More Dilbert

Dilbert!

Platform Companies and Performance

IKEA manufactures almost half of its products in developing countries but sells largely in high-costs countries in Europe and North America. Similarly, Sweden's Autoliv, the world's leading manufacturer of air bags, seat belt assemblies and other automotive safety equipment, manufactures a majority of its products in countries with low labor costs such as Turkey and Romania, and sells to the large automakers, many under pressure to lower expenses, worldwide. Amid the pessimism in the automobile industry, Autoliv has doubled earnings and tripled cash flow from operations over the past five years. These are examples of what a recent article in Forbes Asia describes as "platform companies".

The term, originally credited to Charles Gave, co-head of Hong Kong's GaveKal Research Partners, refers to "companies that manufacture or assemble in low-cost countries and distribute in high-cost countries. The high-cost nations add value in product design, information systems and marketing. A company's 'home country' is merely where it is registered and pays taxes." Autoliv is traded both in Stockholm (where the company is headquartered) and on the New York Stock Exchange. The article, which points to the relatively better performance of stocks of non-U.S. platform companies, in a struggling U.S. equities market, is further evidence of both, growth in outsourcing worldwide, especially Europe, and the positive relationship between outsourcing and financial performance. For example, Autoliv is selling at a remarkably attractive 13 times trailing earnings, with a market cap of $3.8 billion.

Other non-U.S. platform companies: Toyota Motor (91, TM), with a P/E of 14; Nokia (17, NOK), the Finnish cell phone innovator, at a 16 multiple; and Novartis (54, NVS), the Swiss pharma giant, at 20. Platform companies are obviously a particular example of outsourcing of the manufacturing function. However, given that most U.S. firms have outsourced other critical business processes including product development and design, enterprise technology, and customer relationship management, whose benefits are visible over a longer period of time, it would be interesting to see how these outsourced functions impact firm value over time. If firm value develops as a function of outsourcing, the latter may soon become a quasi-investment strategy, in that firms will design their outsourcing deals so that they can structure benefits to maximize firm performance and value.

Who needs SOX?

Close on the heels of the third anniversary of Sarbanes-Oxley, here are some updates to perceptions on SOX, what Business Week dubbed in a recent issue as "the corporate equivalent of root canal".

• Business Week reports that big public companies spent thousands of hours and an average of $4.4 million per firm last year to make sure that someone was looking over the shoulder of key accounting personnel at every step of every business process, according to Financial Executives International (FEI). Designed to nip accounting problems in the bud before they blossom into fraud, Section 404 is a core provision of the 2002 corporate-reform law. The number of companies that disclosed serious chinks in their internal accounting controls jumped to 586 in the first four months of 2005, compared with 313 for all of 2004, according to Glass, Lewis & Co., a financial research firm.
• Pitney Bowes's exhaustive review involved testing 134 processes and more than 2,000 controls in 53 locations -- there were no significant weaknesses.
• Stock markets around the world have overperformed the U.S. Lisa Hess, in a recent issue of Forbes Asia, writes "Let me suggest a few unorthodox reasons for the unimpressive showing of American stocks. Although greater disclosure is a good thing, the new information we're getting is often useless. The double whammy of Sarbanes-Oxley and accountants terrified of their own liability has conspired to generate 10-Qs and 10-Ks written by lawyers for lawyers. No one else can read them, and that harms investor confidence."
• This year the 339 companies on Forbes' roster of closely held businesses sold a trillion dollars' worth of goods and services and employed 4 million people. Last year's count of privately held U.S. businesses with at least $1 billion in revenue was only 305. No evidence of a causal nexus, but by going private, a company can wash its hands of SOX.
• Small and medium sized firms have expressed significant dissatisfaction with SOX compliance standards and recommended differential standards from large public firms. William Gienke at Jefferson Wells pointed out efforts that have been taken in response to these demands. In December of 2004, the SEC launched the Advisory Committee on Smaller Public Companies. This group’s charter is to “assess the current regulatory system for smaller companies under the securities laws of the United States and to make recommendations for changes.” In addition, the PCAOB is hosting forums on Auditing in the Small Business Environment aimed at helping smaller public companies and their auditors learn more about the PCAOB’s work.
• SOX has also seen the growth in offshoring services. Although the business process itself, for which compliance requirements must be met, has not been outsourced, the supporting technology which enables compliance has seen increased outsourcing to India and other low-cost destinations.
• SOX compliance is paying unexpected dividends for some firms. For example, Pitney Bowes quickly consolidated four accounts-receivable offices into one, saving more than $500,000 this year alone. Cisco combined separate steps for selling computer hardware and providing support so that customers could get one-stop shopping. Genentech got a new system to consolidate financial data up and running months ahead of schedule. However, these rewards are largely cited by large firms, and even they agree that they are not getting a full bang for their buck.

The Immigration Effect

The Congressional Budget Office (CBO) said in a report released yesterday that Latin American workers, with less education and wages than U.S. natives, have lowered overall average earnings in the U.S. Employment of low-skilled workers is concentrated in construction, restaurants, food manufacturing, janitorial and maintenance work, and the textiles sector.

The report highlights that given the growth of immigrants, the "commonly cited statistics on earnings growth can be misleading if used as indicators of progress during a period in which an increasing share of the workforce is foreign born". For example, from 1994-2004, the average earnings of male high school dropouts rose 2%, adjusted for inflation, while the average earnings of college university graduates rose 12%. But, the wage gaps between different levels of education was less for U.S. born workers than for the whole population. The average wages of U.S. born school dropouts rose 5.4% during this period.

I have blogged earlier about the economic effects of such wage containment including the rise of a goldilocks economy - lower wages but cheaper goods and services. However, the social effects are equally interesting - the CBO cited U.S. natives making a greater effort to graduate from high school, and new investment in areas where immigrants are concentrated. I would also include demographic realities. Jason Riley at the Wall Street Journal says in a dated article:

"Seventy-seven million Baby Boomers will start dipping into our pay-as-you-go Social Security system by the end of this decade, a phenomenon that will double the current number of retirees by 2030 and reduce the worker-retiree ratio from three to two workers per retiree. That's an enormous burden for a labor force expected to increase by less than 8% over the same time period. To cover the shortfall, payroll taxes would need to rise by at least a third to more than 18%."

The CBO report comes as Congress debates on the permanent residency status of illegal immigrants. One-third of immigrants in the U.S. are estimated to be illegal, in the wake of which, a sound immigration policy is needed more than ever. In his farewell address, President Reagan--who used to receive a third of the Latino vote that Tom Tancredo, Lamar Smith and other myopic Republican lawmakers are so eager to concede to Democrats--spoke about a Shining City that's "teeming with people of all kinds" and has "doors open to anyone with the will and the heart to get here." The COB report promotes a similar optimistic view. As Riley concludes, "the sooner the Republicans start listening to their inner-Reagan, the better off they will be".

Outsourcing vs. Peer Production

Over the last two or three years, increased technological sophistication, which has amplified the cognitive and social capabilities of the population, and the architecture of the Internet, which has enabled networking of these capabilities, actively support group-forming networks, whose members can assemble and maintain persistent communicating groups. These technological shifts, in conjunction with the increasingly information-intensive nature of business processes and the growing importance of knowledge in the economy, have promoted the growth of digital networks to create economic value. Digital networks of productive collaboration coordinate distributed potential sources of effort and aggregate actual distributed effort into usable end products. A key feature of these collaborative networks is effort contribution to creation of a common good with the primary incentive to contribute following diverse social signals. Such “commons-based peer production” (the term was coined by Benkler in his seminal article) is giving rise to a new “contributory economy” characterized by various clusters of cooperation.

I think some business processes lend themselves to outsourcing to such clusters and may be more cost-effective than even offshoring. This is particularly true of business processes where the primary object of production is information and I am talking beyond Wikipedia and open-source. For example, P&G's CEO states that he'd like 50% of the firm's innovations to come from outside the company, a phenomenon known in the firm as "open innovation". Some of the firm's initiatives in this regard include e-R&D where the company posts its challenges online for solutions from around the world, the use of “matchmakers” such as 9Sigma and InnoCentive to find companies or individuals with potential problem-solving ideas, and moderation of diverse customer forums.

Although this may not be the most effective means to tap into growing, low-income markets in emerging countries, I think peer production represents a potent production medium that allows firms to tap into substantially underutilized reserves of creative effort. If utilized efficiently, it can pose a challenge to outsourcing of certain categories of information-intensive business processes including product development, design, and R&D. Clearly, it is the new outsourcing paradigm.

Social Proof

Social proof refers to looking to the actions of others in times of uncertainty to determine appropriate action. One school of organizational research believes that managers imitate peers believed to be successful, to minimize search costs and gain legitimacy. In an earlier post, I had remarked about how companies that announce an outsourcing deal perform on average 1.7 per cent higher in the stock markets benchmarked against others in their sector that have not announced outsourcing deals. This perceived legitimacy of outsourcing may create normative pressures on firms to outsource business processes without clarity on their benefits. It also explains the BPO paradox: increasing investment in outsourcing services despite the inability of outsourcing to meet business expectations. Research also suggests that such mimetic behavior is fragile and can get reversed quite suddenly when companies receive new information. One must ask what will reverse the outsourcing bubble (if that's what it is). You heard it here first.