Better Understanding Industry. Alex Miller, PhD Founder, Aerospace Defense Executive MBA University of Tennessee
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- Tracy Johnston
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1 Better Understanding Industry Alex Miller, PhD Founder, Aerospace Defense Executive MBA University of Tennessee
2 Explaining Key Differences Between USAF Officers and Corporate Officers 1
3 Examples of Different Perspectives Principal Served Issue Military Perspective Industry Perspective Combatants, Congress, Taxpayers Shareholders, Customers Working to Budgets Spend appropriated funds Deliver forecasted profits Cost of Capital No Charge WACC ( ~ 9% in A/D) Time Horizon Annual spend Quarterly earnings Major Legal Frameworks Promotion Process Compensation Laws of War, Uniform Military Code, Federal Regulations (FAR, etc.) Fixed schedule; up or out of uniform Based on grade; federally established rates Corporate Law, Securities and Exchange Commission, Uniform Commercial Code, Contractual Law, Tax Law, Bankruptcy Law, Product Regulation, Antitrust Law, Industry-specific Law Flexible schedule; stay, up, sideways, or new company Based on performance; market established rates 2
4 Questions We Will Cover 1. What are the legal responsibilities of corporate officers? 2. How do corporate officers think about their obligations to owners? 3. What drives shareholder returns from stock? 4. How do corporations think about Good News? 5. How profitable is the Aerospace/Defense industry? 6. How does industry differ from government in thinking about time and money? 7. What are the implications of the drumbeat of quarterly earnings reports? 8. How do corporations structure management compensation and incentives? 9. Are there unintended consequences to corporate incentives? 10. What can you do to help USAF work more successfully with industry? 3
5 1. What are the legal responsibilities of corporate officers? 4
6 The Extreme View 5
7 Corporate Officers Governed by Agency Law Ancient basis in English common law Three types of duty 1. Duty of loyalty agent places interests of principal before self-interests 2. Duty of care agent responsible for being well informed 3. Duty of good faith agent responsible for acting with prudence and in good faith Remedies under the law 1. Gains returned to principals 2. Compensatory damages 3. Incarceration A level higher than that trodden by the crowd 6
8 Do Executives Really go to Jail? 7
9 A Sampler of CEOs Recently Imprisoned CEO/Corporation Crime Imprisonment DeCoster/Quality Egg Unknowingly allowing unsafe products 3 months Stewart/Martha Stewart Living Insider trading/perjury 5 months Nacchio/Qwest Misrepresented sales 6 years Scrushy/Healthsouth Various 6 years Kumar/Computer Associates Misrepresenting books 12 years Forbes/Cendant Misrepresented financials 12 years Rigas/Adelphia Various, including personal use of funds 15 years Kozlowski/Tyco Theft of corporate funds 8-25 years Skilling/Enron Fraud to inflate profits 24 years Ebbers/WorldCom Fraud to hide losses 25 years Stanford/Stanford Financial Investor Fraud 110 years Madoff/Bernie Madoff Securities Investor Fraud 150 years 8
10 2. How do corporate officers think about their obligation to owners? 9
11 What you want out of your investments? 10
12 Creating Wealth: Outperforming Investors Options 11
13 Destroying Wealth: Underperforming Investors Options 12
14 Minimum Expectation 13
15 Frequency of Occurrence Consider The Normal Distribution of Shareholder Returns* Average Return Shareholder Returns *To simplify discussion, assume risks are the same across all options being considered. 14
16 Frequency of Occurrence The Goal: Above Average Total Returns to Shareholders Objective Average Return Shareholder Returns Everybody has the same Goal. Only 50% can achieve it. 15
17 3. What drives shareholder returns from stock? 16
18 Shareholders Seek Total Returns Changes in Stock Price Total Shareholder Returns Dividends Paid Total Shareholder Returns Beginning Ending ( - ) Price Price + Dividends = Beginning Price 17
19 3. What drives corporate shareholder returns from stock? (Simplified Answer) Three Main Drivers We Will Consider: Dividends Price Movement in the Market as a Whole News on an Individual Stock 18
20 Dividends Set by Policy 19
21 The Market as a Whole Boeing Stock Vs SP500, Dow, and Nasdaq for past 10 years 20
22 3. What drives corporate shareholder returns from stock?(simplified Answer) Three Main Drivers We Will Consider: Dividends Price The Market as a Whole News on an Individual Stock Set by Board Policy Beyond Control of Corporation Focus Here 21
23 Surprisingly Good News 22
24 Surprisingly Bad News 23
25 24
26 Continually Delivering Surprisingly Good News 25
27 4. How do Corporations Think About Good News? 26
28 27
29 How Accountants Measure Profits 28
30 Accounting Numbers Reflects GAAP 29
31 GAAP Offers Distorted Information Reliably 30
32 Accounting s View of Profitability Net Profit Margin = (Sales recorded in a given period - Expenses recorded during the same period) Sales recorded in a given period Earnings Per Share = (Sales recorded in a given period - Expenses recorded during the same period) Number of Shares Outstanding 31
33 32
34 Return on Invested Capital % ROIC Scale ROIC Return on invested capital earnings generated by the money the corporation has in use 33
35 Weighted Average Cost of Capital % WACC ROIC WACC Weighted average cost of capital how much it costs the corporation to rent the money it has in use (interest + opportunity cost incurred by investors) ROIC Return on invested capital earnings generated by the money the corporation has in use Scale 34
36 What s WACC? (Hypothetical Example) Balance Sheet Calculating Weighted Average Assets what corporation has invested in Debt what corporation owes Equity what stockholders have invested + earnings reinvested in the business Debt cost is measured as interest expense Cost of equity is measured as shareholder s opportunity cost 33% 6% + 67% 12% =.33(.06)+.67(.12) = =.10 WACC 35
37 Weighted Average Cost of Capital % WACC ROIC WACC Weighted average cost of capital how much it costs the corporation to rent the money it has in use (interest + opportunity cost incurred by investors) ROIC Return on invested capital earnings generated by the money the corporation has in use Scale 36
38 Economic Profit % Economic Profit WACC ROIC WACC Weighted average cost of capital how much it costs the corporation to rent the money it has in use (debt + opportunity cost incurred by investors) ROIC Return on invested capital earnings generated by the money the corporation has in use Economic Profit ROIC-WACC returns in excess of the cost of capital Scale 37
39 Thought Experiment: Apply the Model to Suds % WACC ROIC Scale 38
40 How Large Should Suds Grow? % A B C D WACC ROIC Where Should Suds Stop Investing? Scale 39
41 WACC Becomes the Minimum Hurdle Rate % Economic Profit WACC ROIC Value-creating investments that cover cost of capital and produce economic profits Value-destroying investments that don t cover the cost of capital 40
42 Goal is to Grow Area Under the Curve Economic Profit WACC Economic Profit WACC ROIC ROIC Make Existing Programs More Profitable Finding New Programs that are Profitable 41
43 What Happens Beyond the Edge? % Economic Profit WACC ROIC Planting a Seed: What should corporation s do with its money beyond this point? Value-creating investments that cover cost of capital and produce economic profits Value-destroying investments that don t cover the cost of capital 42
44 Frequency of Occurrence Putting it all together The best strategy for delivering better than average shareholder returns is to drive stock prices up Objective Average Return Shareholder Returns % Economic Profit By consistently delivering suprisingly good news on ability to invest in projects that will generate a return greater than the cost of capital required. Scale
45 Note: None of this is how DoD Thinks about Profit 44
46 5. How profitable is the Aerospace/Defense industry? 45
47 The public thinks corporations are much more profitable than they really are. 46
48 Accounting-based Profitability by Sector, NYU Stern School of Business Industry Name Number of firms Net Margin Tobacco % Bank (Money Center) % Banks (Regional) % Shipbuilding & Marine % Financial Svcs. (Non-bank & Insurance) % R.E.I.T % Transportation (Railroads) % Investments & Asset Management % Drugs (Biotechnology) % Drugs (Pharmaceutical) % Rubber& Tires % Utility (Water) % Entertainment % Beverage (Alcoholic) % Semiconductor % Information Services % Computers/Peripherals % Software (Entertainment) % Hotel/Gaming % Telecom. Equipment % Software (Internet) % Software (System & Application) % Air Transport % Beverage (Soft) % Chemical (Specialty) % Shoe % Brokerage & Investment Banking % Healthcare I&T % Insurance (Prop/Cas.) % Restaurant/Dining % Cable TV % Healthcare Products % Utility (General) % Homebuilding % Power % Insurance (Life) % Chemical (Diversified) % Aerospace/Defense % Broadcasting % Electrical Equipment % Food Processing % Electronics (General) % Household Products % Retail (Building Supply) % Machinery % Reinsurance % Total Market % Apparel % Insurance (General) % Computer Services % 47
49 Accounting Answer to Profitability in Aerospace Defense Industry Firms Net Margin Aerospace/Defense % 48
50 The public thinks corporations are much more profitable than they really are. 49
51 Accounting-based Profitability by Sector, NYU Stern School of Business Industry Name Number of firms Net Margin Tobacco % Bank (Money Center) % Banks (Regional) % Shipbuilding & Marine % Financial Svcs. (Non-bank & Insurance) % R.E.I.T % Transportation (Railroads) % Investments & Asset Management % Drugs (Biotechnology) % Drugs (Pharmaceutical) % Rubber& Tires % Utility (Water) % Entertainment % Beverage (Alcoholic) % Semiconductor % Information Services % Computers/Peripherals % Software (Entertainment) % Hotel/Gaming % Telecom. Equipment % Software (Internet) % Software (System & Application) % Air Transport % Beverage (Soft) % Chemical (Specialty) % Shoe % Brokerage & Investment Banking % Healthcare I&T % Insurance (Prop/Cas.) % Restaurant/Dining % Cable TV % Healthcare Products % Utility (General) % Homebuilding % Power % Insurance (Life) % Chemical (Diversified) % Aerospace/Defense % Broadcasting % Electrical Equipment % Food Processing % Electronics (General) % Household Products % Retail (Building Supply) % Machinery % Reinsurance % Total Market % Apparel % Insurance (General) % Computer Services % 50
52 Economic Profit % Economic Profit WACC ROIC WACC Weighted average cost of capital how much it costs the corporation to rent the money it has in use (debt + opportunity cost incurred by investors) ROIC Return on invested capital earnings generated by the money the corporation has in use Economic Profit ROIC-WACC returns in excess of the cost of capital Scale 51
53 Cost of Capital Data from NYU Stern School of Business Industry Name Number of Firms Beta Cost of Equity E/(D+E) Std Dev in Stock Cost of Debt Tax Rate After-tax Cost of Debt D/(D+E) Cost of Capital Tobacco % 83.45% 48.90% 3.52% 11.64% 2.11% 16.55% 11.82% Retail (Online) % 92.17% 50.54% 4.02% 11.14% 2.41% 7.83% 10.99% Oil/Gas (Integrated) % 85.84% 50.24% 4.02% 8.14% 2.41% 14.16% 10.20% Software (Entertainment) % 90.72% 54.18% 4.02% 1.56% 2.41% 9.28% 10.00% Software (Internet) % 95.76% 64.71% 4.02% 3.80% 2.41% 4.24% 9.97% Oilfield Svcs/Equip % 71.90% 69.62% 4.52% 9.56% 2.71% 28.10% 9.91% Retail (Building Supply) % 84.22% 50.34% 4.02% 23.18% 2.41% 15.78% 9.73% Semiconductor % 88.83% 51.24% 4.02% 9.51% 2.41% 11.17% 9.68% Software (System & Application) % 89.14% 59.22% 4.02% 6.34% 2.41% 10.86% 9.39% Drugs (Biotechnology) % 87.50% 88.89% 6.52% 1.80% 3.91% 12.50% 9.20% Computers/Peripherals % 84.28% 63.91% 4.02% 5.48% 2.41% 15.72% 9.01% Office Equipment & Services % 62.28% 41.58% 3.52% 19.14% 2.11% 37.72% 8.99% Machinery % 78.39% 46.07% 3.52% 15.24% 2.11% 21.61% 8.99% Chemical (Diversified) % 72.32% 40.56% 3.52% 18.35% 2.11% 27.68% 8.97% Aerospace/Defense % 82.99% 46.90% 3.52% 13.51% 2.11% 17.01% 8.86% Electronics (Consumer & Office) % 87.10% 63.42% 4.02% 9.71% 2.41% 12.90% 8.72% Telecom. Equipment % 82.84% 57.78% 4.02% 8.86% 2.41% 17.16% 8.71% Transportation % 76.27% 40.03% 3.52% 18.82% 2.11% 23.73% 8.69% Construction Supplies % 62.86% 42.41% 3.52% 17.00% 2.11% 37.14% 8.43% Semiconductor Equip % 72.69% 54.21% 4.02% 11.25% 2.41% 27.31% 8.41% Metals & Mining % 53.83% 91.02% 7.77% 1.42% 4.66% 46.17% 8.40% Oil/Gas (Production and Exploration) % 54.80% 80.22% 6.52% 2.91% 3.91% 45.20% 8.37% Precious Metals % 66.65% 93.13% 7.77% 1.60% 4.66% 33.35% 8.24% Rubber& Tires % 60.51% 38.00% 3.52% 9.60% 2.11% 39.49% 8.23% Publshing & Newspapers % 66.86% 51.60% 4.02% 13.67% 2.41% 33.14% 8.12% Auto Parts % 75.24% 55.06% 4.02% 9.64% 2.41% 24.76% 8.11% Real Estate (General/Diversified) % 79.70% 40.76% 3.52% 9.64% 2.11% 20.30% 8.05% Electrical Equipment % 82.03% 71.04% 4.52% 6.58% 2.71% 17.97% 8.01% Chemical (Specialty) % 76.12% 50.43% 4.02% 8.45% 2.41% 23.88% 8.00% Healthcare I&T % 84.96% 60.52% 4.02% 6.96% 2.41% 15.04% 7.95% Beverage (Soft) % 81.32% 54.55% 4.02% 5.97% 2.41% 18.68% 7.92% Entertainment % 76.96% 63.16% 4.02% 3.25% 2.41% 23.04% 7.90% Engineering/Construction % 70.47% 57.02% 4.02% 11.63% 2.41% 29.53% 7.88% Furn/Home Furnishings % 76.37% 44.49% 3.52% 15.53% 2.11% 23.63% 7.87% Computer Services % 77.60% 51.74% 4.02% 12.84% 2.41% 22.40% 7.75% Drugs (Pharmaceutical) % 88.49% 77.30% 4.52% 3.90% 2.71% 11.51% 7.72% Real Estate (Operations & Services) % 60.78% 43.44% 3.52% 11.19% 2.11% 39.22% 7.66% Business & Consumer Services % 73.89% 50.13% 4.02% 13.76% 2.41% 26.11% 7.58% Building Materials % 75.10% 44.27% 3.52% 22.43% 2.11% 24.90% 7.54% Transportation (Railroads) % 76.63% 31.20% 3.52% 15.11% 2.11% 23.37% 7.53% Household Products % 83.32% 62.02% 4.02% 8.86% 2.41% 16.68% 7.53% Healthcare Products % 83.68% 62.16% 4.02% 6.42% 2.41% 16.32% 7.45% Information Services % 86.56% 40.74% 3.52% 16.46% 2.11% 13.44% 7.44% Electronics (General) % 83.48% 59.34% 4.02% 9.47% 2.41% 16.52% 7.43% Real Estate (Development) % 61.39% 36.15% 3.52% 1.06% 2.11% 38.61% 7.39% Apparel % 78.21% 60.62% 4.02% 13.84% 2.41% 21.79% 7.26% Trucking % 49.70% 43.08% 3.52% 31.25% 2.11% 50.30% 7.22% Retail (General) % 71.69% 46.87% 3.52% 24.75% 2.11% 28.31% 7.22% Healthcare Support Services % 77.75% 54.32% 4.02% 13.84% 2.41% 22.25% 7.20% Environmental & Waste Services % 72.04% 65.51% 4.52% 7.49% 2.71% 27.96% 7.17% Cable TV % 66.84% 41.58% 3.52% 17.19% 2.11% 33.16% 7.16% Packaging & Container % 64.63% 32.10% 3.52% 21.41% 2.11% 35.37% 7.12% Shipbuilding & Marine % 63.72% 60.89% 4.02% 11.82% 2.41% 36.28% 7.07% Beverage (Alcoholic) % 84.56% 58.51% 4.02% 11.28% 2.41% 15.44% 7.05% Paper/Forest Products % 52.89% 38.53% 3.52% 15.88% 2.11% 47.11% 7.01% Retail (Distributors) % 62.37% 52.36% 4.02% 16.42% 2.41% 37.63% 6.89% Shoe % 93.64% 39.02% 3.52% 18.12% 2.11% 6.36% 6.87% Air Transport % 58.90% 51.95% 4.02% 18.34% 2.41% 41.10% 6.81% Steel % 52.15% 51.52% 4.02% 11.49% 2.41% 47.85% 6.80% Retail (Special Lines) % 68.17% 50.69% 4.02% 19.95% 2.41% 31.83% 6.71% Chemical (Basic) % 61.75% 54.20% 4.02% 8.24% 2.41% 38.25% 6.65% Reinsurance % 71.70% 29.15% 3.52% 20.37% 2.11% 28.30% 6.65% Education % 68.38% 59.62% 4.02% 12.05% 2.41% 31.62% 6.63% Insurance (General) % 70.05% 33.57% 3.52% 21.73% 2.11% 29.95% 6.60% Advertising % 64.00% 71.03% 4.52% 3.90% 2.71% 36.00% 6.57% Retail (Grocery and Food) % 68.08% 51.57% 4.02% 23.56% 2.41% 31.92% 6.56% Green & Renewable Energy % 42.93% 62.36% 4.02% 0.77% 2.41% 57.07% 6.53% 52
54 Estimating WACC for Aerospace/Defense Industry Firms Beta Aerospace /Defense Cost of Equity E/(D+E) Cost of Debt D/(D+E) WACC % 83% 3.5% 17% 8.9% 53
55 Economic Profit by Industry as Estimated by NYU Stern School of Business Industry Name Number of Firms Beta ROE Cost of Equity (ROE - COE) BV of Equity Equity EVA ROC WACC (ROC - WACC) Tobacco % 13.75% % $ $(204.07) 77.34% 11.82% 65.51% Advertising % 8.74% 17.21% $4, $ % 6.57% 53.11% Healthcare Support Services % 8.57% 6.01% $162, $9, % 7.20% 34.30% Information Services % 8.27% 15.51% $85, $13, % 7.44% 30.17% Computers/Peripherals % 10.24% 17.28% $228, $39, % 9.01% 26.69% Entertainment % 9.55% 12.37% $99, $12, % 7.90% 25.10% Computer Services % 9.30% 22.93% $59, $13, % 7.75% 22.35% Household Products % 8.55% 4.91% $92, $4, % 7.53% 21.48% Aerospace/Defense % 10.25% 9.94% $158, $15, % 8.86% 21.29% Food Processing % 7.59% 9.98% $94, $9, % 6.45% 16.68% Electrical Equipment % 9.17% 6.27% $29, $1, % 8.01% 16.34% Shoe % 7.20% 18.76% $16, $3, % 6.87% 15.54% Business & Consumer Services % 9.40% 0.60% $48, $ % 7.58% 14.83% Software (Entertainment) % 10.77% 1.53% $12, $ % 10.00% 14.52% Beverage (Soft) % 9.19% 12.80% $62, $8, % 7.92% 14.50% Office Equipment & Services % 13.16% 16.20% $4, $ % 8.99% 14.03% Machinery % 10.88% 1.88% $69, $1, % 8.99% 13.55% Broadcasting % 10.02% 1.71% $31, $ % 6.17% 13.21% Chemical (Specialty) % 9.75% 12.03% $66, $7, % 8.00% 12.20% Food Wholesalers % 6.65% 4.49% $8, $ % 5.80% 12.14% Retail (Building Supply) % 11.10% 34.54% $21, $7, % 9.73% 11.89% Rubber& Tires % 12.23% % $2, $(324.16) 20.05% 8.23% 11.81% Air Transport % 9.88% 34.25% $40, $14, % 6.81% 11.76% Electronics (Consumer & Office) % 9.65% 8.09% $3, $ % 8.72% 11.46% Transportation % 10.74% 9.58% $29, $2, % 8.69% 11.45% Environmental & Waste Services % 8.90% -0.69% $23, $(165.63) 18.31% 7.17% 11.14% Drugs (Biotechnology) % 9.96% 12.39% $95, $11, % 9.20% 11.13% Auto Parts % 9.98% 11.83% $29, $3, % 8.11% 10.27% Restaurant/Dining % 6.83% 25.09% $36, $9, % 5.86% 10.01% Packaging & Container % 9.85% 7.14% $19, $1, % 7.12% 9.98% Retail (Online) % 11.72% 4.24% $26, $1, % 10.99% 9.82% Transportation (Railroads) % 9.18% 9.37% $51, $4, % 7.53% 9.66% Software (System & Application) % 10.23% 1.49% $213, $3, % 9.39% 9.57% Healthcare Products % 8.43% 1.90% $103, $1, % 7.45% 9.30% Cable TV % 9.66% 9.92% $63, $6, % 7.16% 8.88% Beverage (Alcoholic) % 7.90% 5.13% $16, $ % 7.05% 8.80% Apparel % 8.61% 5.90% $27, $1, % 7.26% 8.73% Recreation % 7.76% 3.45% $14, $ % 6.40% 8.40% Building Materials % 9.33% 3.30% $15, $ % 7.54% 8.37% Drugs (Pharmaceutical) % 8.37% 6.84% $240, $16, % 7.72% 7.47% Engineering/Construction % 10.17% -8.43% $30, $(2,595.29) 15.20% 7.88% 7.32% Telecom. Services % 7.94% 4.27% $135, $5, % 5.52% 7.30% Furn/Home Furnishings % 9.65% 3.91% $14, $ % 7.87% 7.20% Retail (Distributors) % 9.60% 5.36% $34, $1, % 6.89% 6.84% Heathcare Information and Technology % 8.93% 2.86% $49, $1, % 7.95% 6.40% Oilfield Svcs/Equip % 12.72% -4.46% $183, $(8,166.12) 16.19% 9.91% 6.28% Retail (Automotive) % 8.63% 25.27% $14, $3, % 6.37% 6.20% 54
56 Economic Profits in Aerospace-Defense Industry Firms Return on Capital WACC ROC-WACC Aerospace/De fense % 8.9% 21.3% 55
57 Economic Profit by Industry as Estimated by NYU Stern School of Business Industry Name Number of Firms Beta ROE Cost of Equity (ROE - COE) BV of Equity Equity EVA ROC WACC (ROC - WACC) Tobacco % 13.75% % $ $(204.07) 77.34% 11.82% 65.51% Advertising % 8.74% 17.21% $4, $ % 6.57% 53.11% Healthcare Support Services % 8.57% 6.01% $162, $9, % 7.20% 34.30% Information Services % 8.27% 15.51% $85, $13, % 7.44% 30.17% Computers/Peripherals % 10.24% 17.28% $228, $39, % 9.01% 26.69% Entertainment % 9.55% 12.37% $99, $12, % 7.90% 25.10% Computer Services % 9.30% 22.93% $59, $13, % 7.75% 22.35% Household Products % 8.55% 4.91% $92, $4, % 7.53% 21.48% Aerospace/Defense % 10.25% 9.94% $158, $15, % 8.86% 21.29% Food Processing % 7.59% 9.98% $94, $9, % 6.45% 16.68% Electrical Equipment % 9.17% 6.27% $29, $1, % 8.01% 16.34% Shoe % 7.20% 18.76% $16, $3, % 6.87% 15.54% Business & Consumer Services % 9.40% 0.60% $48, $ % 7.58% 14.83% Software (Entertainment) % 10.77% 1.53% $12, $ % 10.00% 14.52% Beverage (Soft) % 9.19% 12.80% $62, $8, % 7.92% 14.50% Office Equipment & Services % 13.16% 16.20% $4, $ % 8.99% 14.03% Machinery % 10.88% 1.88% $69, $1, % 8.99% 13.55% Broadcasting % 10.02% 1.71% $31, $ % 6.17% 13.21% Chemical (Specialty) % 9.75% 12.03% $66, $7, % 8.00% 12.20% Food Wholesalers % 6.65% 4.49% $8, $ % 5.80% 12.14% Retail (Building Supply) % 11.10% 34.54% $21, $7, % 9.73% 11.89% Rubber& Tires % 12.23% % $2, $(324.16) 20.05% 8.23% 11.81% Air Transport % 9.88% 34.25% $40, $14, % 6.81% 11.76% Electronics (Consumer & Office) % 9.65% 8.09% $3, $ % 8.72% 11.46% Transportation % 10.74% 9.58% $29, $2, % 8.69% 11.45% Environmental & Waste Services % 8.90% -0.69% $23, $(165.63) 18.31% 7.17% 11.14% Drugs (Biotechnology) % 9.96% 12.39% $95, $11, % 9.20% 11.13% Auto Parts % 9.98% 11.83% $29, $3, % 8.11% 10.27% Restaurant/Dining % 6.83% 25.09% $36, $9, % 5.86% 10.01% Packaging & Container % 9.85% 7.14% $19, $1, % 7.12% 9.98% Retail (Online) % 11.72% 4.24% $26, $1, % 10.99% 9.82% Transportation (Railroads) % 9.18% 9.37% $51, $4, % 7.53% 9.66% Software (System & Application) % 10.23% 1.49% $213, $3, % 9.39% 9.57% Healthcare Products % 8.43% 1.90% $103, $1, % 7.45% 9.30% Cable TV % 9.66% 9.92% $63, $6, % 7.16% 8.88% Beverage (Alcoholic) % 7.90% 5.13% $16, $ % 7.05% 8.80% Apparel % 8.61% 5.90% $27, $1, % 7.26% 8.73% Recreation % 7.76% 3.45% $14, $ % 6.40% 8.40% Building Materials % 9.33% 3.30% $15, $ % 7.54% 8.37% Drugs (Pharmaceutical) % 8.37% 6.84% $240, $16, % 7.72% 7.47% Engineering/Construction % 10.17% -8.43% $30, $(2,595.29) 15.20% 7.88% 7.32% Telecom. Services % 7.94% 4.27% $135, $5, % 5.52% 7.30% Furn/Home Furnishings % 9.65% 3.91% $14, $ % 7.87% 7.20% Retail (Distributors) % 9.60% 5.36% $34, $1, % 6.89% 6.84% Heathcare Information and Technology % 8.93% 2.86% $49, $1, % 7.95% 6.40% Oilfield Svcs/Equip % 12.72% -4.46% $183, $(8,166.12) 16.19% 9.91% 6.28% Retail (Automotive) % 8.63% 25.27% $14, $3, % 6.37% 6.20% 56
58 Locate Average A/D Firm on this Chart % Economic Profit WACC ROIC WACC Weighted average cost of capital how much it costs the corporation to rent the money it has in use (debt + opportunity cost incurred by investors) ROIC Return on invested capital earnings generated by the money the corporation has in use Economic Profit ROIC-WACC returns in excess of the cost of capital Scale 57
59 6. How does industry differ from government in thinking about time and money? 58
60 Industry Perspective 59
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62 61
63 Applying Time Value of Money to Your Personal Finances Assume you can get a 7% return on retirement funds. What is the implication of investing $5K per year starting at 20 years old vs 30? 2 62
64 Time Really is Money 63
65 64
66 WACC in Aerospace Defense Industry Firms Beta Aerospace /Defense Cost of Equity E/(D+E) Cost of Debt D/(D+E) WACC % 83% 3.5% 17% 8.9% 65
67 66
68 What is DOD s Cost of Capital? 67
69 Thought Experiment Given that A/D contractors incur a cost of capital, but the USAF does not, the two think about the time value of money very differently. How might they take advantage of these differences and work together in structuring an acquisition deal to create additional value to both without any additional cost to either? 68
70 Pay Early and Pay Less (or Get More) Assume Contractor has WACC= 9% and must spend $100 in year 1, all of which is allowable costs. Government s Annual Payments Pay Late Scenario Pay Early Scenario Year 1 $0 $50 Year 2 $25 $25 Year 3 $25 $25 Year 4 $25 $25 Year 5 $75 $0 Total Government Payments $150 $125 Government View of Profits $50 $25 Contractor s Rate of Return 10.9% 11% Questions: 1. Based on these projections, will the contractor make an economic profit? 2. Which option should the government prefer, and why? 69
71 Given Time is Money, Owners Expect Good News Quarterly 70
72 6. What are the implications of the drumbeat of quarterly earnings reports? 71
73 Do Quarterly Earnings Call Make a Long-term View More Difficult? 72
74 Earnings Management 73
75 Predictable Patterns in Short-term Cost Cutting 74
76 1. Cut Training 75
77 2. Cut R&D 76
78 3. Cut Maintenance 77
79 7. How do corporations structure management compensation and incentives? 78
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86 85
87 86
88 87
89 Government Contract Data Source: m 88
90 89
91 90
92 9. Are There Unintended Consequences to Corporate Incentives? 91
93 Can you see any unintended consequences for the heavy use of stock options in senior executive compensation? 92
94 93
95 94
96 3. What drives corporate shareholder returns from stock? (Simplified Answer) Three Main Drivers We Will Consider: Dividends Price The Market as a Whole News on an Individual Stock 95
97 Dividends Set by Policy 96
98 Frequency of Occurrence Putting it all together The best strategy for delivering better than average shareholder returns is to drive stock prices up Objective Average Return Shareholder Returns % Economic Profit By consistently delivering suprisingly good news on ability to invest in projects that will generate a return greater than the cost of capital required. Scale
99 Frequency of Occurrence Which is the easier way to drive up stock price? Objective Average Return Shareholder Returns % Economic Profit Scale 98
100 99
101 Growing Trend of Pulling Cash out of Business and Returning it to Shareholders 100
102 101
103 Why Might It Matter? 102
104 103
105 10. What can you do to help USAF work more successfully with industry? 104
106 Biggest Opportunities For Improving USAF Negotiating with Industry Today A. Reduce adversarial approach B. Basic training C. Insist on preparation D. Stop staff acting as line E. Streamline processes 105
107 A. Reduce Adversarial Approach 106
108 Confrontational Negotiation is Instinctive Because it has Proven to Work. In Certain Settings. 107
109 Is USAF-Industry One of those Settings? Condition Single dimension? Once and done? Relationship unimportant? Yes or No No! No! No! 108
110 109 Maybe there is a better way.
111 From Adversarial to Joint Problem Solving From Me Against You To Us Against the Problem. 110
112 This is Not Soft 111
113 B. Basic Training 112
114 Train on Basic Proven Tools: Search for Common Value 113
115 Train on Basics: How to Discover Value Q A Q A Q You propel the conversation forward with open-ended questions. They steer the conversation with their answers. A Q A Q A Q A 114
116 Train on Basics: Position vs Interest 115
117 Thought Experiment on Position Vs Interest Your boss was just called on the carpet by her boss during her quarterly review. She got asked a lot of questions about costs she couldn t answer. Fact is, nobody can answer them because it would require working across three complex systems to integrate a huge amount of data. Your boss clearly heard she was to get this mess cleaned up or risk being replaced by somebody who can. You are head of information services and you ve been advocating for a new information system to integrate the three systems. It would be a huge undertaking - probably taking years and certainly many tens of millions of dollars - but you feel strongly it is would be worth the effort. Your boss calls you in and this is how the conversation goes: Your Boss: The old man went nuts! We ve got to get costs down and we ve got to do it fast. But I m flying blind - I don t know what my costs are! We are drowning in data, but starving for information!!! I m putting you in charge of implementing a new integrated information system to get this fixed. I ll give you 8 months. You: Eight months?!? 116
118 C. Insist on Preparation 117
119 Preparation Template 1 Question Me You Them Interests? Options? 118
120 Preparation Template 2 Values Mine Ours Yours 119
121 D. Stop Staff Acting as Line Legal Counsel General Manager Director Director Director Line reporting Staff support 120
122 Staff Acting As Line 121
123 E. Streamline Processes Start Pure Waste Necessary Waste Essential Valueadding Work Finish 122
124 123
125 Review of Questions What are the legal responsibilities of corporate officers? How do corporate officers think about their obligations to owners? What drives shareholder returns from stock? How do corporations think about Good News? How profitable is the Aerospace/Defense industry? How does industry differ from government in thinking about time and money? What are the implications of the drumbeat of quarterly earnings reports? How do corporations structure management compensation and incentives? Are there unintended consequences to corporate incentives? What can you do to help USAF work more successfully with industry? 124
126 Closing Thoughts 125
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