Fortune magazine reports that Warren Buffett stated in 1988, “With few exceptions, when a manager with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” Bad business models often result in poor fundamental economics. Business models are hard to get right, and often very hard to change.
A 2014 survey of CFO’s asked about reporting and earnings quality. The Financial Analyst Journal reported the (Dichev, Graham, Harvey and Rajgopal) study in their Jan/Feb 2016 edition. The survey results are full of interesting details including the estimate of 1 in 5 financial statements being “cooked” with material (10% or better) adjustments. That information is worthwhile and it is bolstered by a list of ways CFO’s can tell there is a disconnect between reality and the financial statements. The survey also identified that a goal of financial reporting was about “conveying the long-run view of the profitability…of a bundle of assets”. As interesting as this is, I’d like to focus on another aspect of the article, the sense by the CFO’s of what drives earnings quality.
The survey inquired about factors that determine earnings quality – both internal and external. The top factor was the business model of the company. The other inputs included external factors such as the industry, accounting standards and macroeconomic conditions. Internal factors included internal controls and the aforementioned business model. Clearly, management teams are accountable for internal controls, but the argument for business model is not as certain.
Management teams are hired- they don’t create the business. They are brought in for their leadership, management, talent, knowledge and skills. Consequently, much of the business model is defined before the management team starts. Good business models require a good design in the beginning and careful nurturing. As markets change, business models grow obsolete and no longer fit their markets. Watching video has increased steadily in the last 20 years and yet the local Blockbuster is now a Dollar Tree.
I once joined a company that was earning <1% operating profits, and had no growth. In one year sales were up 10+%, and operating margins increased to 4%. In the next several years, we were never able to get operating profits much above 7%. In the years after I left, operating margins averaged less than 1%, until finally it went bankrupt.
The managers who followed me were a mix, some weak, some strong, some were tactical, some were strategic. When they took the position, they were confident about generating great results, but in the end none were able to solve the business model puzzle. Earnings were invested in a series of new initiatives which never resolved the core problem. Eventually weak profitability and lousy returns on capital resulted in a steady turnover in CEO’s and eventually it was sold to private equity who split out the good assets and bankrupted the rest.
This firm clearly had a business model issue. Flat market share, low returns on capital, little ability to innovate or compete in new segments. Low earnings quality is an outcome of the business model, and tinkering is not going fix it. So what do you do with a business that has poor fundamental economic performance? Here are a couple of strategies that can work.
One way is to get a break, either a technological change, industry change or strategic option which creates an opportunity that allows the firm to innovate. Richard Rummelt discusses this approach in his book “Good Strategy / Bad Strategy”. Blockbuster knew that digital streaming would hurt their business, but couldn’t come up with a strategy that was effective. Netflix, which was in the mail order DVD business, however, did. Searching, selecting and creating this opportunity takes time, resources and patience.
Another option is to pare the business down to the profitable core, and then build up from there. The focus here is on increasing the return on invested capital. A good business invests in projects that deliver a better than market return and prunes functions and divisions that do not. Will the business get smaller? Yes, it will, but the remaining business will provide a foundation for growth.
Both of these strategies have significant downsides for management. Few business leaders are strong enough or are far-sighted enough to risk the company on a technological change. Boards don’t like risk taking and the bigger the business the bigger the inertia. Paring down a business can often mean several years of declining sales. Even if you are adding to profits by subtracting a poorly performing operations, there will be concern by the Board, by investors and even by the management team. CEO and senior executive compensation is highly correlated with company size and declining company size means declining compensation. This is a lot of headwind, which explains why there are so many firms stuck in this state.
The bottom line is that it is a whole lot easier to keep a business model working well, then to fix it after it is broken.
Dichev, I., Graham, J., Harvey, C. R., & Rajgopal, S. (2016). The misrepresentation of earnings. Financial Analysts Journal, 72(1), 22-35. Retrieved from http://0-search.proquest.com.library.ggu.edu/docview/1762049797?accountid=25283