investiledysfunction

The November 3, 2008 issue of Newsweek contained a letter from Mayor Michael Bloomberg to the President-Elect (and now Barack Obama).  This blog is strictly non-political and will remain that way, but Mr. Bloomberg offers a great commercial for portfolio management applied at the public sector level.

In his letter to the president, Bloomberg writes,

“In exchange for legislation creating an infrastructure bank that funds projects based strictly on merit, agree to invest more money on the infrastructure our country needs most.  And you should also demand more from the states and cities that get federal money: hold them accountable for building on time and on budget.  Call it a “New New Deal”: investing more, more wisely and getting bigger returns.”

I’m not sure there has been a better encapsulation of what portfolio management is all about.  I am pretty sure that government and citizens ultimately would benefit significantly from the approach Mayor Bloomberg is advocating.  Competition for funding and holding people accountable for results always yields good results.

I remember when I was younger (much younger), I’d wake up on Sunday morning excited to watch WWF wrestling (now WWE) only to find my dad parked in front of the TV watching Meet the Press or something that I found utterly mundane.  But it seems that I’ve outgrown my fascination with the figure-four-leglock and the camel clutch (former WWF fans will understand those references) and now I’m watching the boring stuff on Sunday mornings.  This morning, I was watching “This Week With George Stephanopoulos” (herein referred to as GS) with many guests including Robert Rubin and Newt Gingrich.  (Please note: as is fashionable these days, this is a ‘bipartisan’ post)

Newt Gingrich and Robert Reich were guests on GS’ show and these two agreed (shocking) that the US government needs to differentiate between expenses and investment.  They argued that investment occurs in improving infrastructure, education, alternative energy, etc while there are expenses which keep the machine running.

They were discussing investments vs expenses in the context of the government.  Yes - you read that right.  So let me explain why this is important.

Brilliont did an analysis of the 800 large and mid-cap companies which found that those who increase investment (expenditures in marketing, R&D, innovation, sales, etc) and minimize expense (general & administrative, IT infrastructure, etc) outperform their peers.  Basically, investing in those things that help the organization attract and retain customers and compete more effectively/efficiently is a good thing.

The key point here is that not every dollar that goes out the door is the same.  Some are strategic and create value and some are non-strategic.  It really is that simple.  Unfortunately, our accounting and treatment of these dollars is all too often not nuanced enough, and every dollar is the same.  This lack of understanding of expenses continues today in corporations which generally have more enlightened or progressive practices than government bodies given the short-term accountability they generally have and their inability to print new money.  So as you can imagine, this type of understanding within the government based on our experience with the public sector is quite rare.

Although Reich and Gingrich’s discussion was only on a talk show, I can only hope that the government (as well as corporations) starts to understand the difference between investments and expenses.  Investments may take some time to pay dividends but when thinking about the long-term, they are very important.  They’re the thing that ensure you have a long-term.  Investments (strategic expenses) need to be maximized and expenses minimized.  This is where the public sector at all levels can take a portfolio approach to its expenses and really improve decision-making and the outcomes they achieve for the constituencies they represent.

Hopefully, this type of understanding can move past talk and begin to impact decision-making within the government.

I’ve previously talked about Kraft, P&G, Wells Fargo, Pernod and others whose CEOs have jumped onto the organic growth bandwagon.  Add to the list private equity companies.  Yes, those soulless, blood sucking private equity types who supposedly want to fire everyone in the name of the almighty dollar (or Euro or whatever) actually do care about company performance, and many are actually quite good at driving it according to a new study.  And the centerpiece to their work is good old organic growth.

The September 2008 issue of CFO Magazine has an article entitled, “Let Us Now Praise Private Equity” by Kate O’Sullivan which discusses a new study by Ernst & Young.  Ms. O’Sullivan writes:

“Often viewed as hard-hearted financial engineers who pile up profits by slashing expenses, P-E kingpins are criticized for their lack of transparency, their much-debated tax status, and, of course, their lavish lifestyles. But a new report offers support for the same case that P-E bosses often make for themselves — namely, that they are not only shrewd investors but also talented managers.”

John O’Neill, Americas director of private equity at E&Y, goes onto comment that “We found that probably only a third of that growth is from cost-cutting.  More than 50 percent is organic growth, and the rest is acquisition-related.”

Let’s do the math on that 50+% from organic growth, 33% from cost cutting and less than 12% from acquisitions.  It seems from the numbers that private equity managers know what the heck they are doing and understand that driving efficient organic growth is key to driving value.  And the numbers prove out their reliance on organic growth is well-placed.

“Private-equity-backed businesses outperform public companies in productivity gains, in employment growth, and in business expansion, measured both in terms of enterprise value — the company’s market value plus net debt — and earnings before interest, taxes, depreciation, and amortization” (quoted from the article)

It seems some of the savviest buyers of companies know that organic growth is the way to go.  When will others see the light as well?

In this recent interview from Business Finance Magazine’s Sept 2009 issue entitled, “The Serial Transformer“, Gary Crittenden, CFO of Citigroup, talks about his efforts to transform the finance organization at Citi.

He touches on many critical points about Finance Transformation which we help organizations with including corporate portfolio management (Investment Optimization), reengineering and driver-based planning.  Some relevant excerpts are below, but I recommend reading the entire article for those interested in creating a strategic finance organization and who are looking for ideas and a high-level gameplan from somebody who has successfully done this before in other organizations.

Gary led such a transformation for American Express Finance which transformed the organization into one of the most respected and strategic finance groups in a large organization.  American Express Finance has been discussed and chronicled by the Harvard Business Review, CFO Magazine, and the CFO Executive Board to name a few.

(shameless plug: Gary also wrote the foreword to my book - more info here)

Here are a couple of noteworthy excerpts:

On Selecting the Best Projects and Investments Using Investment Optimization

“…We think very carefully about every dollar that gets added back that offsets the reengineering.

This process is called investment optimization. We go through and look at the expense dollar optimization and ensure that we have a common definition for expenses across the company. I’m talking about the end-state now — not where we are, but where we’re headed.

In a company that is this large and this complex, even getting the definitions common is important so that somebody who is making an investment in a fixed income trader in, say, Brazil has the same financial metrics, terminal value, and present value calculations.

This is a big part of what has to happen as part of this process. But once you have this, you can then align those opportunities and say which one you prefer. You also know what’s on the margin — what the 20 last things were that I approved that would have the least impact if I had to cut them. You also know what the 20 next things are that you would approve if you had some dollars. And if you’re constantly updating and reforecasting, then you’re always able to ask yourself the question, “Do I need to cut or can I have the opportunity to add?”

On Driver-Based and Rolling Forecasting

“It ties back into this primary thing, which is that we’re trying to drive the performance of the business. There are several different elements to it.

One is to have a rolling forecasting process so that you’re always looking further ahead than you normally would. The way this starts for us is with a strategic plan that looks at a couple of years. This then turns into an annual plan, and then the annual plan gets refreshed each quarter, out for that quarter plus then the additional six months on the end of that, and then we update this twice a month as part of our normal process.

We’re always looking forward and doing a normal update to this. Now, if you’re going to be updating this frequently, you can’t do it from a bottom-up basis. You quickly conclude that you have to use the primary drivers of the business as opposed to the detailed, kind of bottom-up forecasting. It turns out, paradoxically, that doing this is just as accurate as the bottom-up forecasting. In fact, you probably get more accurate data because you’re doing it a lot more frequently.”

We’ve seen Kraft, P&G, Pernod and many other companies in the recent past get on the organic growth bandwagon as they’ve also realized it is the least risky and most coveted by investors.  Our analysis of organic growth efficiency of the S&P 500 over the period from 2002-2007 actually reveals that companies with higher organic growth efficiencies also are rewarded with better shareholder returns.

To that list of the enlightened, let’s add Wells Fargo.  John Stumpf, Wells Fargo’s CEO, states this in no uncertain terms in the August 25th issue of the Financial Times when questioned about doing a mega-deal.  He states, “We don’t need to do a deal.  Organic growth is the core growth engine in this company.”

He later added, “We come from a culture where bigger is not better.  You get bigger by being better, you don’t get better by being bigger.”

Mr. Stumpf hits on organic growth in a practical way and also rightfully disparages the size matters credo which has especially infested financial services.  That said, Wells Fargo is no stranger to acquisitions, but it has tended to do smaller, regional deals which it can fold in to existing operations.

The increasing push and discussion around organic growth is one that we find heartening.  If companies invest in measures to improve their organic growth capabilities, we’ve seen that the numbers paint a very good story.

I’d previously written about Time Warner Cable in a prior post (see Time Warner Cable - A Rant on Why I Don’t Like Monopolies) .  In that, I talked about how customer lifetime value doesn’t matter to a monopoly like Time Warner in NYC because in a monopoly, the customer is stuck with you for a lifetime.

Today, I’ll describe (in much less detail) how the matter ended.  Spoiler alert:  Time Warner’s performance got worse (if that is possible).

With my last bill not reflecting the credits it should have received, I called Time Warner over lunch to just inform them of my prior conversations and to get the credit I’d previously been told I’d get.

The summary of my conversation is that Time Warner informed me I wouldn’t get the credits I’d originally been told I’d receive because of Time Warner policy and that the prior customer service representative misspoke.  While I explained that TWC’s policies nor representative misstatements are not my problem, it was to no avail.

The beauty of this situation still remains that I have no choice but to stick with Time Warner Cable.  So once again, monopolies are great (for the company).  It also makes me look forward to the day when I can use the internet as my television.

More generally, this is worth noting for businesses that can lose customers (unlike TWC).  Organic growth is often best enhanced by maintaining existing customers and cross-selling them on new services and products instead of just aiming to acquire new customers.

The popular blog on all things technology, TechCrunch, recently had a post on something you don’t typically see on the blog - organic growth.  The entry entitled “Does Google Have an Organic Growth Problem” - discusses an analysis by Citi equity research analyst who argues that Google’s organic growth is decelerating.

It was an interesting post and something we were glad to see given our work on organic growth.  Below are our thoughts on the post and the findings about Google.  We’ve benchmarked and analyzed the entire S&P 500 (of which Google is a member) on organic revenue generation and efficiency over the period from 2003-2007, and our #s reveal a similar story, but the picture still is very positive.

We would agree with Citi’s analysis that the organic revenue as a % of total revenue for Google as well as a % of total revenue growth is declining over the longer period we studied.  As compared to Yahoo (the closest comparable to Google if there is one), we have seen that Google is destroying their peer from an organic revenue perspective.Our analysis goes beyond just organic revenue and looks at the efficiency of generating this organic growth, e.g., how much are companies like Google, Yahoo, etc spending to achieve organic revenue growth.  We call this efficiency ratio the Organic Growth Multiplier (OGM).  The logic behind the OGM is that if one company can spend $1 to get $3 of revenue and another can spend $1 to get $5 of revenue, the latter company is healthier and has more momentum in its business.

When we look at the OGM of Google versus Yahoo and versus the larger S&P500 tech financials category, the picture is actually quite pretty for Google.  They’re tops as it relates to OGM which means a dollar of investment into their core business generates more revenue than the average tech sector company.  They also outshine Yahoo on this count as well.

The indexed OGM for Yahoo and Google over the period from 2003-2007 are 50.9 and 312.84, respectively.  Without getting into the quantitative models that underlie this, the point is that Google’s organic revenue efficiency is far superior to Yahoo.

Most importantly from all this work is that we’ve seen that higher OGM and total shareholder return are positively correlated.  So having the ability to generate organic growth efficiently is a good indicator of shareholder returns.

While the assertion that their organic revenue is declining does remain true, the news is not as dire as I’ve been reading elsewhere from those who’ve picked up on this TechCrunch entry.  Yes, if they can turn one of their acquisitions into a money maker, this will obviously supplement some of the organic revenue deceleration that might be evident in their historical core business, but on the whole Google is still a star when it comes to organic revenue generation and efficiency.  The fact that Citi retains its buy rating despite the organic picture is testament to this.

A bit on the methodology.

There are some notable differences from the Citi analysis which despite the similar conclusions do make our analysis more robust.

1.  We’ve looked at a more extensive time period (2003-2007)
2. We strip out market growth for each company.  In essence, if the market is growing at 10% and your company grows at 10%, we don’t give you credit for this.  This is rising tide growth and is not due to management’s actions and investments in the core business.   Organic revenue, therefore, in our models is only the growth we can attribute to management’s prowess (or lack thereof).
3. In our Organic Growth Multiplier, we also look at the efficiency of generating organic revenue by determining how much is spent by each company to achieve its organic revenue.  This gives a truer sense for the efficiency of the company’s organic revenue capabilities.

Amtrak is federally subsidized and to call it’s forecasting capabilities a train wreck (pun intended) would not be an overstatement.  The pseudo-company hasn’t made a profit or met its ridership goals in 37 years.  And yet they’re asking for more money (to the tune of $15 billion) to replace old locomotives and rail cars with more efficient models.

There is a rule of corporate portfolio management and the organic growth it aids and that is you compare promise vs performance for projects and then give resources to those areas where past results and future opportunities are best.  I sincerely doubt that Amtrak’s past projects have done very well, and so it’s fair to assume that this time is not going to be different.  From a federal resource allocation perspective, there are probably better places to place bets.

Managing Director, Pierre Pringuet, of Pernod is looking for some tequila and bourbon.

And while it may make sense for Pernod, the 2nd largest drinks-maker in the world to think of such acquisitions, the organization has for a variety of reasons realized that “organic growth is a must” as Pringuet told the Wall Street Journal in the 7/24/08 issue.

The company’s liquor cabinet is full of brands,  many of which have been gotten through acquisitions (some quite pricey), and now the time and effort turns to generating organic growth.  This is where Mr. Pringuet and his team’s management prowess will really be tested as they aim to generate growth through their actions and investments in marketing, product development, sales, etc.

It’s good to see they’ve seen the light with reference to organic growth.  Now comes the hard work.

Given all of our work focusing on organic growth and its predictive value for revenue growth and total shareholder returns (TSR), I am always glad to see organic growth getting its due in the media.

So when a Financial Times headline from yesterday pronounced that “Kraft Chief Targets Organic Growth“, that was music to my ears.  Kraft CEO, Irene Rosenfeld, commented that the company’s “three-year plan is predicated on organic growth” although she did leave room for M&A to shore up the company’s international footprint.

It’s good to see prominent, world-class companies realizing the power of organic growth and basing their goals on growth measures tied to it.