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Chapter 01: Appendix 1.

3:
Analyzing Satisfactory Underperformance of Corporations
Ozzie Mascarenhas SJ
Sumantra Ghoshal coined the phrase satisfactory underperformance to assess mediocre profitability
goals of certain companies in India (Ghoshal, Piramal and Bartlett 2002: 6-16). For instance, a company
may enjoy high net profits for quite a few years, and may believe that it is doing well, while all the while
it may be destroying its net value. This is a false belief that business-as-usual incrementalism (Ghoshal
et al. 2002: 15) is good and acceptable.
For example, Company XYZ recorded $100 million net profits in 2002, $120 million in 2003, $144
million in 2004, and $172.8 million in 2005. That is, XYZs profits were growing 20% each year, and
you may consider this as satisfactory performance. Indeed, this is lot of money, but it is satisfactory
underperformance. Established companies, like Company XYZ, continue to reap profits because of
established resources they have had such as a large customer base, their loyalty, strong brand equity, a
good and ubiquitous distribution network, and the like. All these resources would have been built by
earlier generation of managers, while the incumbent management is taking credit for them and for all the
returns they generate. The one question all management must face each year or even each strategic period
is: Are adding value to the company? Or, related to this, What are we doing to add value to the
organization?
A deeper analysis of XYZs profit returns indicates a diminishing added value. The same companys
balance sheet indicated that it had equity of $1,600 million in 2002, and $2,000M, $2,700M, and
$3,600M for the years 2003, 2004 and 2005 respectively. Similarly its debt structure was $800M,
$1,000M, $1,350M and $1,800M for each of the years 2002-2005, respectively. Thus, the profit figure
was a pathetic 6.25% of equity (ROE) in 2002, 6.00% of equity in 2003, 5.33% in 2004, and 4.8% in
2005. This is gross underperformance when the same company borrowed capital at 10% in 2002, 10.5%
in 2003, 11% in 2004 and 11.5% in 2004. At these rates of cost of capital, the company was increasingly
destroying value each year since 2002: 3.75% in 2002, 4.5% in 2003, 5.44% in 2004, and 6.7% in 2005.
Worse, these profit margins were worse than practically all risk-free bank returns during 2002-2005.
The results are captured by Table A 1.3: 1.1. Hence, we need to calculate value destructions based on
a) cost of capital, b) on risk-free-return (RFR), and c) on both cost of capital and RFR. Exhibit I shows
the ghastly figures of progressive value destruction from 2-2 to 2005. The last row indicates the
combined value destruction totals all the net profits increasing by 20% each year are increasingly
destroyed such than by 2005, the total net profits when adjusted for all value destructions was a net loss
of $49.5 million. Moreover, smart investors quickly perceived the value-destruction process, and hence
underinvested in the companys stock, and eventually, stock price began to depress, negatively affecting
market capitalization, ROI, EPS, and P/E.
Further, when the same company benchmarked its performance with the industry captain or major
competitor in the India, USA, UK and Japan respectively, for the same years 2002-2005 and along the
same ratios, their underperformance was even more pronounced and glaring. Little wonder, company
XYZ faced near bankruptcy in 2006.
Further, the satisfactory underperformance soon became distressing underperformance when one
considers subsets of ROA (return on assets) measured by return on capital employed (ROCE), return on
invest capital (ROIC), return on net assets (RONA), return on business assets (ROBA), and the like

specific ratios of ROA. Lastly, profitability should be assessed against weighted average cost of capital
(WACC).
ROI is a variation of ROA (return on assets), where the term investment (I) refers to either the firms
total assets or a subset of its assets. ROI is calculated as earnings before interest and taxes (EBIT)
divided by total assets ([EBIT/TA] = ROA), or divided by net assets ([EBIT/NA] = RONA or return on
net assets), or divided by invested capital ([EBIT/IC] = ROIC or return on invested capital). Net assets
are the same as invested capital. The latter is defined as cash + working capital requirement + net fixed
assets. Working capital requirement (WCR) is a measure of the firms net investment in its operating
cycle, and is calculated as operating assets (e.g., receivables, inventories, and prepaid expenses) minus
operating liabilities (payables, accrued expenses). Net fixed assets or non-current assets are fixed assets
(e.g., gross value of property, plant and equipment, building) minus accumulated depreciation.
Obviously, since invested capital is the same as net assets, ROIC is equal to RONA, and both are called
operating profitability ratios.
Other ratios of operating profitability are also meaningful. For instance, according to the managerial
balance sheet, net assets or invested capital (= cash + WCR + net fixed assets) is the same as total capital
employed, that is sum of all the sources of capital used to finance net assets (= short term debt + longterm debt + owners equity). Thus, ROIC = RONA = ROCE (return on capital employed).
If you want to evaluate the performance of a business unit that has no control over its cash or over the
interest income, then a variation of ROIC excludes cash from invested capital and excludes interest from
EBIT. This measure of operating profitability is called return on business assets (ROBA). A parallel
measure of operating profitability is ROTA or return on total assets. ROTA = EBIT/total assets (as
reported by a standard balance sheet). ROTA, however, is different from ROA. ROA is EAT/total assets.
Thus, ROIC, RONA and ROCE are more general operating profitability ratios while ROTA and ROBA
are more specific operating profitability ratios. Moreover, since all five operating profitability ratios are
variations of ROI or ROA, we use ROI as the measure of performance/underperformance here, given that
we have already reckoned ROA under criteria 13-14. When company data is available from balance sheet
and income and loss statements, then one could investigate performance/underperformance in relation to
more detailed operating profitability ratios such as ROIC, RONA, ROCE, ROBA and ROTA.

References
Ghoshal, Sumantra, Gita Piramal, and Christopher A. Bartlett (2002), Managing Radical Change: What Indian
Companies must Do to Become World-Class, Penguin Books.

Table A 1. 3: 1.1: Analysis of Company XYZs Satisfactory


Underperformance
Performance Variable

Fiscal
Year 2002

Fiscal
Year 2003

100

120

144.0

172.8

20%

20%

20%

1,600

2,000

2,700

3,600

800

1,000

1,350

1,800

6.25%

6.00%

5.33%

4.8%

10%

10.5%

11.0%

11.5%

3.75%

4.50%

5.67%

6.70%

Value Destruction as $M:


(Cost of Capital - ROE)*Debt

30

45

76.55

120.6

Net Profits after adjusting for Value


Destruction based on Cost of Capital
($M)
Risk-free returns (RFR):
(FDIC or Banks)

70

75

67.45

52.20

7.00%

8.00%

8.50%

8.75%

0.75%

2.00%

3.17%

3.95%

Value Destruction as $M:


(RFR-ROE)*Debt

6.00

20.00

42.80

71.10

Net Profits after adjusting for Value


Destruction based on Risk Free
Return ($M)
Net Profits after adjusting for value
destruction based on both cost of
capital and RFR ($M)

94.00

100.00

101.20

101.70

100 - 30 - 6 =
64.00

120 - 45 - 20 =
55.00

144 -76.55
-42.8 = 24.70

172.8 - 120.6
-71.10 =
- 49.50

Net Profits ($Million)


Annual Growth in Profits
Total Equity ($M)
Total Debt ($M)
Return on Equity (ROE)
Cost of Capital (Interest Rate)
Value Destruction as %:
(Cost of Capital ROE)

Value Destruction against Risk-Free


Returns as %: (RFR-ROE)

Fiscal
Fiscal Year
Year 2004
2005

Business Executive Exercises on Measuring Satisfactory Underperformance


1.

Motorola almost bankrupted in 1985: its profitability collapsed from 6.3% to 1.3%, a drop of sheer 80%.
Japanese competition had forced Motorola out of the DRAM business. It slipped from the 2 nd to the 5th
position as a supplier of semiconductors and was considering a merger of its semiconductor operations with
Toshiba. Even in the pagers and cell-phone businesses, the Japanese companies were forging ahead in the
battle of miniaturization and featurization. By 1988, however, Motorola turned around completely.
Profitability rose to 5.3% and Motorola demonstrated clear leadership in the pager and cellular phone
businesses. Motorola was back in the DRAM business. It emerged as a major supplier of semiconductor
products to the most demanding customers of the world. Analyze what happened to Motorola within 19851988? For instance if Motorola did the following:
a)
b)
c)
d)
e)
f)

How and when did Motorola get back into the DRAM business?
How and when did it re-establish leadership in the pager and the cellular phone businesses?
How and what innovative and price competitive products did it generate during 1985-1988?
How and when did it regain position as a major supplier of semiconductor products?
How did it shorten development time for its new products during 1985-1988 from 3 years to 1.8 years?
What design improvements did it initiate such that the average number of parts per product dropped
from 3400 to 630?
g) How did it cut the order-to-shipment period from thirty to three days during 1985-1988?
h) How did it drastically reduce product defects per million from 3000 to 200 during 1985-1988?
i) What other strategy did it adopt to emerge victorious within three years in a very competitive world?
2.

Industry determinism is one of the most devastating managerial beliefs. Yet imaginative, creative and
innovative companies thrive despite industry stagnancy, turbulent markets, and economic chaos (Collins
and Hansen 2011). To prove this point do the following:
a)

b)
c)
d)
e)
f)
g)
h)
i)

j)
k)
l)

On the X-axis, at equal space intervals, list some of the major industries, such as airlines, automobiles,
petroleum, semiconductors, banking, telecommunication, tobacco, etc., and find out the average
profitability of these industries for a consecutive five-year period, say 2004-2009 (e.g., Use CRISIL
database for such data), and plot these numbers on the vertical Y-axis.
Note and explain high-profitability industries versus low profitability (stagnant) industries.
Next, for the same industries and the same five-year span, study other performance measures such as
EPS, P/E ratio, or shareholder value creation. Compare the high and lows under (c) to those under (b).
Technically, the same highs and lows will emerge.
Next, check the figures of (b) and (c) for the best performing company in each industry, and plot these
numbers on the Y-axis. [For such data, use Capital-Line database in our library].
Study the plot: are the ups and down much smaller and why?
This plot will not parallel average industry profitability: why?
The performance of the best performers in different industries or businesses will be a lot similar than
the average performance of those businesses why?
Even in stagnant industries, there will be individual companies that do very well, almost as well as the
best performing companies in any business why?
Study their imaginative, creative, designful and innovative activities as indicated by 1) the number of
new patents they have owned during the same period 2004-2009, 2) by the number of new products
and services they have generated as brand new market offerings, 3) by the number of new markets (by
cities, states, countries, regions and continents) they have entered during the same time period, and 4)
by their market capitalization and Tobins Q values.
Which companies are around the industry averages or below, and why?
Which companies are successful outliers during the same period, and why?
Study the mindsets of companies that thrive under (k): they deliberately chose not to be with industry
averages but to excel all others by benchmarking not against the average and the comparable, but
against the best outliers.

3.

Following the argument and findings under (2), especially (k) and (l), study the following successful
outliers using various databases or media sources:
a)

Ispat International N. V. (registered in Holland and headquartered in England, UK) under the
leadership of founder and CEO, Lakshmi Niwas Mittal, still thriving amid the ruins of the stagnant
steel industry.
b) Richardson Sheffield in England, the source of the worlds best cutlery today, still a great outlier
leading the upper end of the cutlery market through their superb workmanship and quality, even though
the industry nearly collapsed owing to tough competition from Hong Kong during the last two or three
decades, and other low-cost-high-quality Asian producers.
c) Hastings Jute Mills in India: this company has surged forward along the Grand Trunk Road starting
from Calcutta that is still exhibiting the corpses of once thriving jute mills, and under the leadership of
Kajaria Brothers, owners of Hastings Mills since 1994.
4.

Outstanding performance can be achieved even when competitors are much bigger and stronger, argue
Ghoshal, Piramal and Bartlett (2000: 18-19). In this context study the outstanding performance of much
smaller companies that came from behind to surpass or nearly equal the global industry captain:
a)

Komatsu of Japan stalking world giant International Caterpillar in the heavy earth mover and road and
building construction industry.
b) Canon, the little camera company of Japan, jumped into the Xeroxing business in the late 1960s, and
today is pioneering the camera and copier industry amid great giants such as Xerox, Kodak, 3M,
Nashua and Smith Corona.
c) Zee TV is still successfully combating against the industry Goliaths of Rupert Murdoch and his Star
TV, and Doordarshan in India.
5.

Radical performance improvement is possible even when you are already very successful, contend
Ghoshal, Piramal and Bartlett (2000: 20-22). If this is true, then the study the outstanding radical
performance of great global industry leaders such as:
a)

General Electric over the last 30 years, under the determined leadership of legendary CEO Jack Welch
during yester years, who transformed GEs already successful business portfolio, organization, culture
and behavior. Jack Welch succeeded Reginald Jones in April 1981 as CEO and chairman of GE, and
Jones had already doubled GEs sales and tripled its profits during his tenure as CEO and chairman of
GE.
b) Hindustan Lever in India has been a perennially successful company in FMCG. Sushim Dutta
inherited a very successful company from the legendary Ashok Ganguly, and changed the company
fundamentally by merging tea gardens, the food and beverage businesses of Brooke Bond and Lipton,
food business of Kissan, and other detergent units such as Tomco into its big detergent operations, to
create an integrated Unilever Group of companies. Duttas successor, Keki Dadiseth, also
revolutionized Hindustan Lever to catapult its size to over $10 billion in sales, and ignited
entrepreneurial spark plugs in the middle ranks of the company.
6.

In view if Business Executive Exercises 1-5, do the following:


a)

Study great Indian companies of today such as Maruti Udyog, Hero Honda, Bajaj Auto, ICICI,
HDFC, Tata Group, Infosys, Wipro, Reliance, Thermax, Hindustan Lever, Bharat Forge, Zee
Telefilms, and the like.
b) Pair and study these Indian giants against corresponding global giants such as Toyota, Honda,
Matsushita, NEC, General Electric, Unilever, Philips, IBM, Microsoft, Intel, Procter & Gamble
(P&G), Star TV, and so on.
c) Redo exercise (2) on each pair.
d) Outstanding performance can be achieved even when competitors are much bigger and stronger.
Demonstrate this in relation each pair you have chosen.
e) Radical performance improvement is possible even when you are already very successful. Prove
this proposition in the pair of companies you have selected for investigation.

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