This year will be different

A New Perspective on Strategic Planning

By Dean Maschoff, Dave Thompson

July 12, 2002 — Events of late last year-September 11, economic uncertainties, Enron’s collapse, rating agency concerns, and the resultant credit crunch-signaled that times were uncertain.

Ask Chuck Watson, Bill McCormick, Dennis Bakke, or Ken Lay. However, it is apparent that some energy companies did not anticipate which uncertainties would affect their business.

As a result, already in the first quarter of 2002, many companies were forced to lower their earnings expectations for the year (see table, above).

Clearly, risk has increased and the world has changed. But have strategic planning and the resulting strategies changed? This year, we suggest energy companies launch a redefined strategic planning process-one that is highly analytical and balances earnings growth, value creation, and risk analysis.

Earnings Growth
Gone are the days when any company participating in the newly dynamic, deregulated energy market could secure double-digit earnings growth. As evidenced in the first quarter of 2002, a number of energy companies have backed off their growth projections, at least as far as 2002 is concerned.

Although earnings growth targets need to be talked about somewhat more carefully these days, the reality is that energy companies-all companies-need to answer Wall Street’s question: What are your short- and long-term prospects for earnings growth?

Going forward, it is critical that the strategic planning process identifies a specific growth goal that represents “stretch” for the organization. A stretch goal forces management to think and to perform in new ways. The use of a growth target, such as a long-term EPS goal, combined with other appropriately aggressive performance measures can drive “visionary” thinking-challenging constraints and the status quo.

While the development of growth objectives can act as the catalyst for out-of-the-box thinking, too often shareholder value creation and risks are ignored. The new strategic planning process must move beyond a primarily growth-driven plan and incorporate analyses and frank discussions related to value creation and risks.

Value Management
To maximize returns to shareholders, an energy company’s strategic planning process must seek out value creation opportunities across the entire asset chain-an extremely complex task, to say the least.

The application of Value Management concepts to strategic planning takes place in two ways: (1) understanding where value is created or destroyed within the existing business portfolio, and (2) assessing the impacts of growth initiatives on shareholder value. The ultimate outcome should be the optimal deployment of capital resources across both existing businesses and new opportunities.

Companies must accept the challenge to move from simple value metrics (e.g., NPV or ROE) to a greater understanding of where value is created and destroyed using measures such as Risk-Adjusted Return on Invested Capital or Return on Risk Capital. The application of higher hurdle rates for risky businesses, liberally applied to project approvals, is too often ignored when looking at entities within the portfolio.

A SBU or investment may be projected to return above the corporate cost of capital when, in fact, compared to its risk profile, it may be destroying share-holder value. At a minimum, management should talk about which strategies can improve performance or why a certain business should remain in the portfolio.

Strategic planning must take a more sophisticated view of the utility business and apply the same degree of analysis that all investment opportunities receive from a value creation/destruction perspective.

Risk/Volatility Analysis
Value concepts provide a needed filter, but akin to many traditional analyses, they only provide a static view of the plan. When the concept of Risk/Volatility Analysis is applied to strategic planning, management can build a truly dynamic view of the future.

Risk/Volatility Analysis seeks to determine the impact of uncertain risk drivers on key performance measures such as earnings, returns, and interest coverage. This next evolution of strategic planning embraces the analytical concepts from enterprise risk management, for example Monte Carlo simulations and risk drivers with probability distributions.

Understanding the interactions among SBUs and their impact on overall portfolio variability is a primary application of risk in the strategic planning process. For example, the concept of a M&A strategy to reduce risk, an unlikely concept a year ago, now becomes an interesting discussion for management. Clearly, acquisitions or investments in new business lines have to make strategic sense, but ignoring risk and the impact on earnings volatility is inconsistent with recently’s business environment.

Identifying the impact of key drivers across the enterprise is another example of Risk/Volatility Analysis:

“- How exposed are we to energy commodity prices-gas, power, coal?

“- How could new environmental policies impact the utility’s level of risk?

“- Beyond the earnings to contribute, how do our non-regulated businesses impact the volatility of our earnings?

For example, in connection with one recent client engagement, management was stunned to learn that their current plan had significant earnings at risk. Downsides associated with the core business (e.g., increasing likelihood of significant expenditures for environmental compliance, lower margins in wholesale power markets) suggested that achieving growth targets would be very difficult, if not impossible.

The Risk/Volatility Analysis forced the team to deal with a number of “sacred cows” and resulted in new thinking on their long-term growth objectives and fundamental corporate strategies.

The truth is, management often has limited insight as to how reasonable their plan is from a risk perspective. Is the plan achievable? Do we have a 50-50 chance of success or a 1-in-10 chance? The new strategic planning process has to be able to answer these questions and identify actions to address variability in the plan.

Action Plan
Any planning process worth its salt considers growth, value, and risk in some fashion. The question is, has the business environment–challenges, opportunities, uncertainties-changed sufficiently so that senior management needs to adopt a new approach to strategic planning? The answer is a no-brainer … yes. Now, the questions are what and how.

To improve this year’s strategic planning process, a company can take steps with the objective of building, improving, and moving the process forward over time.

“- Ensure the process leads to strategies that are aligned with quantified growth targets. These targets should set the bar high enough to drive creativity and changed thinking throughout the entire leadership team.

“- Develop analytics related to value creation for SBUs and for the corporation as a whole. Use these value analytics to make portfolio decisions-which businesses to grow and which businesses to sell or divest. Focus the process on identifying strategies that will improve value creation.

“- Embed risk/volatility analytics throughout the process. Don’t let the process shoot down a strategy with a generic hand-wave like, “I think it’s too risky.” Or, don’t accept a strategic growth proposal with, “I think the risks are manageable.” Be specific. What are our earnings at risk? What are the top five risk factors to our business and how important are they? How does a given strategy impact our risk profile?

“- Create an overall process that is information- and analysis-based, without getting bogged down in dozens of income statements, probabilities, etc. Force fact-based strategic conversations on the trade-offs of growth, value, and risk.

In today’s dynamic business environment, a company’s planning process must take into account a wide range of possible industry marketplaces and structures, as well as a higher degree of uncertainty. If any business process needs to move to a new level, it’s the strategic planning process. The stakes are too high.

To contact Dean Maschoff, e-mail to dmaschoff@mcr-group.com. To contact Dave Thompson, e-mail dthompson@mcr-group.com.

For more information, visit MCR Performance Solutions’ web site at http://www.mcr-group.com.

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