Confessions of a Serial Cost Cutter
How many times have you seen friends, neighbors or family try and start a business and fail? What did their initial task list look like? Acquired an office, computer, a new car or van, furniture, etc. What do these types of items have in common? They are fixed costs with very little productive value. A drain on precious capital. Early in my career, I went to work for a struggling steel mill. Back in those days the steel industry was battling with foreign competition , recession and high labor costs. A situation not too different from the plight our airlines find themselves in now. The government in its effort to shore up its basic industries provided this mill with loan guarantees to rebuild its capital structure, but did not allow for the working capital to weather the rebuilding process. The effort was a failure.
How do you approach your fixed costs? Are they out ahead of your business? Do you know how much revenue has to come through your door each morning when you unlock it to pay for turning that key?
I have received many offers from various consultants to help me lower and control my costs. Here are a few tips you can apply yourself.
- Forget hiring the cost control consultant. Your money ahead already, and besides, you already know more about your business than the consultant ever will.
- Do you know what the five to ten largest expenditures your company makes are each year? Find out and go to work on them. Negotiate with your vendors or shop them around. The savings will come fast.
- We all want to be liked, but labor costs will be one of our largest expenses. Keep it fair, but keep it under control.
- Do you want to be the best performer in your market? Always ready to win the wars of competition? Then work at being the lowest cost producer or provider.
- Don't forget, quality and service always matter. Finding a new customer always cost more than keeping an existing one.
- Talk to your friends, vendors, customers and employees. The best prices, services or products are not going to just find you.
- Know how that purchase is going to make money before you buy it.
- Learn how to say no.
- Only use debt for the most productive of investments. Leveraging always has it time and place, but it can rob you of flexibility and future opportunity.
There are hundreds of little ways to reach your end on maximizing your bottom line. Let your fixed costs lag your growth. Remember to apply these principles to both your personal, as well as, your business financial situation. The First has a direct impact on the decisions you make in the second.
Good Advice for The Small Business
I have been working on a post about my own philosophies on cost controls that any small business should consider, but here is a recent post with a list from the Entrepreneurial Mind that any small business person should keep in front of themselves at all times.
Blogging and the Corporation
I am sure this topic will be coming to an employment law seminar near you soon. In the news, Apple is pursuing a case against several blogs that have had inside product development information leaked to them. For those employees that might be involved, I believe that you will find that Apple is well within its rights to pursue you. The Judge has already ruled in Apples favor in two of the cases. While senior executives are oftentimes trained at length about protection of intellectual property, I doubt that little of this education filters down to the rank and file of the company in any meaningful way.
This leads me to a recent blog posting by Michael Hyatt - CEO concerning corporate blogging policy. Two approaches to blog policy are highlighted. Attributed to Microsoft there is the simple approach - "One Microsoft blogger told me that the only rule his company provided was, "Be smart." Then their is the not so simple approach put forth by the author that includes 14 terms and conditions, a list of acceptable blog hosting site, creation of a Blog Oversight Committee and paragraphs of disclaimers of possible liability.
My guess is that, since bloggers tend to be an independent bunch, Mr. Hyatt will find that the average employee blogger will simply forego his alliance site. This leads to the issue of training and communications. The malicious will be who they are. In a world of blogs, chat rooms and message boards we in the executive ranks will need to be constantly vigilant and educate our employees as best we can so that they can protect themselves from the pitfalls of their endeavors.
The SOX Effect
I have run onto excerpts of this paper a couple of times, including this post at Professor Bainbridge. William J. Carney of Emory University has published a paper on SSRN titled "The Costs of Being Public After Sarbanes-Oxley: The Irony of 'Going Private' ". We, as private investors, need to be very concerned about this trend, especially if we focus our investing in the small and micro cap area. In my experience, company's intending to go private tend have basically lost their incentive to maximize shareholder value, and the premiums paid in these transactions tend to be below average. For the companies that attempt these transactions, it is becoming an open invitation to shareholder litigation. This type of litigation tends to be a bigger win for the law firms involved than for the actual investors.
The paper also covers the issue of companies delisting to avoid the costs of complying with the Act. From a policy point of view, I cannot see where driving a number of smaller companies outside the sphere of regulation is a road we want to go down. Investing has always been risky, but risk reward ratios are going out of balance due to the cost of regulation.
Managing Charity
Several years ago I was looking for a better way to manage my charitable giving. Gains in my investing would leave me with resources to give and a burning desire to increase my charitable giving for selfish tax related and personal reasons. For various reasons, I didn't always have the long list of proven charities or that single cause to which I wanted to funnel large sums of money. Finally a close friend directed me to a method that provided a means to manage my giving. Most large mutual fund companies today provide charitable giving accounts. In my case I chose the T. Rowe Price Program For Charitable Giving. I was able to transfer restricted stock with a large built up gain without recognizing the gain myself. In addition I was able to take the market value of the stock as a charitable deduction. The account then allow me to invest these funds and direct charitable contributions over time as I saw various needs arise.
Today it is easy for me to direct funds to the charities I believe in without regard to the daily condition of my bank account. As value is built up through the investing of the account, I am actually able to direct more giving than I might have by directly giving. And as my own circumstances have improved over time I have been able to add to the fund and manage the timing of the tax consequences.
To be sure, where the IRS is involved there are rules. The site that I have linked above will make them clear. It also has links to assist you in researching qualified charities and articles that will help you clarify your own goals and focus your giving. I would encourage anyone who is looking to manage the charitable giving in their life better to take the time and research these accounts. You and those you support with your giving will never be disappointed.
First Grade Economics
My seven year old son attends a Charter School here in Colorado. Despite what the press would lead you to believe, if you want to find a Charter School near you here in Colorado, you simply find the state achievement scores by school for your county and find the highest rated schools. Last night was that time of the school year when my lovely bride and I made the trek over to school for a parent-teacher conference. The little "E" is a first grader who loves schools and pressing people's buttons, and his teacher is a dedicated young woman who (like almost every teacher, administrator and parent involved in this school) has values that line up with the values of my lovely bride and I.
After the usual conversations regarding the E's current academic strengths and weaknesses, our teacher shared a story of how things are currently progressing in class. All year the first grade has been on a reward and penalty system. Tickets are earned for various good deeds and achievements, while tickets are paid back for various wrong doings and indiscretion. Like in any free market, tickets earned and saved can be used to purchase small rewards from the toy box (the small gifts in the box are donated by various parents during the year). Over the past few weeks the class has been moving into a study of the American Revolution and our old buddy King George. As you may recall, King George was not very much like our current President George on the issue of taxes. To teach this point, Miss C has introduced taxes to the ticket reward system. If a little achiever earns two tickets, one ticket goes into the King George Tax Jar. And what have these fine little first graders learned from this lesson? As Miss C pointed out with a coy little smile on her face.
They don't like TAXES!
Reclaiming Your Company
To be sure, a number of high flying companies have been caught up in scandal over the past few years. It is an age old problem. There are any number of solutions that are being tried. Many new ideas to solve the problem are being bandied about. The problem is many are expensive to implement or ineffective or both. The turmoil is being used to advance various agendas, but only give false hope to investors.
Take a look at Section 404 of the Sarbanes-Oxley Act. This calls for documentation of the company's internal controls, testing, correction of weaknesses, outside audit of controls, management opinions on effectiveness and outside auditor's opinions on the management's opinion. This whole exercise is culminated with the CEO and CFO giving their sworn affirmation not once, but twice that they are in control and there are no errors. These affirmations are presrcibed by the SEC and no deviation or qualification of the wording is allowed. This whole process is consuming vast amounts of leadership time and mountains of cash. The immediate reward for the investor is lower earnings and a lower stock valuation. The long-term reward includes less resources for product development or acquisitions, and a management that is more focused on their personal liability and criminal risk generated by inadvertent error by themselves or their staff.
In the end errors still happen. Bad judgment is still an everyday occurrence. Everyday the articles still flow in the business press of financial restatements and SEC inquiries. They will continue to grab headlines, because the reality is they were always there.
Another example of a false flag for the investor's hopes is the new SFAS 123R which directs companies to expense the value of stock options at the time of grant. Instead of considering why stock options can lead a management astray and into poor decision making, we enact an accounting rule to try and discourage its use. Stock options are not the real problem. The concept of aligning employee, management and investor interests is really quite sound. It is in the implementation that the incentive goes wrong.
Since most stock options generate a tax liability at the time of exercise, the average employee is basically forced to sell shares and not hold the stock. This defeats the whole purpose of the stock option since ownership is not established. Other practices such as immediate vesting of options play right into encouraging fraud. The discovery of fraud is almost always a matter of time. Fraud can be covered up for one, two or three years, but eventually outside influences come to bear. Overstatements start to become evident as they build on the Balance Sheet or banks demand payment on hidden obligations.... Eventually every house of cards will fall. Why do we allow our management the opportunity to reap rewards in such a small window of time when longer term vesting would reduce much of the risk.
In the end, the cures to these ills will not come from rules and regulations. It will come from good governance. It will not come from wasting the company's resources or trying to shoe horn every company into a certain set of controls and having them perfectly documented and complied with. It is one thing to prescribe that outside auditors will deal more directly with a company's Audit Committee, but it pure foolishness to believe that a small group of outside board members can provide the day-to-day diligence over a diverse accounting staff performing a variety of complex tasks.
Meanwhile, the outside auditors are being disengaged from the executive management that we are so worried about. New independence rules are preventing the outside auditors from giving advice on new accounting rules and their application. They can no longer provide services such as completing tax returns for executives. Many of these types of functions were once consider useful since they gave the outside auditor a view into how aggressive management was and gave early warning into the executive's own personal financial position. Now the tools that would have raised early flags are being stripped away and the audit firm is flying with a shroud over its head.
The time is coming that investors will need to take back their companies. If we were following grandma's sage advice about an once of prevention, we would be heading in the right direction, but in our current climate we are applying the principle backwards. Today a pound of prevention is worth an once of cure. It is time to come back to core principles of holding people accountable. Investors need to hold their Boards accountable and Boards their managements. Outside auditors need to reevaluate what task they were hire to do and who they really serve. In the end, it will come down to governance. It will come down to investing in companies with quality managements. Boards and investors will need to discipline themselves to take a longer view and provide incentives accordingly. Regulation is simply flushing scarce resources down the drain, and as it always does in a free market, will destroy our ability to compete effectively.
Employee Communications
Our company is small, which means I have a couple of other titles beside CFO, such as Chief Computer Geek and Chief Guy in Charge of Human Resources. Early in my career with another company that was acquired by a large east coast corporation, I became Chief Guy in Charge of Talking to New York. How did I come to own these positions of authority? I guess I just don't know how to get out of the way. At least I don't have to clean the toilets (any more). So this week I have begun a new experiment in employee communications by creating a Blog that will serve as a running corporate newsletter. No printers! No deadlines! No searching for content! Just addressing issues and communicating ideas on my schedule as I see fit. The following is a sample of one of my first postings (the names have been changed to protect the guilty):
Inside Information
As I was driving to work yesterday, I was listening to the Business for Breakfast Show on Radio 1060 AM. During the Stock Talk segment of the show, one among us called the show to discuss our stock's performance. To this person's credit, they did identify themselves as an affiliate of the company when asked by the host, which I am sure changed the nature of the conversation. It actually turned into a nice commercial for the company's stock, but it does give me cause to remind everyone that you must be very careful about insider trading rules.
Everyone is subject to the company's insider trading policy, but you are also subject to various securities laws concerning inside information. I don't want to see anyone at this company become the next Martha Stewart. Whether it is conversations with radio shows, your personal stock broker, ex-employees or friends if you have not seen information you know about the company in a press release from the company, you should not share it. Over my career, I have seen ex-employees here and at other firms call their friends within the company to get an idea of how things were going at the company. In one case, the ex-employee had taken a job as a stock broker and was in a position to pass that information on to clients (sound like a case you have heard in the news this past year?). In a second case, the information from these casual conversations was showing up on a chat board on the company. As I read other company's message boards on sites such as Yahoo, I will quite often see insiders talking about their own company. Again, I am quite familiar with a case where the folks using the chat board were charged with a felony.
If you are not familiar with these laws, you may want to do some research to become familiar. If you have not read the company's insider trading policy in a long time you might want to reread it once in a while to stay familiar. The best policy, however, is to simply avoid detailed conversations about the company's performance or plans. I would simply hate to see any of us break into jail and take an unexpected all expenses paid vacation.
Has Buffet Taken His Eyes Off The Ball
I couldn't help but notice this morning that Berkshire Hathaway, led by the Oracle of Omaha himself Warren Buffet, has announced a ten percent decrease in profits for 2004. I don't normally follow Berkshire, but it seems odd that Mr. Buffet would sneak this little piece of bad news out on a Saturday morning. To be sure, the news was not all bad with profits for the fourth quarter up 40% and another big payday announced when Gillette was acquired. Yet, there are the investigations by the State of New York and the SEC to come. Warren has a knack for seeing opportunity where many of us don't, but he also seems to have a misplaced concern over how we compensate our employees and the way we run our businesses. Maybe this year in his shareholder letter he will look inward a little more, but I doubt it.
Sarbanes-Oxley - Can We Stand The Cost?
"You can't legislate intelligence and common sense into people"
Will Rogers
The stories keep rolling out on what to do for small companies (under $75mm market cap) that will come under the requirements of the internal control provisions of the Sarbanes-Oxley Act. Almost 700 companies self reported weaknesses last year before the first outside audit of controls was performed. The first reports with management and auditor reports on internal controls are due later this month although the smaller companies in this group ( $75MM - $750MM market cap) have been granted an extention of 45 days. Thus a number of Form 10-K's will be filed without these reports and amended later.
The SEC continues to mull over all types of actions. They have asked COSO, the group which drafted the framework for implementing internal controls back in the early 1990's, to rework their framework for smaller companies. Right now COSO is scheduled to meet in April with the hopes of of drafting a new framework by late summer. Some of the members of COSO are now talking about adding elements to the framework to dictate how companies will conduct their internal communications. So now not only will we totally eliminate all mistakes and fraud in the accounting process, but we will now perfect all communications in the workplace. The best part is this age old problem will be resolved in a mere five months.
The head of the SEC is now reportedly asking the Commision's staff to review the situation of implementation of internal control policies and propose an extention. What comfort should be taken from this. A small filer with a December 31, 2005 year-end needs to have their controls reviewed, implemented and staff trained by the end of June to have a chance of success in this process. This would leave the filer six months to start internal auditing, remediate weaknesses, implement changes and audit further. Why is the Commission waiting to pick a new deadline, when small filers needed an answer months ago?
While the SEC sits on its hands, the quality companies will have wasted time, effort and precious capital trying to reach a higher standard than what is attainable. Another problem is looming over the heads of our regulators. Last year almost 200 companies voluntarily delisted and took themselves out from under the requirements of Sarbanes - Oxley. They are basically refusing to comply. The real rush toward this movement is yet to come. As I attend the seminars and network with others like myself, I find there are many who have not started the work. Their companies simply do not intend to comply.
How does this fit in with the SEC's mission? Their whole existence is based on protecting the investors in public companies. The Commission failed investors in the 1990's. Our large public accounting firms failed us at the same time. The Finacial Accounting Standards Board worried about how to take stock options away from executives by trying to change the nature of equity to expense, while a small group of company's executives changed the nature of debt to revenue to enrich themselves. Did Congress investigate this group and their failures? Not really. We saw the parade of corrupt executives before Congressional Committees where nothing was said to protect the guilty. Then Congress passed legislation to punish the innocent in hopes of catching the few. They created a new bureaucracy to watchdog the public accounting industry, but our real culprit, Arthur Andersen, is long gone.
Where does this leave the SEC. They are enforcing a law that is taking billions of dollars out of corporate profits and investor's pockets every year. Their mission of reestablishing investor confidence, is being undermined by hundreds of companies reporting material weaknesses with probably thousands more to come. Small public companies who face compliance or being turned into perpetual money losing machines have their eyes on the exit. This is also true of the larger foreign companies that flocked to the US markets for cheaper capital. If they leave our markets, they can go back to the sane rules of their own local markets.
Will Congress self evaluate what they have done? Evaluate the costs and rewards? Will the SEC go back to the Congress and look for changes? Given the manner in which these people are currently acting, the damage will have to be done first. How many companies will have to close their doors, delist or report to the public that they just can't comply? How far does the market have to go down before a Congressperson looks at their own broker statement and asks how did this happen? My guess is it will need to be a deep drop before our Congress can look at itself and say, I made a mistake.
Note: Today, as expected, the SEC has announced that the implementation dates for non-accelerated filers to implement Section 404 Internal Control Proceedures has been extended by 12 months.
When The Gatekeeper Lies
It has always been my contention that the one of the keys to good investment decisions is to pick companies with good management. But, knowing good management isn't always easy as pointed out by this article from Reuters - Witness in WorldCom Trial Admits to Lies. Ex-CEO of Worldcom, Bernard Ebbers is currently on trial in New York for his part in the financial collapse of his former company. Mr. Ebbers is a former poster child of the great managers of the 1990's that led us to the stock market crash of 2000, 2001..... The CFO of Worldcom, Scott Sullivan, was also a darling of the financial press during this time. For the better part of last week, Mr. Sullivan who has already plead guilty to financial fraud, has been testifying against Mr. Ebbers. As the article chronicles, Mr Sullivan came under cross examination yesterday. Judging by this and other articles Mr. Sullivan lies. He loves to lie. And, there is no one he evidently won't lie to. He lied to the Board, shareholders, analysts, the press, the government and who knows who else. This brings us to the question we need to ask our selves as investors. If Mr. Sullivan were committing his crimes today, what law, or control system, regulation or agency would stop him. How much money and diligence would it take? If I gave you the books of Worldcom with its millions of entries, would you be able to pick out the few fraudulent entries? Remember this, their outside auditing firm didn't. And finally, remember that Mr. Sullivan would be the gatekeeper over all this sophisticated, expensive new internal control.
Can Politicians Stop Fraud - Part 1
When Enron, Worldcom, etc., etc. broke to the headlines our Congress undertook to stop corporate fraud dead in its tracks at enormous cost to investors. Laws have been enacted, regulations created, new bureaucracy created and the same large public accounting firms who couldn't catch this mess the first time are collecting the lion's share of the fees to watch over this. Should we believe that our investments are safe when we see headlines like this from the Associated Press - Elections - AP
Ex-Democratic Aide Admits Stealing Checks
This enterprising young man plead guilty to stealing $360,000 in campaign contribution checks from the Democratic Senatorial Campaign Committee. When politicians cannot safeguard their own money, how safe is yours?
Sarbanes - Oxley
Time to move on to a subject that is consuming the professional life of myself and others like me. The Feb. 10 edition of the Wall Street Journal ran an article that the head of the SEC, William Donaldson, was starting to moderate his position on certain reforms for public companies including the new internal control rules that evolved from the Sarbanes-Oxley Act. The article then went on to hardly mention this area, which points at two problems. As we near the first annual filing date for our largest corporations we are about to find out just how much trouble they are having meeting these rules, and secondly the Commission really does not know how to set these rules in terms of their cost and reward.
This problem may become the problem of all of us who invest heavily in stocks for our retirements. While the SEC has been making cheerleading statements for the past 6+ months on the state of these efforts raising investor expectations, the fact is that almost 700 companies have reported finding major weaknesses in their control systems through the end of the year. Is this the tip of the iceberg? As the these Annual Reports on Form 10-K, with their auditor and management reports on internal control, start to flow out in late March and through April we should focus our attention on the smaller companies involved in this reporting cycle. When we look at the reports of the accelerated filers ( greater than $75MM market capitalization), what I expect we will find is that as we get closer to the bottem end of the company size range the percentage of companies with reportable weakness will go up dramatically.
The truth is that we probably should not be that concerned. We cannot legislate away criminal behavior completely. Bad people will find ways to do bad things, and people under extreme financial pressure will sometimes turn to fraud and stealing in an effort to resolve their problems. The fact that the cookie jar is being watched through internal auditing will deter a certain percentage of those who might commit embezzelment and fraud, but the most commited and innovative will still find a way.
The second truth is that the internal contol efforts of Sarbanes-Oxley are more likely to focus in and deter the smaller frauds and embezzelments. In the major Enron and Worldcom type frauds, there was much colusion amoung officers and this is nearly impossible to stop. Much of the money defrauded came from investors outside the company and was the product of inflated stock prices. These types of massive stock frauds can only be perpetrated at the largest of companies. The smaller the company, the smaller the reward and economic damage.
The current average cost for compliance now exceeds $2,000,000 per company. If an experienced executive was deciciding the value of this insurance premium in relation to the potential for fraud, these amounts would probably never be paid. As we start to look at the results we have produce in our first efforts, it is time for Mr. Donaldson and the SEC to step up and show some leadership. It is time to slow this train down and evaluate what we have received for our time and money.
