Management Lesson 3:

Business Economics

What management should be aware of is the importance of the fundamental economics of a business. If the economics of a business are inferior, success would be hard to come by and the business would eventually suffer in the long-term. To quote Warren Buffett : "With few exceptions, when a manager with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact." This factor influences Warren Buffett's investment strategy. According to him : "I want to be in businesses so good that even a dummy can make money." Let us use United Chemical Industries (UCI) as an example.

UCI manufactured polypropylene and polyethylene woven bags in the early 90s and controlled 30% of the local market. However, even with the increasing market share, its pretax margins fell from 12.4% in 1990 to 4.8% in 1996. The business was commodity-like, with no product differentiation, no pricing power and low barriers to entry, resulting in an industry oversupply. The reliance on high-cost locally sourced raw materials rendered the products uncompetitive in the export markets. Unable to compete globally and locked in a fierce price war back home, UCI's results inevitably suffered, despite its strategy of increasing its production capacity. Not surprisingly, the majority shareholder sold out in 1996 when an attractive offer was made. Among the 17 PN4 companies, UCI was not the exception. How does one improve or enhance the business economics?

Improving Long-Term Economics

Improving or changing the fundamental economics of a business is not easy. In Malaysia, government regulations and its economic policies have a massive bearing on the economics of a business. The long-term consequences are often negative for companies and the entire economy. Unless our politicians and policymakers change them for the better, it is very difficult for the individual company to improve the economics of its business. Very briefly, moving the economic and business environment of Malaysia towards a more performance-based, free market type would greatly reduce the serious distortions found in our industries and economy. Apart from this, the economics of a business can be influenced by technology, marketing and business strategy-related factors like innovation, research and development, product differentiation, branding, cost leadership, positioning and sticking to core competencies. The 3 most common generic competitive strategies are cost leadership, product differentiation and focus. Failure to position itself within either of these strategies or popularly known as 'stuck in the middle' could almost guarantee the firm low profitability in the long run, as experienced by most of the 17 PN4 companies featured.

[1] Cost Leadership

Many companies compete on price. To be successful, a company needs to be cost effective and ideally have cost leadership; that is, it has to be the lowest cost producer. An important element in this strategy is market share. Without a critical mass, a firm could not leverage on the economies of scale to bring down its costs. However, it is not just about minimising costs of raw materials, labour and overheads. What is most important for the company is to be the most productive and efficient in order to be the most price competitive, at all times. This is a concept that many managers failed to grasp. Productivity and cost efficiency should not be implemented only when times are bad. It is a constant and relentless process that should be applied throughout the ranks, from senior management down to the workers on site. If and only when the entire company operates as a truly low-cost entity can the firm succeed.

[2] Product Differentiation

An option available to companies is the strategy of product differentiation. To succeed, the product or service offered by the companies has to be perceived as unique. The perception of uniqueness would in turn form a strong defense against the competitive forces and thereby, creating brand loyalty, pricing power, higher margins and higher barriers to entry. To achieve this value-added feature requires a combination of product engineering and research, technology, marketing and, of course, an unblemished reputation. These companies often lead the industry and dictate its progress and structure, which explains the superior earnings potential and above average returns. Just like cost leadership, none of the 17 PN4 companies had these.

[3] Choice of Strategy

Depending on the nature of products and services, companies can pursue a strategy of either product differentiation or cost leadership. For cost leadership, a company must truly embrace the lowest-cost concept in their everyday operations and practically live and breathe it. Firms that are unable to do so may squeeze some profits if the economic conditions are accommodative. Otherwise, like many of the PN4 companies, they will just crumble under the heat of competition. For those seeking above average returns, we advise companies to progressively step up the value chain by continuously investing in brand development, research and development, innovation and technological advancements. It is only through these value-added qualities that firms could realistically command a decent return in the long run and not succumb to the harsh economic forces of the industry.

The examples of UCI, Maruichi and the former Rothmans (now known as BAT) are highly educational. Maruichi is a market leader in the steel industry and is well-known for its cost leadership. The former Rothmans was a huge success with branding and was a market leader. Its Dunhill is still the number 1 brand. What is interesting from the figure is that UCI and Maruichi are both in the commodity type of business. As is obvious, the pretax margins for Maruichi are much higher than that of UCI. Then the pretax margin of BAT is consistently higher than that of Maruichi.

Management lesson 4:

How Not to Expand

There are 2 ways to achieve growth; [1] Organic and [2] Acquisition. Organic growth is achieved by expanding the existing business, either through an increase in production capacity or introducing new products or opening new markets while growth by acquisition is by acquiring existing companies in the same or different business. Both types of growth models have their strengths and weaknesses and the choice of how, when and where would depend on the industry structure, management capability and financial resources of the companies involved. However, as seen from the PN4 companies featured, there are many lessons to be learned from the implementation of their expansion plans.

Industry Structure

Companies that grow by increasing their production capacities should be able to translate these into profitable sales. UCI is a good example where this did not succeed. Instead of more sales and earnings, the rise in capacity worsened the excess supply in the industry. UCI had to contend with low utilization rates and low margins. Management should carry out industry research prior to any expansion plans or be so cost-effective that they can profitably capture new or existing demand. Also, the company has to be financially strong to ride any protracted competition. An overstretched management like in the case of Uniphoenix is to be avoided.

Long-Term Commitment

A common feature in the failures of many expansion plans is the lack of long-term commitment. In 1994, CSM entered into a joint-venture with Nestle to manufacture ice cream, etc but sold its 49% stake to Nestle for RM50,000 in 1999. In 2001, Nestle reported that the "ice cream business has made a turnaround and shows the highest growth rate in the Nestle world." CSM knew that Nestle has a very long-term focus. Many of the expansion plans of the 17 PN4 companies did not have a long-term commitment from top management. If they could not bear the initial pain and see the venture to fruition, they should not have expanded in the first place. Buying a lottery would have been less costly.

Overseas Expansion

Overseas expansion, especially to neighbouring Asian countries, was very popular and glamourous during the pre-crisis years. However, as shown by Esprit, Mancon, Promet, SCK, etc, such ventures failed miserably. Besides the overgearing factor, the companies probably expanded without proper due-diligence and thinking of the risks involved. It is probable that SCK could not foresee a civil uprising in Cambodia but was it not conscious of the risks by venturing to a politically unstable country? Did Mancon conduct proper due-diligence on the titles of land use rights and the titles to the properties of its subsidiaries in Hong Kong ? Expansion anywhere is never easy. Expanding abroad is even more difficult. It is glamourous and so easy to underestimate the difficulties and the work involved.

Management Lesson 5:

Financial Management

The fact that the 17 companies are classified under the PN4 category would have meant that they are in deep financial distress. A great deal of damage was due to very poor financial management or even the lack of it. Basic errors like overborrowing, ignoring cash flow management and overtrading were evident in most of the companies featured.

How Should One Gear Up?

In expanding and diversifying, many of the 17 PN4 companies relied heavily on debt financing. By gearing up, companies would theoretically be able to reap the benefits of leverage (e.g. higher returns on equity, etc.). If mismanaged, a high debt level can be devastating. Sales of Esprit rocketed from a mere RM17.94 mln in 1991 to RM202.84 mln in 1996, financed by heavy borrowings. In 1996, the group had a whopping RM233 mln in borrowings. Its gearing ratio was approximately 7.6 times, signalling a very risky and vulnerable financial structure. When the sharp rise in interest rates drove up its debt servicing cost to RM49.9 mln in 1998, the group tottered. Subsequently, a spiral of events started that culminated in the operations of the group coming to an abrupt standstill in 1998.

The risk of such a calamity happening is convincing enough for some managers to avoid debt altogether. However, many companies find it difficult to ignore the use of leverage in their pursuit of growth. The danger, however, lie not in the use of debt per se but rather recklessly using it. A common error is to rely on short-term borrowings to fund long-term expansion plans. An example of this error can be seen in Nauticalink when it sought short-term borrowings to finance the purchases of its long-term assets. When its various capital-intensive expansion plans failed and its existing core business waned, the group's financial well-being was seriously compromised.

What should the ideal debt level be? For some, the most ideal is not to gear up at all. For those that need to, companies should aim for debt levels that they are financially and operationally comfortable with, incorporating factors like the strength of balance sheet, the cash-generating abilities and cash flows of their operations, prevailing interest rates and the duration of the loans. All these are inter-related and should be taken into consideration when one decides how much to borrow. In their financial management, companies should always be prepared for any unexpected developments.

Working Capital Mismanagement

Another mistake made by the PN4 companies is weak working capital management. In a competitive environment, many companies resort to having liberal credit policies. In so doing, they impose a strain on cash flows and working capital and exposing themselves to defaults. This explains the huge provisions for doubtful debts made by the 17 PN4 companies, which contributed greatly to their financial distress. In 1997, sales of Zaitun were RM39.35 mln but trade debtors totalled RM37.21 mln, almost 95% of its sales. This is an extraordinary liberal credit policy. It also signalled the group's total reliance on credit to generate sales. This policy contributed greatly to Zaitun's financial problems. It is not that credit should not be extended as it is an integral part of doing business but it has to be done with adequate control and within limits. The problems faced by Zaitun show the consequences of an overly liberal credit policy, done without proper due diligence and risk management.

Lack of Financial Flexibility - Illiquid Assets

In managing a company's finances, a critical aspect that deserves attention is its financial flexibility. This is especially important during recessions, where financial resources tend to be overstretched as business conditions deteriorate. Without liquid assets, companies could easily be drawn into a cash flow crisis, which would then snowball into a financial mayhem. Property development and construction companies are often exposed to this, as their assets comprise illiquid assets like land, development projects, etc. During the recession, Sateras's massive holding of investment properties, land & development expenditure, totalling RM140.4 mln on 31/3/02, could not be liquidated to settle its loans, lower its debts or ease its cash flow problems and as a result, affected its operations badly.

Overtrading

Companies that engaged in overtrading are also particularly susceptible to financial ruins. Overtrading occurs when companies generate high levels of sales with very low levels of assets. In 1996, Autoways had total assets of only RM38.4 mln but its sales were a massive RM321.0 mln - a clear indication of its inadequately capitalized financial structure. Although it is normal for construction companies to have high capital turnover ratios, Autoways was certainly overtrading. Worst of all, its very few assets were also illiquid. When the financial crisis occurred, the group could not liquidate its assets fast enough to settle its outstanding obligations and subsequently, suffered from a credit crunch which crippled its operations. Inadequately capitalized companies rely heavily on debts to fund their expansion but such a risky capital structure would not be sustainable in the long run as they are very susceptible to unexpected downturns in the economy or shocks.

Management Lesson 6:

Do Not Speculate

Whilst waiting for opportunities, companies often invest their cash reserves in financial assets (i.e. quoted shares, corporate or government securities) in order to generate higher returns. In fact, it would be irresponsible for management not to utilize its cash asset more efficiently, especially if interest rates are low. However, this is different from active speculation on a highly leveraged basis.

Debilitating Losses

Out of the 17 PN4 companies featured, as many as 6 suffered debilitating losses from such speculations. Had they not succumbed to the greed or hysteria prevailing in the stock market at that time, these companies would have been in a much healthier state. As a rough measure of its severity, the losses suffered by Repco and Autoways just from their share trading activities equalled 15.9 times and 6.4 times their respective shareholders' funds in 1996.

Risks of using Margin Financing

Bear in mind that the risk is not in the purchase of securities per se. The risk was speculation magnified by using margin facilities; meaning that the companies borrowed to speculate. In so doing, these companies were not only exposed to the price movements of their share holdings but also the added burden of maintaining enough collateral. This brings the risk of forced selling by their financiers in the event of failure on their part to meet margin calls. Interest expenses have to be serviced as well. In some cases, interest expenses would run into millions and thereby, strangling the companies' financial resources and cash flows. Furthermore, it is ironic that the speculation financed via margin financing is classified in the balance sheet as 'investment'.

Fun Managers or Fund Managers?

Equally worrying is that the corporate managers had misplaced beliefs in their own abilities to be fund managers. Perhaps they were caught up by the frenzy in the market and must have thought it would be easier and faster to generate returns trading shares than from their own core businesses. For example, in fiscal year 1998, Repco had sales of RM315.89 mln, of which RM266.3 mln was from its profitable gaming business. During that period, the group bought shares amounting to RM411.5 mln and sold them for RM340.77 mln, resulting in a huge loss of RM70.72 mln, practically wiping out that year's gaming profit of RM47.34 mln. A further provision of RM207.88 mln, including interest charges, was made in 1999 and with that, the entire company was thrown into turmoil.

A Question of Integrity

As if the losses suffered were not hard enough for the ordinary shareholders, there were many incidents that would raise questions about the integrity of management. Most of the 17 PN4 companies had not disclosed or obtained the necessary approvals from their shareholders until it was probably too late and as such, kept ordinary shareholders in the dark throughout. There were also instances where the share transactions involved the interest of current or past directors and substantial shareholders of the company. It is bad enough that companies engaged in speculation using borrowed funds but to do so without the knowledge and approval of their shareholders is unforgivable. How else would shareholders' rights and interests be safeguarded?

Conclusion

In summary, the management lessons from the 17 PN4 companies are : [1] The harmful impact of management changes, [2] When to focus or diversify, [3] The wrong way to expand, [4] Neglecting the business economics, [5] Financial management ignored and [6] No seductive speculation. From the evidence presented, it is clear that management plays a defining role in the eventual success or failure of companies and only with quality management can shareholders' value be enhanced and not suffer from the same fate as the 17 PN4 companies featured. i Capital will continue this conclusion series in a later issue with the "Economic lessons."