A Letter to the Chief Executive
What’s behind the annus horribilis of 2001? Not the economy, terrorism, or the “dot bombs.” Rather, long before this recession, hubris and pressures to fulfill Wall Street’s expectations set the stage for many companies’ current woes: overcapacity, price wars, scrutiny of accounting practices, and fragile, post-layoff workforces.
In this fictional letter to a CEO, a board member decries two flaws in the current American management model:
We must now learn from the past—and set our companies on a new course. Here’s how to get started.
The Idea in Practice
First, understand pre-2001 corporate behaviors:
Example:
Firms defined unrealistic growth goals, then implemented unrealistic plans to meet them—including expensive acquisitions, new plants and equipment, new hires, and increased compensation. Results? Overcapacity—and a generation of executives who feel entitled to be millionaires.
Example:
Businesses invested in marginally profitable products and entered new markets without asking themselves if they could wrest share from rivals. Though unsound, these actions offered hope of “making the numbers.”
Then, set realistic expectations—through new conversations with key constituencies:
Example:
Refocus analysts’ attention on your management of the business—not on quarterly financial results. How? Be more forthcoming—and less obfuscatory. Clarify company strategy, its risks, and your firm’s potential as an investment. Disclose progress (or lack thereof) on key initiatives, then link it to future financial results.
Which leaders will restore sound, long-term decision making to their companies? Those who deliver clear, consistent messages in the context of a meaningful mission.
Editors’ Note: This fictional letter from a board member to a CEO highlights the challenges and complexities of running a business in today’s uncertain environment. While avoiding the facile bashing of U.S. executives so common these days, it nonetheless casts a hard light on the flaws that have recently been exposed in the American management model. We hope that you find it an illuminating, and bracing, read.
Dear CEO,
I’ve been reflecting on the recent board meeting. We were all encouraged by the third-quarter revenue numbers and the improving forecast for the year. The stabilization of our gross margin, despite the price cuts, speaks well of your latest cost reduction initiatives. On the whole, I think we can safely assume we’ve weathered the current storm. However, while we can all be grateful for the recent signs of an upturn in our performance, I suspect the next year or two will hold many challenges.
Indeed, the stabilization of our situation offers only a brief reprieve, if any at all. Like many companies these days, we have a workforce that remains fragile after surviving rounds of layoffs. We operate in an industry that still has decidedly too much capacity. And we are embroiled in a market share battle that shows no signs of abating. I’m not sure if anyone really knows which of our competitors started the price war—for all I know, we did—but we’ve only just begun to see the effects on margins and market share. Furthermore, some of our competitors’ recent earnings restatements and their use of “creative” accounting will surely bring more scrutiny to our company in the months ahead. In short, you’ll have your hands full indefinitely.
That is precisely why I’m writing to share some thoughts on a less obvious, but nonetheless critical, issue: your role as the leader of the company during this time of uncertainty. I know I risk sounding like every pundit in America when I raise these issues, but I want to talk to you openly about your role and responsibilities in the future. I think my long service on the board and those years we spent working together on the industry council have earned me that right. Or perhaps, merely your indulgence.
I will spare you a sermon on the need for integrity in our financial reporting. I must admit, however, that even by the jaded standards of someone who has served as a director of public companies for more than 15 years, I’m shocked by what we’ve witnessed in the last several years. As the chair of the Audit Committee, I remain satisfied both with the accuracy of our financial reporting and the performance of our auditors. Similarly, I’m not concerned about the level of your compensation or dealing in our stock. Nonetheless, we must guard against even the appearance of rapaciousness or self-dealing, lest we invite intense scrutiny from the business press, the union, and institutional investors.
This risk is just one way in which the current circumstances have thrust you into a position where your actions will have a disproportionate impact on the company’s prospects. As the famous World War II admiral Bull Halsey once said, “There are no great men, only great challenges that ordinary men are forced by circumstances to meet.” I think the next couple of years will offer those “great challenges” and will require all your skill to meet them. Another observation: Whether you like it or not, your career is apt to be judged by your performance over that period.
As you know, I’ve watched this industry closely for many years—seven of them as a CEO myself—and this isn’t the first downturn I’ve seen. As I’ve thought about it, though, I’ve come to reject most of the analogies between this and previous recessions as flawed. In my view, the most important feature of this recession is what happened in the years preceding it. It was during that time that we fell victim both to our hubris and to the pressures to perform up to Wall Street’s expectations instead of our own.
In retrospect, it is now clear that because of our desire to “meet or beat the street,” we made a number of strategic choices and instigated a series of changes to the underlying management system that caused us to fall harder and faster than necessary. For example, you and the CFO consistently told the market that we could grow profits at a 15% compound annual rate, even though our core businesses were struggling to hit 4% top-line growth and we were close to exhausting our supply of sensible cost reduction options. Sure, the consultants told us it was possible. And yes, the rest of the board and I got caught up in the rhetoric and went along. But look where that left us when the downturn hit.
After all, it wasn’t the recession that caused us to make three acquisitions in two years at very, very high prices (ah, the benefit of hindsight!); the need to fuel that growth did. Nor was it the recession that caused us to expand our capacity in anticipation of gaining market share; rather, it was our own overly optimistic sales forecasts that led us to that decision. Where did those forecasts originate? From line managers trying to fulfill profit goals that we created after meeting with the analysts. Because we bought into the analysts’ logic instead of asserting our own, we ended up with unrealistic goals and similarly unrealistic plans to meet them.
We didn’t just add marginal plant and equipment, but marginal people as well, right across the workforce. The tight labor market scared us and we overreacted. We had the hiring spigot turned on all the way almost until the day we pulled the plug. No wonder the Internet chat rooms are full of angry comments. We changed the story we were telling employees practically in midsentence. It wasn’t the tight labor market, though, that caused us to increase executive compensation and, especially, to award options to everyone at the vice-president level and above. The Compensation Committee did that with the input and encouragement of management. (Again, as a former member of that committee, I have to shoulder some of the blame here.) The liberal granting of options helped create a generation of executives who now think they’re entitled to become millionaires.
I’m not saying these decisions and others were necessarily all that wrongheaded at the time. As I reflect on it, however, one thing does stand out. I think we were guilty of focusing more on what others expected of us than on what we knew was the real potential of the company and the real opportunities in our industry. In the last few years, we’ve defined our strategy more and more in terms of outcomes—How do we grow revenue at this rate, or EPS at that rate?—and less and less around the substantive decisions that actually drive those outcomes—How do we gain leadership in this market, or should we invest in that technology? Driven by the need to meet stretch financial goals, we’ve invested in plants making products that are only marginally profitable. We’ve ventured into new markets without asking whether we’ll be able to wrest share from rivals who intend to defend their turf as fiercely as we defend ours. In short, we took new initiatives simply because they gave us some hope of making our numbers, not because we were confident that the business logic was sound.
Despite what the headlines say, I think the root cause of many of the problems that became apparent in the last 24 months lies not with the economy, not with September 11, and not with the dot-com bubble. Rather, it lies with that willingness to be led by outside forces—indeed, our own lack of conviction about setting a course. Now that things are settling down a bit, I think you need to take a deep breath and think about how to use this annus horribilis as an opportunity to break some bad habits. Specifically, I think you should use it to alter the fundamental nature of the conversations you’ve been having with some of your key constituencies: Wall Street, the board, the senior executive team, and the rank-and-file workforce. Since last year’s performance eliminated any chance of fulfilling the expectations we helped create in each of these constituencies, let’s reboot and set expectations that are based on reality.
Let’s start with Wall Street. During my 15 years on your board, I’ve watched as the agenda of the board meetings has become more and more focused on the analysts, their expectations, whether we’ll meet them, et cetera, et cetera. Until recently, we talked about how to manage these expectations. Even though the SEC has put the kibosh on all the private, in-depth briefings and whispered conversations with analysts, we’re still spending too much time figuring out whether and where we’ll fall in their expected range. In my view, that’s putting the cart before the horse. Too often, last year’s “strategic initiatives” have been scrapped in the interest of this quarter’s earnings. Investments and acquisitions we had celebrated as major growth vehicles have been pared back, sold, or written off—in response to skepticism from analysts or the rating agencies as much as out of managerial conviction.
What bothers me is that we seem to have lost control of the situation. We spend more time talking about what the analysts think we should earn than we do discussing what the company is capable of earning. I realize that we have a credenza full of bankers’ reports telling us that “high performance” companies grow their earnings at 15% annually. I just haven’t seen the corresponding study showing how you do that in a market that is growing in the single digits, with a company that has gone through multiple waves of cost reduction and asset rationalization.
What bothers me is that we seem to have lost control of the situation. We spend more time talking about what the analysts think we should earn than we do discussing what the company is capable of earning.
Once upon a time, analysts studied companies in order to understand their potential, describe the case for investing to their clients, and make recommendations. Many of them developed a deep understanding of how particular companies had positioned themselves, how the fundamental economics of an industry worked, and what company-specific risks various players faced. Admittedly, the world and our business have gotten more complicated during my tenure on the board, but it seems to me that many of our current analysts don’t have that type of understanding. When news is grim, they always seem shocked, scurrying to rewrite their estimates and relegating companies that surprise them to the “penalty box.”
Well, our company is in the penalty box now. But it was inevitable, if not this year, then soon. The earnings tightrope was too long and the market winds too high for us to meet their expectations. So let’s not fight it. Let’s exploit it. I think we should move away from managing the market’s expectations and invest more time in building the analysts’ understanding of the company and its fundamental economics. That means being much clearer about our strategy, what risks it entails, and what the analysts need to believe about us and our markets to think we’re a good investment.
Now let me be clear: I’m not advocating that we simply do a better job of “investor relations”—at least as the term has been defined in recent years. I’m talking about basing our discussions with analysts on the fundamentals of our business. At present, we spend most of our time with them trying to predict our quarterly earnings down to the very last penny. Last year, we forecast annual earnings within a range of 20 cents per share. Given the previous year’s earnings of $2.25 per share, we were offering a number with roughly a 10% margin of error. How can we make such a forecast when we compete in a global business that has not only normal systemic risks but also competitive, product-liability, and exchange-rate risks, among others?
I’m not advocating that we simply do a better job of “investor relations”—at least as the term has been defined in recent years. I’m talking about basing our discussions with analysts on the fundamentals of our business.
Instead of engaging in this virtually meaningless exercise, let’s give the analysts a better understanding of the progress—or lack thereof—we’re making on key strategic initiatives and then link that progress to future financial results. We currently do the opposite, obfuscating what’s going on in the business to leave ourselves future flexibility. But if growth in a new product or gaining access to new channels is key to our success, then we need to be more forthcoming about how we’re doing. It’s not as if the analysts won’t find out eventually. And I’m sure we can provide this information with enough discretion to avoid publishing anything a determined competitor couldn’t find out independently.
By being more forthcoming, we can get analysts to focus on what we’re actually managing—the business—and less on what we can’t manage nearly as precisely—the quarter-to-quarter financial results. It will also relieve them of the burden of surmising the cause-and-effect relationship between our strategy and our financial results—and us of the burden of speaking to them obliquely. If nothing else, the analysts ought to be grateful, given the cloud that hangs over audited financial statements. If we get out in front on this, I think we have a real chance to differentiate ourselves from our competitors.
I think you’ll find an approach that I features visible, accurate, and reliable information about corporate performance much more to the liking of the board, too. I’ve complained to you before that the senior executives seem to treat our strategy reviews with them like a dinner at the in-laws. They’re on their best behavior, say as little as possible that might be remotely controversial, and define victory as a clean getaway. I don’t think the more experienced directors like the degree to which we have been shut out of substantive discussions. We all know that you’re cautious about inviting too much back-and-forth. Indeed, all of us directors run or have run our own outfits and know that too many cooks spoil the soup. But you don’t have to substitute pablum for soup. If you adopt the type of discipline I’m suggesting you adopt in your discussions with the Street, you will greatly elevate the quality of the discussions we have in the boardroom. You’ll also have a board that adds more value and is more committed to your program.
I should add that, at some point, it doesn’t matter what I prefer or what you think about the substance of board meetings. Enron and WorldCom changed everything. I don’t know of a single director of a publicly traded company that hasn’t reviewed his D&O insurance policies in recent months. No one in his right mind is going to put his reputation at risk by not knowing what is really going on in companies whose shareholders he represents. Just as shareholders should insist on a far clearer line of sight between financial projections and management actions, boards will insist on understanding the links between management decisions and business risk. Your board will certainly be one of them.
Let me turn to the senior executive team. I’ve been concerned about where these managers have been focusing their attention in recent years. During last spring’s off-site, I chatted with many of them. They are bright and motivated, no doubt. However, in my conversations with them, each seemed unduly concerned about this year’s budget, making the quarter, and the market’s reaction to our recent “negative” earnings guidance.
Now, maybe that’s what they thought I wanted to hear. And certainly, when I was in their shoes, I also was cautious about what I brought up with an outside director. But I think it’s indicative of a more fundamental, and potentially insidious, problem. If we look at how these folks get paid, it should come as no surprise that they focus on the share price. In recent years, several things have happened. The tolerance for short-term performance problems has become almost nonexistent. And as an executive team and a board, we have consistently signaled to top managers that they had better make the numbers, or else. Why? Because we feel we have to make the earnings estimates, or else. And, by loading executives up with options, we guaranteed that they would focus on share-price performance as well.
Certainly, the Compensation Committee eagerly embraced this program as a vehicle for ensuring that executives focus on shareholder value. But I wonder now whether we actually accomplished that purpose. Should these people really be checking the hourly movement of the stock price at the expense of worrying about product marketing, the workforce, and asset utilization? Someday, once they have proven themselves at the business-unit and group-VP levels, they will find it important to monitor the health of the overall corporation, as reflected in the fluctuations in its stock price. For the moment, though, they should focus on those things they control directly.
Furthermore, it would seem to me that through our use of options we’ve infected top managers with the same type of short-term thinking that was the punch line of every joke about American management 15 years ago, when American executives were criticized for managing by the numbers and lacking any real sense of their business or industry. More importantly, I wonder if we’ve skewed their expectations. I realize that during the height of the dot-com bubble, everybody and his uncle believed their destiny was to get rich, young. We certainly accelerated the pace of salary and bonus increases to keep the best of our executives, when we feared they would head off to some new-economy start-up. Obviously, that fear has passed. Still, the aftereffects linger.
Through our use of options we’ve infected top managers with the same type of short-term thinking that was the punch line of every joke about American management 15 years ago.
Don’t get me wrong: As you know, I have argued in board meetings that there is a market for executives, and we have to meet that market to keep our top talent. You will credit me, I think, with being an unstinting ally in helping to maintain our position in the top quartile of executive compensation in our industry. While I think that is important, I don’t think we should fall into a mindless, keeping-up-with-the-Joneses mentality. Every year, our compensation consultants tell us that the mean has shifted upward; every year, we meet the new standard. And, in recent years, that has meant not only increasing the number of options and broadening the group of recipients but also repricing them when our stock price fell. All of that added up to a huge shift in the expected value of our managers’ compensation from salary and bonus to options. But after the battering our stock took during the tumultuous weeks the market experienced in the summer, we’ve shifted them on to thin ice. At this point, I don’t think it’s an overexaggeration to say that the fundamental, underlying logic of our executive compensation program is in tatters.
I think we need to revisit the logic of compensation for executives. We have to refocus them on their specific responsibilities by linking their individual rewards more materially to their performance in advancing our strategy. I’m not suggesting that we abandon shareholder value creation as our overarching metric. But I do think we should start deconstructing that metric into component parts that are related to our strategy and reward executives on that basis. Let’s embed in the compensation system the same logic we’d like the market to adopt.
Finally, I believe we are fooling ourselves if we think that the issues I have outlined above are lost on the nonexecutive workforce. Just what have they seen from us in the last five to ten years? First, they have witnessed a massive increase in both the reported value of executive pay packages and the amount of press coverage those packages receive. More importantly, they have seen a fundamental change in the way we approach the business. Simply put, they believe we lack commitment to it—and to them. Many would call us not only selfish but spineless. New product programs come and go, not on their merits, but on our ability to fund them year to year based on earnings requirements. Functions ranging from IT to internal audit are outsourced, their employees unceremoniously seconded to new employers like so many indentured servants. Procurement “rationalization” results in the termination of longtime suppliers. Overhead cost reduction campaigns, “delayering,” and early retirement incentive packages are followed by a massive ramp-up in hiring—and then equally precipitous layoffs.
What message do these moves send to our employees? Basically, we’re saying: “When the chips are down, don’t count on us.” And that’s a message that’s not only heartless by dangerous. I believe our employees want the company to succeed and, on the whole, are willing to put up with a lot to ensure that outcome. But they have to be given some reason to make that sacrifice. We no longer denominate success in building great products or providing a great place to work, but in cents per share. Frankly, that is not enough.
Our employees want the company to succeed and, on the whole, are willing to put up with a lot to ensure that outcome. But they have to be given some reason to make that sacrifice.
Implicit in what I’ve been saying is the need for you to rethink how you exercise leadership in this company. Leading in a time of uncertainty is a fundamentally different task from leading in a time of unquestioned irrational exuberance. If we think about those leaders whose greatness evinces itself in times of trouble, what we remember is their ability to communicate. Their messages always share the same qualities—clarity, consistency, and an underlying moral purpose. Moreover, they demonstrate the integrity of those messages through their actions, setting a course and then staying with it in the face of adversity and opposition. In short, they say what they mean and do what they say.
Their messages may be delivered in the native dialects of their different constituencies; these leaders, after all, know their audiences. But the overarching theme is the same. And it embodies a mission that people can rally around.
Let’s face it. You don’t motivate people with “Let’s knock ourselves out again to make another stretch quarter.” As rallying cries go, this isn’t exactly, “Once more unto the breach, dear friends!” To inspire people to follow you, to commit themselves to your endeavor, to make needed sacrifices, you have to offer an inspiring mission. It doesn’t need to be dramatic, but it does need to be meaningful. I think restoring sound, strategic decision making that looks beyond tomorrow’s analyst’s report will take us a long way toward a mission of which we can all be proud.
The results will take care of themselves.
Joseph Fuller is the CEO of Monitor Group, a global professional services firm headquartered in Cambridge, Massachusetts.
A Letter to the Chief Executive
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