Steinhoff’s downfall: Ignoring strategic principles and the perils of asset intensity – Ted Black

In this article, Ted Black discusses the downfall of Steinhoff, highlighting the importance of measuring the right strategic principles to avoid such failures. Black argues that managers find it hard to face up to the challenges that come with high asset intensity by adding more capacity and reducing costs. However, these decisions are often made with great optimism and not enough caution, leading to the compounding of the problem. Black’s article illustrates this with the example of Steinhoff, where the asset base grew at an average of 35% a year from 2000 to 2016, with 50% of it being intangible by the end. Black concludes by emphasizing that measuring and rewarding CEOs and top management using the company’s share price makes no sense, as 80% of the value is established by people who might as well be throwing darts or mud at the wall to see what sticks. Ultimately, the Steinhoff board didn’t measure the right things and trusted the wrong person, leading to the company’s downfall. Read the article below.

Live and don’t Learn … That’s us!

By Ted Black

With any “turnaround” firm, the news that sent its capital market value plunging over the cliff probably shocked the directors. We can safely assume they ticked all King Code boxes but were they doing their real job for shareholders –  linking management’s strategy to results? Maybe not if they had blind trust in the CEO.

Four strategic principles to measure are:

  • Quality of product and service. A customer focus is the most important one for profit and long term growth.
  • High market share where you choose to compete is likely to give you better returns.
  • High asset intensity is a strong drag on profitability – also affected by,
  • Vertical integration – a major cause of it. It can pay to move into customer or supplier value chains but often not. The gain rarely pays for the assets you buy.

Managers find it hard to face up to the troubles high asset intensity brings. They don’t lift it on purpose, but they cause it. To grow sales and reduce costs, they add capacity with: new plant; mechanise production; give customers longer credit terms; expand product lines and hold more inventory. All done with great optimism, not enough caution.

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Acquisition decisions for growth taken at board level compound the problem. Look at Steinhoff over time:

Strategic principles

With a climbing operating profit margin from 2011 (ROS%), the correlation between market cap and asset growth is near perfect. 

Nice work if your pay package links to share price and size, not asset productivity – management’s prime task.

With growth through acquisition, you pay too much and end up with a pile of  intangible, “financial” assets.

Shouldn’t shareholders expect a return on them?

But who takes responsibility for their productivity?

Operating managers don’t. They “own” only the tangible assets.

From 2000 to 2016 Marcus Jooste grew the asset base at an average of 35% a year. By then, 50% of it was intangible. The Mattress Firm deal is a typical case. He paid US$3,8 billion for US$1,6 billion assets of which US$1 billion were already intangible. 

This is the impact of deals like that on the asset intensity curve:

Asset intensity

“So what?” is a typical response. Well, as a manager or director, if you were to put yourself into a shareholder’s shoes, what return would you expect for your cash? Given other opportunities for it, a 20% return is realistic.  Couple that to interest charges, and over the 15-year period it works out at a 10% cost of assets.

To make board and management realise what asset intensity means, put that charge onto the income statement before interest and tax. Once you go above 100% asset intensity, returns fall sharply, borrowings rise, and you’re likely to show a loss before tax as this chart shows:

A perfect negative correlation of -1,0!

You may think 20% is too high an expectation for equity. Well, apply that same 10% cost to Shoprite and how do the firms compare?

The message sent should get everyone’s attention. Then, take things further and look at economic profit – mine isn’t the purist’s calculation but simply Cash Profit after tax before dividends, less the 20% charge for equity.

In time the value destruction curve becomes unstoppable. However you choose to calculate economic profit/loss, it was a big number by 2015 and an even bigger one today. Yet the Steinhoff board was caught by surprise, as were the capital markets. There’s a reason for that.

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In 2012, a Spectator article described an interview with Nobel prize winner Daniel Kahnemann on the irrational behaviour of our financial system and the difficulty of fixing it. He said that economists make rationality the focus of their work.  Their mathematical proofs of market efficiency depend on the belief that we make rational choices.

However, after many careful experiments on hundreds of people, he and his late colleague Amos Tversky showed it isn’t true. In many cases we can be relied on not to do what will most effectively benefit us. We are not reliably rational. “This not because we’re too moral or too nice to be selfish,” he says. “It’s because we’re too stupid. We all tend to be wildly over-optimistic … we continue to make the mistakes even when they’re pointed out to us … it’s the way we are!”

He was once asked to help a finance firm design a bonus scheme to reward those best at investing – picking shares that performed best and made most money for investors. He studied eight years of data for each fund manager and found, over that time, not one had better results than would have been achieved by chance. He concluded you’d do just as well, sometimes better, if you chose to invest by rolling dice or tossing a coin.

It’s the reason why measuring and rewarding CEOs and top management using the share price makes no sense. 80% of the value is established by people who might as well be throwing darts or mud at the wall to see what sticks! They certainly didn’t see what was coming at Steinhoff.

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Back to Kahnemann – he said that arguments presented with evidence, numbers, tables and so on don’t convince people. Reading or hearing conclusions from people they trust convinces them. You trust someone and believe them. 

The Steinhoff board certainly believed and trusted Jooste. The trust was misplaced. They didn’t measure the right things and showed yet again that asset intensity, sooner or later unless you correct it, will upset the applecart …

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

*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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