Talking about strategy » free cash flow

Stop asking ‘What is Strategy?’

Kim Warren — Wed, 11 Jan 2012 09:46:48 +0000

Online groups seem obsessed with asking what Strategy is, and what’s its value. If we don’t know, we can hardly expect others to listen to us. It’s simply setting powerful but realistic aims, and defining how to get there. It’s purpose is to create business value (NPV of future free cash flows). Because things change, these must be updated continually. (In non-commercial cases, the purpose is to achieve non-financial aims, though within financial constraints).

So, let’s stop debating this basic issue, and focus on working out, codifying, and explaining how to do strategy well, whatever the circumstances.

Exploiting decline

Kim Warren — Fri, 09 Dec 2011 16:07:21 +0000

A senior exec student points out a common blind-spot – the strong cash-flow possible in mature/declining sectors. This firm, part of a global business, makes large-volume manufactured products, sold through distributors to numerous installers.
Management diverts resources away from any sector where growth slows, but as in other cases, there is easy money to be made. Everyone else avoids the sector too, so little effort is needed to steal business, and lack of interest keeps margins OK too. Profitability ratios may not be high (which can drive still faster decline as firms keep cutting costs essential to business maintenance) but quantities of cash-flow can be huge.
It’s worth revisiting the principles of the Boston Matrix [whose damaging impact resulted from mis-understanding and mis-application, rather than flaws in the basic logic] – that over an industry life-cycle, free cash-flow goes from strongly negative, while heavy investments and spending are needed to capture growth, to strongly positive, when most of that spending has been done and large volumes of business drive large revenues. A key piece to remember, though, is that competition has to be driven out, to avoid those late-life cash-flows being competed away.

Beware divesting core business

Kim Warren — Mon, 18 Jan 2010 11:09:04 +0000

A rare example of clear and useful academic research from Emilie Feldman at Harvard [but treat it with care - see below]. Emilie “investigates “legacy” divestitures, the sale or spinoff of a company’s historical core business. Firms appear to divest their legacy businesses within the context of larger efforts to reshape their identities. I find that operating performance deteriorates in the years following legacy divestitures, and this decline appears to be linked to a loss of intangible resources embedded in the legacy businesses, as well as to the disruption of synergies between legacy businesses and other units within the divesting firms. These results illustrate the challenges associated with divestitures that impact firms’ resources in unexpected ways and shed light on the difficulties firms may experience when they attempt to overhaul their identities.”

Warning – its an academic paper, but get it here. And .. it’s another finding based on answering the wrong question. It’s entirely possible that these divestitures decrease profitability, but increase growth in free cash flow, which is what investors actually value, because the firms immediately start spending to exploit growth opportunities that will deliver future cash flows whilst holding down short-term profitability. It is even probable that the divested core business was making OK returns [ROIC] because it was mature and [a] didn’t justify any spending on growth and [b] could be sold at a good price in a consolidating industry.

Nevertheless, it should give cause to think carefully before buying into a transformation. Remember, strategic transformations are very rare, and even more rarely successful.

Analysts press for underinvestment

Kim Warren — Fri, 30 Oct 2009 09:06:53 +0000

I have noted before that stock analysts need know little about how strategy affects firm performance, so an academic study on the impact of stock analysts on firms’ investment behaviour is intriguing. The unpublished working paper by Benner and Ranganathan at Wharton finds that negative pressures from analysts to improve cash flow and stock price trigger reductions in strategic investments during periods of technological change. Two examples:

One analyst continually pressured Kodak to cut costs and investment in digital technology: “…we suspect that investors are growing increasingly restless with the gradual pace of cost-cutting … Kodak’s not a player in digital imaging…we consider the opportunities for Kodak to materially alter its growth trajectory with digital imaging technology to be relatively slight over the next three to four years…” (Prudential, February 1995) – and “Shareholders will revolt once the meager (and distant) potential returns from electronic imaging become clear…we are eager to see shareholders’ reactions when they realize how much of their money is squandered on ‘digital nonsense’” (Prudential Securities, 1994:7).
“ …difficult secular issues face the US telecom sector. The troubled state of the US telecom industry is not news to anybody…the most supportive valuation measures continue to be dividends and free cash flow yield…we are recommending a switch from Verizon to BellSouth…there are several arguments favoring BellSouth…cash yield at BellSouth is greater than at Verizon… we like the clear policy of returning cash to shareholders that we see at BellSouth.” (Morgan Stanley report on Verizon, April 3, 2003) – and – “Investors are forcefully questioning the wisdom of inflicting earnings and free cash-flow pain through rebuilding of core consumer businesses. If the competitive environment is to remain subdued, then one should clearly reduce the speed of new product roll-outs, contain investment and maximize short term ROIC.” (Deutsche Bank report on Verizon, January 26, 2006)

These analysts clearly believe that both Kodak and Verizon should abandon ‘wasteful’ efforts to develop knowledge and capabilities to respond to the new technological environment and return cash to investors. The paper’s authors wisely recognise [unusually for an academic strategy paper!] that the key concern should be the present value of likely future cash flows and imply that both companies might have been right to invest in new technology.

But were the analysts wrong? Both companies faced decline of their previous core consumer-based business, so doing nothing probably would have led to declining cash flows for investors, perhaps to the point of shutting down completely. Building capabilities to create new lines of business to exploit that consumer franchise could have led to sustained longer term cash flows.

On the other hand, the investment could have been ill-advised, if there was little chance of developing anything that might have led to sustained long term cash flows. Kodak, for example, made $2.2bn operating profit in 1996, after spending $1.0bn on R&D. By 2001, operating profits were only $1.2bn, and the company still spent $0.8bn on R&D. By 2008, profits were negative, but still R&D absorbed $0.5bn of cash flow. Little evidence here that continued investment in R&D helped sustain long term cash flows.

On the other, other hand, Verizon has raised operating income continually from $5.3bn to $16.9bn between 2003 and 2008, so it is hard to make a case that their efforts to rebuild their consumer franchise were ill-advised. Unfortunately, we can’t tell what BellSouth’s more cash-conserving strategy would have delivered, because they merged with AT&T. However, the merged entity seems to have driven strongly to grow the customer-base with up-to-date products and services – could it be that AT&T saw in BellSouth a resource that had been under-exploited though mean development efforts, offering an opportunity for enhanced future growth in free cash flows from reversing that policy?

Without detailed analysis we can’t know exactly what would have been right in either case – but at least someone is asking about how analysts try to change managers’ strategic decisions.

New book-opening

Kim Warren — Thu, 11 Jun 2009 12:17:26 +0000

Just updated the revised opening for chapter 1 of Strategic Management Dynamics, which you can download from www.strategydynamics.com/smd-new-start. This includes an important correction to the explanation of free cash-flow on p.27 that was unfortunately introduced when the document was laid out – apologies.

Reminder – This document reviews through some well-known cases the current philosophy and some basic tools of business strategy to make the case for a continuous, holistic approach to strategic management, i.e. strategy dynamics.

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