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COMPANIES THAT FORGOT THE CUSTOMER
Author: Andrew Cornell
Publication: Australian Financial Review (17,Sat 26 Nov 2005)
Edition: First
Section: Perspective
Keywords: Qantas (4)
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When you can't watch a movie on the net ... When you can't stretch your legs on a plane ... When the bank can't take care of your money ... Blame it on corporate Australia's habit of under-investing in the future
Across the spectrum, companies are having to face the fact that cost cutting does not constitute an investment in keeping their customers happy.
This week new Commonwealth Bank of Australia chief executive Ralph Norris admitted the bank had to work harder on customer service. It seems that satisfied customers stay with the bank and are more profitable. They are the key to sustainable earnings. And they like branches and helpful humans.
It sounded like a "Doh!" moment: "Oh, customers, that's what we're about; we're in a service industry, we better invest in service." CBA just hadn't made that investment.
In another core franchise, business banking, Norris confessed to a decade of "under-investment".
CBA, though, is hardly alone. There's Telstra: "Doh! We're a technology company and we haven't invested enough in technology infrastructure." Or Qantas: "Doh! We're an airline and we haven't been buying enough planes." And Coles Myer: "Doh! We're a modern retailer and our supply chains are old-fashioned."
Across the corporate spectrum companies are having to face the fact that they have under-invested in the future of their business. Instead, they have pursued shorter-term earnings growth through cost cutting and skimping on maintaining and growing core parts of their business.
These companies have, in ANZ Bank chief executive John McFarlane's memorable phrase, "harvested" without considering future crops.
David Kirk, the new chief executive of Fairfax, the publisher of this paper, has made the point that companies such as Fairfax have not been sufficiently "aggressive" about the future. He explains why: "More considered risks of course, to make acquisitions or to start products, or launch things, to position the company for growth, and growth inevitably is more risky because you're often putting costs out there before you can see whether the revenue's going to work."
The Business Council of Australia agrees the malaise - which goes by the ungainly name short-termism - is a major problem and commissioned a research paper for its annual review called "Beyond the Horizon: Short-Termism in Australia".
"Leading corporate managers, investors and other major participants suggest that short-termism is increasingly a driver of market behaviour and a potential constraint on longer-term value creation," the BCA concludes.
It defines the issue as "the excessive preoccupation with projects, activities and investment designed to deliver improved near-term returns and outcomes at the expense of those that could deliver higher returns and outcomes over the long run".
More technically, it becomes "investment myopia" - inflating the value of near-term returns or, alternatively, excessively discounting future returns.
So Coles Myer finds itself two to three years behind arch rival Woolworths in supply chain management. The blow is doubled: Coles Myer is now spending $600 million over three years while Woolworths lowered its cost of doing business by $1.15 billion in 2004-05 aided by its previous investment in the Project Refresh supply-chain overhaul.
Behind this investment myopia, paradoxically, is a sharper focus on investment performance. The major investors in companies - institutional shareholders and fund managers - are now judged on their quarterly returns. They in turn transmit that constant pressure on to companies. Although fund managers say they are not chopping and changing on a quarterly turn, pressure exists.
In its report on short-termism, the BCA notes the reality: "While the three- to five-year range is an important gauge of performance, it is a lagging indicator and in practical terms gives little guide to future performance.
"As the only way to climb the fund manager league tables is currently one quarter at a time, there are strong competitive pressures to achieve results on a short-term basis. In circumstances where fund performance has been poor, quarterly performance can take on a heightened significance."
A former head of strategy at Colonial remembers being in the target's "war room" during CBA's successful takeover bid.
"We had been constantly speaking to our major investors, gauging their reaction to the bid, talking to them about the long-term value we were building into the company," he says. "We thought they were on-side. But you could watch, as the price moved, those funds just cashing in, one after the other, as they achieved their quarterly performance numbers. They didn't give a f--- about the long term."
The BCA research supports this interpretation: "It may be, however, that short-termism is the result of rational decisions made within an incentive framework that skews the decision makers' focus towards the achievement of short-term rewards, even to the detriment of long-term returns," it says.
"The structure of the funds management sector, the shortening of media/reporting cycles, and increasing levels of media scrutiny are often cited as examples of incentive frameworks which affect the behaviour of fund managers and corporate decision-makers."
Thus the incentives for Qantas to constantly upgrade its fleet of planes are offset by the disincentive of market reaction to spending programs. But the investment can't be postponed indefinitely and Qantas has now committed to a $20 billion renovation of its fleet over 10 years from 2010, on top of a $9 billion program already begun. Not only is Qantas's existing fleet nearing the end of its natural life, the cost of maintenance and rocketing fuel bills from less fuel-efficient older aircraft mean the decision to delay replacement has proved even more costly over time.
The overriding imperative in these cases has been to demonstrate to the market that management is focused on keeping costs down.
The distortion was compounded by executive remuneration schemes that set cost-reduction targets as hurdles for bonuses and other incentives. In a very direct manner, business managers were being encouraged to gorge themselves on the carcasses of sacked workers. Maybe you miss your revenue target but you still make your cost-cutting KPI (key performance indicator).
The BCA cites a Duke University and University of Washington study of 401 senior financial officers of United States companies which found 78 per cent would give up economic value in exchange for reporting smooth earnings growth. Fifty-five per cent of respondents would delay the start-up of profitable investment projects to avoid missing an earnings target, while four out of five executives would defer maintenance and research spending to meet earnings targets.
"Investors prefer the certainty of results today to the prospect of higher but possibly riskier results tomorrow," says ANZ's McFarlane. "The institutionalisation of money together with regular fund performance benchmarking has refocused shareholders towards shorter-term returns. Annual guidance is now almost a given.
"The consequences of short-term underperformance are material. This is in sharp contrast with the purpose of companies, which is essentially to produce acceptable returns for shareholders over the medium term."
Kevin Eley, chief executive of HGL, a listed investor in private companies (see story opposite), sums up the situation: "The first thing to recognise in the public and private company thing is that with private we are in for the long term. With public companies, it is very difficult to consider issues from the long-term perspective."
The temporal mismatch is perhaps best illustrated in the resources world, where a project maybe 10 or even 20 years in development and may run for 100 years. But sharemarket valuations, based on discounted cash flows, don't work over those periods.
Iconic Australian mining figure Arvi Parbo, former managing director of Western Mining Corp and chairman of BHP, made precisely this point in a eulogy for WMC when it was taken over by BHP Billiton.
Paying tribute to Lindesay Clark, a 40-year veteran of WMC, Parbo noted "funds were allocated for bauxite exploration in the Darling Range in the 1950s and for nickel exploration at Kambalda in the 1960s. These modest sums were a severe strain on the company's finances at that time.
"Had discounted cash flow (DCF) calculations then been popular, neither of these projects would have proceeded: the bauxite had been pronounced uneconomic by previous investigators, and there had been no nickel found in the goldfields after 70 years of intense exploration for gold."
Yet today the combined value of the companies that emerged from that vision, WMC and Alumina, approaches $20 billion - more than 300 times the $50 million (in today's dollars) Western Mining was then worth.
The challenge is complex. According to McFarlane "the three main challenges facing companies today are staying alive, producing value for shareholders and building an enterprise that will not only survive but also succeed over the longer term".
Another manifestation of short-termism is executive churn. The blunt response of many boards to shareholder pressure over performance has been to sack chief executives.
According to Booz Allen Hamilton, the underlying tenure of CEOs is 4.9 years - less time than a typical businesses cycle.
The growing recognition of under-investment today is a reaction to several factors. In part it is cyclical. The director of Advanced Strategies at AMP Capital Investors, Michael Anderson, says the ratio of capital expenditure (a current measure of investment) to depreciation (a measure of past expenditure) shows Australian companies are in an above-cycle phase of investment.
"I suspect there are two elements there," he says. "One is catch-up, coming off a period of under-investment in 2002 after the dotcom collapse. The other is a recognition of the strong Australian and global economy and the need to build capacity."
Anderson argues investors such as AMP Capital Investors do not have a short-term perspective and predilection for immediate returns at the expense of longer-term sustainability. "AMP Capital Investors pushes long-term incentive plans for executives, we want long-term shareholder value, we want companies to invest," he says. "That's why we argue executives should be incentivised to participate in the fruits of investment three years down the track."
Anderson concedes that the market does react much more quickly than five or even three years ago. Analysis is much more sophisticated, and some companies may not do a great job of explaining their plans.
The market can still be capricious. When ANZ reported its recent record profit, the bank's expenses grew nearly 8 per cent. McFarlane's explanation was straightforward: the bank had hired thousands of new staff and opened branches, investment was ongoing for growth in the future. The share price was crunched. ANZ stock lost almost 2 per cent on the day of the announcement as investors reacted to the short-term implications of the investment cost.
McFarlane was unapologetic: "We have consciously reduced this year's result for future gains," he said.
With McFarlane's record, investors can be confident those future gains have a good chance of emerging. And the share price did recover.
Yet, as the examples of other major companies show, the prevailing ethos has been that it's better to keep today's shareholders happy by holding back expensive investment - which will only benefit tomorrow's shareholders.