suppliers – Escondido Framework

Should customers have come first in the GKN battle?

I don’t disagree with Michael Skapinker often, but his commentary on the successful bid by Melrose for GKN in today’s Financial Times “Customers should have come first in the GKN battle” had me getting out a metaphorical red ballpoint to mark his homework.

It was a shame. He made such a good start, rehearsing points that he has made well in the past about shareholder value:

Whose interests should companies serve? For decades, the answer, particularly in the US and the UK, was shareholders’. Total stock market return, the argument went, was clear and measurable and it kept managers focused — until Jack Welch, former General Electric boss and one of shareholder value’s greatest champions, denounced it as “the dumbest idea in the world”.

That was in 2009. Mr Welch was not the only business chief to notice that the financial crisis had shredded the idea that if companies looked after shareholders, everything else would follow. Josef Ackermann, then-head of Deutsche Bank, said: “I no longer believe in the market’s self-healing power.”

A little later in his article, I also awarded him marks for citing the late Sumantra Ghoshal of London Business for arguing in 2005 that:

the people whose contribution should be recognised first were employees, who also took the biggest risks;

shareholders could sell their shares far more easily than most employees could find another job;

and employees’ “contributions of knowledge, skills and entrepreneurship are typically more important than the contributions of capital by shareholders, a pure commodity that is perhaps in excess supply”.

Not content with citing Sumantra Ghoshal with approval, Skapinker moved on later in the article, in the context of the intervention by the Tom Williams, chief operating officer of Airbus’s commercial aircraft division, about the need for long-term investment and strategic vision in the aircraft industry, to cite “the great” Peter Drucker for saying that

the purpose of business was to create a customer. Without that customer, there are no jobs for workers, no returns for shareholders and no strategic skills for nations.

All good stuff, and essentially consistent with Escondido Framework thinking, but Skapinker and others who were unhappy at the outcome of the bid seem to have missed the point about what was happening.

During the takeover battle, much was made of the heritage of GKN, whose origins lay in the founding of the Dowlais Ironworks in the village of Dowlais, Merthyr Tydfil, Wales, by Thomas Lewis and Isaac Wilkinson ion 1759. John Guest (whose name survives in the “G” of GKN – formerly Guest Keen and Nettlefold) was appointed manager of the works in 1767, and in 1786, he was succeeded by his son, Thomas Guest, who formed the Dowlais Iron Company. However, the links to the multinational automotive and aerospace components company of 2018 are slight and accidental.

The company acquired by Melrose consists of four major divisions: GKN Aerospace (Aerostructures; Engine Products; Propulsion Systems); GKN Driveline (Driveshafts; Freight Services; Autostructures; Cylinder liners; Sheepbridge Stokes); GKN Land Systems Power Management; PowerTrain Systems & Services; Wheels and Structures; Stromag); and GKN Powder Metallurgy (Sinter Metals; Hoeganaes). This is a collection of businesses that is the outcome of over a hundred years of acquisitions and disposals across the globe¹. At least at the parent company level, there is little to suggest the opportunity for much value creation from them all being part of the same corporate entity.

What business was GKN plc in? The management of a portfolio of business units, primarily in manufacturing but some in services, spread across a range of different industries and technologies serving a variety of different types and classes of industrial customers, many but not all being OEMs.

Who were the customers of the corporate entity, as opposed to the subsidiaries (which are the entities that interface directly with the purchasers of goods and services, with their employees, and with suppliers)? Perhaps the subsidiaries themselves, insofar that they derived value from the parent company and investment funds, in return for cash returned to the parent? Perhaps the employees of the subsidiaries, at least in so far as they were beneficiaries of a corporately administered pension scheme (that, incidentally, Melrose committed to topping up with an extra £1 billion)?

Much has been made, including by Michael Skapinker in his article, of the 25% of the shares that were in the hands of hedge funds and other short term speculators who had only bought them very recently in the hope of a quick return. Presumably they bought these shares from owners who were willing to sell at a lower price against the possibility that the Melrose bid failed and the share price under the existing management team would fall.

Melrose’s argument during the takeover battle was essentially that it is a management team with a record of successful managing corporate assets who would replace a management team that has been destroying value in its management of the GKN portfolio. The commitments Melrose made along the way to the customers for the GKN subsidiaries’ goods and services and to their employers (in part evidenced by the promises relating to the pension scheme), suggest that they are not old fashioned asset strippers, selling off assets as part of strategy to wind down wealth creating business units. Rather, they appear to understand the business that the GKN plc is currently in, which is managing a portfolio of businesses, adding value to those where it can, and selling those to which other companies can add more value.

If this is indeed the approach that Melrose takes, it will reflect a mindset in which the board thinks about the businesses within the portfolio as customers for the corporate centre, recognising that if there are other corporations that can provide individual business units with a better deal, let them go. And that will make it easier to keep their customers in the capital markets, to whom they have spent the last few months marketing themselves, happy, loyal, and committed.

¹ Wikipedia history of GKN plc since 1966

Marketing, not just about consumers

At some point in the late 1990s, I wrote a short piece for Word on the Street, the Brackenbury Group’s client newsletter, which demonstrates one of the core propositions behind the Escondido Framework very clearly. The relationship between the organisation and all its “stakeholders” is at its heart a marketing relationship:

Marketing is too important to be left to the marketing department. Marketing departments address only the consumers of the products or services that a company sells to those it thinks of as its customers. But the truth is far wider than this.

Companies should apply the marketing way of thinking in all the markets in which they operate. This means not just the “downstream” market, but also to the “upstream” markets: funding, labour, bought in goods and services. The company is marketing an investment opportunity to its shareholders and debt providers. It is marketing careers and contracts to existing and prospective employees. It is providing opportunities to its suppliers with markets and channels to other markets.

The marketing mindset involves understanding the differing needs of differing customer segments, thinking about how to adapt your offer to meet the needs of your target customer and then doing it consistently, understanding the trade-offs they make between different attributes of the product or service you provide – of which price is only one dimension, determining where you can achieve an advantage over your competitors. It also includes what most non-marketing people understand as “marketing”, communicating these benefits to customers in ways that lead eventually to a profitable sale.

In most companies, marketing activity occurs sporadically in the functions that face “upstream”. Presentations are given to investors and financial PR consultancies are returned to put a positive gloss on results. Advertisements are placed, glossy brochures and upbeat web pages prepared, and roadshows taken round campuses to attract prospective recruits. Invtitations to tender and requirements lists are circulated, and subscriptions taken to web-exchanges as part of the sourcing process, whether for services, real estate, or components and real estate.

But in few companies does marketing explicitly underpin the way in which directors and managers in finance, HR, buying and purchasing, IT, property approach their responsibilities. They need to think about their “customers” in the same way that their downstream facing colleagues do about the people or businesses that are customers for the products and services the company sells. Applying tried and tested approaches from the downstream markets to the upstream markets to dealing with the financial markets will yield precious basis point reductions in the cost of capital and reduce paranoia about awkward investors or even takeover. In HR policy, it will reduce total employment costs – not just outlays on wages and salaries, or even improved retention, but also through enhanced productivity. And in purchasing it will translate into competitive advantage through lower total costs of supply, higher service and priority treatment.

A new way of looking at the firm

The Escondido Framework starts from the assumption that the company (in common with many other forms of organisation) is defined by its interfaces with the various market places in which it operates, in the simplest form the markets for labour, raw materials, capital and finished goods or services. These are, in effect, its boundaries. And while there are differences between markets, in essence they all reflect an exchange between two parties for mutual benefit – the employee receives payment and other non-financial rewards for his labour; the supplier of raw materials payment for the goods provided; the supplier of funds either interest or dividends and the prospect of capital growth for forgoing use of those funds for his own short term benefit; and the customer goods or services in exchange for payment. The Framework also reflects the view that being a party to the exchange does not of itself mean that the other party has a “stake” in the company or “own” it in any absolute sense. There may be a contractual relationship between the party and the company which reflects the terms of the exchange and provides structure for enforcement but essentially this is a mutually beneficial relationship in which both parties have duties to deliver their side of the bargain.

Within the Framework, there is no assumption that any of the providers to the company – of labour, raw materials, capital or revenue – any superior rights or claims over the company, in traditional parlance, “ownership”. Legal devices may be put in place by the state, or may exist in the form of contractual agreements that provide these other parties with rights, for example: in the form of wages and employment rights; to payment for goods at a particular point in time; to payment of interest or dividends; and to return of capital under prescribed terms and with differing degrees of confidence. The contracts and legal frameworks may also define mechanisms under which these other parties may enforce these rights, but enforcement is also be a function of other considerations that reflect market conditions rather than the law, for example: what alternatives are available to a workforce with a specific set of skills and ties to a particular geography; what other customers are available for the raw materials, and how much are they willing to pay; what will other prospective providers of capital pay for these shares or bonds, and how easily can we replace the existing board and executive team; and how often do customers in consumer markets consider, let alone read terms and conditions.

The Framework suggests that the company can be considered as a “virtual space”, existing between these market interfaces. The location and shape of each of the market interfaces reflects what economists think of as the demand function and marketing academics describe as indifference curves, i.e. how customers make trade-offs between the various attributes of a product. These are also shaped by the competition that the company faces: when recruiting from a limited pool of skilled employees; for sourcing scarce raw materials; seeking funding from a limited capital market, or seeking the custom of consumers who can buy from other companies or who may be able to substitute one item for other goods. Remove the competition and the market interface or boundary moves outwards, increasing the volume of the “virtual space” available to the company. Improve the operating efficiency within the company or secure a competitive advantage over other participants in one of the markets concerned and the volume of the “virtual space” will also increase.

At any particular point in time, for any particular product or service it sells, these interfaces will be brought together, or resolved, at a single virtual point at which of each of the providers is rewarded at prices that are, all things considered, satisfactory to them. In perfect market equilibrium, all prices would be at market clearing levels, no-one would realise economic rents, and there would one point at which the interfaces would be resolved. No self-respecting economist has ever viewed the perfect market paradigm as anything other than a useful benchmark for understanding a world which is dynamic and virtually always distant from the paradigm, and in this the Escondido Framework is no different. In reality, the “virtual space” is just that, an available set of points at which the price levels may be resolved. Depending on the scale of the external market failures that allow for the internal organisation of economic activity to generate greater efficiency, there is potential for the management of the company to elect where to set prices and where on the indifference curves to locate the marketing proposition to each of the other parties (suppliers or labour, raw material, capital and custom), and how to allocate the economic surplus that the absolute volume of the “virtual space” represents.