Author: John

Risk Mitigation for CFO’s

In my earlier post, I noted that converting uncertainty to known-unknowns requires thinking hard about the potential things that can go wrong and having a good risk identification search process.  I broke risk down into true risks, which are insurable at some level (known frequency and severity) and uncertainty, which could be hard uncertainty (can’t be known at a reasonable cost) and soft uncertainty (can be known relatively cost effectively).

Many firms do a poor job of searching for problems.  I have found several styles of management teams that struggle dealing with risk.

  • Insular management teams are prone to very large areas of soft uncertainty. Home grown executives are often dealing with problems for the first time.  Unaware of problems at other firms they repeat mistakes long solved elsewhere.  A diverse management team of backgrounds, industry and experience is just a better management team.
  • Management teams that are dominated by a single executive also tend to underestimate risks. Although I’ve worked with some great CEO’s, no one executive can reasonably see or know all the questions.  If the CEO calls all the shots, over time, management teams will let the CEO handle all the thinking too.
  • Firms with long term winning track records can begin to ignore risks as success begets complacency in the company culture. Company culture can be a great strength, but when the culture becomes too dominate, it blinds management to problems.  Andy Grove suggested that only the paranoid survive, which is good advice.  However, when you win a lot, it is tough to remain paranoid.
  • An executive team that is highly incentivized by the stock price (usually with options) tends to stay focused only on the positive news, and to only invest in strategies that appear to have a direct correlation with option value (usually growth initiatives). Stock options skew management priorities because the risk is one-sided.  If the stock price fails to increase or the company goes bankrupt the options are worthless.  So for the option holder, ignoring the risk of a blow-up makes sense, they only get paid if the stock goes up.  In these firms, it can be hard to get management focus on the known issues, much less invest in searching for unknown potential problems.

CFO’s have to assess risk.  To do this, we must examine the business, the environment and the management team.

Managing Risks

When I try to manage risks, I start with a good scan of what could go wrong.  Some of these we insure, some of these we cannot.  Frank Knight broke risk into two categories, uncertainty and real risk.  Real risk is calculable, it has a frequency and a severity.  Uncertainty has neither.

Donald Rumsfield’s comments on knowledge can be related to risks. Rumsfield stated that there are known knowns or things we know we know.  These risks have a known frequency and severity and are generally insurable and controllable.

There are known unknowns, which are questions which we have, but which we don’t have an answer.  These are complicated risks that can’t fully be insured because the frequency is low, or the severity is incalculable.  These risks can still be managed.

Finally, there are unknown-unknowns, where we are not aware of the questions or the answers.  Risks that are unknown can’t be managed or insured. This category is the same as Knightian uncertainty.

The risks that make business crack up are generally unknown-unknowns and are often a surprise to management and investors.  Risk management for the CFO becomes a process of handling the various real risks and trying to better understand Knightian uncertainty.

Bad and unusual events that we were not aware of are sometimes referred to as black swan events.  Nassim Taleb defined black swan events as a surprise with a major impact. The thing about black swan events is that it may be a surprise to you, but it doesn’t mean mean that the event wasn’t known by others.  That is true also for Knightian uncertainty.  A larger knowledge base decreases uncertainty and unknown unknowns can be reduced by learning.

I therefore break uncertainty into two slices, hard and soft.  Soft uncertainty are issues that could be learned with a reasonable investment in diligence and research. Hard uncertainty can’t be.  The trick is to convert soft uncertainty into complicated risks, where management, insurance and reporting processes can be brought to limit losses.  Hard uncertainty remains retained risk.

   “Risk comes from not knowing what you’re doing.” – Warren Buffett

Converting uncertainty into something that can be managed requires an open mind and a sense of paranoia.  CFO’s who think risk management is an annual lunch with the broker are going to find themselves surprised by events.

Some thoughts on Risk Management

CFO’s are usually tasked with risk management. Often that means being in charge of the insurance renewal negotiations.   Basically this consists of an annual conversation with your broker on new policies that have been developed to help eliminate some new exposure which you weren’t aware of, and by the way, at a price that you can’t afford.   Generally, the broker buys lunch, which is the best part of the transaction.

CFO’s that define risk management as simply buying insurance make a mistake. Corporate risk management has to include problems that can severely damage or destroy a business but are basically un-insurable. The types of problems we’ve seen with credit cards and hacking are a CEO’s nightmare. A single instance can cause irreparable damage to sales and the value of the business. How does a modern risk manager or CFO deal with these types of “all-in” risks?

Risk is usually defined as a function of frequency and severity. Frank Knight, back in the 1920s, argued that there are two realms of risks. Simple risks, which have a known frequency and severity, and uncertainty which is not and cannot be known. Pretty much if an insurance company writes a policy, you know they’ve got a frequency distribution and a good handle on severity.   After all, insurance companies aren’t stupid. The big risks, however, remain in the uncertainty realm and those risks remain uninsured and uninsurable. Knight also noted that entrepreneurs generate profit by dealing with uncertainty and not risk.

Since we can’t know the future, business have to learn to deal with both types of Knightian risk. Dealing with known frequency and severity risks can be difficult, but the biggest challenge are in uncertainty or unknown distribution risks. Donald Rumsfield said: “The message is that there are no “knowns.” There are things we know that we know. There are known unknowns. That is to say there are things that we now know we don’t know. But there are also unknown unknowns. There are things we do not know we don’t know.”

Paraphrasing this into risk speak, we have insurance that covers the simple risks we know. Complicated risks that we are aware of but aren’t well known can only be partially covered by insurance. In these cases we manage the risks, putting in control processes, training and contingency plans to limit the occurrences and severity. Unknown risks by definition are retained and aren’t managed. Without a reporting processes, problems start, grow and can overwhelm a firm. This is true uncertainty.

What makes a risk truly an unknown-unknown? Does it imply that no one nowhere knows the risk? It does not. It simply means that the current management team is unaware of the risk. Nassim Taleb has a great story about a turkey who during its life considers the farmer a benefactor. The week before Thanksgiving the turkey finds out the plan, and imagines it an unforeseen and unknowable event. It might have been for the turkey, but it is not for the farmer.

The risks that will hurt your business are generally the ones that you aren’t managing. Integrated risk management is about pulling together efforts that manage exposure, control what can be controlled and insuring what can be insured. A good integrated risk management plan includes bringing the management team together to focus on the key risks, whether they involve credit cards, hacking. off-shore oil wells or workers compensation.

What a Good CFO does…

A good CFO helps the CEO run the company.  The CEO’s job is to set a vision, hire management, build a culture and make sure the firm has enough capital. A CFO partners with the CEO by buying into the vision and taking on responsibilities for managing capital and building the management team and culture.

CFO Magazine a couple of years ago tried to define the difference between a good CFO and a great one.  They basically concluded that great CFO’s understood the customers, used data and analysis to distill problems down to simple words that the team can use to run the business.  I like to think that having a CFO in the mix helps all parts of the management team get better, by bringing in new concepts and ways of thinking about problems.

The basic functions of a CFO revolve around reporting & compliance, treasury functions and strategic planning duties.  The main difference between an accounting manager or controller and a CFO is a matter of perspective and approach.  A CFO focuses on the longer term, and often on issues affecting people outside the business.

Reporting and compliance are often handled by a Controller who manages the monthly close, and maybe the annual audit.  The Controllers focus is on this month and this quarter.  The CFO should be a decent accountant, but they add value by asking the right questions.  A CFO helps define the key indicators (both internally and externally) that need to be tracked, managed and communicated.  A good CFO thinks through the business model so that when it shows up on the financial statements, the data is not just right, but the accounting policy is sound.

Treasury functions (borrowing, investing) require thinking out a couple of years, and an investor/outsider perspective.   Figuring out cash needs, matching borrowing with investments, estimating the debt vs equity ratio are relatively simple calculations. The art is in the estimates.  Managing the relationships with the bankers, lawyers, investors and advisors requires understanding the needs of the firm as the outside advisors.  If you don’t trust your CFO to handle this responsibility, you don’t have a CFO.

The CFO is a leader on the executive team in implementing strategy and a planning process.  Converting from a simple annual budget to a strategic plan and multi-year budget requires someone to run the process.  Coordinating projects, assessing investments and developing workable plans is a balancing act frequented by “no’s”.  Good CFO’s build relationships across the organization to make those no’s understandable and the yes’s more likely to be successful.

A lot of planning includes thinking about the world outside the firm: customers, the environment and what is going on in the industry. Firms are often buffeted by economic storms that could be foreseen, for those who would look.  If the CFO is not facing outward, it is unlikely any other executive will be either.

CFO’s have to be thinking out a year or two and sometimes longer.  The quarterly earnings focus that the street demands is a false choice.  Great performances can’t be generated quarter after quarter (and year after year) if you are focused on closing transactions in the last two weeks of a quarter.

Capital allocation and investing in technology and capabilities requires thinking about how things will look in the future.  I’ve signed dozens (maybe hundreds) of leases with 20+ year life.  If you can’t think further ahead than next month you can’t make long term investments.

I am sure that there are great CFO’s and lousy CFO’s.  What separates them is the perspectives they bring and the actions they take.

The Problem with International Growth

Best Buy is a multinational firm with operations in the United States, Belgium, Bermuda, Canada, China, France, Germany, Ireland, Luxembourg, Mexico, the Republic of Mauritius, the Netherlands, Portugal, Spain, Sweden, Turkey, Turks and Caicos, and the United Kingdom.  Sales are split 75%/25% domestic (US) and international.   Asset investment approximates this with a rough 60/40 spread between domestic and international.  Profits are a different story.  Operating profits domestically were 5.6% in 2009 while international operations were at 1.5%.  That means 93% of profits are driven by domestic operations and only 7% internationally.  On a return on investment basis, international then uses 2.7x more investment to generate a dollar of sales and each international sales dollar generates about 70% less profits than a domestic sales dollar.

An illustrative example can help us understand these underlying numbers.  A domestic investment of $250 should generate an increase of $1000 in sales, which will generate $56 in profits and a 22.4% return on investment.  The same investment internationally will cost $680 to generate $1000 in sales.  This investment will return $15 and generate a 2.2% return on investment.  To generate the same profits internationally as our $250 investment did domestically we’d have to invest $2.500.

A possible reason for Best Buy to invest so much in the international business is the eventual returns they will generate.   The evidence doesn’t support that conclusion.  When the domestic business had the same level of investment as does the current international operations it was 2007 and the operating profit rate was 6%, approximately 4x where the international segment is now.  When the BBY domestic segment was at $9b annual in sales (1998) the operating income rate was 3.5%.  So neither investment size nor additional sales will give investors comfort that the BBY international segment returns are likely to increase.

US based retailers have a long history of wasting capital in international expansions.  Starbucks, Wal-mart, Borders amongst others have pulled out of overseas operations in the past few years.  There are some very good reasons for these investments failing.

First, the US is a very large relatively heterogeneous market.  Although the world is getting smaller, it isn’t small enough so there aren’t some product and business model issues that have to be changed by country.  Those changes require extra merchandising support, local distribution and local management. The size of the US market creates low overhead costs.  That is not true internationally. The management team you hire in Canada cannot manage Mexico also.

Secondly, the US is wealthy and doing business here is relatively efficient.  Consequently retailers here generate strong returns.  Moving away from a high return market is always going to be unattractive, every incremental dollar looks less effective. Comparing capital investment in the US with capital investment in the international segment is a bit misleading.  Reaching a similar capital investment for the opportunity might require 2-3x more capital internationally than in the US.  Although Best Buy has invested $6b in their international operations, they have only achieved a very small international market share vs their US share.

Thirdly, retailers in the US live on low paid workers which have relatively high levels of turnover.  This is not the employment model that Europe follows.  Although Best Buy does not have very high employment turnover, their number for this last year was 36%.

Fourth, international growth is rarely organic.  If you have to buy your way into a market you end up paying market price.  Organic growth is about adding value by putting together parts (merchandise, systems, processes, people and real estate), not through acquisitions.  Adding value to an acquired asset is more difficult.  Incremental sales are harder to generate, incremental profit opportunities are usually have lower gross margins or higher inventory requirements.

Finally, real estate costs are higher internationally.  This is due to land use decisions and issues related to ownership and development of property.  Landlords internationally take more of the profit equation than landlords in the US, usually because the competition for space is greater.  When landlords have multiple bidders for the same space, they will end up with higher rents and a higher portion of the value added created by the retailer.

So why does a management team continue to invest in growth when the returns are so poor?  Best Buy’s management team has a web-site that speaks to why they want to continue to grow.  Sometimes growth becomes such a part of a firm’s self-image that they continue to do so well after the investments make sense.  I don’t know if that is the case at Best Buy, but the return on investment results don’t look good.

Management and the Self Attribution Bias

People often boast about their efforts when things are going well and place the blame elsewhere when things are going poorly.  This is called the self-serving or self attribution bias.  This tendency to think the best of ourselves and attribute good performance to our hard work helps us maintain high levels of self-esteem.   Assigning the responsibility for poor performance to some external factor also helps maintain an idealized picture of oneself.  To the extent that you exhibit this bias you probably go through life a little happier about your accomplishments (you deserved them) and take the bad experiences less personally (after all when bad things happen –it’s not your fault) than most.  For the most part this bias is really only annoying if you live with a teenager, as they are especially good at avoiding responsibility.

Management teams also sometimes show this bias.  Williams-Sonoma’s (WSM) management team for example is clearly taking credit for the recent good news after avoiding responsibility for the earlier bad news.

Last year when comparable store sales turned negative on the third quarter conference call, Howard Lester, Chairman & CEO, noted that “during the third quarter, the unprecedented downturn in the US financial market had a significant impact on our business.”  Lester on the call also pointed that “the stores look terrific” and that “by and large, this thing is more macro now”.  On the same call Dave DeMattei, the then Group President of Williams-Sonoma, and Sharon McCallum, CFO, both commented on the “these difficult economic times”.   Although the management team admitted that merchandise could always be improved, the clear message was that the bad numbers were due to the economy.

During this years’ Q4 conference call the incoming CEO and current President Laura Alber noted in her discussion on Pottery Barn that “Comparable store sales increased 11.5%, and authoritative cohesive assortment and compelling price points, combined with a highly effective inventory management strategy  drove these significantly improved results.”   Alber doesn’t mention, of course, the fact that comparable store sales were down 29% at Pottery Barn during the same quarter last year.  So if you’d ended Q4 2007 with $1,000 in sales, you’d now have $792in sales, clearly not a significantly improved result.  Lester also commented “year-over-year growth trends once again sequentially improved, which validates for us, the effectiveness of our merchandising and marketing strategies that were deployed during the year”.   WSM’s overall comparable store sales were 7.6% in the fourth quarter following a negative 22% last year.

The downside of the self attribution bias is that it distorts the participants understanding of the circumstances.   In the case of Williams-Sonoma, the high compensation for the management team is ostensibly due to their skill at running the business.  If a significant part of their performance in the 2002-2007 time period was because of the housing boom and not management diligence then the shareholders have been poorly served.   WSM sales are down significantly from 2006 and 2007; this is clearly a smaller and less profitable business than it was two years ago.  Interestingly, the stock price today is $2 higher than it was at the end of 2008 when profits were almost 2.5x higher.

Of course the most obvious alternative explanation for the “significantly improved results” might just be the improving economy.  Comparable store sales across the board were better for retailers in Q4 this year and WSM’s recovery wasn’t really exceptional or significant.  It was expected.