Think Like a Private Equity Guy ? No, Think Like An Owner !
I'd like to weave several threads together here and a recent CNBC vidclip offers up a perfect
excuse. In it Robert Pozen, MFS Investment CEO says public companies should think like PE guys. Well, maybe, but there are a couple of caveats and exceptions. But take a look for yourself to start. In fact our argument is that there's good, bad and incompleteness - the trick though is to think it thru against the right shopping list of understanding performance.
The threads we're weaving together are the role of enteprise performance in generating profits and earnings (Have You Seen the Elephant ?: More on Earnings) with some earlier discussions of the widespread failures of enteprises to deliver value (Kaptain Karl's Test: an Icahn-like Inventory of Enterprise Performance). Pozen suggests five factors as a good starting place for unlocking value - his hypothetical example envisions a PE firm buying a company for a 20% premium (original value of $5B with a PE purchase at $6b) leading several years later to a $15B sale, a 300% increase in value and a 200% (or better) return. Impossible !
His five factors are Cash (too much on the balance sheet), Capital Structure (not enough debt), the Operating Plan, Management Incentives and Board involvement. Well that's all great in theory. In practice the theory hasn't held up very well though the argument for PE firms is that they can radically improve performance. In actual practice, and especially over the last several years, PE firms buy a company, Fluff it and Buff it, Leverage it up using funny money, drain it with special returns (lowering their risk and investment while guaranteeing return) and Flip it.
Yet at the end of the day many namebrand supposedly bluechip companies are NOT performing the way they could or should. And Pozen's suggestions are a good starting point for management and investors - but sadly and dangerously incomplete. Instead an investor should take a page from Benjamin Graham or Warren Buffett - think like an OWNER ! In other words ask yourself what makes a company work and work well.
There are five factors any long-term investor should investigate and that define a performance evaluation checklist that goes a long way toward improving the odds of a lower-risk and higher return. Enterprise Performance results from five key factors:
- Core (concept, product/service, value proposition, and business model)
- Strategy (goals, activities and actions, resources & capabilities, plans & controls and timeframes)
- Operations (core, e.g. manufacturing operations, product development, marketing & sales, procurement, customer service, technology, etc.)
- People
- Execution
At any given time you should know what these factors are for a value investment, how well the company is doing with them and what's likely to happen in the future. If you look at the good companies, for example Toyota, P&G, Tesco, GE, McDonald's, et.al. it's pretty clear where they're firing on all cylinders or not. And conversely if you look at the headlines for mal-performing namebrands, MSFT, WMT, Dell, Citi, Pfeizer you can see where breakdowns that are destroying value are happening.
A previous post complete's a series of deeper digs into these factors for Home Depot and is worth taking a look at: Performance Re-visited: Another Trip to HD's Woodshed
Let's consider the five factors in a little more depth:
1. Core - they key questions to look into are what products or services is a company providing and what value do they provide to their target customers. And then what is their Business Model. Many of the badly performing bluechips problems stem from the exhaustion of the business model and the need to re-think it. You also need to apply this to investigating each major line of business for large companies.
- For example WMT's basic model is EDLP (Every Day Low Price) yet it's saturated the domestic US market and getting beat by TGT which has higher priced products but much better service and higher value. Similar assessments could be made of Dell, MSFT, PFE and others.
2. Strategy - what methods or approaches are these companies taking to realize their value ? What actions and activities are they pursuing, are the right resources and capabilities in place, is there a good management system to provide the right plans and controls, and is the right set of timeframes being pursued ?
- For example the recent headlines on Citi, Bear-Stearns and Merrill suggest, at least to me, that they all jumped on the structured debt bandwagon late and in a me-too fashion. And without the right capabilities, people or managment controls, especially for risk. They've basically shot off their own feet - at the knee and we're in the process of finding out if it's higher.
3. Operations - are all the right functional capabilities in place to suppor the core value proposition and are the right resources in place or being developed ?
- MSFT gets its' money from Window and Office where the core competency is coding and product development. Yet Vista has orders of magnitude less functionality than Longhorn was intended to. Why ? Because (do a search on Code Red and MSFT) they lost their touch in this core capability.
- Dell's value proposition was a good box at a decent price. Plus the customer service wrapped around it that made them a safe, reliable choice and was really the key strategic factor behind their early acceptence and growth. When they started treating Customer Service as a cost to control instead of a strategic investment the handwriting was on the wall - three years before it blew up visibly. Imagine, taking a critical & differentiating factor that made your whole business model work and letting it wither in support of cost control.
4. People - are the right people with the right skills and right attitudes in place ? You can judge this just by talking to the frontline folks - are they interested, attentive and customer-oriented ? If no there's problems big problems. On the other end are the right executives in place ? Both Chuck Prince and Stan O'Neal drove off their competitors for the top job, in a set of maneuvers worthy of an Italian city-state's princely court and testimonials to Machiavelli. In the process deep skills in the critical risk management core competency were driven off. More to come on that.
5. Execution - is there a plan in place, is it backed up by firm commitments of time, returns, actions and measurements ? In other words is the strategic plan being executed, in support of the business model and are the operating plan and strategy aligned ? If you look at our shopping list of troubled bluechips the thing you find most often is a lack of effective execution. And a substitution of internal agendii for focus on value delivery. That's otherwise known as politics - the bane of empires and enterprises. At least when narrow political goals are given priority over doing what's best for the business.
- Pozen suggests a critical factor is management having the right incentives - Here, Here ! When executives are getting the vast majority of their compensation from stock options and when they are rewarded for short-term stock performance all their incentives are to manipulate stock price at the expense of long-term performance. A perfect case in point is Eisner and Disney (the book to read is Disney Wars -outstanding and insightful).
- Pozen also suggests that Boards are not paying enough attention, don't have the right skills and are spread too think. Again, Here,Here ! When companies lack a good management system that lays out a clear strategy based on the Business Model, when operations and strategy are mis-aligned and when there are not clear measurements of success then there's little chance of the Board knowing what should be done. Let alone being capable of getting it done. If Executive management had to present worked out operating plans and demonstrate strategic alignment Boards would have the sort of control mechanism that would be reduce or eliminate many of the problems we've seen; and are seeing again with the credit market problems and the financials.
- Ironically a good integrated operating plan coupled to a decent management system would make the company run better, define a whole new way of measuring executive performance, give Boards a clear, simple and structured way of monitoring and managing that performance and enormously improve communications to the market. In other words the right kind of structured execution framework fixes both the management incentive and board oversight problems. And does so organically and constructively.
Taken all together these factors define the beginnings of a blueprint for evaluating company performance and for thinking like an owner. Sometimes they'll be tought to dig into but on the whole the information required is available and easier and easier to get. But these days online resources take you a long way. 10-Ks & Qs are readily accessible, analysts presentations are online and a search will often find details of suppliers, customer and markets. All without too much cost or effort.
It's up to the investor, or employees for that matter, to do their homework. But there are major opportunities here - if you seize them. And don't we come full circle or won't we ? In other words more than any other investor the PE guys should be applying versions of this sort of analysis.