Selling Home Depot Supply

This article describes critics who think Home Depot should not be selling its Supply unit, which serves contractors. The critics argue that the firm is forsaking the potential growth in that segment simply because it wants to "exorcise Nardelli's ghosts." The critics argue that the private equity firms will make a great deal of money on the Supply unit.

The critics are missing a crucial point. The issue is NOT whether the Supply unit is an attractive and potentially quite profitable business. This issue is whether the Supply unit is BETTER OFF as an independent company vs. within Home Depot. Moreover, the issue is whether Home Depot's retail business is better off on its own or when combined with the Supply unit.

This example demonstrates a larger point. When firms consider diversification, they must not only look at whether a new business unit will provide higher growth and profits... they must also consider whether that new unit will perform optimally as part of the diversified firm, or whether it will be better off on its own or as part of some other corporation. Shareholders benefit most when a business unit is located in an organizational situation in which it can perform best.

Mike Watkins on The Mistakes New Executives Make

Michael Watkins has a wonderful new post on his blog about the mistakes executives make when they join a new firm. He points out that many executives stumble because they try to recreate the organizations from which they came. There is no question that this is true. I have seen this so many times in my research and consulting.

I can recall one remarkable incident in my class several years ago, when Emerson Electric's former Chairman and CEO, Chuck Knight, visited my class. We discussed Emerson's highly regarded strategic planning process. I told the class that there is no one best way to conduct strategic planning; instead, a firm must match its strategic planning approach to the industry dynamics, firm strategy, organizational culture, and leadership style of the CEO. To bolster this point, I shared a quote from Charlie Peters, one of Knight's top executives at Emerson. Peters once said, "

• "Many companies come to Emerson wanting to find out what we are doing and why it works. But often, the trip is wasted. Our process works for us because of the type of impact we are trying to have on our businesses and because of our CEO, Chuck Knight – how he likes to operate and his relationship and status with the divisions. Other companies can’t duplicate that."

Interestingly, a student then asked Chuck Knight if he would have tried to replicate the Emerson strategic planning process if he had gone on to another firm, rather than retiring after he stepped down as CEO of Emerson. Knight offered a fascinating answer. He said that it probably would have been the wrong thing to do, in that the new situation most likely would have called for a substantial adaptation of the Emerson process to fit the needs of that particular company. However, he said that he would have been tempted to simply transport what he done at Emerson to the new firm. He said that this is what CEOs do...they rely on what made them successful. It's easy to convince oneself that this approach will work anywhere.

Knight's remarkably thoughtful comments reinforce the point that Mike Watkins makes in his blog. It is incredibly tempting for executives to want to replicate the the methods and techniques that worked for them in other organizations in the past. However, in business, there is often not "one best way" to do things. Success in business is so often about fit or alignment. The methods and practices must be adapted to fit the current situation and context.

China, Outsourcing, and Transaction Costs

Each day seems to bring new headlines regarding tainted products from China. Mattel has been hit especially hard, with the discovery of many toys containing lead paint. For me, the news about tainted Chinese products offers an opportunity to remind students and executives how to think strategically about outsourcing, rather than focusing singlemindedly on manufacturing cost reductions.

Let's go back to the fundamental strategic choice regarding vertical integration. What should drive the decision by a firm to produce its own inputs (or to conduct its own manufacturing in-house) versus outsourcing these activities to external vendors? Firms need to consider more than simply the direct manufacturing costs of performing these activities in-house vs. outsourcing them. They must consider the transaction costs associated with outsourcing production. In other words, how expensive is it to write contracts with external vendors, to monitor vendor behavior, enforce contractual provisions, control quality, etc.? Many firms underestimate these "costs" associated with using the market (i.e. outsourcing to an external vendor) versus keeping certain activities within the firm.

Quality control can be a very important reason why production is kept in-house instead of outsourcing it. We are learning from the tainted Chinese products situation that the transaction costs associated with quality control of outside vendors can be very high. The transaction costs come not only in the form of expenses associated with monitoring external vendors, but also in the form of a damaged brand in the event of a major recall.

Let's take a simple example of how control can be a key reason for keeping certain activities in-house. Why does Apple choose to operate its own retail stores? One reason is that they want to control the customer experience and the quality of the customer service that people receive. Of course, there are other reasons as well, but control is a critical one. Similarly, Disney owns some hotels in and around its theme parks because it wants to control the quality of the customer experience. Consider the risks and costs associated with having external parties in charge of the experience that families have at a Disney resort.

My argument is not that outsourcing should never occur. I simply aim to remind managers that they must consider the nature of transaction costs when making the outsourcing decision. Of course, there are transaction costs associated with keeping production in-house. The key is to compare the transaction costs of using the market (outsourcing) vs. keeping production in-house.

Finally, firms have to remember these strategic decisions are dynamic in nature. It may make sense to keep certain activities in-house at this point in time, but then outsourcing may become more attractive down the road. For instance, Disney used to own its retail store chain. One can see why they might want to control that customer retail experience. However, once they had operated this chain for some 15 years, they made the decision that they now could establish a licensing agreement, and allow an experienced retailer (Children's Place) to run the chain. Think of it this way. In the 1980s, when they launched the retail chain, they might have felt it was quite difficult, costly, and risky to establish a contract with an outside firm to operate Disney stores. However, now that Disney has run the stores for many years, they may feel more comfortable that they can write an enforceable contract that allows them to maintain quality control without running the store themselves.

Merck & Sunk Costs

The sunk cost effect refers to the tendency for people to escalate commitment to a course of action in which they have made substantial prior investments of time, money, or other resources. If people behaved rationally, they would make choices based on the marginal costs and benefits of their actions. The amount of any previous unrecoverable investment is a sunk cost and should not affect the current decision. However, research demonstrates that people often do consider past investment decisions when choosing future courses of action. In particular, individuals tend to pursue activities in which they have made prior investments. Often, they become overly committed to certain activities despite consistently poor results. They “throw good money after bad”, and the situation continues to escalate.

Many companies face the problem of the sunk cost effect. In fact, it's particularly problematic for firms involved in extremely expensive and lengthy product development projects. In those situations, the sunk costs can be enormous, and it can be very difficult for managers, scientists, and/or engineers to walk away from a project in which they have not only invested a great deal of money, but also much time, energy, and personal reputation.

A recent Business Week article suggests that Merck has found a way to try to combat this problem. Here's a snippet from the article (for the entire article, click here):

Merck is rewarding scientists for failure. One of the hardest decisions any scientist has to make is when to abandon an experimental drug that's not working. An inability to admit failure leads to inefficiencies. A scientist may spend months and tens of thousands of dollars studying a compound, hoping for a result he or she knows likely won't come, rather than pitching in on a project with a better chance of turning into a viable drug. So Kim (Merck R&D head Peter Kim) is promising stock options to scientists who bail out on losing projects. It's not the loss per se that's being rewarded but the decision to accept failure and move on. "You can't change the truth. You can only delay how long it takes to find it out," Kim says. "If you're a good scientist, you want to spend your time and the company's money on something that's going to lead to success."

Jensen vs. Langone

Business Week has a good wrap-up of an interesting exchange about private equity between Harvard Professor Emeritus Michael Jensen and Home Depot founding investor Ken Langone. These kinds of spirited discussions aren't typical for the Academy of Management meetings. I wish that we could find more ways to infuse the meetings with these kinds of exchanges between practitioners and academics.

Private Equity IPOs

Private equity seems to be all over the headlines these days, with a range of issues coming to the fore. I'd like to focus here on the issue of private equity shops going public. To me, the rationale is very weak. One of the fundamental reasons why private equity firms add value is their superior model of governance and control. As I have written previously, private equity firms have expanded rapidly, in part because they solve some of the governance problems posed by the large publicly traded corporation, with its separation of ownership and control. In short, I believe the ownership and governance structure of a private equity firm has the potential to dramatically reduce agency costs relative to a publicly traded firm.

Going public changes things significantly. For years, strategic management scholars and consultants have argued (and shown empirically) that conglomerates (unrelated diversified firms) trade at a discount, that they are worth less than the sum of their parts. You all know the reasons - they have been well-articulated over many years. Well, if a private equity firm goes public, then precisely what is the difference between it and the typical conglomerate? The private equity firm begins to look much more like the usual unrelated diversified firm. A private equity firm no longer can argue that its governance structure poses a substantial advantage over the old style publicly traded conglomerate.

I have heard many of the reasons why private equity firms are going public, beyond the fact that it offers an opportunity for enhancing personal wealth. Access to capital, ability to recruit and retain talent, management successsion... none of these seems like a persuasive argument. These firms have been wildly successful raising capital and attracting talent, while remaining privately held. Even if there were some advantages to going public, they must be weighed against the substantial disadvantage outlined here with respect to agency costs and corporate governance. To me, those disadvantages clearly outweigh the possible benefits of conducting an initial public offering.