Operating Acrobatics and Accounting Games

Warren Buffet will have you believe that’s the stuff earnings guidance or companies’ performance forecasts are made of. A recent Financial Times article (subscription required) concurs. It points out that what started out as a practice to make companies more accountable and focuses achieving tangible results for shareholders has now turned into a myopic vision that’s grounded in short-termism and indifferent to the long-term interest of shareholders.

And I am inclined to agree. I was recently reading an article in the Harvard Business Review on capability sourcing at 7-Eleven. The article traces the organizational form of the company over the past decade, ultimately relating it to firm performance. 7-Eleven began as a traditional, vertically integrated company. However, in 1991, toward addressing issues of declining profits and market share, the company did a volte-face on its operations strategy. In a deliberate break from the vertically integrated business model, 7-Eleven decided to outsource every operation that was not mission critical. The company relinquished ownership of many parts of its business and used creative partnerships to pioneer entirely new capabilities, all while retaining control over critical operations and decision processes.

How does this relate to the anti-earnings guidance camp? Well, it emphasizes the importance of a long-term vision for a company and the allied need to lengthen the investment horizon of fund managers. 7-Eleven has phased its organization change over the past decade and the results too, although sure, have been slow to surface. The time (italicized) taken to realize benefits are evident:

“It (7-Eleven) reduced head count 28% from 43,000 in 1991 to 31,000 in 2003 and flattened its organizational structure, cutting managerial levels in half from 12 to six.

Today (as of 2004), 7-Eleven consistently outperforms competitors. Same-store sales have grown in four out of the last five years. In the past two years, it has dominated the industry's vital statistics, with same-store merchandise growth at almost twice the industry average, revenue per employee at just about two-and-a-half times higher, and inventory turns at 72% more than the industry average...

...7-Eleven's stock appreciation over the past five years has outpaced all major competitors, including Casey's General Stores, the Pantry, and Uni-Mart.”

One can only wonder if Jim Keyes, who spearheaded 7-Eleven’s outsourcing strategy, was compelled to focus on making it by a cent, whether the company would have pursued a long-term divestment strategy aimed at tightening operations. However, one can make an educated guess. The Financial Times article points out that:

“More than 80 per cent of some 400 executives questioned by the academics John Graham, Campbell R. Harvey and Shivaram Rajgopal admitted they would reduce spending in important areas such as research and development, maintenance and hiring in order to meet earnings targets. More than half said they would delay new projects even if it meant sacrificing long-term value."

Perhaps, smaller companies need to communicate their earnings potential as their funding rests on repeated contacts with the market. Perhaps, it’s part of the marketing process of established public companies. But, as the article points out, these are not the obstacles:

“For a start the salaries, and even the jobs, of both analysts and fund managers are heavily dependent on quarterly performance. And with trading volumes rising sharply in recent years, the average time investors hold a stock is down to a mere nine and half months, heightening the market's need for rapidly delivered information on the short-term outlook…(A short investment horizon) is true for America's business leaders. With the typical chief executive of a large US company expected to last no more than five years, few can be expected to set their sights on the long term.”

It’s only fitting that I mention Dell. In earlier posts, I talked about how the company has its offshoring and outsourcing strategies right. But, clearly, it takes time for these investments to pay off. And until then, the company must pay the price for breaking all links in the short-termism chain. And we must hope desperation does not spin more Apples.