Extreme Cost Cutting?
Wall Street cheers cost-cutting. So do investors. In theory, it lowers expenses, which increases profits, and that improves stock performance. But cost-cutting can also go too far, to the point of cutting corners. That’s when companies incur dangerous efficiencies in the name of saving money and increasing profits.
We’ve had a number of really good bad examples in the past couple of years.
The Volkswagen cost-cutting story is only the most recent example of how the strategy turned to cutting corners and ended in disaster.
On September 18, it came out that Volkswagen skimped on emissions-testing equipment during a six year period, from 2009 through 2014. The skimping involves 10.8 million diesel powered vehicles. The purpose was to get around emissions testing requirements in the US for only a few hundred thousand of those vehicles. The omission of the required equipment saved the company about 400 euros per car, or about $4.8 billion in total.
But when the equipment omission came to light, the company faced an avalanche of bad news. Volkswagen has experienced or is facing the following:
- Criminal investigations
- Substantial fines
- A corporate governance crisis (Volkswagen’s CEO resigned on Sep.22, after claiming no knowledge of the missing equipment)
- The company’s stock has plummeted – some 29 billion euros in market capitalization has been wiped out on the heels of the scandal
- It’s likely that substantial damage has been done to a well-regarded automaker, that is likely to show up in reduced sales
Broken down on a per shareholder basis, it’s been estimated that Volkswagen shareholders have lost 140 euros for every one euro saved as a result of excluding the testing equipment from the vehicles.
It will be a while before the Volkswagen scandal is completely worked out, but the financial loss suffered by the company far outweighs the benefit received even at this early stage. This is a classic case of a major company turning cost cutting into corner cutting.
This side of the Atlantic Lumber Liquidators generated a similar cost-cutting crisis earlier this year.
Back in March it came out that Lumber Liquidators was cutting corners on its hardwood floors. The company had its flooring manufactured by factories in China that were using unacceptable levels of formaldehyde in the wood. Though the company insisted that its wood flooring was up to code, tests revealed that much of it included glue that had between six and 20 times the legal limit on formaldehyde in the state of California. Formaldehyde is a known carcinogen.
Installing wood flooring is extremely popular among American homeowners. But it is also a very expensive upgrade. For example, according to Home Depot, the cost of installing 1000 square feet of wood flooring cost at least $6,760. Lumber Liquidators however was selling its flooring product for $2,740, substantially less than half the cost at Home Depot.
Naturally, Lumber Liquidators’ much lower priced wood floors were extremely popular with consumers, generating a large market share for the company. But as a result, it is now estimated that some 100 million square feet of toxic wood flooring is now installed in American households.
The company tried to buy a larger market share by cutting corners selling the cheaper wood flooring manufactured in China. Now the company has a huge mess to clean up.
In May, Lumber Liquidators’ CEO Robert Lynch resigned as a result of controversy. At that point, the company stock had fallen more than 60% just since March. Shortly after, Dan Terrell, the company’s chief financial officer also left the company. Meanwhile, the company is being investigated by the Consumer Product Safety Commission, specifically for the use of formaldehyde in the products that sells.
Cost-cutting fever got the better of General Motors in 2014, and the company is still cleaning up the mess now.
In May of 2014, the company was fined $35 million by the National Highway Traffic Safety Administration (NHTSA), as a result of failing to recall cars with faulty ignition switches for a period of more than 10 years. The company was aware that there were problems with the switches, but chose not to act. More than 100 people have died as a result of the defective ignition switches.
The NHTSA fine is probably the smallest of GM’s payments. 15 employees were fired as a result of the scandal. The company is facing customer lawsuits for as much as $10 billion, and has resulted in the recall of 23 million GM-built cars around the globe. In September, GM paid $900 million in fines with the US Department of Justice.
Including the above fines, but not all pending lawsuits, the delayed recall of the ignition switches is already cost GM $4.4 billion.
Ironically, the ignition switch scandal has not hurt GM’s stock price. It’s recently been in the neighborhood of $33 per share, which is only slightly below where it was before news of the scandal broke. But it can be argued that the overall market increased significantly during that time period, while GM’s stock price languished, given that the company was mired in legal battles with an uncertain liability.
Cost-cutting has become a heavily worked strategy in recent decades. But it’s clear that, like virtually every other strategy existence, cost-cutting suffers from diminishing returns. An overzealous attempt to cut costs can lead to corner cutting disasters, costing both lives and money.
Moral of the story: be careful investing in any company that seems too aggressive in cost-cutting efforts. Corner cutting could be hidden in the mix.
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