Uncategorized – Bates Creek Consulting

It is a Crisis. What to do now.

Have you ever fallen off your bicycle? One minute you are zooming along, next picking gravel out of your skin. Happens too fast. Crises are like that, firms click along and too suddenly they are kissing the pavement.

There is a great book written about planning by Stan Davis called Future Perfect (my copy is from 1994). The book dealt with how we can create a different future by pulling apart how we view products and delivery. By now the idea of home delivery and separating the physical product from the information content is the very nature of many internet businesses.

In it he notes that we must manage the beforemath:

In the industrial economy, our models helped us to manage aftermath, the consequences of events that had already happened. In this new economy, however, we must learn to manage the beforemath; this is, the consequence of events that have not yet occurred.”
Stan Davis

In every crisis there is time and opportunity. What you do at the beginning of a crisis will help you control that consequence of events that leads to the aftermath.

As I’ve noted before, CFOs help CEOs run the company.

Step one for both is to manage cash. Every crisis includes the problem of cash flow. Get a firm handle on the cash in the business, what is coming in and what is flowing out. The cashflow model you review most often is done on a set time frame: annually, monthly or weekly. Whatever time frame you are using, go one step closer. Runway behind you and altitude above you are no help when you are flying a plane. Figure out your cashflow runway first. Make enough runway so that you can safely last well, well past the crisis. You may not have to sell that prize piece of real estate but if your cash flow plan says you need the money in month seven, and it will take 60 days to list and close, then you know when you have to take action.

Step two is to develop a plan to protect the main profit-making portion of the business. Don’t cannibalize what works to shore up what isn’t working. This is a hard one for senior management. The years of planning and capital investment are sunk in a new division and now we are in crisis. I’ve watched great company’s go bankrupt trying to continue growth initiatives in a crisis. That recently launched product or new store? Be prepared to retrench. I worked at a company with limited cash resources which renewed leases on money losing operations because they were statement locations where we’d spent considerable capital obtaining and putting into operations. Unfortunately, they weren’t making money and they tied up considerable capital. Sunk costs must be ignored. Keep what makes you money, making you money. If you don’t know which products, operations, segments are most profitable, find out fast. Some 10% of your customers generate below average profit rates and some 10% of your products deliver below average return on investment. Cut those first.

Step three is to be bold. Generally, changes suggested by an entrenched management team are too shallow. We love what has worked. Sometimes the only way to make a business profitable is to pare it back to the profitable core and start growth over. Get smart about what business we are in and what business we aren’t in. This role is uniquely the CFOs. The saying goes “CEOs love their children” but the CFO knows that businesses aren’t children. Generate a range of options for whatever contingencies are reasonably possible. Start identifying likeliness, severity and possible options to reduce both of those. The time isn’t wasted. Options identified on how to keep one customer happy can be used to keep vendors in line also. But whatever you do, keep in mind what drives profit in the business. I’ve suggested several bold ideas in meetings, which were rejected initially but were embraced later. It isn’t disloyalty to admit that a division isn’t working or that the environment has changed and strategy has to change.

Step four is to move quicker. Napoleon said “There is one kind of robber whom the law does not strike at, and who steals what is most precious to men: time.” Time, space and action can define most problems. Space and action can be changed, time can’t. Whatever management process you have it must work better in crisis. Meetings that lack relevance must be canceled and new agendas developed that better fit the problems the firm is facing. Many firms go from monthly to weekly meetings, and some from weekly to daily. More time helps but equally as important is who is invited to the meetings, what is discussed and whether actionable tasks are generated. I’ve seen management teams dither for months while opportunity and cash leak away. Take a fresh look at how the team works and make the needed changes. Now.

Step five is to manage the staff. In a crisis, everyone is a little on edge. Your staff is worried about their jobs and even when they say they are not worried – they are lying. In a crisis, you must spend more time communicating. Emotion is more important than information. Most of your communications are going to be read for emotion first and then content. Be as clear as possible and repeat yourself. Sounds stupid but when people are in crisis they don’t listen too well. They are like the Far Side cartoon called “blah, blah, blah Ginger” where the dog only hears its name. When people are nervous, they forget who to trust. Don’t let your staff find out what the business is doing on the internet, tell them first what is going on and what you are going to do. And then tell them again.

There is no guarantee these (or any) actions will result in the business thriving or even surviving. However, doing these five things will improve your odds of success.

How do you avoid a crisis?

I have been tracking the Coronavirus for about a month and a half, my first email on the subject was back on February 14^th. At that time, it looked like it was going to fizzle. It hasn’t.

“How did you go bankrupt?” Bill asked. “Two ways,” Mike said. “Gradually and then suddenly.” – Ernest Hemingway

Firms fail all the time. They survive when the sun is out and the environment is consistent, but when change comes, even if expected, they can’t adapt and failure results. During a bankruptcy meeting at the court I overheard the case before ours. The owner had lost a significant portion of his business but failed to downsize staff, equipment and space and in a couple of years was in bankruptcy court. I commented to our attorney that if the owner had just recognized and taken some action he wouldn’t be in this mess. The attorney commented that was true for everyone in bankruptcy. The challenge is recognizing the need for change and the development and execution of actions to solve the problem.

Start-ups are generally dealing with crisis every day and they good at solving the problem. What used to work, doesn’t. Procedures and processes are revamped shortly after development. The management team is having strategic planning sessions every month laying out a new course. As a firm grows, it becomes less flexible and processes are written, reviewed and put into a book. The firm achieves a level of effectiveness, so efficiency becomes more important and redundant staff which provided flexibility is removed from the company. This process works great in a static market. Unfortunately we are not in a static environment. Here are my four steps to keeping the start-up mindset going as you grow.

Keep your head up. Too many management teams are inward focused. They care about what goes on in the next office more than the next building and even less about what is happening across the world. When I started out we had a news service curated by the company librarian. We would receive via a buck slip (names of the relevant executives to be checked off as read) a package of the most relevant articles that affected our firm, our competitors and market. Today that may be your RSS feeds. Management meetings would include time to discuss what we learned. Understanding and wisdom was shared through the team. Black swan events happen all the time, especially if you are not paying attention. Cut down on surprises, make sure your team is looking outside the firm.

Build multiple redundant plans. A plan is a decision on what you are going to do to achieve some goal. If you have only one plan, any change will mean you have no plan. All plans are about an uncertain and possibly unfriendly future. Good plans think through contingencies and outline potential options. Bad plans reflect the present circumstances. Charlie Munger talks a lot about decision trees and thinking about options and choices. Most schools don’t do a good job of teaching this skill. Learn it. Thinking through what could happen along with what actions could be taken will make your plan more robust.

Build a diverse team. “None of us is as smart as all of us” – Ken Blanchard. Recent research talks about the decision-making advantage of a diverse team. History proves this true. Good teams work together but also bring experience and perspective. We’ve all worked with the executive who has 10 years’ experience which is really 1 years’ experience 10 times. Different perspectives help make everyone smarter. Seven people you went to grad school will be a great party, but your shared viewpoints hide rather than illuminate options. I’ve worked with a lot of executives: both great ones and a few not-so-great. Great ones don’t always fit, but they always add value. Organizations are quick to exit the “poor fit” team members who don’t share similar viewpoints. Fit works great when the environment is static. When the environment changes “fit” drops in relevance and competence rises.

Only the Paranoid Survive is more than a book by Andy Grove. I don’t wish you to be truly paranoid. Paranoia is a symptom of illness. But I’ve now worked with too many businesses which when successful consider themselves brilliant and special, and when difficult times come they shatter. In the stock market we used to say, don’t confuse brains with a bull market. It is easy to make money when everything is up and to the right. Don’t drink the lemonade, keep humble. This section is likely wasted at this time. By now you‘ve figured out that the tide has gone out as Warren Buffet says, and who is naked. This crisis will pass but don’t forget – there will always be crises.

A quick relaunch update

Bates Creek is focused on helping government contracting firms grow using state of the art accounting software and services. If you are thinking of moving off of quickbooks or GCS, give us a call.

Being Right when you are Wrong

Good luck can be bad, and sometimes we are right for the wrong reasons.

I worked with a company putting in a small market strategy. The idea was to put units with a subset of product in smaller markets. The idea was a good one, the plans were fine, but the implementation was fumbled when the test units were all placed in large markets. Instead of testing a small market strategy, they tested a small unit strategy. The results exceeded expectations. The small units performed great and a major investment initiative was undertaken. Several years profits were dumped quickly into new units. Unfortunately, the investments were made in small markets where results were nothing like the test markets. The next management team (and there is always a next management team) spent over five years shuttering these units while the stock dropped 90%.

Investments are made incrementally: a decision is made, an action implemented, a result is achieved. We review our results and make the next decision. When we get a good result based on a bad process, we change our criteria and understanding of the investment cycle.

When a good result happens after a bad decision process, management is mislead. Now the bad decision process gains momentum. Further decisions follow the bad process and the odds of further problems increase. The factor that caused the good result (big competitor leaving the market, change in government policy, innovation) is also not examined or recognized. The management team attributes their success to something else, usually their own intuition or skill. Humility is an executive management teams best friend. Over confidence and hubris precede the fall. One portfolio manager I worked with was especially skilled at identifying overconfidence in management teams.

When you have a good decision process you can still get a bad result. After all, business is about taking on risk. If it isn’t risky, investing in a business would be like investing in a bond. It is not.

When you follow a good investment process and lose, you can second guess your process or implementation schemes, or you can identify some other relevant factor. Sometimes, as they say “crap happens”, the market, customer, technology. competition change and your results are bad. Of course, some firms don’t look too closely at the results of their decisions. No one wants to admit error, especially a CEO who has committed personal power to a particular course of action.

How do you avoid this? It’s not as easy as remaining humble. Good decision processes are defined by good results. Taking the long odds when the payoff is low is stupid. But in business, the odds are not apparent as they are in a book about poker or on the tote board at the horse race track. Risk is estimated and a good result tends to lower our assessment of the bad risks and increase the upside potential. Often a careful review will identify unknown variables that mitigated the risk. Sometimes a counterfactual is helpful as a tool to identify whether your risk assessment is accurate. For example, what if the competitor in this market hadn’t closed the month after our opening?

Often we just need to update our assumptions slowly and continue to gather information as we move through the process. Another couple of test units would have helped, or a second review of the market size after the units are open to see if they remained classified as “small markets”.

Luck can be bad or good. Both can mislead. And sometimes, when you have positive luck, and the sun shines seven days in a row, enjoy it.

Simple, Better Decisions

Although I prefer to help businesses grow, sometimes growth goes bad and the company becomes a turnaround. I worked with a firm that went through a very rapid growth phase, was hit with an unexpected event, and ended up declaring bankruptcy. I joined shortly before the bankruptcy and saw them through the money raise and bankruptcy exit. It is a valuable experience that is way under appreciated by hiring managers.

One day early on in the process, the outside corporate counsel (a close friend) and I were sitting in the back of the court room waiting for our turn. Several smaller cases were being heard by the judge. After listening to a few of the facts, I noted to my friend that if these firms made a few relatively small decisions six months earlier they could have avoided the whole bankruptcy proceeding. The lawyer turned to me and said “every case in bankruptcy court could have been avoided by making a few better decisions earlier.” Although this doesn’t sound that profound now, it did to me then.

Decisions have consequences, and bad decisions lead to bad outcomes. Although it can be personally satisfying to blame one person or one decision for a bad outcome, there are often multiple decision points and multiple people involved and plenty of opportunities to take another path. The downward spiral of performance is often accompanied by a closed mind. You can’t fix a problem you won’t see.

Management teams repeat their core message to the staff, which communicates strategies and values. This repetition helps solidify the culture and keep the company on track. Unfortunately, as circumstances change, sometimes the strategies must change. Repeating the company line when it is no longer relevant is like dancing for rain. The only winner is the guy getting paid to dance.

Worse yet management teams that don’t recognize change become further out of touch with the front-line staff that faces the market and the changes. Respect declines when your boss is telling you to focus on “a” when you can clearly see the problem is “b”.

The first rule of holes is “when you find yourself in one, stop digging.” Management teams need a method of tracking performance that tells you when you are in a hole, an open mind to recognize that circumstances have changed and the fortitude to go and fix the problem.

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Dr. John Zott is the Principal consultant at Bates Creek Consulting. John is the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and comments regularly on issues that affect consumer businesses. If you are looking for a CFO for your e-commerce/retail/consumer company, or are a former student, colleague or would just like to connect – reach out.

The map is not the territory – Setting up a Chart of Accounts

Accounting is a numerical history of a business. We summarize the millions of transactions into a cogent one page document that tells the status of the business. The financial statements however, are not the same as the business. Alfred Korzybski said that “the map is not the territory”, referring to the object and its’ representation. A financial statement summarizes, and a summary leaves out details. Tracking which data goes where is the job of the general ledger and chart of accounts.

The core of reporting is the chart of accounts. Financial statements summarize sales into one line. Accounting might have half a dozen sales accounts and hundreds of departments, which all roll up to one single number – sales. These accounts are used to better understand the summarized information. Sales are reported net of returns, but accounting departments track the returns in a separate account so that department heads can see if return rate is trending up or down. If your ERP or sales software tracks returns, you probably don’t need a separate account for tracking that information.

However, accounts seem to proliferate. Charts of accounts grow over time – someone wants to know some summary fact of the business and the systems that generate that data don’t supply the summarized data to management. Commonly at retailers it is a POS (Point of Sale) system that runs the cash registers and reports summary data to a sales data warehouse or general ledger. Usually they only report data to the general ledger, so operating data is sourced from accounting records.

In an e-commerce firm it is the order entry and fulfillment systems, which may not be connected with purchasing or payroll systems. In addition, management has come to rely on the controls put in place in a general ledger system. In the 1990s we used a lot of database query tools that would often give different answers based on query design, so one meeting might have three different set of numbers based on who’d written the query.

The use of data warehouses should decrease demand for general ledger detail. Sales splits can be done in more detail using a database with all the relevant sales data, rather than the general ledger which might contain only weekly summary data. However as the needs of the company change, often it is easier to just add an account number than reconfigure a reporting system. Data warehouses – an idea that dates back 20 years – still don’t function as well as they should. So the g/l becomes a stand in.

I’ve typically used a couple of hundred “natural” accounts for businesses from $5m to $500b in revenue. An account like “sales” or “payroll” are called natural accounts. These are modified by department code and sometimes other codes for cost accounting or for projects. This can result in thousands of combinations. In a typical retailer with 100 stores they would support 60-70 natural accounts, for 6-7,000 combinations. Add in district and regional codes you could reach another 1-2,000 combinations. Designed right that level of detail is easily handled by your accounting team. Designed wrong and you spend hours trying to reconcile the source systems to the general ledger. Which adds cost without benefit.

Manufacturers sometimes have additional codes for production cost allocations. If you are running the same line in two buildings, under one department, you might also use a location code. All these codes end up making a chart of accounts pretty complicated. This is worsened if you end up layering on the complexity as you go, rather than plan it in. Knowing going in you will likely need a location or a production line code and planning for it makes a big difference later.

Much of the complexity of the chart of accounts depends on what information you will want to retrieve. Simple natural accounts and department codes can get a business a long way. Accounting codes begin to change if you are running project-level or fund accounting. Sometimes you can keep the reporting structure out of the chart of accounts. For instance, if you have a district manager with 10 units, you likely don’t track the district code in each transaction, but roll up the district report by selecting which units are in a district when you summarize the data. This is the default mode for most firms who report with excel. Changing the unit roll-up when a district manager leaves the firm is not Excel’s strength. Excel’s data summarization and analytical tools have improved, but realistically, converting from a trial balance to report is an area ripe for errors.

If you have online reports, managing the access in an ERP system can be a hassle, unless you have some hierarchy built into the system. Imagine allocating 600 units amongst 60 district and 10 regional managers? If each of the units had an assigned district and regional code, the reporting would be much easier to manage and control. With the rise of reporting dashboards, this feature is almost always built in.

The general ledger and financial statements are summaries but useful ones, where similar data is grouped, analyzed and decisions can be made. Too big a chart of accounts and you will spend hours managing complexity rather than providing information. Too small a chart and you will your time breaking out the details you need. A map is a representation of a territory which can be held in your hand and used to navigate. Good design and a thought for the future of the business will help develop a solid organization for your accounting data so that it will supply you the information you need to navigate.

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Uber and Reality.

A friend recently interviewed with a startup where the senior management group was upset that the CFO was requiring receipts and documentation for the use of company credit cards. They had decided to replace the CFO because they didn’t want to be troubled by providing receipts.

Sooner or later this company – like so many others – will face reality. When and how they will face reality is unknown. They may run out of cash, suffer a major defalcation or the company is sold, goes public or matures and profits become tougher to obtain. Providing receipts will be the least of their problems.

Facing reality is what Uber is doing now. The Board finds itself without much of a senior management team, no back-up plan and a rapidly sinking investment valuation. Changing CEO’s isn’t easy – I’ve been through the drill a couple of times. Planning is essential and thinking probabilistically is critical.

Thinking probabilistically isn’t hard. Using a decision tree is a good way to start. The tree in this case might have had three branches depending on the outcome of the investigation. Branch 1 would be no or only a minor finding, branch 2 would be a significant finding and branch 3 a major finding. The odds of branch 1, no or a minor finding would be low, they’ve had steady turnover in the ranks and there have been a lot of negative disclosures, I’d estimate 15%. The odds of branch 2 “significant” would be high, I guess 60% . A significant finding would require some senior turnover and changes in the culture.

Hiring a big deal law firm and a consulting firm to probe 3 million documents and survey employees anonymously isn’t cheap. A significant finding is most likely. Finally the third leg would be a major finding where the top management team needs to be fired or a significant restructuring undertaken. That accounts for the remaining 25%.

When the CEO decided to have an investigation of sexual harassment claims in February, there was a distinct possibility that the result would be significant or worse. Facing a 25% potential turnover in the top management group should have focused the Board on a backup plan. When Mr. Kalanick’s mom passed in a boating accident at the end of last month the odds of turnover increased.

Review Covington & Burling’s report recommendations (see here) and then guess at what facts justified these recommendations. The first set of recommendations states that the CEO’s responsibilities need to be reassigned. The second set aims at Board governance; which should have figured out the problem in the first place. The recommendations suggest that they found significant problems with leadership. Uber is facing reality now.

We used to joke about managers who’d used the “force”. The “force” was an unreality field that surrounded the manager, and within that field they could manipulate facts and time to justify whatever they wanted to do. Eventually since there are not Jedi’s in business, reality catches up. I worked for a CEO who ran the business by anecdote even when we had facts. We spent months on the wrong strategies based on incomplete understandings. He’d repeat the same anecdotes in every meeting, certain of his rightness, even as the business crumbled. Reality didn’t penetrate until he was fired in a crisis. The company never recovered.

I am unhappy when capital is wasted, but I really dislike the toll the failure to face reality takes on the people who work for these businesses.

I worked for a company that opened up a Texas operations center, reproducing it’s California central office. The strategy was to be more local in sourcing. After a year or two, the CEO realized this was a bad strategy, and ended up shutting down the office. The sad part was one of the junior people who’d moved their life to Texas was so upset by the closing and the layoff, committed suicide. Obviously there were other issues in this person’s life, but as senior executives, we shouldn’t forget that decisions have consequences beyond return on capital.

VC’s and PE firms are focused on return of capital. Board members are usually required to do what is right for the company. VC and PE firms have come up with investment vehicles which absolve themselves of any fiduciary responsibility to the company. They are held accountable only to investors in their funds, not to other investors or stakeholders. Uber’s board had full confidence in Mr. Kalanick (see here) in March even while turnover of senior executives and the search for the COO continued. The company never hired a COO or a CFO and turnover still continues. All that being said, the “money” Board seats appear to be more rational than the founder’s board seats.

Uber’s board is dominated by the founders with super-voting shares (see here). This structure supports founders regardless of competence. Facebook and Google have this structure but they are primarily technology businesses. Uber is challenged because it is a people business, like Target or McDonald’s and the founders are not competent executives. Uber has 5-10x more employee/drivers than Facebook has employee/contractors, yet Uber is run like it is some sort of “two guys in a garage” startup. The non-founder portion of the Board has as little control as the drivers or employees do. The Board’s failure to take action makes sense, they are powerless. The board can either support Mr. Kalanick or be ignored.

Founderitis is a destructive disease to businesses. When a business outgrows it’s entrenched founder (through special voting shares) there will be a lot of pain, both for capital and for people. The VC’s and PE firms are well compensated for the pain and they don’t want or need my sympathy. My concern is saved for the thousands of drivers, workers, vendors and customers who will deal with the fallout.

Uber has been great for thousands of people. I like the service and it’s made the world a better place. But, I can make an argument that it has been poorly run from the perspective of: capital, management, stakeholders and ethics. Screwing up a company doesn’t just mean you’ve screwed the investors, it also means you’ve screwed customers, employees and vendors.

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Dr. John Zott is the principal consultant at Bates Creek Research & Consulting.

He is also the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and comments regularly on issues that affect growth businesses. If you are looking for a CFO for your consumer company, or are a former student, colleague or would just like to connect – reach out.

CFO thoughts on Business Models

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

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.

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.