The Value Manager

In Chapter 1, we argued that value creation is the ultimate measure of performance for a management team. This chapter explains, primarily through a case example, what it means to manage for maximum value creation—in other words, to be a value manager.

Becoming a Value Manager

Becoming a value manager is not a mysterious process that is open to only a few. It does require, however, a different perspective from that taken by many managers. It requires a focus on long-run cash flow returns, not quarter-to-quarter changes in earnings per share. It also requires a willingness to adopt a dispassionate, value-oriented view of corporate activities that recognizes businesses for what they are—investments in new productive capacity that either earn a return above their opportunity cost of capital or do not. The value manager's perspective is characterized by an ability to take an outsider's view of the business and by a willingness to act on opportunities to create incremental value. Finally, and most important, it includes the need to develop and institutionalize a managing value philosophy throughout the organization. Focusing on shareholder value is not a one-time task to be done only when outside pressure from shareholders emerges or potential acquirers emerge, but rather an ongoing initiative.

The process of becoming value-oriented has two distinct aspects. The first involves a restructuring that unleashes value trapped within the company. The immediate results from such actions can range from moderate to spectacular; for example, share prices that double or triple in a matter of months. At the same time, the price to be paid for such results can be high. It can involve divestitures and layoffs. Management can avoid the need for cataclysmic change in the future by embracing the second aspect of the managing value process: developing a value-oriented approach to leading and managing their companies after the restructuring. This involves establishing priorities based on value creation; gearing planning, performance measurement, and incentive compensation systems toward shareholder value; and communicating with investors in terms of value creation.

By taking these steps to ensure that managing value becomes a routine part of decision making and operations, management can keep the gap narrow between potential and actual value-creation performance. Consequently, the need for major restructuring that goes with large performance gaps will be less likely to arise. Those who manage value well can guide their companies in a series of smaller steps to the higher levels of performance that even the most comprehensive of restructurings cannot match.

In the balance of this chapter, we illustrate the integrated application of value management principles by presenting a case example distilled from the real-world experiences of client executives with whom we have worked. Our purpose is to show the process of transforming a company in terms of value to shareholders and management philosophy. The case serves as an overview of and framework for the application of the more detailed valuation approaches developed in the main body of this book.

EG Corporation Case

Part 1— Situation

In early 1999, Ralph Demsky took the helm of EG Corporation as chairman and CEO. For the previous 10 years, Ralph had been president of Consumerco, EG Corporation's largest division. Consumerco had been the original business of eG before it entered other lines through acquisition. Major institutional shareholders had recently become dissatisfied with EG's performance.

The EG Business

EG Corporation had sales of just over $3.5 billion in 1998. The company was in three main lines of business— consumer products, food service, and furniture—with its Consumerco, Foodco, and Woodco divisions.

Consumerco manufactured consumer products and sold them through a direct salesforce to grocery and drugstores throughout the United States. It had a dominant market share (more than 40 percent) in the majority of its product lines, all of which had a strong branded consumer franchise.

Woodco was a mid-sized competitor in the highly fragmented furniture business. Woodco had been created through acquisitions and consisted of eight separate smaller companies acquired over 10 years. All served the mid- to lower priced end of the market with complementary product lines. The Woodco companies sold their products under their original brand names. As of early 1999, the companies were still operated as autonomous units, but EG had begun to combine the companies into one unit, consolidating separate administration, sales, and production functions to the extent feasible. EG also planned to establish an umbrella brand to tie together the wide range of Woodco product offerings and establish a base for adding new lines.

Thus far, the Woodco businesses had turned in uneven financial results. Management capability in the eight businesses varied widely. Moreover, Woodco's business performance was to differing degrees dependent on keeping up with the latest in furniture styling and fashion. Some of the companies were skilled in this area, but the disastrous consequences of missing the trends had been brought home over the years by their uneven performance. Despite this, Woodco's management was convinced that EG could build a large and successful business. The managers believed consolidation would reduce Woodco's operating costs significantly and strengthen the company's management control over the businesses. They thought the new common sales and marketing thrust would lead to increased volumes and higher margins. The Woodco management's convictions were lent some credence by the existence of several other players in the industry that earned consistently high returns, achieved in part by rationalizing less-efficient companies that they had acquired.

Foodco, EG's third main division, was in the food service business. Foodco operated a small chain of fast-food restaurants, as well as providing food service under contract to major corporations and other institutions around the country. It had been essentially built up from internal growth plus a few small acquisitions over the last five years. The former CEO had viewed Foodco as a major growth vehicle for EG and had backed aggressive expansion plans and the associated capital spending. As of early 1999, EG's Foodco unit was earning a profit but was still in the early stages of its development plan. It was a small player in the restaurant business and had only a few institutional food service accounts. In both businesses, it faced formidable competition, but management believed that its operating approach and EG Corporation's Consumerco name recognition, which was being used as the branding proposition for Foodco, would establish Foodco as a major factor in the industry.

Beyond Consumerco, Foodco, and Woodco, EG Corporation owned a few other smaller businesses: a property development company (Propco), a small consumer finance company (Finco), and several small newspapers (Newsco). No one currently employed by EG could recall why EG had acquired these businesses. They had been added to the portfolio in the 1970s. All were earning a profit, though they were small by comparison with EG's three main divisions. (See Exhibit 2.1.)

EG's Financial Performance

Overall, EG Corporation's financial performance had been mediocre for the last five years. Earnings growth had not kept pace with inflation, and return on equity had been hovering around 10 percent. Part of the problem was that EG had been hit with unfavorable "extraordinary items" that had depressed bottom line results. Beyond this, though, the company had failed to deliver on overall commitments for growth and operating earnings in its businesses for the last few years.

Exhibit 2.1 EG Corporation—Businesses

From an investor's standpoint, the company's stock price had lagged the market for the last several years. Analysts bemoaned the company's lackluster performance, especially in view of its strong brand position in Consumerco. They were disenchanted with the slow progress in building profits in other parts of the company. Some security analysts had gone so far as to speculate that EG would make a good breakup play. EG Corporation's board and senior management were frustrated by their inability to convince the market that EG should be more highly valued.

Ralph Demsky's Perspective

Ralph Demsky was familiar with EG's worrisome corporate situation and had been a vocal advocate of a sharper focus on shareholder value for EG for several years. Ralph was convinced that great opportunities existed for EG to boost its value. Upon retirement of the previous chairman and CEO, the board had tapped Ralph to lead EG because of his controversial ideas and his strong operating track record leading Consumerco.

Ralph knew he needed to act fast. His plan was first to uncover and act on any immediate restructuring opportunities within EG. Then for the longer term, he would put in place management systems and approaches to ensure EG did not pass up rich opportunities.

Ralph As Restructurer

During the first week of his tenure as CEO, Ralph began a project to assess restructuring opportunities within EG. He wanted to take action soon to build value for EG's shareholders and to convince the market that EG could be worth more than its current market value.

To carry out the project, he structured a task force with himself as chairman, the chief financial officer (CFO), and the other heads of the businesses. Analysts from the finance staff supported the valuation work, while each business-unit head was responsible for getting the work on his or her business done. The team met twice a week to review progress, develop conclusions, and—importantly—keep up the tempo of the work. Ralph expected the project to provide actionable recommendations within six to eight weeks.

Ralph had thought long and hard about doing the review with a smaller team, perhaps consisting of him, the chief financial officer, and several financial analysts, to maintain secrecy and speed up the process. However, he had rejected this alternative for several reasons. First, he wanted to draw on the best judgment of his senior managers about the prospects for their businesses. Second, he wanted to involve them from the outset because they would play a key role in carrying out the business improvements that were sure to be identified. Finally, he wanted them to learn the process by doing it, since he planned to undertake a similar thorough review annually.

As an analytical framework, Ralph envisioned investigating the value of EG's existing businesses along six dimensions, which he thought of as forming a restructuring hexagon (see Exhibit 2.2). The hexagon analysis would start with a thorough understanding of EG's current market value. Then the team would assess the ''as is" and potential value of EG's businesses with internal improvements, the external sale value of the businesses, growth opportunities, and the opportunities to increase value through financial engineering. All these values would be tied back to EG's value in the stock market to estimate the potential gain to EG's shareholders from a thorough restructuring. The comparison would also help to identify gaps in perceptions between investors and EG management about prospects for the businesses. When their analysis was complete, Ralph and his team would have a thorough, fact-based perspective on the condition of EG's portfolio and their options for building value.

Exhibit 2.2 Restructuring Hexagon

Current Valuation

The first thing Ralph did was to review EG's performance from the standpoint of its stockholders. He already knew that EG had not performed particularly well for its shareholders in recent times and that operating returns had not been as good as everyone had hoped. But Ralph wanted to be more systematic in his review of the market's perspective. His team set about examining EG's performance in the stock market, its underlying financial performance, how it had been generating and investing cash flow, and the market's implicit assumptions about its future performance.

What Ralph found was disturbing—and revealing. EG's return to investors had indeed been below the market overall and below the returns for a roughly assembled set of ''comparable" companies (see Exhibit 2.3). When he looked at the current valuation of EG relative to peers, he was disappointed, but not surprised, that his company was also valued lower relative to the book value of invested capital (Exhibit 2.4).

What also stood out from the analysis were a couple of events that had knocked down the value of EG relative to the market. In the period 1992 to 1997, EG had made several acquisitions to establish and build the Woodco furniture businesses. Ralph noticed a decline in EG's share price relative to comparable companies and the market around the date of each acquisition. In fact, when the team calculated the impact of these declines on the total value of EG, they realized that the decline in EG's total value was about equal to the dollar amount of the premiums over market price EG had paid to acquire the companies. Evidently, the stock market did not believe EG would add any value to the acquired businesses. It had

Exhibit 2.3 EG Corporation—Shareholder Returns versus Comparables

Exhibit 2.4 EG Corporation—Comparative Current Valuation

viewed the acquisition premiums EG had paid as a damaging transfer of value from EG investors to the selling shareholders in the acquired companies.

Ralph thought that this made sense. Since EG had not in fact done anything to these companies since they were purchased, there was no reason for them to be worth any more than their pre-acquisition value. It didn't seem to matter that the deals had been carefully structured and financed in part with debt to avoid diluting EG's earnings per share. The market had seen through those gimmicks.

Looking next at the financial results of each of EG's businesses, the team noted that Consumerco had generated high, stable returns on invested capital (35+ percent) for the last five years. However, the businesses' earnings were only growing at the pace of inflation. EG's Woodco business had suffered steadily declining returns. The earnings of the Foodco business, on the other hand, were growing, but returns on investment were low because of high capital investment requirements in the restaurants. All of these factors had conspired to depress overall EG returns on capital and hamper growth in profits.

One investment analysis Ralph found especially intriguing was a cash flow map of EG based on information for the last five years (see Exhibit 2.5). What it showed was that EG had been generating substantial discretionary or free cash flow in the Consumerco business, a large portion of which had been sunk into Woodco and Foodco. Relatively little had been re-invested in Consumerco. Moreover, little of the cash had found its way back to EG's shareholders. In fact, on a five-year basis, EG had in effect been borrowing to pay dividends to shareholders. Since Ralph believed that shareholder value derived from the cash flow returns EG could generate, he became increasingly suspicious that EG had taken the cash Consumerco had generated and re-invested it in businesses that might not generate an adequate return for shareholders.

To round out his perspective on EG's valuation by the stock market, Ralph spent a day reading all the reports securities analysts had written recently about the company. He then went to visit several of the leading analysts who followed EG's stock, to gain their perspective on the company's situation. He was surprised at the favorable reception he received. Apparently, the previous CEO had little regard for securities analysts. He had never met with them individually to understand

Exhibit 2.5 EG Corporation—Cumulative Cash Flows

Five years ending December 31,1998

1 fcquals after-tax operating profils plus depreciation,

2 Equate capital exp-eiidiiures, acquisitions, increases in working capital, and otiier assets.

3 Net ol tax benefit.

their views. When he did meet with them, it was always to tell them why the stock should be more highly valued, never to listen to what they thought about EG. One of the analysts illustrated why EG lacked credibility with the market by showing Ralph the analysis in Exhibit 2.6. This showed that analysts had to consistently revise downward their earnings forecasts.

What Ralph heard about EG was disturbing, but corresponded with his view of the situation. The analysts thought EG had been complacent for the last five years or more and had pursued new businesses with little regard for the returns to be generated. Moreover, they felt EG would remain an unattractive investment candidate unless Demsky took actions to demonstrate more commitment to creating value for shareholders. However, management would need to see this potential and act on it. They thought some synergies were possible with strategic acquirers for some EG businesses, but the real problem at EG had been a management that was not serious about generating value for shareholders.

EG's "As Is" Value

Ralph's team turned its attention next to assessing the value of each component of the EG portfolio on the basis of projected future cash flows. To do this, the team members developed cash flow models for each business and then set to work assembling key inputs for the projections, many of which were available from each

Exhibit 2.6 EG Corporation—Continuous Earnings Disappointments

unit's business plan. They needed to know projected sales growth, margins, working capital, and capital spending needs. The finance staff meanwhile developed estimates of the cost of capital for each division.

When they had the inputs assembled, they ran two sets of discounted cash flow valuations as preliminary benchmarks. The first was based on simple extrapolations of the operating results for each business from recent historical performance; in this case, they chose the last three years. They used these projections to estimate the value of each EG business, as well as the cost of corporate headquarters activities and the value of nonoperating investments. Exhibit 2.7 shows the ''value buildup" the team used to compare the total value to EG's market value. They noticed several points immediately. First, the total value based on history was substantially below the value of EG in the marketplace. Second, the Foodco food service/restaurant business would be worth far less than the capital EG had invested in it during the last few years, unless performance improved dramatically. Third, the vast majority of EG's value was represented by the cash flow generated by Consumerco. Finally, the corporate headquarters costs, when viewed on a value basis, were a large drag on overall EG value—almost 25 percent.

After reviewing the disturbing results of the historical extrapolations, Ralph asked the team to look at the value of EG assuming the performance estimates in the current business plans were achieved. The results, shown in Exhibit 2.8, were also less than comforting. The total value of EG would be above its market value if the plans came true, but only by about 10 percent. On the face of it this was good news, but Ralph knew that the plans were very aggressive, at least by normal EG

Exhibit 2.7 EG Corporation—Value Based on Historical Extrapolation

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