based management. Thus, late in 1997, we employed Stern Stewart to begin a pilot program in the Pillsbury packaged foods business. GrandMet and Guinness then merged to form Diageo, a portfolio of food and drink brands marketed in 200 countries with 85,000 employees and an annual turnover of around £14bn. Even before the merger itself, I needed a team that was efficient and focused on Diageo's business aims - a team that embodied the culture I foresaw for Diageo. EVA was one of the tools, which that would help enormously in this process of post-merger integration. While its financial aspects can be relatively technical, EVA can be explained as simply as it needs to be: a good training program with useful tools can help people to understand how to use EVA every day. At Diageo a policy of "Simplify, Simplify, Simplify' meant that everyone could recognize its benefits. At the same time, up to 300 managers at the highest levels received much more comprehensive training. Value-based management was seen as a new, fresh and rational approach to management and encouraged people to make fact- based decisions according to an agreed process in the light of the various strategic alternatives. Banking the bonus Where EVA scores over other metrics of shareholder value is in the areas of remuneration and day-to-day tools for evaluation that are both practical and personal. It not only measures performance but helps people enhance it. Because EVA can be measured at any point in an Organization, bonuses linked to EVA are a powerful influence on corporate behavior, aligning shareholder and management interests, and helping to address one of the thorniest issues facing businesses in Europe - how pay is tied to
performance. In calculating Diageo's incentive program, we first agreed what the market's expectations were for the company as a whole and for individual businesses within the company. We then agreed the improvement in economic profit for those businesses, across three years, in line with those market expectations. That gave the target for bonuses. If you exceed the expected improvement in economic profit, your bonus goes up. Stern Stewart argues that there should be no limit to that bonus, because there is no limit to how high the share price can go. The bonus bank is vital. Essentially, each manager's bonuses are "banked", to be paid out over a number of years; that is, only half the bonus bank can be paid out in any year. Otherwise, a manager could perform brilliantly in Year One and, because he or she perhaps skimped on longer-term investments such as brand advertising, crash in Year Two. Clearly, a company cannot pay a bonus one year and take it back the next. The bank ensures that performance is sustained and is rather an elegant solution to the tendency of managers to try and play the system. EVA also encourages accountability and opportunity. During my time at Ford, I learned the importance of accountability - defining it, being specific about what needs to be done, by when, how the results should be measured and, of course, exactly who is accountable. In the minutes of a meeting, for instance, writing three sets of initials under a single "action point" typically resulted in confusion and the abdication of responsibility. That said, it may be difficult for individuals on there own to solve problems, which is why team-working and team decision-making are important. I tend to put teams of up to 30 people into the same incentive scheme rather than encourage an individualistic approach. This policy does not blur accountability, however, because the whole team is accountable and members hold each other accountable in the process. For its most senior executives, Diageo also has an L-TIP, or Long-Term Incentive Program. Most similar senior incentive schemes generously gauge a company's performance using the FT-SE 100 Index. Diageo's is designed more rigorously around the fact that it is one of the world's leading consumer goods companies. Hence the L-TIP establishes a global peer group of 19 companies - direct competitors such as Kellogg, Nestlé, Unilever and McDonald's, and the best-performing consumer goods companies, such as Coca-Cola, Gillette and Procter & Gamble. In order to maximize their bonuses under the L-TIP scheme Diageo executives must put the company at the top of that peer group over three years. Coming fifth wins them 100 per cent of
the agreed bonus; fourth, 125 per cent; and first, second or third, 150 per cent. Between fifth and tenth we operate a sliding scale, but if Diageo fails to make the top ten, its executives get nothing. It is a tough order, but one that 90 per cent of shareholders approved at our annual general meeting. But the program was criticized - unfairly, I believe. Critics argued that world-beating companies were somehow more likely to yield their place in the top rank to others, simply because they had been at the summit of success for a long time. Should Diageo then choose 19 failing companies as a peer group? The other argument against the L-TIP - with which I have rather more sympathy - is that if all companies are performing poorly, but Diageo is performing less poorly than its peer group, executives will still benefit, despite a potential share slide. We've built in safeguards to make sure that that doesn't happen. (Essentially, the remuneration committee must be sure that the underlying performance of the company improves over time in real terms.) From top to bottom How far will EVA penetrate the Organization? It can go right own to the production line. At the moment 2,000 employees are being trained directly by Stern Stewart, of whom 1,400 will receive incentive remuneration in line with EVA. Below that point, managers will explain what their teams can do, in practical terms, to improve EVA. Take a maintenance man on one of the production lines of the Pillsbury food business. EVA might seem like common sense, but the idea is to turn complex concepts into practical advice on a personal basis - for instance, reducing levels of breakdown, improving productivity, lowering costs, and increasing value. The improvement in value is key, powering Diageo's success by profitable organic growth, through quality, marketing innovation and new product development. Such recommendations are not new: companies have been improving quality, innovating in marketing and developing new products for centuries. Unfortunately the typical reward program, which measures only profit on a short-term budget, doesn't encourage them. First, when only profit is measured, anything influencing capital is ignored: people talk about capital efficiency but only manage for profit when this is all that matters in the reward program. Second, when we measure against short-term budgets, anything that has benefits appearing in future years will not be rewarded. Managers in many companies will tell you that if you pursue these initiatives the short-term costs hurt, but the benefits are simply "baked into' future budgets. EVA is robust enough to set targets
over a number of years and prompt more innovative and entrepreneurial management in return. As in the example of Scotch whisky, value-based management also inspires judgments about whether a new or existing brand will generate a decent return. This approach can create its own problems. Acquisitions, for example, must cover the cost of capital in just a few years. For a new spirit brand to do the same is challenging; it takes many years to manoeuvre a product into a premium position. Bombay Sapphire, for instance, was sold after ten years for a nine-figure sum to Bacardi, probably just as it was reaching economic profitability (the sale being a condition of the Diageo merger laid down by the US Federal Trade Commission and European Commission). Could EVA stifle innovation? True, it makes it more likely that different managers with different styles - each valuable in their way - will make similar decisions, but innovation does not have to suffer. Early on, people tended to reduce their capital base, sweating their assets and making them work harder. But people soon saw that companies investing to create value consistently grew value fastest. Rigor was tempered with increasing knowledge of how to make the maximum returns. For example, Diageo has a highly profitable $1 bn US food service business, part of the Pillsbury food business. This provides convenience products such as part-baked bread, to hospitals, restaurants, canteens and so on. Over a period of six months, it scrutinized every stock-keeping unit (SKU) - each product, in all its different sizes and formats, with reference to the retail channel through which it was sold and found that 23 per cent were simply not creating value. Not only that, but its dealings with certain customers was not creating value either. In other words, we didn't have a good food service business. We had a good business dragged down by a quarter of its operations. There is no automatic decision to eliminate the value-destroying SKUs. It may be, for instance, that they are necessary to ensure that we offer a consistent range of products. It may be that they can be converted from product offering which destroy value to products, which create it. Divestment is a last resort, in order to restore value. In the event, we did indeed reduce total SKUs by 23 per cent. Dealing with value-destroying
customers was, naturally, far more difficult. One solution was to change the product mix - in other words, sell them something else. Because this improved the value resulting from our relationship, it improved the value that our customers got out of it. For instance, we sold several customers part-baked rather than frozen dough, which significantly cut their labor costs. The way ahead Three years ago, when I first began to explain our move to value-based management to investors and analysts, I was given a very cautious welcome. Now there is almost uniform acceptance EVA as a value-building tool. What is second nature in the US is increasingly valued in Europe. My message is this: there is now evidence on both sides of the Atlantic that this approach to management works. Many more companies are talking about it than actually acting, but those that do act benefit enormously. But two words of warning. First, employee incentives must be tied to the shareholder value program. It is the incentive that changes behavior, and changing behavior is what changes companies. This has certainly been the case within Diageo. Second, doing it intuitively does not work. A company has to go through the hard work of understanding how it works, introducing the detailed processes and imposing the disciplines. It has to win people over. In the end, however, it seems to be well worth it.