Ted Black: Are successful turnarounds due only to brilliant CEO’s?

By Ted Black*

Recently, several “turnarounds” have been under the media spotlight. One of them is the good ship Omnia. Seelan Gobalsamy, took the helm in 2019. After scraping off expense barnacles and dumping heavy asset ballast, he and his crew have now caught a fair “sales” trade wind. The trimmed, asset lighter firm seems set on a north easterly course of better growth and returns. 

Yet, for a turnaround to succeed or fail, must the CEO be brilliant? 

From his mentor Benjamin Graham, Warren Buffett learnt it doesn’t pay to spend time with managers of firms you invest in. They tell you what they want you to hear. Also, their personalities may affect your judgment. He said: “When management with a reputation for brilliance tackles a business with a reputation for bad economics, it’s the reputation of the business that remains intact.” 

His wry comment takes us to his castle metaphor and the “moats” he seeks before investing – the ones that deliver economic returns. You build them by first choosing a market sector with big opportunity. Next, design the right business model to focus and concentrate its resources. Then, at operating level, secure your strategic position through productivity – a constant process of cost and quality improvement that removes waste in the system. 

Deep and wide moats help achieve the prime goal of all firms – to attract and keep well paying customers. It also means, if you think like an “Owner”, that the firm delivers an operating cash return that covers the after tax cost of equity. It’s an economic result like leaven in bread. It lifts a firm’s value. 

Few boards establish what that number is. This means there’s no demand made to the CEO and management team for a return on assets (ROAM) that achieves the economic goal an owner would expect.

So, what do Omnia’s numbers tell us so far? 

Typical turnarounds follow a few steps. The first one, started by GE’s “Neutron Jack” Welch back in the 1980s, affects people. It’s savage bloodletting – called “downsizing” in management speak. Today, there’s a lot of it going on in the tech world. Easy to do, it has a quick, short term impact on profit. Trading wolves on the “Street” love it. They bay for blood and then reward option loaded top management with a sharp rise in the share price even if the uptick in profit isn’t that great. 

In Omnia, there have been management changes – another turnaround step – but without deep cuts amongst people. However, trends below show the marked effect of lower expenses linked to improved sales:

ROAM is a financial, strategic marketing measure, not an accounting one. Everything links to sales. A Rand spent on COGS generated sales of R1,29 in 2019 and R1,27 last year. The trend is flat and like most manufacturing firms, it’s around 80% of sales. 

However, in 2019 where a Rand of OPEX  won sales of R4,53 by 2022 it grew to R6,82– a 50,5% increase. The overall result was a ROS of 7,4%.  That’s close to 2014’s 9% when a Rand of OPEX got R7,04 in sales. For the next five years after that, the OPEX spend rose by 74% and sales only 14%. The ROS margin plunged to zero.  

To have a sustained “lowest delivered cost” moat – the prime strategic goal for a manufacturing firm – the main focus must be on COGS, not OPEX. It’s always more than 80% of total costs and expenses.  

On the other side of the ROAM equation, there’s another a big cost caused by the asset base. It’s the capital cost per unit of product sold and it takes us to one more of Buffett’s pithy insights. 

Because most CEOs get to the top by excelling at marketing, production, engineering, admin, even corporate politics, they aren’t good at allocating capital. They seem unaware that the more asset intensive a firm becomes – declining sales per Rand of assets – the harder it is to make an economic return. 

Here is Omnia’s asset: sales productivity trend – Asset Turnover (ATO) – from 2014:

For six years in a row, management grew the asset base faster than sales. The prime ROAM asset productivity ratio (ATO) fell steadily from R1,54 per Rand of assets to R1,0 – a 36% drop. Buying two stand-alone companies was the main cause. You’re always likely to pay too much for them.

The segment information in annual reports refers to “Net Controllable Assets”. In 2020, they were R12,4 billion when total assets were R18 billion. Someone on the board might well have asked, “who’s responsible for the productivity of the balance of R5,6 billion?” 

R2,6 billion of it was “Goodwill” – the premium paid for the two companies. When looking at target firms, you would expect robust debate at board level prompted by another question to management like: “How will you make a return that’s high enough to pay the economic costs of all the ‘Goodwill’ you want us to pay?” 

Judging by many boards, you can lay a safe bet the issue wasn’t raised. Or, if it were, did anyone truly grasp what it would mean? Didn’t they see that if you pay too much, you transform a high return business into a low return one? Especially if you measure them only on “Net Controllable Assets”?  

Given some of the heavyweights amongst Omnia’s directors you would think so. There was probably much more debate on how to pay for them than how to avoid the value destruction that could follow.

The skill in allocating capital applies at the task level too. But it’s much more than “controlling” working capital. You want operating people, the ones who build the moats and where the seeds of strategy are sown, to see and get rid of “waste” in the system. It takes us to the most fundamental asset productivity measure of all – the Cash-to-Cash Cycle . This is the time it takes from paying to being paid. The aim is to reduce it. To “Spin the wheel”!

The effects on COGS start from the time marketing and sales decide what products they want to sell. Often it isn’t what customers really need. The things that go wrong – the “Snafus” – start there. The further they go through the system, the more the complexity, the bigger the costs. 

Most ‘Snafus” occur with communication breakdowns at overlap points between functions and people. They cause rework, rejects, making too much product, waiting and other non-value added activity. 

Inventory, or stock, is the big one but this chart shows how Omnia has speeded up the cycle over the last four years:

The half-year results show a big investment in stock, but for good reason – to exploit a big, short-term sales opportunity and a good allocation of capital at the task level.

Finally, the last chart shows the clear link between ROAM achieved and market value of the firm as a multiple of owners’ equity.

The link with ROAM is clear. If Gobalsamy and his team keep on this course they’ll soon reach a ROAM result high enough to achieve an economic profit – the true measure of their ability. Omnia used to achieve it before management started winding down its critical productivity ratio – ATO.

The aim now should be to set course for an ATO of 2,0 and the sails will really fill.

So, in the end, must the CEO be brilliant? 

No, but effective in Peter Drucker’s terms?

Definitely yes!

But if a firm has no moats, or the ship isn’t seaworthy, depending on which metaphor you prefer, CEO effectiveness isn’t as important as we might think. That will be the problem with other contenders for rescue we can look at.

1 What Makes an Effective Executive by Peter Drucker – HBR – June 2004

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*Ted Black has held senior positions in organization development, general management and been a director of companies. He is the author of the best seller “Who Moved My Share Price?” co-authored with Professor Andy Andrews.

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