Cedric Read’s presentation: The CFO is in a unique position to look ahead and really design the business of the future based on his view of the future targets for shareholder value – we’ve seen a move away from historic profit-based measures for measuring the value of companies. Free cash-flow, largely based on the Rappaport model, is the new consensus and we see only a very small proportion of a company’s shareholder value being represented by the assets on the balance sheet. Much more now is based on future expectations or intangible assets. But CFOs are in a position to be benchmarking their companies against their peer group and providing stretch targets for the CEO.
When I worked at BP Amoco, they put a lot of effort into changing the finance function, on the basis that if you change finance, you are in a much better position to change the business. Finance can be a big barrier to change. If you’re trying to break down traditional boundaries between geographies, business units and business processes, finance is a good place to start. Finance should have a vision in its own right in order to focus the company better on its overall business vision.
We underestimated a number of things in the original book [CFO: Architect of the Corporation’s Future (special book offer, see page 46)] which is why we’re now working on a new one [to be called e-CFO: Financial Management for the 21st Century]. Firstly, it’s the speed with which we’ve globalised, and the speed with which industries – such as entertainment and communications – have converged, but above all we underestimated the speed with which the Internet would take off and electronic businesses would flourish.
We’re seeing a move away from investment in physical assets into intangible assets. How well equipped are we as accountants, FDs, financial management specialists, etc to deal with that transition? There’s now a greater focus on the customer – acquiring customers, valuing customers and more importantly finding out what customers value in your organisation.
This all means changing ways of doing business. I’m doing a fair amount of consultancy at the moment on something called “blow up the budget”, to abandon that traditional stricture. Most people argue it gives a degree of control. But the speed with which business models are moving today, fixed annual time-frames become totally irrelevant to managing the business and actually stop you doing the things that will secure the future of the company. But the way you allocate capital then becomes even more important, and one CFO told me recently that the easiest way to make friends was to tell them he wanted to abandon budgeting – but you lose them quickly when you explain that there needs to be even more work to replace that system. Historical reporting is also odd: if companies are being valued on future expectations and future cash-flows, why on earth do we bother reporting our historical stewardship information?
We’ve made our judgements in the past on the assumption that capital has a cost and is scarce. In fact, capital is fairly plentiful and fairly cheap today. The constraint is not so much about finance, but talent and time. We’re designing year-long plans then saying, “Well there’s eleven months to go, what do we do in the first month?” And we’re rewarding people for seniority when a lot of the talent is actually quite junior. We still treat people as a cost, rather than as value, as an asset.
The point that Tom Meredith, CFO at Dell, makes is that the more their business grows, the less capital they require. Working capital goes negative as they’re bringing the cash in quite simply before the cash goes out, and they’re not holding the inventory. Amazon takes that model a stage further, it’s all about generating cash then re-investing that cash fast in expanding their customer base. So there are new models on project appraisal, cash generation and cash deployment. But these companies will have to start showing profits as an indication of the health of their business model in terms of long-term cash sustainability.
In the 21st century, we’re going to have some new principles emerge in the financial management world. We’re going to have valuation principles that can deal with the short-term rather than just the long-term; deal with the future not the past; deal with the instability that’s built into your business models and the way in which your customers are behaving; develop valuation principles that are not focused on tangibles in the way that the old ones are and were, but around the intangibles, valuing the R&D, valuing the advertising and branding, valuing the innovation and talent within the organisation – in fact the things that make up the majority of a company’s valuation; and valuing the customers and the customer base; valuing investments not as risks, but as opportunities – in the financial world we are trained to be risk-averse rather than opportunistic. Finance has now become more a knowledge manager in the organisation, dealing with the knowledge around these intangibles and constraints.
A lot of people are asking what is the role and value of the corporate centre. Diageo, when it was formed, had a portfolio of businesses and faced that question – what are investors expecting that corporate centre to deliver as opposed to investing in those individual businesses. Should some of the support services, such as finance, be shared or dedicated to the individual business units, because we are going to see a lot of change; we may want to keep our systems and support processes dedicated as opposed to shared to give us greater flexibility.
When people ask me for my vision of finance in the future, I say that’s a virtual capability – I actually quote John Smith, FD of the BBC, who puts it at the centre of a web of relationships. It will almost certainly be less that half its size today. It’s globally-based on product markets – it’s not geographic, which for some companies, like Procter & Gamble, is a big move that they’re making. It’s integral to all key decision-making, as it is at Dell. The CFO is at the centre of this portfolio of options, a venture capitalist looking forwards – not backwards where he’s made most of his money up to now; and he’s got to embrace these new disciplines and new frameworks and feel accountable for creating value in the business in his own right.
Lord Renwick: In an AOL/Time Warner scenario, where obviously the management forced the financial institutions to support them, what happens at some point if it doesn’t get a rate of return, when they’re feeling the cash pinch?
Read: For the Procter & Gambles of this world, that are taking it cautiously and in proportion to where they think the value is going to be created on the Internet, and very much in the business-to-business area, they’re concerned that they’ll be rated by the stockmarket in terms of their traditional business model and won’t necessarily have their Internet operations rated against the new metrics. Then you have the business-within-a-business syndrome – how to manage it, but also how to get the stock market to rate it.
Access to huge amounts of capital to fund it isn’t a problem, for those well-established companies to finance the Internet ventures. But then you move to the start-ups, the dot.coms, and there’s a huge amount of effort going into securing their finance and there is hype and froth in the market which is prepared to back it, and people are playing the odds game with one-in-ten succeeding. There is gambling on the froth too.
Neil Warner: I know fund managers who openly admit it’s a gamble, which I find appalling, given they’re managing people’s pension funds. It is essentially gambling. But they feel they have to be there.
Read: Otherwise they’ll be criticised by their investors for not taking advantage.
Neil Warner: But that’s pulling other businesses through to try and want to get this rating where there may be no value.
Read: Yes, and if you look at Dell selling computers direct, it’s a business model which does have some intrinsic value in it, which investors would back, and then it was Internet enabled. That, to me, is a sound way of moving into Internet trading. Amazon is just selling books and distributing them, and there doesn’t seem to be a lot of value in that somewhere along the line.
Richard Hobell: What is actually underlying the values is something that is both very intangible and very volatile as well – not something that is fixed, as in the traditional business models. The other message is that we’ve got a long way to go before we actually clearly define what it is that underlines value and what key performance indicators we’re looking for in a business. We’d all agree that KPIs are the way forward, but I don’t think there’s any balanced scorecard, or anything like that, which gains universal agreement.
Read: We consult around the cash-flow basis for valuation, and we think that through all this volatility the safe way is to translate everything into cash flows and future cash flows. Certainly, we find it very difficult to reflect the volatility unless you take more of an options-based approach, looking at things over a shorter term in terms of what it might be valued at and the probability of it succeeding from one period to another. Taking account of risk in the cost of capital is really testing the technique to its limits.
Norman Renfrew: A lot of what we’ve heard, without being disparaging, was re-cycling trends that we’ve seen in the past. You use different buzzwords, but at the same time Keynesian theory still comes out whatever we like to call it. Basically, the entrepreneurs who get the timing right [on the economic upswing] are going to be the ones who are successful, and maybe they’ll be successful enough to weather the downside. But most people, when things are going wrong [on a macro-economic level], will return to the basics of accounting, cash-flows, profits and all that. We might say it’s old hat, but at the end of the day, when the chips are down, these are the sort of controls that people go back to. And if you have no budgetary system and nothing really rigorous to put in its place, then I would suggest you’re highly vulnerable, you won’t know where you are.
Read: Absolutely: if we do abandon budgeting, we have to put something more rigorous in its place, and it’s a question of what that something is. It does cause you to think more fundamentally about what it is that you’re trying to achieve as a business, how you’re going to measure it, and over what time-scale it’s most appropriate to measure whether you’re succeeding or failing. The budget, and particularly the annual context in which it’s set, is inappropriate.
Rene Carayol: I keep challenging my finance director that I’m not going to be a slave to accounting principles and policies. I don’t know the answers, and I take the message about the necessary rigour; but not so much so that it strangles the business opportunity, and that’s the challenge. I do know that the practices of yesterday will not work. They hinder the pace I want to move at.CEO, property sector (name withheld): Do you think there’s an element of hysteria here – that in fact nothing has really changed? The world has been moving very fast in the past 20 years, and all that’s happened is along has come e-commerce and everyone’s got hysterical: abandon budgets, chuck everything out of the window, let’s do everything differently because the world is moving faster. Are you sure you’re not over-reacting?
Read: I agree, we shouldn’t blame the Internet for the demise of the budget, and I agree that the pace of change, thanks to the Internet or something else, has meant that annual budgeting is looking outdated.
Asif Mashardi: I wondered if your whole concept of the e-CFO wasn’t a complete misnomer. I don’t think the Internet’s changed anything. I think the thing that’s really changed the role of the finance director is the availability of finance. The development of the capital markets has transformed in the last decade, and finance is no longer the scarce commodity that it was. That means you can grow businesses very fast and you don’t have to make profits to balance it. It’s turned the FD into a kind of corporate financier rather than a cost-controller. Everyone’s confusing that with the Internet, which isn’t the fundamental thing at all.
Read: Every business today needs an Internet focus, and it will change the way things are done. So in that sense it’s an appropriate name. We must get the CFO focusing on the impact of the Internet.
Dr Eric Warner: Some of us are involved in businesses that are more mature. Getting the message across and changing the posture of the organisation to address these questions and debate them is very difficult. At the management level? Maybe, but trying to drive it down to the operating units is really hard, not surprisingly because people see it as a threat, it’s about driving out cost, it’s about redundancies, all that good stuff from a financial accounting view. Getting it discussed frankly can be more difficult than in some of these newer organisations.
Read: There is a resistance to change. But it’s perverse: the companies which are in the best position to take advantage of the Internet are the companies which are established, which have the brands and the relationship with customers and the experience. Some will be agile enough to take advantage and some won’t.
Hobell: The question here seems to be this: is this incremental change, or should people change what they do at work tomorrow as a result of this discussion?
Neil Warner: Most of the debates in businesses I’ve been in have centred around “Let’s not throw the baby out with the bathwater,” because what we have today works – the shareholders understand it, the employees understand it. Can we tune a part of it, at increasing speeds, to operate under these new metrics and new technologies? The idea of flipping suddenly is completely wrong. You have to encourage debate and speed up change, but you can’t throw out 100 years of history. When you come to shareholder value, in my model, it used to be you’d do a ten-year cashflow, stick a terminal value in and figure out what your whack is. Well, the terminal value is after three years now, if you’re lucky. How do you put a terminal value on that kind of model?
Read: Well, what would it be worth in six months’ time – to someone else if you choose to sell it, or to yourself if you take advantage?Neil Warner: That seems to me a non-value-added role then. I had a meeting only today with someone whose only purpose was to set up a business to get bought out. The long-term value to the customer was not his priority. It falls apart in those terms.
Read: Building up entities outside your corporate entity, and taking up other partners in order to do it, provides you with an opportunity to move outside the traditional business model. You still have to have a business plan, particularly if you’re raising money. But one thing is for certain: the business plan will be wrong, because you’re in a volatile, uncertain environment, and therein lies both the risk and the reward.
CEO: Well, that’s always been the case – whenever you put a plan together it’s not going to last, but it’s a tool, it’s a discipline.
Read: You have to have a view of the business, yes. And you have a view of what value you’re creating for your customers and why you’re doing it rather than someone else.
Meenu Bachan: One of our senior contacts in Morgan Stanley Dean Witter said that the key thing is that they decided a long time ago that they wouldn’t have budgets because, in many organisations, for long periods, departments aren’t co-operating with each other, they’re competing. So they decided to do away with that negative process. They have commission targets and all have a performance metric, and every project is judged on its merits at the local level where they’re good at making fast decisions.
Read: There is this concept of virtuality, where companies can take some of the routine operations and maintenance and put them in low-cost environment, which means for the rest of the organisation these operations are virtual. On the other hand, while people can grasp this concept (many companies are outsourcing servicing and support to places like India with a well-educated but cheap workforce), the real tease is in the other part of what the finance function does in terms of supporting decision-making and playing their part in strategy: will that become virtual in the sense that it doesn’t have a lot of permanent infrastructure about it? It’s integrated in the business, it’s fast moving, so you’re doing different jobs every day. There’s starting to be more and more virtuality around that role now. And companies are going to find partnering with organisations which develop some of these skills and attitudes becomes more important.
Carayol: I couldn’t agree more. Because of this de-skilling of the finance function, because we have access to a lot of the skills elsewhere, through networks and virtuality, I’m seeing the opportunity not to have to buy skills, and I can buy the personality that suits the culture I’m trying to build. I don’t find the finance people I’ve been looking for in traditional finance roles, either. It’s those that want to come into the dot.com environment that are making it happen, it’s a new breed. And they will be the CEOs of tomorrow, because they’ve already taken one big risk, where they’ve moved from one career path in which excellence and expertise over a long period raise them to a senior position to walking into something that’s extremely high risk. I can see in the future that the finance people who cross that bridge will be the CEOs of tomorrow.
Read: I’d also go to the ICAEW here in London and ask why isn’t the training curriculum addressing the needs of financial management of tomorrow as well as just dealing with the statutory and accounting standard requirements. They would agree with you, I think. But we are currently moulding the raw material in the wrong disciplines.
Dr Phil Blackburn (chairing): One of the key things that I will be taking out of this is that while I’d heard of risk management before, I’d never considered the specialism of “opportunity management”. To me that sounds like one of the missing parts of the jigsaw. And there needs to be a major answer to the question of the valuation of intangibles. I love the description of talent being a key intangible – talent leading to future cash-flows is one of the equations I’d really like to see us work more on. Finally, we must also work out what to do “when our heritage is not necessarily part our destiny” – that is a beautiful epithet for the e-CFO.