Improving the yield on your corporate investment portfolio

Transcription

1 Improving the yield on your corporate investment portfolio Improving the ROI on corporate investments through improved risk management and governance Andrew Walker, Director Deloitte Consulting LLP

2 Executive summary The rapid pace of change in how we use technology and connect with one another is placing significant pressure on companies in the technology, media and telecommunications (TMT) industry. Amplifying this pressure is an increase in competitive intensity 1 at a time when there has been a profound erosion of brand loyalty by consumers. The result is a market in which many TMT companies are vulnerable to a substantial loss of market share from new and often unforeseen products and competitors. Companies can improve their investment returns by strengthening their governance and decision making models and processes. Case studies indicate that establishing the appropriate investment management framework and processes will allow the company to increase its yield on investments by 10% 15% 2, and create the basis for the company to become more aggressive in its markets while building a portfolio balanced between current and future earnings. In order to survive, TMT companies are increasing their investments to both improve their business operations and expand their product and service offerings. However, many companies find that their investments are not generating the expected rate of return. The reasons for this tend to be twofold: 1. Some companies lack the processes necessary to identify, define, and mitigate the risks to their investments. 2. A number of companies lack the appropriate governance and management structures necessary to optimize their individual investments, as well as their portfolios. A World of Options As this paper is being written, there are currently a number of telecommunications carriers claiming to offer the fastest 4G network, at least 20 tablet competitors to the ipad, and 200+ TV channels offered as part of any basic package by any one of the 4 options most households have for TV. In addition, there are other disruptive technologies and companies that offer free telecommunications services, media, and gaming. 1 The concept of Competitive Intensity is discussed in Competitive Strategy, Michael Porter, Deloitte Case Studies As used in this document, Deloitte means Deloitte LLP and its subsidiaries. Please see for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting. 2

3 Increased investment as table stakes The TMT industry is increasingly crowded with new and disruptive competitors (Figure 1). The number of companies, coupled with the pace of change in how consumers and businesses use technology, has created a market in which it is increasingly difficult to maintain pricing power and margins. Companies in the industry are faced with an unending series of challenges as new products and technologies threaten their current businesses and profit centers. As noted in Deloitte s 2010 Shift Index, winning companies are barely holding on while losers are rapidly deteriorating.3 Companies in this industry are left with little choice but to invest heavily in their future products and businesses to survive. Figure 1 Number of S&P500 companies % increase in TMT companies in S&P500 in the last 20 years Exacerbating these challenges is the decline of brand loyalty by consumers. Over the past 10 years, the percentage of consumers who are loyal to a particular brand has fallen from 69% to 44% (Figure 2).4 While there are companies within the TMT industry that have insulated themselves from this phenomenon by introducing high costs of switching, those companies that drive their earnings from the design and strength of their products are at risk of substantial losses should their competitors launch better products. Total Telecom Media Technology Source: Deloitte Analysis, 2011 Figure 2 80% Brand loyalty is at an all time low and declining 69% Consum Consumer brand loyalty 70% er loy al ty tr end 60% 50% 44% 40% 30% The number of competitors, coupled with the loss of brand loyalty, creates a market which is particularly threatening to established players, while providing substantial opportunity to new entrants. As an example, VIZIO, a company founded in 2002 became the largest seller of HDTVs in the United States by 2007, seizing significant market share from the established players in just a matter of five years.5 20% 10% 0% Source: Deloitte Analysis, comscore ARS Data 1 Deloitte LLP (2010). Measuring the Forces of Long Term Change, 2010 Shift Index. 4 Multiple, including comscore ARS 5 VIZIO.com/about 3 Improving the yield on your corporate investment portfolio 3

4 Investments are not generating the required rate of return Deloitte LLP (2010). Measuring the Forces of Long Term Change: 2010 Shift Index % 5% 4% 4.2% 3% 2% 1.3% 1% 1.2% 0% ROA ROIC1 (less NIBCLs) ROIC2 (less NIBCLs and cash) Source: Compustat, Deloitte Analysis Figure 4: Investment Portfolio Expected (Green) versus Actual (Blue) 50 Current programs 40 Consumer Business Wholesale Expected discounted payback years Projected discounted payback years 10 0 Current programs total Expected 4 years Total investment cost $(22) MM Five-year cumulative benefit $100 MM $(77) MM $48 MM $(102) MM $103 MM Five-year NPV -40 Projected Discounted payback Five-year NPV w/4x terminal 6.1 Years $(121) MM 2Q11 (est.) 1Q11 (est.) 3Q10 2Q10 1Q10 4Q09 3Q09 2Q09 1Q09 4Q08 3Q08 2Q08 1Q08 4Q07 3Q07 2Q Q10 (est.) 2. Assumptions/sensitivity risks Small percentage changes to large numbers often create can t miss business cases. A review of a number of TMT investment portfolios suggests that investments in the areas of cloud computing, adjacent markets, international expansion, and professional services suffered most from these types of risk. 6% 1Q07 1. Program delivery risk The risks associated with delivering the expected result on time and on budget. These risks tend to be the set that garners the most focus. Still the history of the industry is rife with examples of missed schedules, cost overruns, and unrealized expectations, particularly on projects and programs that involve substantial changes to IT and large migrations of data. 7% 4Q06 There are three categories of risk in any investment a company decides to undertake (Figure 5). These risks need to be understood, quantified, mitigated, and included in management discussions both prior to the project as well as during its implementation. These risks are as follows: 8% 3Q06 Risk management A primary issue that companies face is that they do not appropriately identify and mitigate risks during the investment process, and they lack the appropriate management model and processes to track, identify, and mitigate new risks as projects progress. Figure 3: Return on invested capital (ROIC) ( ) $ MM cumulative cash flow For all of the well-publicized successes in the TMT industry, companies across all industries have been seeing a long-term decline in their expected returns6 (Figure 3). Based on a review of a number of TMT companies investment portfolios, it appears that one of the causes for this underperformance is the lack of definition and understanding of the investment risks and a structural mismanagement of their investments. A review of a set of investments made by one TMT company revealed that the portfolio was substantially underperforming expectations (Figure 4). In this case, the company s investments were progressing, but shifts in schedule, costs, and benefit realization had substantially eroded the portfolio s performance. 3Q064Q061Q072Q073Q074Q071Q082Q083Q084Q081Q092Q093Q094Q091Q102Q103Q10 4Q101Q11 (est.)2q11 (est.) (est.) Adjusted with projections Including revenue benefit

5 3. External risks and dependencies Market and competitive forces, frequently unknown when the investment decision is being made, often erode the investment s business case.7 This problem is particularly acute in the TMT industry given the pace at which new products and technologies replace existing offers, and new competitors enter the market. Figure 5 Program delivery risks Risks associated with the ability of the organization to successfully deliver a high-quality program in a timely manner within the budget L In making investment decisions, many companies fail to include a weighted-risk analysis against which the investments are measured. Such analyses are useful in evaluating the likelihood of achieving the expected return on investment (ROI). Further, the models used often fail to apply a sensitivity analysis to the business case to understand how changes in assumptions will affect the investment. Portfolios also tend to be overweight on investments to solve current business problems at the expense of investing in innovation that will provide for future earnings the net result is that the company becomes mired in a reactive loop in which it is forever playing catch-up to its more forward-looking competitors. Within the portfolio, companies often fail to segment their projects into the primary types of investment a company makes (Figure 6), raising the risks of mismanagement or failure. Most investments will naturally fall into one of three types: 1. Value investments Projects that are consistent with running the business. These tend to be low risk and L H External risks/dependencies Risks associated with external market factors, such as competitor activities, innovations, or regulations. For example, revenue cases based on market share gains might be at risk of a competitor launch of a comparable or superior product at a lower price point Figure 6 High Quadrant 2: High Value, High Risk 5 Program 5 6 Quadrant 1: High Value, Low Risk 1 Program 6 Program 2 Transformative 11 Program 11 Program 1 H Venture 2 10 Program 10 M Value (ROI) Investment management In addition to risk management, companies often suffer from challenges in how they manage both their individual investments and portfolios. In managing the portfolio, they sometimes lack a governance model and processes that describe how the company will allocate its prospective investment dollars year-over-year. These companies investment portfolios tend to suffer when long-term plans are scrapped to address the latest competitive development or trend. Clearly, some flexibility is necessary and should be within plan; however, substantial losses result from frequent changes in direction. Assumptions/sensitivity risks Risks associated with the assumptions within the program business case. For example, revenue cases with a high degree of variability or those that rely on small percentages of large numbers would be regarded as being high risk Medium Quadrant 4: Low Value, High Risk 4 Program 4 7 L Low 8 High (5) Quadrant 3: Low Value, Low Risk Program 7 3 Program 3 Value 9 Program 9 Program 8 Medium (3) Low (1) Risk Level A series of examples of External Risks & Dependencies are explored in The Black Swan, Nassim Nicholas Taleb, Improving the yield on your corporate investment portfolio 5

6 relatively low return. While they are generally low risk from a delivery perspective, they tend to suffer from external risks as the company continues to make safe investments, even as the market shifts. They typically include efforts related to incremental improvements on products, services, and existing IT. These projects are typically managed using well-known and understood project management frameworks. 2. Transformative investments Investments designed to change how the company operates to make a substantial and measurable improvement to EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) margins. These projects often focus on restructuring a portion of the business or a substantial M&A activity. They require a management and governance framework substantially more robust than is used in a value investment effort. However, they might be mismanaged by companies that treat them like large value investments, rather than recognizing that these efforts require a governance model with substantially more executive involvement and management rigor. 3. Venture investments An investment designed to explore a new and evolving product or service. TMT companies invest in these efforts with the expectation that a number of them will fail with the payback on those that succeed offsetting losses from the failures. These investments suffer the most from assumption and sensitivity risks, and could be mismanaged as the company attempts to use the same governance and management frameworks as are used when managing value or transformative investments. For example, the highly defined project plans, issue logs, and status meetings needed to keep a value investment on track can be very limiting in the venture environment where the team s focus is better spent on innovation and design. In managing both the portfolio and the individual investments, companies often fail to segregate and manage their investments based on both their type and expectations. The result is that many of these projects fail to achieve their expected results because the management frameworks, project expectations and resource allocation models tend to be misaligned with what is needed. 6

7 How to improve your company s yield on its investment portfolio In evaluating the set of possible investments, companies need to look beyond the investments net present value (NPV) and payback, as these alone do not fully capture the relative benefits and risks of projects or the interdependence of investments within a portfolio. Rather, companies should build their portfolio with a focus on assembling the collection of projects that is likely to provide the highest total risk-weighted return on investment. 8 In building and governing the optimal portfolio, the company should try to address the interdependencies between projects, tradeoffs between short- and long-term goals, the three categories of investment risk, optimal levels of funding, and the alignment with business strategy. 9 Within the optimal portfolio is a range of projects that can be prioritized or grouped based on complexity, potential value to the company, risk, and level of alignment to business strategy and the company s roadmap. Below are a series of steps that a company s leaders should follow to improve the management of their investments: 1. Evaluate the current investment portfolio: Review the current investments the company is making to determine whether the risks Program Delivery, Assumptions & Sensitivity, and External have been appropriately factored into decisions, whether each investment is being managed using the appropriate framework, and whether the project aligns with the company s business strategy and roadmap. In reviewing the investments made by a number of clients, we ve found that the output of this evaluation is often a call to action to develop an improved process for investment decision making and governance. 8 Deloitte Development, LLC. (2010). Is your project selection process aligned with the strategic objectives of your organization? Selecting and managing capital projects to achieve the potential for higher returns. 9 Deloitte Financial Advisory Services. (2007). Converting Strategy into Results Through Capital Efficiency. 2. Establish a governance model and process for managing your company s investment portfolio: Investments need to be evaluated, vetted, and scored in a manner that allows for an improved analysis and discussion about alignment to the company s strategy, investment risks, and how to manage the investment. Within this model, investment decisions are made and the performance of investments evaluated on a regular basis. 3. Create expectations for managing and reporting on investments: The standard approaches to project management are often inappropriate for both venture and transformative investments, just as the sort of free-form creativity required for a venture investment or rigor required for a transformative investment would overwhelm the typical value investment. Given the differences in the types of investments a company makes, it might consider establishing guidelines and expectations for how each type will be managed. 4. Change how you measure a program s success: Executives and managers responsible for program delivery are typically incented to keep the program running even as its business case erodes. As a result, corporate portfolios become filled with zombie projects that drain resources while delivering returns that lag expectations. Companies should create ways to recognize and reward executives and managers who report on and kill their own projects when the business case erodes. 5. Establish processes and tools for evaluating investment risk in a consistent and repeatable manner: Risk identification and management are often assigned to the managers responsible for delivering the project. The result is that these activities tend to focus on project risks to the exclusion of sensitivity and external risks. Further, risk management often becomes a mix of bureaucratic processes in which the focus is on a weekly risk log and a cynical exercise in which middle management uses risks to attack threatening ideas. Companies would be well-served to move these activities up the management chain and assign ownership of them to the higher levels of the investment decision and governance team. Improving the yield on your corporate investment portfolio 7

8 6. Align the portfolio to the business strategy: As the structure, processes and tools are established and codified to better manage a company s investment portfolio, it should naturally shift to align with the company s business strategy and roadmap. The portfolio can then be shifted to the emerging priorities of the company, and away from solving today s problems where a high percentage of investment is typically focused. The benefits of establishing the processes, framework, and governance model for managing the corporate investment portfolio are both quantitative and qualitative (Figure 7). The quantitative benefits are the potential improvement of the companies investment yield once the risk management and governance processes have been implemented, while the qualitative benefits tend to be associated with the development of competencies necessary to avoid bad value investments and to improve their management of its transformative and venture investments. Instituting a new approach for the management of the company s investments involves creating a framework and process which shines a light on both investment decisions and performance within functional silos. While there can be resistance to this effort as projects and investment decisions are scrutinized, this approach creates a framework for the company to improve how it is directing its investment and to improve its returns. Figure 7 Type of investment Typical area of improvement Examples of poor investments made by TMT companies Case study benefits Quantitative Qualitative Value Improved recognition of external risks reduces number of bad investments Telecom building copper networks in new neighborhoods (2008) Newspaper buying additional printing capacity for mid-market paper (2007) Typical company portfolio is 75% 85% value investments. Portfolio savings can reach 5% 10% by killing investments that don t support the company s future growth. Reduction in low value work allows company to redirect investments and resources to more important efforts. Transformative Improved governance model, processes and capabilities for managing these types of investments Tech company s >$100m ERP program goes off track. Company replaces Systems Integrator mid-project (2009) M&A transaction fails to achieve expected synergies and future state operating model is not defined (2009) Improved yield on transformative investments can improve portfolio by 3% 5% given the scope and scale of these efforts. Development of transformative capability allows the company to become more nimble in shifting its business and makes it a more threatening competitor. Venture Improved recognition of sensitivity risks Improved governance model, processes and capabilities for managing these types of investments TMT product company fails to achieve growth in services business based on expectations of moving from 0% of market to 2% (2008) TMT company struggles with design and creation of cloud business Project VP notes we have no idea what we re doing & [the company] doesn t know how to invent something like this. (2010) Improved development timelines and management increases likelihood of successfully developing new ventures. Improved yield based on ability to successful translate venture into growth business. Improved ability to innovate and develop into new markets stabilizes the business for long-term growth. 8

9 Conclusion Given the criticality of investment success in the TMT industry, companies would benefit from refining their approach, risk management, and governance frameworks. One approach to doing this is to establish a governance model and framework for managing the investment portfolio in order to evaluate projects based on weightedaverage risks and benefits, ROI, and payback period. Such improvements in how companies evaluate and manage risk, govern their portfolios, and manage individual investments can help improve the overall performance of their investments while providing management with better flexibility in how it responds to competitive threats. This publication contains general information only and is based on the experiences and research of Deloitte practitioners. Deloitte is not, by means of this publication, rendering business, financial, investment, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte, its affiliates, and related entities shall not be responsible for any loss sustained by any person who relies on this publication. Copyright 2011 Deloitte Development LLC. All rights reserved. Member of Deloitte Touche Tohmatsu Limited