Going down the cost ladder to go up the share price ladder
CEO: “How many people do we need to lay off?”
Adviser: “We have calculated it to be about 16,000. That will contribute to about 80% reduction in COGS and operating expenses, with the rest coming from a host of other measures.”
CEO: “Can you explain the calculations in brief?”
Adviser: “Sure. A staff reduction of about 16,000 through the five levers of outsourcing, lean, automation, digital and analytics will save your company around $750 million per year on an operating cost base of $7.5 billion. This can be supplemented with an opportunity to save another $250 million through other cost cutting measures, thus adding up to a total projected saving of $1 billion.”
CEO: “Hmmm. So, what will be the impact for our shareholders?”
Adviser: “Well, that will expand your operating margin from the current level of about 25% to about 35%, almost doubling your net margin to 20%.”
CEO: “Does that mean that we could double the EPS for our shareholders?”
Adviser: “Absolutely! For your 200 million outstanding shares, the EPS can double from $5 to $10 per year.”
CEO: “I am worried about the impact on growth due to the current economic situation, arising from all the lock-downs and other disruptions due to the pandemic.”
Adviser: “The pandemic and governments’ decisions are beyond our control. We can focus on what is in our control. We are yet to completely assess the impact on growth, but for a moment even if we assume no growth this year, this operating model redesign can significantly enhance shareholder value.”
CEO: “What will be the impact on inherent value?”
Adviser: “Let’s assume a growth rate of 0%.” Saying this, he moved to the whiteboard again on which he had already written down the following equation —
Intrinsic value = [EPS × (8.5 + 2g) × 4.4]/Y
“Since the current yield on AAA-rated US corporate bonds is 2.5%, our intrinsic value under the two scenarios is as follows.” Saying this, he wrote —
Scenario 1 — Intrinsic Value= (5 × 8.5 × 4.4)/2.5 = $ 74.8
Scenario 2 — Intrinsic Value= (10 × 8.5 × 4.4)/2.5 = $ 149.6
“You see. We can double the intrinsic value of your shares. Now, when the market sentiment is low, we perhaps cannot expect a proportional increase in the market price of shares, but surely investors will see the value in due course of time.”
CEO: “What about the other two streams of our turnaround strategy — sales transformation and capital allocation?” He asked this question as he turned back a couple of pages in the handout provided to him by his Adviser and looked at this slide again.
(Please refer to the article“How many people do we need to lay off?” for more context.)
Adviser: “We have worked it out. We will need to invest in sales transformation to get future growth once we emerge out of the economic downturn due to the pandemic.”
CEO: “Surely, that will cost money and reduce the EPS?”
Adviser: “You are quite right. However, we have calculated an additional investment need of only $100 million. For a year, that could depress your EPS projection from $10 to $9.5, but we can counterbalance that.”
CEO: “How would that work?”
Adviser: “The good news is that not only do you not have any outstanding debt, but in fact you have more than $2 billion of cash on your balance sheet. We could buy back around 10 million shares with about $ 750 million cash. That will bring the EPS projection back to $10.”
The CEO was impressed with the thorough work done by the management consultant. However, something seemed to still trouble him. He looked up at his book-shelf. His eyes focused on a specific book. It was “Apple Confidential 2.0” by Owen W. Linzmayer. He recalled something that he had read in the book.
“The cure for Apple is not cost-cutting. The cure for Apple is to innovate its way out of its current predicament.”
– Steve Jobs
The CEO decided to share his troubling thought with his trusted adviser.
CEO: “Well, can our actions not have unintended consequences to our reputation in the market as well as among our employees and prospective employees? Will it not have an impact on our quality or our ability to innovate? Are you sure that this is the best approach?”
Adviser: “Let’s remember two things. The first point is that the board has appointed you to show deliver results within a couple of years. So, you don’t have luxury of the long term. The second point is something the American economist and professor at Harvard Business School, Theodore Levitt has stated in “Thinking About Management.”
“Costs are always higher than expected, even when they are expected to fall. They require scrupulous scrutiny and constant containment.”
— Theodore Levitt
The CEO heard his Adviser, thought for a moment and quickly made the decision. For he knew that a good leader needs to take decisions quickly.
Postscript: This concludes “Think like a management consultant.” This forms a part of the series, “How can we solve problems in four ways?” This is the fourth article in the same series. The second one was, “Think like a software engineer” and the third one was “How many people do we need to lay off?” I will discuss the two remaining approaches in future articles.
