Hostess’ Twinkie Defense Is a Failure

Hostess Brands filed for liquidation this week.  Management blamed its workforce for the failure.  That is straightforward scapegoating.

In 1978 Dan White killed San Francisco's mayor George Moscone and city supervisor Harvey Milk.  The press labeled his defense the "Twinkie Defense" because he claimed eating sugary junk food – like Twinkies – caused diminished capacity.  Amazingly the jury bought it, and convicted him of manslaughter instead of murder saying he really wasn't responsible for his own actions.  An outraged city rioted.

Nobody is rioting, but management's claim that unions caused Hostess failure is just as outrageous. 

Founded in 1930 as Interstate Bakeries Co. (IBC) the company did fine for years. But changing consumer tastes, including nutrition desires, changed how much Wonder Bread, Twinkies, HoHos and Honey Buns people would buy — and most especially affected the price – which was wholly unable to keep up with inflation. This trend was clear in the early 1980s, as prices were stagnant and margins kept declining due to higher costs for grain and petroleum to fuel the country's largest truck fleet delivering daily baked goods to grocers.

IBC kept focusing on operating improvements and better fleet optimization to control rising costs, but the company was unwilling to do anything about the product line.  To keep funding lower margins the company added debt, piling on $450M by 2004 when forced to file bankruptcy due to its inability to pay bills.  For 5 years financial engineers from consultancies and investment banks worked to find a way out of bankruptcy, and settled on adding even MORE debt, so that – perversely – in 2009 the renamed Hostess had $670M of debt – at least 2/3 the total asset value!

Since then, still trying to sell the same products, margins continued declining.  Hostess lost a combined $250M over the last 3 years. 

The obvious problem is leadership kept trying to sell the same products, using roughly the same business model, long, long, long after the products had become irrelevant.  "Demand was never an issue" a company spokesman said.  Yes, people bought Twinkies but NOT at a price which would cover costs (including debt service) and return a profit. 

In a last, desperate effort to keep the outdated model alive management decided the answer was another bankruptcy filing, and to take draconian cuts to wages and benefits.  This is tanatamount to management saying to those who sell wheat they expect to buy flour at 2/3 the market price – or to petroleum companies they expect to buy gasoline for $2.25/gallon.  Labor, like other suppliers, has a "market rate."  That management was unable to run a company which could pay the market rate for its labor is not the fault of the union.

By constantly trying to defend and extend its old business, leadership at Hostess killed the company.  But not realizing changing trends in foods made their products irrelevant – if not obsolete – and not changing Hostess leaders allowed margins to disintegrate.  Rather than developing new products which would be more marketable, priced for higher margin and provide growth that covered all costs Hostess leadership kept trying to financial engineer a solution to make their horse and buggy competitive with automobiles. 

And when they failed, management decided to scapegoat someone else.  Maybe eating too many Twinkies made the do it.  It's a Wonder the Ding Dongs running the company kept this Honey Bun alive by convincing HoHos to loan it money!  Blaming the unions is simply an inability of management to take responsibility for a complete failure to understand the marketplace, trends and the absolute requirement for new products.

We see this Twinkie Defense of businesses everywhere.  Sears has 23 consecutive quarters of declining same-store sales – but leadership blames everyone but themselves for not recognizing the shifting retail market and adjusting effectively. McDonald's returns to declining sales – a situation they were in 9 years ago – as the long-term trend to healthier eating in more stylish locations progresses; but the blame is not on management for missing the trend while constantly working to defend and extend the old business with actions like taking a slice of cheese off the 99cent burger.  Tribune completey misses the shift to on-line news as it tries to defend & extend its print business, but leadership, before and afater Mr. Zell invested, refuses to say they simply missed the trend and let competitors make Tribune obsolete and unable to cover costs. 

Businesses can adapt to trends.  It is possible to stop the never-ending chase for lower costs and better efficiency and instead invest in new products that meet emerging needs at higher margins.  Like the famous turnarounds at IBM and Apple, it is possible for leadership to change the company. 

But for too many leadership teams, it's a lot easier to blame it on the Twinkies.  Unfortunately, when that happens everyone loses.

 

Size isn’t relevant – GM, Circuit City, Dell, Microsoft, GE


Summary:

  • Many people think it is OK for large companies to grow slowly
  • Many people admire caretaker CEOs
  • In dynamic markets, low-growth companies fail
  • It is harder to generate $1B of new revenue, than grow a $100B company by $10B
  • Large companies have vastly more resources, but they squander them badly
  • We allow large company CEOs too much room for mediocrity and failure
  • Good CEOs never lose a growth agenda, and everyone wins!

“I may just be your little rent collector Mr. Potter, but that George Bailey is making quite a bit happen in that new development of his.  If he keeps going it may just be time for this smart young man to go asking George Bailey for a job.” From “It’s a Wonderful Life an employee of the biggest employer in mythical Beford Falls talks about the growth of a smaller competitor.

My last post gathered a lot of reads, and a lot of feedback.  Most of it centered on how GE should not be compared to Facebook, largely because of size differences, and therefore how it was ridiculous to compare Jeff Immelt with Mark Zuckerberg.  Many readers felt that I overstated the good qualities of Mr. Zuckerberg, while not giving Mr. Immelt enough credit for his skills managing “lower growth businesses”  in a “tough economy.” Many viewed Mr. Immelt’s task as incomparably more difficult than that of managing a high growth, smaller tech company from nothing to several billion revenue in a few years.  One frequent claim was that it is enough to maintain revenue in a giant company, growth was less important. 

Why do so many people give the CEOs of big companies a break? Given that they make huge salaries and bonuses, have fantastic perquesites (private jets, etc.), phenominal benefits and pensions, and receive remarkable payouts whether they succeed or fail I would think we’d have very high standards for these leaders – and be incensed when their performance is sub-par.

Facebook started with almost no resources (as did Twitter and Groupon).  Most leaders of start-ups fail.  It is remarkably difficult to marshal resources – both enough of them and productively – to grow a company at double digit rates, produce higher revenue, generate cash flow (or loans) and keep employees happy.  Growing to a billion dollars revenue from nothing is inexplicably harder than adding $10B to a $100B company. Compared to Facebook, GE has massive resources.  Mr. Immelt entered the millenium with huge cash flow, huge revenues, and an army of very smart employees.  Mr. Zuckerberg had to come out of the blocks from a standing start and create ALL his company’s momentum, while comparatively Mr. Immelt took on his job riding a bullet out of a gun!  GE had huge momentum, a low cost of capital, and enough resources to do anything it wanted.

Yet somehow we should think that we don’t have as high expectations from Mr. Immelt as we do Mr. Zuckerberg?  That would seem, at the least, distorted. 

In business school I read the story of how American steel manufacturers were eclipsed by the Japanese.  Ending WWII America had almost all the steel capacity.  Manufacturers raked in the profits.  Japanese and German companies that were destroyed had to rebuild, which they progressively did with more efficient assets.  By the 1960s American companies were no longer competitive.  Were we to believe that having their industrial capacity destroyed somehow was a good thing for the foreign competitors?  That if you want to improve your competitiveness (say in autos) you should drop a nuclear bomb on the facilities (some may like that idea – but not many who live in Detroit I dare say.)  In reality the American leaders simply refused to invest in new technologies and growth markets, allowing competitors to end-run them.  The American leaders were busy acting as caretakers, and bragging about their success, instead of paying attention to market shifts and keeping their companies successful!

Big companies, like GE, are highly advantaged.  They not only have brand, and market position, but cash, assets, employees and vendors in position to help them be even more successful!  A smart CEO uses those resources to take the company into growth markets where it can grow revenues, and profits, faster than the marketplace.  For example Steve Jobs at Apple, and Eric Schmidt at Google have found new markets, revenues and cash flow beyond their original “core” markets.  That’s what Mr. Welch did as predecessor to Mr. Immelt.  He didn’t so much take advantage of a growth economy as help create it! Unfortunately, far too many large company CEOs squander their resources on low rate of return projects, trying to defend their existing business rather than push forward. 

Most big companies over-invest in known markets, or technologies, that have low growth rates, rather than invest in growth markets, or technologies they don’t know as well.  Think about how Motorola invented the smart phone technology, but kept investing in traditional cellular phones.  Or Sears, the inventor of “at home shopping” with catalogues closed that division to chase real-estate based retail, allowing Amazon to take industry leadership and market growth.  Circuit City ended up investing in its approach to retail until it went bankrupt in 2010 – even though it was a darling of “Good to Great.”  Or Microsoft, which launched a tablet and a smart phone, under leader Ballmer re-focused on its “core” operating system and office automation markets letting Apple grab the growth markets with R&D investments 1/8th of Microsoft’s.  These management decisions are not something we should accept as “natural.” Leaders of big companies have the ability to maintain, even accelerate, growth.  Or not.

Why give leaders in big companies a break just because their historical markets have slower growth?  Singer’s leadership realized women weren’t going to sew at home much longer, and converted the company into a defense contractor to maintain growth.  Netflix converted from a physical product company (DVDs) into a streaming download company in order to remain vital and grow while Blockbuster filed bankruptcy.  Apple transformed from a PC company into a multi-media company to create explosive growth generating enough cash to buy Dell outright – although who wants a distributor of yesterday’s technology (remember Circuit City.)  Any company can move forward to be anything it wants to be.  Excusing low growth due to industry, or economic, weakness merely gives the incumbent a pass.  Good CEOs don’t sit in a foxhole waiting to see if they survive, blaming a tough battleground, they develop strategies to change the battle and win, taking on new ground while the competition is making excuses.

GM was the world’s largest auto company when it went broke.  So how did size benefit GM?  In the 1980s Roger Smith moved GM into aerospace by acquiring Hughes electronics, and IT services by purchasing EDS – two remarkable growth businesses.  He “greenfielded” a new approach to auto manufucturing by opening the wildly successful Saturn division.  For his foresight, he was widely chastised.  But “caretaker” leadership sold off Hughes and EDS, then forced Saturn to “conform” to GM practices gutting the upstart division of its value.  Where one leader recognized the need to advance the company, followers drove GM to bankruptcy by selling out of growth businesses to re-invest in “core” but highly unprofitable traditional auto manufacturing and sales.  Meanwhile, as the giant failed, much smaller Kia, Tesla and Tata are reshaping the auto industry in ways most likely to make sure GM’s comeback is short-lived.

CEOs of big companies are paid a lot of money.  A LOT of money.  Much more than Mr. Zuckerberg at Facebook, or the leaders of Groupon and Netflix (for example).  So shouldn’t we expect more from them?  (Marketwatch.comTop CEO Bonuses of 2010“) They control vast piles of cash and other resources, shouldn’t we expect them to be aggressively investing those resources in order to keep their companies growing, rather than blaming tax strategies for their unwillingness to invest?  (Wall Street Journal Obama Pushes CEOs on Job Creation“) It’s precisely because they are so large that we should have high expectations of big companies investing in growth – because they can afford to, and need to!

At the end of the day, everyone wins when CEOs push for growth.  Investors obtain higher valuation (Apple is worth more than Microsoft, and almost more than 10x larger Exxon!,) employees receive more pay (see Google’s recent 10% across the board pay raise,) employees have more advancement opportunities as well as personal growth, suppliers have the opportunity to earn profits and bring forward new innovation – creating more jobs and their own growth – rather than constantly cutting price. Answering the Economist in “Why Do Firms Exist?” it is to deliver to people what they want.  When companies do that, they grow.  When they start looking inward, and try being caretakers of historical assets, products and markets then their value declines.

Can Mr. Zuckerberg run GE?  Probably.  I’d sure rather have him at the helm of GM, Chrysler, Kraft, Sara Lee, Motorola, AT&T or any of a host of other large companies that are going nowhere the caretaker CEOs currently making excuses for their lousy performance.  Think what the world would be like if the aggressive leaders in those smaller companies were in such positions?  Why, it might just be like having all of American business run the way Steve Jobs, Jeff Bezos and John Chambers have led their big companies.  I struggle to see how that would be a bad thing.

Other side of the storm

Today the U.S. Congress failed to pass a bail-out bill to buy up bad bank assets.  Before the vote, the Dow Jones Industrial Average was down about 300 points.  After the vote, the DJIA fell to close down about 700 points (read about the vote and market reaction on Marketwatch here.)  So, is the end near – or is everything going to work out OK?

I’m reminded of the scene in It’s a Wonderful Life where George Bailey (played by Jimmy Stewart) is invited by the town patriarch, Mr. Potter, to take a job for Mr. Potter.  As he starts the conversation Mr. Potter says something close to "George, back in the Depression when everyone lost their heads you and I kept ours.  You ended up with the Building and Loan, and I ended up with everything else."  The crisis happened, and lots of people got hurt.  Some came out OK, and some did very well.  On the other side of a crisis, there are winners.  It’s just that often those winners are not the same people who were winners going into the crisis.

Over the last several months we’ve seen some big changes in financial services.  We’re seeing some losers already.  But we’re also seeing some plays being made that could become winners.  It was the announced losses at Citibank, which led to the firing of their CEO Mr. Prince, that first alerted people to the reality of this crisis.  Today, Citi announced it is buying Wachovia bank in its play to be a long-term winner.  The new CEO says this is a rare opportunity for huge gain with almost no risk.  It was JPMorganChase that first took a play to expand in this crisis with the acquisition of Bear Sterns, which many people at the time thought was done for a remarkably small amount of money.  Later JPMC bought Washington Mutual for a fraction of its asset value.  And Bank of America has moved aggressively, buying up the very troubled Countrywide Financial that was the first mortgage institution to fall, and later taking over Merrill Lynch the weekend when Lehman Brothers went bankrupt.

Will Jamie Dimon of JPMC be the next Mr. Potter, taking over control of his local market during a crisis? Some of these may become big winners.  On the other hand, all 3 may falter. 

What we know is that the demand for loans (the product that banks sell) is not going to disappear.  That market may hiccup, but demand will continue to grow.  Government, corporations and individuals all will continue to need loans.  As the standard of living rises in China, India and elsewhere demand for loans will go up.  And the winner will be the business that develops a solution to the future market needYou can’t judge the value of these actions by looking at how these businesses did in the past – because that past is gone.  It’s all about the future.  So, what should be the scenario for 2015?

  • Will the dollar continue to be the world currency – the source of denominating oil and other commodities as well as most transactions?  Or will we see a change to the Euro, or perhaps a basket of currencies put into some sort of as yet unavailable currency instrument?
  • Will people continue to save their money in currencies, as deposits in banks, or will there be a re-emergence of keeping stores of value in silver, gold, and other commodities (in India, many people still carry their savings as jewelry on their arms).
  • Will U.S. based companies dominate the equity markets, or will companies from the "emerging tiger" countries become relatively more powerful?
  • Will the primary source of deposits be in the USA, Europe, China, India, or elsewhere? 
  • What rate of return will depositors require on their investments?  Will this vary by region?
  • Will real estate values in the USA, Britain, France, Germany, Japan, Brazil, Russia, Taiwan, Hong Kong, Singapore, Taiwan, China and India go down?  Go up?  Will there be big differences between regions?  How will the differences vary?
  • Where will deposits, regulations and legal devices converge to be the primary source of loan origination?  The USA?  Elsewhere?

Who wins depends on who has a good set of scenarios about the future.  Not because they can predict, but because they are prepared for different potential outcomes, and they can shift to meet Challenges.  And if you are an investor, your pick between the 3 mentioned – or possibly ICBC, HSBC, Banco Santander, Mitsubishi, ABN Amro, BNP Paribas, UBS or Royal Bank of Scotland?  How will the big U.S. banks compare in a global market – and one that is less dominated by the USA?

Too many investors don’t have future scenarios when they investThey buy equities, or make loans (buying bonds), on the basis of company history.  But the value you receive for investing has nothing to do with what the company did in the past – it’s all dependent upon the future.  When an industry crisis occurs, like the one in financial services today, those who survive – and those who thrive – do so because they have a good set of scenarios about the future.  There is no doubt some will come out of this crisis as winners.  They may be players who had nothing to do with the past – or they may be companies people in the USA know very poorly.  But if you are going to invest in financial services, you better have a good set of scenarios – and you better watch closely to see how things develop.

Note:  Looking at the 3 companies referred to here, one is acting quite differently than the others.  While Citibank and Bank of America are moving fairly slowly to change, JPMC is moving very, very fast with its acquisitions.  Within 3 months of buying Bear Sterns, JPMC had dismantled the company, consolidated its assets and let go its employees.  After acquisition many companies spend months trying to work their way toward some sort of "merged" solution – only to spend huge quantities of cash and end up with higher costs and lower revenues.  At JPMC we see one company forcing its Success Formula onto its acquisitions – no belabored effort.  Rather fast moves taken to consolidate assets and keep the Success Formula in place.  Whether the JPMC Success Formula is the right one for the future is yet to be seen.  But the leader’s actions at JPMC are far more likely to be effective for shareholders than the actions being taken at the other institutions.  Especially if JPMC is able to shift with the marketplace.