Capital Allocation: When the Right Thing Is Hard to Do.
Allocating capital to the activities that will build long-term value should not take courage -- but it does. Doing what analysts demand should not lead to failure in the market -- but often, it does.
For years, Ryder System treated top-line sales growth as the drive-train of its business. Why? That's what analysts demanded. So Ryder complied, pegging bonus and compensation programs to sales. Its people delivered what they were paid for. Ryder got sales, all right -- but on terms that actually destroyed economic value over the long term.
Its reward for doing what analysts demanded was a failing stock price and a hail of criticism from analysts. A new management team is now refocusing the company on value-building business, but so far the analyst reaction can fairly be described as lukewarm.
In a similar vein, the senior management team at much-admired office furniture-maker Herman Miller faced a tough choice when they decided to build a new business for the New Economy. Even though shareholders would be better off in the long haul, in the short term, earnings would take a hit. Chief financial officer Elizabeth Nickel didn't have to ask to know what analysts would say about that. Wall Street had already been pressuring the company to do an acquisition that would build earnings even while it destroyed economic value.
When Nickel talks about how it can be tough to look at things differently, she means making decisions that build long-term wealth for shareholders even when those decisions look bad when measured by popular analytical standards. The first thing aspiring managers learn in business school is that regardless of what they do, their job is to make money for shareholders.
But in the real world, that's often not what they're praised and paid for. Few CEOs face facts as forthrightly as Berkshire Hathaway's Warren Buffett, who in his most recent letter to shareholders said, "My 'one subject' is capital allocation." Buffett, of course, is a legendary value investor, and value investors assume that the market eventually recognizes and rewards companies that build real economic value.
But like the heroine in a Jane Austen novel, GFOs and CEOs take a big risk when they hew to that principle: the risk that at the end of the day they'll be alone with their principle. Analysts don't clamor for value, but rather for acquisitions at almost any cost and earnings growth seemingly regardless of quality.
Even Bennet Stewart, co-founder of New York consulting firm Stern Stewart, says, "Sometimes you just have to take your medicine and hope for the best." Stewart and partner Joel Stern developed and trademarked EVA, which stands for Economic Value Added. More than a mere metric, EVA is a whole philosophy of managing a business, combined with an incentive system mat pays people to deliver economic value and penalizes them when they don't.
"What makes it powerful in capital budgeting is that you can't increase EVA unless you increase profit by enough to cover the cost of the additional capital you invest, so it provides a natural cost audit of projects," says Stewart. At most companies, he adds, managers who propose new investments have to justify the investments initially on a net present value (NPV) basis. But once the investment has been made, the managers are evaluated by some other yardstick, such as earnings or sales growth, and the cost of capital no longer factors in to their performance review.
"So managers have an incentive to get all the capital they can," Stewart says. "The head office knows this, so it installs hurdle rates. Managers respond by raising their assumptions. The whole process of capital budgeting is characterized by mutual deception. It's like kabuki theater -- everyone is wearing a mask -- and it creates a poisonous atmosphere of checking and surveillance instead of teamwork."
Proponents -- including the companies profiled here -- say that an EVA program removes the incentive for managers to fudge numbers on their capital allocation requests and provides a self-policing mechanism in the form of a bonus bank that defers payment of bonuses until promised improvements in EVA are actually delivered. Managers wind up thinking like owners, making decisions that are in the enterprise's long-term economic best interests, almost reflexively allocating capital to its most productive use.
It makes so much sense that it shouldn't take guts. But it often does, as the following profiles show.
Herman Miller's Dilemma
In October, Herman Miller plans to launch an online initiative that Brian Walker, president of Herman Miller North America, says "is about reinventing the entire channel, designing products that are less complex, require fewer parts and pieces and allow more self-service for the end customer." The initiative, Herman Miller RED (at www.hermanmiller.com), is aimed squarely at the growing market of small and emerging businesses run by New Economy entrepreneurs who appreciate imagination and creativity but don't find either in the furniture at their local office superstore. "You have a lot of young people whose work is about being inspired, and we believe there's an opportunity to carve out a whole new segment," Walker says.
Early on, Walker's people put together a business plan for the new venture, with projected financial statements over a three- to five-year horizon. The financials were encouraging. Capital investment required to support the new business was fairly light, and the returns looked good. There was one problem, however. GAAP accounting treats the investment in R&D and Web technology for Zeeland, Mich.-based Herman Miller's New Economy business differently from the investment in brick-and-mortar and assembly lines for an old-economy plant.
Investments in factories and equipment are capitalized and amortized over the new plant's useful life. Investments in R&D, brand and other intangibles must be expensed. Moreover, says CFO Nickels, the technology costs the company was allowed to capitalize had to be amortized over three to five years, versus 10 to 15 years for brick-and-mortar plants, and would therefore hit the income statement harder.
"For dot.coms, it appears that the market has implicitly capitalized a lot of those costs," says Walker. "The market views their negative earnings as investments in the future. It's more difficult for a traditional Old Economy company trying to participate in the New Economy, because when it affects my earnings, it's more difficult for Wall Street to say, 'We'll give you a break on this."'
Internally, this wasn't much of an issue. Herman Miller long ago abandoned GAAP accounting for internal management purposes. Says Nickel, "EVA is the basis for all business decisions we make. We spent $140 million on capital items last year, and every single item was decided on EVA. The senior team has to pay attention to outside perceptions, but when we talk internally, we talk about EVA, and we get paid for EVA, and if you bring a capital request forward, it has an EVA analysis attached. So we've built all of our financial management systems -- and insofar as possible, our compensation systems -- around EVA."
The EVA analysis of the new online initiative showed that while it would take some time for the intangible investments to produce returns, the venture would add value over the long haul. EVA accounting would allow the costs to be matched against revenues. But from a GAAP perspective, the new venture looked like a body blow to the income statement. Earnings per share (EPS) would get staggered.
"We got into a conversation about, 'Maybe we shouldn't do it this year,'" Walker recounts. "The question I posed to the group was, 'How would we view this if it was capitalized and not expensed on the income statement?' We looked at each other and said if it were capital and not expense, we'd do it; the problem was [that] it was hitting EPS."
They decided to go forward, but in a way that would not impact EPS immediately, by re-evaluating and re-prioritizing other expenditures in order to free up capital for the new venture. "What is important about this story is that it illustrates how if we're not careful, even a company as focused on EVA as we are can fall into the trap of looking at short-term EPS. Much of the outside world still looks at EPS, whether you like it or not, and the question is, how do you balance between the two?" says Nickel.
The question arises not only with investments the company plans to make but also, curiously enough, with investments it decides not to make. Nickel recounts the story of an acquisition opportunity that came her way recently. "We looked at it from an EPS standpoint, and it made a lot of sense, it would have added a lot to the bottom line," she says. "But it would have required a big investment in working capital."
Herman Miller may be an Old Economy company, but it has one characteristic typically associated with such New Economy stars like Dell: negative working capital. Like Dell, Herman Miller is essentially an assembler that farms out manufacturing to its suppliers. Walker explains, "We don't build until we get your order, then we blast it to our suppliers, and when it comes in we assemble it and ship it." So Herman Miller has scant investment in inventory.
The proposed acquisition, on the other hand, was paid more like a construction subcontractor than an assembler. Its earnings were high, but earnings didn't tell the whole story, because the earnings number in GAAP accounting left out the cost of capital.
Herman Miller opted not to do the acquisition. "We walked away from it. We took lot of grief from analysts who said we should have done the deal because it was good for EPS, and from a P/E [price/earnings] standpoint would have worked," says Nickel. Eventually, Herman Miller was able to convince one of the most critical analysts that it had done the right thing by walking him through their EVA analysis.
But, the experience was instructive. "In this economy, it takes courage to look at things differently," Nickel concludes.
Turning Ryder's Thinking Mound
Restraint and caution could hardly be expected from a company whose founder, Jim Ryder, once reacted to being chased by Miami police by driving his yellow Maserati to his house, going inside, grabbing a gun and pursuing the cops all the way back to their station house. Ryder started his company in 1932 in the teeth of the Great Depression, and spent nearly five decades building a sprawling transportation and logistics empire whose strategy could fairly be described as growth for growth's sake.
Ryder eventually recognized the need to turn over the reins to professional managers, but the obsession with growth continued. During the 1980s, Ryder acquired more than 100 companies on a bet that federal deregulation of the industry would be a bonanza For the transportation business. The bet turned out to be wrong, and misguided capital allocation and incentive systems prompted Ryder's field marketing organization to book amazingly unprofitable deals for the sake of making sales.
C.J. (Corky) Nelson joined Ryder in April 1999 as senior executive vice president and CFO to help undo the damage.
"I don't want to be critical of the past organization. We don't dwell on that," he says carefully. "Historically, a lot of this was driven by capital markets and equity analysts. One of the significant measurements is top-line revenue growth, and if you're going to be a growth company, you had to show significant top-line growth. We had compensation programs built around generating top-line revenue growth, but they didn't consider the cost of capital, so business would often be booked at break-even, or even at an EVA loss."
Shortly after Nelson came aboard, he was surprised to discover that a whopping 40 percent of the business that Ryder's field organization wrote actually destroyed economic value. For example, it was customary for field representatives to approach a customer in the third year of a five-year lease and suggest that the customer replace the old equipment with new equipment, under a new contract. Marketing people saw this practice as an effective way to shut out competitors who could be counted on to appear at the end of the original lease term with attractive offers of their own. But economically, the practice was costly. It meant giving up significant cash flows that would have come in during the last two years of the lease.
"We've now educated people to look at the entire five-year term of the lease and consider the EVA of the whole period; any give-up [during] those five years has to be made up in a new lease," Nelson says. As a result, Ryder's marketers are less eager to sell but more attentive to making real, economic profits on what they do sell. "Transactions with positive EVA are up some 900% over previous quarters, and quarter after quarter that will translate into significant after-tax earnings for the company," Nelson says. He's pushed an understanding of the value of capital all the way down the organization to the warehouse staff who make decisions on purchasing or servicing forklifts and conveyors, and the technicians who service equipment leased from Ryder.
In the past, for example, a technician might suggest as a preventative maintenance measure replacing tires or other parts on equipment leased to customers, without considering the cost of lending the customer a replacement vehicle while the service was being performed. "Now we ask the technician to look at the cost of the part, the cost of his labor, the downtime of the vehicle and what that costs us, and help him evaluate the trade-off. We don't make him an expert on EVA, but we make him an expert on the drivers of EVA," the GFO says.
Ryder has identified EVA drivers in all of its businesses. In its logistics management business, for example, Ryder's contracts reward the company for reducing inventory levels for its customers, so the key EVA driver is inventory. "Our work with EVA will never be completed," Nelson says. "It's an ongoing mission to educate people, to put it in practical language for the people on the front line."
Early returns are impressive. The amount of value-destroying business written by the field organization is down from 40% to 4% of the total business written. "Those that are still negative have been done for strategic, customer-related reasons," Nelson emphasizes.
Some analysts' response to Ryder's EVA program has been enthusiastic. Credit Suisse's Gary Yablon wrote in July, "A base of momentum is building which we have not seen in a long while -- raising estimates for the first time in a number of years." Morgan Stanley's James J. Valentine opined, "For the first time in a decade, we can say that we're not overly concerned with Ryder management's ability to execute on its plan." Both analysts rate the stock a "strong buy," but other analysts who follow the company rate it anywhere from "buy" down to "hold."
Nelson is philosophical about that. "I don't worry about how the stock is trading today or tomorrow. I'm convinced that when the company is hitting on all eight cylinders, the value of the stock will be higher than it is today."
Briggs & Stratton Shifts Gears
Briggs & Stratton started out making odd-looking automobiles in 1920, but soon found that its real mission was low-horsepower motors for a range of home and yard applications. It first achieved profitability in 1929, and spent the next six decades in the black.
But success may have spoiled the company. It's fair to say it took its eye off the ball when it comes to shareholder value. One of the worst investments in the company's history was a state-of-the-art, robot-heavy plant in Menominee Falls, Wis., built in the early 1980s to meet Japanese competition.
Says senior VP and CFO Jim Brenn, "The technology used by the Japanese on premium engines was overhead valve technology. It was more fuel efficient, less polluting -- and it was one of those, 'They've got this, I need this to compete' decisions." Marketing promised massive sales, and while manufacturing resisted a little because of the high costs of new machining centers, the resistance was blown away by marketing's insistence that the new engines were the wave of the future.
The wave turned out to be a mere ripple. In the mid-1980s, Briggs & Stratton decided to build another type of engine in the plant. After all, it was there to be used. It wasn't until 1990 that anyone really looked at the cost of capital. The company found that the Menominee Falls plant was severely negative on an EVA basis. When the managers proved unable to make the plant earn its cost of capital, Briggs & Stratton wrote off the investment and began sourcing the engines from a third party -- in Japan.
"Prior to EVA, we could tell we were bleeding, but it was the EVA metric and ability to get marketing and manufacturing and accounting to talk in a common language that made things clearer and got everyone focused," Brenn says.
Now, new capital investments must pass through a series of "tollgates" before they can be approved. "A new product can cost us $15 million in tooling, more or less," Brenn explains. "Before we invest any capital, we prove to ourselves that the return on capital is positive and makes sense. Probably two or three new projects get rejected every year because they don't pass the EVA screen."
In 1995, an EVA analysis led the company to make a $140 million capital expenditure to open new plants in the South, a decision that moved 2,000 jobs out of Milwaukee. An early retirement plan resulted in a $33 million hit to GAAP earnings, controller Todd Teske recalls. That resulted in some very serious conversations with analysts. But perhaps the worst criticism came from an unlikely quarter. Briggs & Stratton's reallocation of capital led the National Catholic Reporter newspaper to call for the ex-communication of CEO John Shiely, a former altar boy.
"It was a very unpopular decision, but we defended it based on the economics that the EVA measurement led us to believe were there," Brenn says.
Shareholders have seen a payoff from the new focus: Briggs & Stratton's stock price quadrupled in the early 1990s. Indeed, it briefly sextupled before falling back a bit when the tech stock bubble distracted the market from Old Economy firms. Brenn isn't just hopeful that the stock price will go up again -- he's determined to make that happen. "We have to make that stock price grow or we don't get rewarded," he says.
That's thinking like an owner -- but one who also realizes that a company isn't measured on its stock alone.
Gregory J, Miliman is a New Jersey-based business writer and frequent contributor to Financial Executive.
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|Author:||Millman, Gregory J.|
|Date:||Sep 1, 2000|
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