Wednesday, January 4, 2017

Corporate America's Failures and Why the Economy Isn't Growing

Gallup, known for its polling business, also has a blog on its website.  In a recent posting, Jim Clifton, the Chairman and CEO of Gallup discussed why Corporate America is failing.  Let's look at what he had to say:

"Companies are failing to grow organically. CEOs talk a big customer game and then go back to their offices, acquire their competitors and lower prices. 

Shockingly, boards of directors encourage this.

Acquisitions are the current growth strategy of Forbes Global 2000 companies. As a result, the number of publicly listed companies traded on U.S. exchanges has been cut in half in the past 20 years -- from about 7,300 to 3,700.

According to the World Bank, the number of listed companies on all global exchanges -- currently 44,000 -- has flatlined since 2006, with a recent two-year decline.

The herd is getting pretty small. At some point, this acquisition strategy hits a wall. It makes you wonder how long we'll need the New York Stock Exchange and Nasdaq.”

Here is a graphic from Bloomberg showing how the number of publicly listed companies in the United States has changed since 1975:

A 2015 paper by Craig Doidge, G. Andrew Karolyi and Rene M Stulz looks at what they term the "listing gap".  They note that the listings per capita has also fallen from 30 listings per million Americans in 1996 (when the number of U.S. listed companies peaked) to only 13 listings per million Americans in 2012, a decline of 56 percent.  Companies delist from stock exchanges for one of three reasons:

1.) as a result of a merger
2.) as a result of being forced to delist
3.) as a result of voluntarily delisting (i.e. going private)

The authors' analysis suggests that missing new listings explain 54 percent of the listing gap while delistings explain 46 percent of the listing gap.  From 1997 to 2012, the United States had 8327 delists in total of which 4957 were due to mergers.  If the U.S. merger rate over the period from 1997 to 2012 had been the same as the average from 1975 to 1996, the United States would have had 1655 fewer delistings.  Had the United States retained the same historical merger rate as in the years from 1975 to 1996 and the same number of delistings for cause, the United States would have gained back almost 45 percent of the listings it lost in the post-peak period.

A rising number of mergers appears to be the key to the issue.  Rather than innovate, companies expand their market share by getting rid of their competitors.  By getting rid of competition, they can raise prices on their existing product lines, with the ultimate hope of boosting their profits by eliminating their competitors.  Unfortunately, mergers tend to result in "corporate realignments", in other words, staff cuts, office and factory closures etcetera.  The biggest upside, however, is found in the small print in most annual reports.  Named Executive Officers generally have post-merger compensation packages that result in massive payouts of cash (generally multiples of their base salaries) as well as immediate vesting of stock options and performance benefits.

Let's look at an example.  Back on April 25, 2014, Microsoft acquired substantially all of Nokia Corporation's stock for a total purchase price of $9.442 billion as shown here:

At the time of the acquisition, Microsoft hired 25000 Nokia employees as part of its business plan.

Despite that, Microsoft declared the true value of the intangible assets that they acquired:

In Q4 2015, Microsoft recorded $7.5 billion worth of goodwill and asset impairment charges related to their Phone Hardware business (i.e. the Nokia acquisition).  In addition, they cut 788 jobs in an attempt to "refocus its phone efforts".  In May 2016, Microsoft gutted its phone business, laying off a further 1850 workers and writing down an additional $950 million.  In July 2016, Microsoft announced that it would cut an additional 2850 workers, mainly in its smartphone hardware business and global sales unit.  So much for that acquisition!

In November 2015, I posted at article on total factor productivity (TFP).  TFP is defined as... 

"…the portion of economic output that is not explained by the amount of inputs used in production.  As such, its level is determined by how efficiently and intensely inputs are used in production.  

In its simplest terms, total factor productivity can be thought of how technologically dynamic an economy is or the rate of technical change in an economy.  TFP plays a very important role in economic fluctuation and economic growth and is strongly correlated with output and hours worked.  A large portion of TFP growth is created by innovations that have significant implications for the business cycle.

Here is a graph showing how total factor productivity has grown on a year-over-year basis since 1990:

According to the Conference Board Total Economic Database, TFP in the United States is far below trends seen in the early 2000s:

Perhaps it is the lack of technological dynamics that has resulted in Corporate America choosing to merge rather than innovate.

Let's close with an addition quote from Jim Clifton’s blog posting:

"Gallup analytics find most companies can double their revenue by simply selling more to their existing customer base. There are tens of millions of dollars of lost growth opportunities in single customers, let alone hundreds of millions of dollars throughout your customer base.

Note to boards of directors: Rather than pay unrecoverably high prices for acquisitions, Gallup recommends that all our clients immediately implement a hardworking, authentic organic growth strategy -- one that requires a comparatively tiny investment."

Organic corporate growth is what contributes to a healthy and growing economy.  As we can see in the Microsoft - Nokia debacle, mergers and acquisitions create nothing and ultimately result in a shrinking contribution to the global and domestic economies.

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