This material is taken from Harvard Business Review
PART I.
The
Case of CPC International.
In the summer of 1986,
financial analysts began to speculate that CPC International, a leading
manufacturer of food products in the United States and abroad, was ripe for
major restructuring. In the early fall, the tone and content of the speculation
changed as investor discontent grew, and word on the street was that CPC was
being considered for a takeover by Con-Agra, Revlon, or an inside management
group. These rumors turned into reality in October, when an investment group
headed by Ronald O. Perelman attempted an unsolicited takeover. Could this
outside intervention have been avoided? Quite possibly, if the board had had a
formal strategic-review process in place. It is just such an event that a
strategic audit is designed to avoid. It is helpful to review the events in the
CPC case leading up to the Perelman raid to see how a review process might have
worked.
If CPC had had a strategic review process in place before
the downturn, past performance would have signaled trouble.
Corn Products was founded
in 1906 with the development of a wet-milling process to refine corn
by-products—corn starch, syrup, and oil—for both consumer and industrial use.
In 1958, it merged with Best Foods, which was a grocery products company with
well-known brands. At the time of the merger, however, the company was
dominated by the wet-milling division, which was in a capital-intensive,
high-volume, low-margin industry subject to periodic bouts of competitive
overbuilding. The intent of combining the two businesses—later renamed CPC
International—was to diversify the product line and enhance opportunities for
growth and profitability in consumer products.
Beginning around 1980,
the profitability of corn refining underwent serious, steady erosion because of
overcapacity in the industry, and a widening gap developed between the
performance of the corn byproducts and that of consumer foods. For example, in
1977, the return on assets (ROA) in consumer products was 24.4% and in
corn refining, 12.6%; but by 1983, the ROA in consumer foods was 25.5% and
in corn refining, only 6.6%.
Despite these data,
management remained committed to its traditional revenue base in corn refining
and to a long-term strategy based on the expectation of improving competitive
performance in that industry. And management made no attempt to conceal from
shareholders the effect its strategy was having on performance. Indeed, over an
18-year period beginning in 1974, CPC consistently used its annual report to
present comparative data on the components of its corporate return on equity.
Furthermore, the data were presented for the current year and the four
preceding years in an identical format each time. It is rare for a public
corporation to maintain such consistency and even more unusual for it to keep
reporting the drivers of equity value over such a turbulent period in its
history.
Although the actual
disparity in performance between corn refining and consumer products was
difficult to observe early on, it was impossible to conceal during the period
from 1983 to 1985, when there was a short-term decline in the profitability of
the consumer foods line. As the data reveal, CPC reported a dramatic decline in
the corporate return on equity from 18.5% to 10.5%, turning a public
spotlight on the milling operations’ persistent drag on earnings. (See the
exhibit “The Strategic Audit Report Card for CPC 1977–1989.”) Capital market
analysts and the financial press began to suggest that CPC should divest all or
part of the milling business and release the full market value of the Best
Foods product line to investors.
If a Strategic Audit
Process Had Been in Place Before 1985, CPC s Board Might Have Preempted the
1986 Takeover Attempt. Through 1985, lower margins in corn wet-milling
contributed to a declining corporate profit margin. Reduced leverage and the
declining turnover of assets exaggerated the erosion in return on owners’
investment (ROI). After 1985, and subsequent to restructuring, corporate
margins improved, largely because of the increased emphasis on higher-margin,
branded consumer products. CPC saw a dramatic and immediate gain in ROI in
1987, with continued improvement in asset turnover and use of leverage.
There is no record of
what went on in the CPC boardroom at the time of this unfavorable public
attention. We do not know whether any of the board members challenged the
wisdom of the strategy in place, although the speed of management’s response to
subsequent events suggests that either the board or management—or both—had
previously analyzed and debated alternatives to the strategy. Certainly the
board could not plead that it lacked objective historical evidence on the
inherent weaknesses of the business. The takeover attempt by Perelman occurred
two years into the tenure of new CEO James Eiszner and forced his hand. He
mounted a vigorous and successful defense, implementing many of the changes
advocated by outside critics, including the divestiture of CPC’s substantial
corn wet-milling division in Europe.
The outcome of the
restructuring was immediately apparent in CPC’s financial performance in 1987
and was reflected in rising market values for CPC stock as well. However, the
costs of restructuring under the guns of a battle for control were substantial.
In addition to the legal costs, there were the costs of negotiations conducted
in haste and from a position of weakness—namely, the sale of underpriced assets
and the repurchase of over-priced stock. And there was a management team
preoccupied with staying in office rather than doing the job it was hired to
do.
So CPC’s turnaround was
dramatic and positive, but the costs of lost time and opportunities were high.
This much we know. I suggest we can also be sure of another thing. If a formal
board-level strategic-review process had been well established before the
downturn between 1983 and 1985, periodic discussions about strategic direction
between the board and management would have centered not on optimistic promises
for the future but on the pessimistic realities of past performance. Set
against the backdrop of public debate and investor discontent over the
strategy, these discussions could well have resulted in a less costly and
painful readjustment of the company’s strategic path.
PART
II. The Board’s Unique Perspective
There will be some who
resist the idea of another strategic-review process on top of management’s
existing annual reviews and reports. They will say, Isn’t this overkill?
Shouldn’t review be a joint effort with management? Isn’t management best
qualified to select the appropriate criteria to evaluate the company’s progress
within its industry?
The answer to all these
questions is no. Management and the board have unique and distinct perspectives
on strategy. Managers are charged with turning strategic vision into
operational reality. Of necessity, they must focus on one strategic path at a
time and pursue it relentlessly to maximize its potential for corporate
profitability. If managers equivocate, they default on their obligations to
employees and shareholders alike, eroding much-needed morale and commitment. In
this context, the best standard of performance by which to motivate the
organization is a relative one—to ask how the company is performing relative to
previous strategies, relative to the results of last quarter or last year,
relative to the best competitors in the same product markets. But performance
evaluation designed to motivate the people in an organization is not intended
to challenge the chosen path.
The board’s mandate in
strategic oversight is distinctly different. Its responsibility is to represent
the perspective of investors and question the strategic path itself. The
board’s evaluation of the validity of the existing strategy mustn’t be based
simply on the performance of the company relative to itself, its industry, or
its past performance, but rather on comparisons between returns derived from
the current strategy and those possible from other strategies. Management may
think it’s dealing with disloyal boards at times, but from directors’
perspective, they are the “loyal opposition.”
Although the two
perspectives converge when board and managers are developing strategy,
management’s role in executing the strategy precludes it from
also objectively evaluating the strategic path once it is in place. The
strategic audit, therefore, must be directed by independent board members
rather than by management insiders. And the board—not management—should select
the key criteria to monitor strategic results.
