Turning around a State-Owned Enterprise (SOE) which is a significant contributor to the national economy would be like fixing an airplane’s engine in mid-flight: the conventional rules do not apply since the risks are so high. However, SOEs on a growth-drive could use targeted acquisitions to enable their turnaround. Read on to discover the ten best-practice ideas for doing so.
In November 2008, thousands of Chilean workers went on a national strike demanding higher salaries. Many more protested across schools and universities. The paralysing strikes caused a national shutdown of essential government services such as hospitals, schools and sanitation. Even though the government eventually raised salaries, Chile’s reserve fund, a rainy-day fund equal to approximately a third of the national GDP, remained largely untouched.
Chile’s Minister of Finance at that time, Andrés Velasco, was the architect of those tough austerity measures and faced the wrath of the protesters. In several instances, protesters burnt effigies of the minister. Although worried government officials pressed the minister to release more cash, he refused. When the finance minister had taken office in March 2006, Chile had approximately US$5.9 billion dollars in treasury holdings. Fuelled by surging copper prices, the minister was able to increase those reserves to US$48.6 billion during a 3-year copper boom – an eight-fold increase. The majority of this increase came from state-owned copper miner Codelco, whose profit contribution, in the form of taxes and dividends, provides approximately 13 percent of government revenues. The minister’s frugality enabled Chile to generate its largest budget surpluses in recent memory and the country became the only net creditor Latin American country. Eschewing extravagant expenditures, funds were invested abroad, mostly in government bonds, and the yield was used to increase educational funding and extend social security.
Therefore, when the global economy went into recession, Chile was on a side of economic history unfamiliar to most Latin American countries. It had cash and did not need to seek a bailout or cut back state aid. The treasury holdings were used to help smooth potentially wrenching cut-backs in salaries and benefits. The government was widely praised for using the fund to provide tax cuts, subsidies, federal bailouts and cash handouts to poor families during the recession.
As the prudent fiscal policy of stashing-and-cashing helped Chile ride out the recession, the markets responded favourably. Chile’s main stock index, the Ipsa, was one of the best-performing emerging markets indices and the Chilean peso rallied against the U.S. dollar to become a top-performing emerging markets currency. In a change from the effigy burning, the minister was lauded for his achievements. Heralded as the man who single-handedly tamed the commodities cycle, his approval ratings almost doubled within six months and he was recognised as Latin American Finance Minister of the Year. He left Chilean politics as one of its most popular leaders.
The effectiveness of Chile’s expenditure strategy is beyond doubt. Many Chileans benefited from the prudent planning and execution. However, the Chilean government may have erred strategically in its accumulation plan to create its vast treasury holdings. To amass its rainy-day fund, it removed profits Codelco desperately needed to improve the company’s competitiveness and production capacity. Critics have long argued that the practice has hurt Codelco and the company should have more retained earnings to fund its capital investments. The argument, however, is only one half of the story and, by constantly citing the need for more capital, ignores the root cause of Codelco’s problems.
Codelco is an inefficient state entity generating a far lower return-on-invested-capital than its copper-mining peers. It is more important for the government to first transform Codelco into an efficient mining company before significant new capital developments can be undertaken. Undertaking capital programs without addressing the productivity issues will lead to increases in revenue but will not lead to the maximum possible return on invested capital, the key driver of value. To understand the transformation challenge ahead, Chile’s past attempts at reform must be understood.
Formed in 1976, Codelco was, and remains, the single largest contributor to the Chilean treasury. It is world-renowned for its safety, generous pay packages and automated mines that feature state-of-the-art mining technologies with well-constructed tunnels, effectively ventilated shafts, well-sign-posted corridors and every conceivable amenity needed to run the facilities. Yet, the surging copper price, which swelled Codelco’s contribution to the treasury reserves and helped Chile during the recession, masked underlying structural problems at the company, which the government has not fixed.
Over the last 15 years, Codelco’s operating costs crept up to the point where the company was not as efficient, competitive or profitable as some of its private sector competitors mining adjacent copper deposits. In the last four years alone, the cash cost of production went up ~170 percent and was ~50 percent higher than cash costs of a geographic peer.
As efficiency declined, so did Codelco’s total mined volumes. In 2012 Codelco’s production dropped by 5.1 percent, its lowest production level since 2008, while Chile’s overall 2012 production increased by 3 percent. In other words, Codelco was shrinking in a growing market.
An SOE tries to improve performance
The drops in production and productivity were largely the result of an inability to secure sufficient retained earnings for capital investments and a government unwilling to implement necessary management changes. Historically, government officials were eager to bolster tax revenues and had reduced Codelco’s investment budget to accomplish this goal. Moreover, restructuring such a prized national asset would be largely unpopular amongst the general electorate. Despite its funding constraints, and substantial challenges such as lower ore quality due to aging mines and increasing supply costs, Codelco had tried to improve its performance.
To boost production, it opened new mines and began feasibility studies to expand existing mines. A new CEO, from the private sector, was brought in to drive the capital expansion program and bring an external viewpoint to the board. Codelco was encouraged to take on more debt to fund its capital program, seek out joint-ventures with private companies and sell its few non-core assets. The new CEO changed the management structure and began a process of shifting the company’s focus onto profitable growth.
However, these changes, as encouraging as they were, did not address the core of Codelco’s health problems nor did they last long. For one, immediately after the devastating 2010 earthquake, Codelco’s effort to retain more of its profits was again rejected by the national government. In other words, despite the above changes, Codelco was still treated as an SOE subsidizing the “greater good.” The new CEO left to join a private sector competitor after only two years at the helm.
Even if Codelco were to receive more capital, deep and persistent problems would prevent it from generating competitive returns. Codelco had failed to address the critical cultural issues buffeting the company. As far back as the 1990s, management identified a need to introduce a more entrepreneurial, lean and competitive culture to reverse the creeping operating costs. Realizing this would be difficult to achieve within the current organisational inertia, the decision was made to divisionalize the Radomiro Tomic mine. Allowed to develop its own independent management style, support systems, operating philosophy and culture, the mine represented the hope that it could break free of Codelco’s paternal culture and create an effective management philosophy which could be transplanted to future mines.
By all accounts Radomiro Tomic was destined to achieve its goals. It began introducing leaner operating processes and borrowed innovative methods for managing suppliers. However, internal resistance to the changes grew and Codelco shortly thereafter merged the facility into an existing mine complex to create a new mining division. Soon thereafter, Radomiro Tomic’s operating costs rose.
Codelco’s management has a chance to restart the Radomiro Tomic experiment with the planned Ministro Hales mine and Chuquicamata underground mine. Although these mines can serve as a blueprint for future developments and seed the cultural change Codelco needs, it is unlikely they will be used to introduce a newer and leaner operating model. They will likely adopt the very same processes and approach which have negatively impacted Codelco’s productivity.
Turning around iconic state-owned enterprises has been a perennial challenge of governments around the world. In the majority of cases, governments are unwilling to take drastic measures as these could prove unpopular and the results may not come through in time for national elections. This leads to a cascade of half-hearted attempts, fuelled by denial, before a dramatic dip in performance forces a bailout or some other form of intervention. By this time, any form of intervention will be costly to the state, the company, tax-payers and employees. Therefore governments, mistakenly believing all transformations are messy, costly and fraught with risk, delay the process or cancel them altogether. In other words, they simply pass the costs of the turnaround to a future government, thereby sacrificing the potential of the business. Poorly executed, business transformations usually are a failure. However, a transformation can be effectively managed by following 10 best-practice ideas that are unique to SOEs.
1. An agreement between the state and SOE. The majority of SOEs either are significant contributors to the government’s revenue or control vital parts of the economy. Therefore, the decision by an SOE to change direction without understanding the needs of the country, and the impact thereon, could lead to disaster. It is necessary for the board of the SOE to sit down with the government and discuss its owner’s needs. When this is mapped out, the SOE can develop a set of plausible options to meet those needs while adjusting its internal strategy. If transformation of the SOE compromises the needs of the government in any way, the SOE must outline the magnitude of the impact and help the government understand how the growth and competitiveness of the country will be affected. Contingency plans should be jointly developed as needed. The old dictum applies – never make your boss look bad. A policy of no surprises should exist. If anything happens which derails the SOE’s contribution to the state’s strategy, the board of the SOE will lose credibility with the state, thereby making it even more difficult for any future strategy changes to be endorsed. Moreover, precious goodwill will be lost among the electorate.
2. Cut through the laboured and tired old arguments for and against change. Discussions about improving SOE performance are not new. Those about Codelco’s performance, for example, have been ongoing for approximately 15 years. The debates have been ongoing for years or decades at many other SOEs as well. Therefore, over time, the various stakeholders have mapped out entrenched positions on the issues, trends and discontinuities in the sector. A group of stakeholders will then use every opportunity to inform other stakeholders about their beliefs, hoping to bring on board more converts to their way of thinking. Stakeholders, expecting to hear the same tired discussions at every caucus simply close down and stop listening since they do not expect to hear new ideas. Therefore, to get stakeholders to listen, it is crucial to change the dynamic of the discussion. CEOs of SOEs which have managed successful transformations have used all types of tactics to reframe the debate, from showing the board movies highlighting key ideas, to inviting fierce competitors to address management, to inviting the management team to spend a weekend strategy session with clients. The idea is to provide a new context for old debates.
3. History, relationships and causality matter, and must be considered. It is crucial for management to understand the set of circumstances that, over the preceding years, led to the current state of affairs. The build-up sequence helps explain causality. Moreover, in any organization, there is usually a complex set of relationships driving the issues. Unless this is understood, the wrong issues could end up being addressed. For example, Codelco’s problems will not be addressed by simply increasing investment, which is what many would want. While this is certainly needed, it is more vital to address the manner in which those investments are made. Crucially, in examining history, it is essential not to blame past administrations or management. This practice merely creates anxiety among current employees who worry how far down the organization such blame will permeate. The role of management is to work within the limitations of the assets it inherits. Trying to assign blame wastes valuable time. In other words, if you took the job, you now own the problem.
4. Transforming an SOE is more about execution than strategy. Contrary to popular belief, the best practices for transforming an SOE are far from being secrets locked away in a bunker. They are all well-known and well-documented. Assuming the strategy is correct, what separates turnaround successes from failures is the effort to think through the communication, implementation and cultural considerations. The CEO is ultimately just one person and must first develop a practical turnaround strategy which he personally believes will work and can, therefore, share with conviction. The chief executive must thereafter convince a few influential direct reports to support the strategy. Over time, more executives will come on board until a cascading effect occurs throughout the organization. As a few successes come through, more areas of the organization will begin to support the process. Transformation is rarely a big-bang approach. SOEs are usually large organizations anchored by years of entrenched ideas and thinking. Although a proper transformation will only start to show results after one to two years, for a large SOE, it will likely only be completed after three to five years. The government must expect this and provide the necessary support management needs to execute such a long turnaround.
5. The CEO can only manage what he measures. This requires measuring the will, capacity and capability of his executive management. In assembling and managing his executive team, the CEO needs to focus on three requirements. Looking at just one executive provides a glimpse into these requirements. For the CFO, as an example, a typical week means meeting sceptical analysts, investors, bankers and employees who will constantly ask for more data and examples to assess the merits of the proposed plan. It takes patience and planning to get his team to understand the new strategy. It will mean galvanizing an entire finance department to shift direction to support an, as yet, unproven plan. All other senior executives will face similar challenges. Therefore, the first requirement is having the will to get to work every day and persistently work through these obstacles while calmly convincing sceptical employees.
The CFO, like every executive, is usually very busy. Therefore, the second element consists of finding the time to manage key parts of a transformation. To determine if an executive supports the transformation, calculate their turnaround allocation ratio. That is the ratio of the time spent on managing the turnaround versus dealing with day-to-day issues, which should ideally be delegated. Anything less than 60 percent should raise warning bells. Executives vote with their time allocation. An executive not committed to the SOE’s turnaround is not only hurting the company and employees, he is ultimately hurting the country’s competitiveness.
Thirdly, determination and a clear diary amount to little unless the CFO has both the technical skills and tactical charm to do the work. Good intentions will amount to little when a new systems installation, for example, incorrectly allocates costs, thereby causing unplanned cost surges in some quarters. As well, the CFO is both unable to grasp the issue and lead a concerted effort to fix the problem. Therefore, the capability of the executive is vital, as is his ability to galvanize action through clear communication.
6. The most sustainable turnarounds focus on both revenue and cost. It should come as no surprise to anyone that cost reduction, without revenue growth, only leads to a one-off jump in the share price. Therefore, all restructuring programs must cater to both cost reduction and revenue growth. Resource SOEs are different in that they typically focus too little on cost reduction. As commodity prices increase, they find it easier to focus on revenue expansion rather than cost containment. Many increase profits by pushing through aggressive capacity expansion and acquisition programs while avoiding the more difficult-to-implement cost reduction programs. Although revenue-driven growth is easier to pursue for commodities SOEs, it ultimately does not fix the long-term inefficiency issues, which ultimately drive return on invested capital.
7. Arrange performance metrics to encourage value creation. Employees will only embrace the new strategy if their performance metrics are tied to those actions which ultimately create more value for the company. While many employees support exciting management changes, many will not know what to do on Monday morning to align themselves with the new way of thinking. Crucially, management should not expect employees to develop their own performance metrics in isolation. Hundreds of departments preparing their own performance measures without guidance drains productive hours and creates a confusing mess of good intentions but little value. Management must cascade new performance metrics into the organisation and then leave it to the organisation to align these metrics with operating targets. At the same time, it must carefully track adherence to the metrics.
8. Empower functions that allow the little things to be done well. It is vitally important to identify enabling functions early and give them the authority and power to succeed. Functions like tax, internal audit, IT, treasury, capital planning, HR and corporate training can, through their actions, enforce principled decisions which the rest of the organization must follow.
Therefore, one important way to speed up the transformation process is to ensure these enabling functions are fully aligned with the transformation. As staff functions, they are usually easier to control than the line functions which may take more time to convince. For example, if a Monday morning meeting between a line division’s representatives and internal audit focuses on cost reduction as a priority, and internal audit is empowered and encouraged to root out and address wasteful expenditure, a signal will be sent that it is no longer business as usual.
If those same representatives meet with the capital planning department the very next day and the department outlines early considerations to rank project investments on return-on-invested-capital rather than throughput improvement, the mindset change will continue, merely because the line divisions are routinely confronted with the new priorities from different messengers across the organization. This creates a consistent and cohesive message that the turnaround is real and will impact every part of the SOE.
That is as good a starting point as any to begin the transformation discussion and journey. However, the enabling functions must have the authority and backing of management to carry out their roles. Initially, there will be resistance and if the line divisions feel that the enablement functions do not have management support, the transformation will unlikely be taken seriously and could stall permanently.
9. Ensure that the ability to innovate is dispersed across the SOE. Crucially, there should never be an innovation department isolated from the rest of the organization. This creates the impression that innovation should not be within the DNA of every department, but rather managed by a unique group of individuals. This is a counterproductive message to send. Everyone should be responsible for innovation.
It is also important to define innovation. Far too many companies are focused on home-run ideas which transform sectors and garner headlines. Incremental innovations are just as important, provided the business model is competitive. Moreover, it is highly unlikely lower-level employees will be able to develop new business models which shift the entire organization. They may be able to develop new products and processes which are innovative, but the business model will then need to be packaged around this. This is the role of management: providing employees with the environment to develop new ideas and supporting the promising initiatives.
10. Accept the fact there will never be one hundred per cent agreement. In a utopian world a CEO will toil away for weeks and then deliver that one speech which changes the organization. In the real world that will never happen. At all times of the transformation, even when everything is going according to plan, there will be vocal and aggressive critics in the market and within the organization. Management must not allow adulation to be the primary metric of success. Management must create sustainable shareholder value and fulfil its mandate to be successful, even if it means taking unpopular steps in the short-term. The management team must take every opportunity it can to communicate progress, the strategy and definition of value to employees. Multiple formats should be used, and the message must be repeated until employees care enough to ask questions, contribute, or even challenge the ideas. Management must try to create excitement and interest about the path forward so that employees feel they are part of something important and essential.
Mergers & Acquisitions as a driver for turnarounds
If we built a map of every major successful or unsuccessful SOE turnaround initiated in the last decade, we find a consistent pattern: the majority of turnarounds were initiated by the arrival of a chief-executive officer who either previously ran a successful private or public entity, or at least served in a previous role with distinction, sometimes within the SOE itself.
The similarity that should be noted is not the exceptional résumés of the new chief executives. Rather, the notable similarity is that one person is consistently expected to accomplish what many others had failed to do. That model, the lone ranger model, as evidenced by the performance of SOEs around the world, has worked a few times but usually fails. However, while the best practices discussed above can improve the turnaround of an SOE, it is possible to leverage the significant M&A appetite among resource SOEs to accelerate the turnaround process.
Resource SOEs are now in the asset-grab phase. They meet their state-mandated goal of securing supplies through acquisitions, which also allows them to drive up their share prices and/or net asset values. It is assumed the SOE wins on all measures. Or does it?
The more assets the SOE acquires, the greater the increase in commodities extracted in the future, the greater the expected cash flows and the greater the dividends to the government. However, at a certain point, this asset-grab game plan will have declining returns. This is because the acquiring SOE is usually inefficient and simply exports inefficient practices to the acquired company. In other words, the asset-grab phase is characterized by an SOE exporting its management practices while, loosely speaking, extracting and using the mineral resources. If this asset-grab strategy plays out to its logical conclusion, it does not fix the SOEs efficiency problems.
The end result is a bloated SOE which never learned to be efficient. It only knows how to create value via asset acquisition and not via efficient management of those acquisitions. This is analogous to private sector resource companies increasing throughput at the expense of cost efficiency – a problem many mining majors faced post the recent resources boom. Yet there are only so many oil fields, for example, which are readily available for sale around the world. At some point all the readily available fields will be acquired, leaving the bloated SOE to pursue value creation, and security of supply, via acquisitions in countries suspicious of its intentions, acquisition of other SOEs, and exploration for new fields or better management of existing fields.
The CNOOC-Nexen deal
Acquisitions in countries suspicious of its intentions will become increasingly difficult when the SOE tries to control more of the world’s critical reserves. The commentary around the 2012 CNOOC-Nexen deal demonstrated this. CNOOC’s next acquisition in North America, or abroad, will receive a tougher reception, simply because allowing further consolidation by a foreign entity, whose raison d’être is set by a foreign government, is unlikely to muster local voter support, let alone support among local legislators. People tend to fear what they do not know and cannot control.
Acquiring other SOEs is almost certainly off the table since the need for country X’s oil SOE only increases as country Y’s oil SOE controls more global supply.
By this process of elimination, an SOE is left with the final two options, better exploration abilities and better resource management. These are two options which can only be executed by access to technical skills, operating best-practice and a competitive employee culture – areas typically in short supply at SOEs.
Many SOEs have the mind-set of acquiring the asset first and worrying about its management later. Yet at some point the inefficient SOE must find a way to efficiently manage its resources, and the sooner the better.
A smart SOE will merge both requirements by evolving its M&A strategy beyond the asset-grab phase. Rather than merely looking for reserves, it will seek companies with exceptional reserves, management talent and technical skills. This would be the talent-grab phase where the visionary board of an SOE understands not just its resource limitations, but also its management and technical limitations and uses acquisitions to close this gap.
In this situation the SOE does not merely try to benefit from the reserves in the ground but also extracts and imports management and technical best practice, an equally valuable resource.
Adopting this model has many benefits
First, it strategically positions the SOE for the end-point of its acquisition strategy, which is managing its assets efficiently. Rather than a lone-ranger CEO trying to implement change across a vast organization, the CEO can bring in change agents from the acquired company or even rotate staff into the acquired company. It creates many more touch points for learning better ways to run the business. It is one thing to resist a CEO’s plans to improve efficiency, but quite another to resist possibly thousands of employees with proven skills, high levels of education, effective R&D output and a track record of getting the job done. That said, the CEO must deliberately, and subtly, position the acquired company as a change agent and protect it from operating divisions who may try to dismantle the business for short-term gain or to protect their turf.
Second, it makes SOEs appear less threatening to the country where the acquisitions are taking place. Rather than purge the senior ranks of the acquired company and replace them with loyal employees from the head office, the opposite happens. The senior management of the acquired company are provided with a far more compelling and challenging leadership narrative – how do they help a global behemoth operate more nimbly and responsively? If challenges that matter are indeed the greatest employee motivators, then this approach to acquisitions could be one of the greatest means of employee retention.
Third, many commodity SOEs are afflicted by resource-myopia by assuming that the value of a resource is solely determined by ownership of the resource. In the capital intensive resources industry, R&D is a competitive requirement to ensure that the maximum value of the resource can be extracted at the lowest costs with the least displacement to the environment. Most R&D must be supplemented by geographically proximate institutes, not by universities in China, India or Russia, which may not be equipped to understand the local ore bodies nor have access to the requisite technology. This learning posture encourages the SOE to maintain the acquired company’s relationships with local universities and the local population. This serves the dual purpose of improving yields and extending the reserve life while integrating the SOE into the local communities through the universities.
Fourth, this talent-grab approach matures the SOE’s management philosophy. SOEs tend to operate on a cultural version of the not-invented-here syndrome. Not only do they struggle and are sometimes unwilling to import best practice, they also tend to staff critical positions with citizens from the home country. In a rapidly integrated world where understanding cultures and responding to voter sentiment is increasingly essential, the SOE is always going to struggle unless it integrates more than the asset under the ground. Culture, values and norms are important and embracing them can only make the SOE stronger and more relevant.
By thinking strategically about acquisitions as a driver of a turnaround, SOEs can fulfil their state-deemed mandate of ensuring security of supply while improving efficiency. And by implementing all of the above best practice ideas, transforming an SOE can become a managed process that creates value.
At the end of the day, an SOE’s ultimate owner, the public, must understand that transformation of the SOE is not necessarily the prelude to a privatization program. It is, however, the prelude to the SOE’s sustainability and the voters’ own prosperity.