Mini Case I and II

 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.