Why cost cutting never works!

Cost cutting never improves a company. Period.

We've become so used to reading about reorganisations, layoffs and cost cutting that most people just accept such leadership decisions as “best practice”. No matter the company, or industry, it has become conventional wisdom to believe cost cutting is a good thing.

As a reporter recently asked me about layoffs at Yahoo, “Isn't it always smart to cut heads when your profits fall? Of course not. Have the layoffs at Yahoo in any way made it a better, more successful company able to compete with Google, Microsoft, Facebook and Apple? Given the radical need for innovation, layoffs have only hurt Yahoo more -- and made it more likely to end up like RIM (Research in Motion.)

But like believing in a flat world, blood-letting to cure disease and that meteorites are spit up out of the ground , this is just another conventional wisdom that is untrue; and desperately needs to be challenged. Cost reductions are killing most companies, not helping them.

Take for example Sara Lee. Sara Lee was once a great, growing company. Its consumer brands were well known, considered premium products and commanded a price premium at retail.

The death spiral at Sara Lee began in 2006. “Professional managers” from top-ranked MBA schools started “improving earnings” with an ongoing programme of reorganisations and cost reductions. Largely under the leadership of the much-vaunted Brenda Barnes, none of these cost reductions improved revenues. And the stock price went nowhere.

With each passing year Sara Lee sold parts of the business, such as Hanes, under the disguise of “seeking focus.” With each sale a one-time gain was booked, and more people were laid off as the reorganisation continued. Profits remained OK, but the company was actually shrinking - rather than growing.

To prop up the stock price all available cash was used to buy back stock, which helped maximise executive compensation, but really did nothing for investors. R&D was eliminated, as was new product development and any product launches. Instead, Sara Lee kept selling more businesses, reorganising, cutting costs --- and buying its own shares. Until finally, after Ms. Barnes left due to an unfortunate stroke, Sara Lee was so small it had nothing left to sell.

So the company decided to split into two parts! Magically, it is like pushing the reset button. What was Sara Lee is now an even smaller Hillshire Brands. All that poor track record of sales, profits and equity value goes POOF as the symbol SLE disappears, and investors are left following HSH - which has only traded for about 2 days! No more looking at that long history of bad performance, it isn't on Bloomberg or Marketwatch or Yahoo. Like the name Sara Lee, the history vanishes.

Well, “if you can't dazzle 'em with brilliance you baffle 'em with bull**it” W.C. Fields once said.

Cost cuts don't work because they don't compound. If I lay off the head of Brand Marketing this year I promise to save $300,000 and improve the Profit & Loss Statement (P&L) by that amount. In effect, a one-time improvement. Now , ignoring the fact that the head of branding probably did a number of things to grow revenue, the problem becomes, what do you do the next year? You can't lay off the Brand V.P. again to save that $300,000 twice. Further, if you want to improve the P&L by $450,000 this time you actually have to find 2 directors to lay off!

Shooting your own troops in order to manage a smaller army rarely wins battles.

Cost cuts are one-time and are impossible to duplicate. Following this route leads any company toward being much smaller. Like Sara Lee. From a once great company with revenues in the $10s of billions, the new Hillshire Brands isn't even an S&P 500 company (it was replaced by Monster Beverage). And how can any investor obtain a great return on investment from a company that's shrinking?

What does create a great company? Growth! Unlike cost cutting, if a company launches a new product it can sell $300,000 the first year. If it meets unmet needs, and is a more effective solution, then the product can attract new customers and sell $600,000 the second year. And then $900,000 or maybe $1.2M the third year. (And even add jobs!)

If you are very good at creating and launching products that meet needs, you can create billions of dollars in new revenue. Like Apple with the iPhone and iPad. Or Facebook. Or Groupon. These companies are growing revenues extremely fast because they have products that meet needs. They aren't trying to “save the P&L.”

And revenue growth creates “compound returns”. Unlike the cost savings, which are one time, each dollar of revenue produces cash flow that can be invested in more sales and delivery, which can generate even more cash flow. So if growth is 20 per cent and you invest $1,000 in year one, that can become $1,200 in year two, then $1,440 in year three, $1,728 in year four and $2,070 in year five. Each year you receive 20 per cent not only on the $1,000 you invested, but on returns from the previous years!

By compounding year after year at 20 per cent, investor money doubles in five years. That's why the most important term for investing is CAGR - Compound Annual Growth Rate. Even a small improvement in this number, from say 9 per cent to 11 per cent, has very important meaning. Because it “compounds” year after year. You don't have to add to your investment -- merely allowing it to support growth produces handsome returns. The higher the CAGR the better.

Something no cost cutting programme can possibly due. Ever.

So, what is the future of Hillshire Brands? According to the CEO, , the company's historically poor performance could be blamed on ----- wait ----- insufficient focus. Alas, Sara Lee's problem was obviously too much sales! Well, good thing they've been solving that problem.

Of course, having too many brands led to too much lateral thinking and not enough really deep focus on meat. So now that all they need to think about is meat, he expects innovation will be much improved. Right. Now that HSH is a "meat focused meals" company, and the objective is to add innovation to meat, they are considering such radical dietary improvements for our fat-laden, overcaloried American society as adding curry powder to the frozen meatloaf. Not exactly the iPhone.

To create future growth the first act the new CEO took to push growth was -- wait -- cutting staff by $100million over the next three years. Really. He will solve the “analysis paralysis” which seems to concern him as head of this much smaller company because there won't be anyone around to do the analysis, nor to discuss it and certainly not to disagree with the CEO's decisions. Perhaps meat loaf egg rolls will be next.

All reorganisations and cost reductions point to leadership's failure to create growth. Every time. Staff reductions say to investors, employees, suppliers and customers: "I have no idea how to add profitable revenue to this company. I really have no clue how to put these people to work productively -- even if they are really good people. I have no choice but to cut these jobs, because we desperately need to make the profits look better in order to prop up the stock price short term; even if it kills our chances of developing new products, creating new markets and making superior rates of return for investors long term."

Hillshire's CEO may do very well for himself, and his fellow executives. Assuredly they have compensation plans tied to stock price, and golden parachutes if they leave. HSH is now so small that it is a likely purchase by a more successful company. By further gutting the organisation Hillshire's CEO can reduce staff to a minimum, making the acquisition appear easier for a large company. This would allow a premium payment upon acquisition, providing millions to the executives as options pay out and golden parachutes enact.

And it might give a return to the shareholders. If the ongoing slaughter finds a buyer. Otherwise investors will see the stock crater as it heads to bankruptcy. Like RIM and Yahoo. So flip a coin. But that's called gambling, not investing.

What investors need is CAGR. Not cost cutting and reorganisations. And as I've said since 2006 -- you don't want to own Sara Lee; even if it's now called Hillshire Brands.

(Adam hartung is the managing director at Spark Partners.)