Friday, June 18, 2010

PRODUCT RECALLS-A CURSE OR A GOOD NEWS?

Product recalls have earned much criticism over time. First, it was considered a taboo with consequences that could spell doomsday for the accused. Then, it made the shareholders utterly uncomfortable. Today, the CEOs are being forced to embrace it as a part and parcel of their lives. After all, is a product recall so unforgivable an act?

What’s it with product recalls that gets the world staring at the accused with a frown-filled skeptical look? Profit-seeking investors count such actions on behalf of the corporations as just another signal of failure heaped upon failure. But the inevitable truth is – the buck stops at the CEO, or in other words, the man at the top! My discussion focuses on the recent slamming of Akio Toyoda, whose family-founded Toyota Motor Corporation has amassed recalls of 8.4 million vehicle units so far during the year, which included the iconic Prius, Corolla and Camry models. The US government, of course, gave him a stick of its own – $16.4 million in fines payable to US Safety Regulators for failing to warn about the defects on a proactive basis. Meanwhile, work went on at Toyota’s plants.

A majority of the studies conducted over decades on product recalls comment that recalls, in general, tear down both investor and consumer sentiments. Some have gone to the extent of even quantifying how disastrous recalls can prove to bottomlines and share prices. One such report published in the Quarterly Journal of Business and Economics claims after analysing 269 product recalls over a period of 20 years that the mean cumulative abnormal returns (MCAR) were negative over the post event period, hovering around 3% from day 13 to 36, with the largest MCAR being -3.55% on event days 19 and 20. Several studies in the past by Jarell & Peltzman (1985), Pruitt & Peterson (1986), Hoffer (1987), Bromiley & Marcus (1989), Davidson and Worell (1992), Thomsen & McKenzie (2002), Chu, Lin & Prather (2005), Heerd, Helsen & Dekimpe (2007), Chen, Ganesan & Liu (2008), Zhao & Stephen (2009) have also proven that product recalls are associated with decrease in shareholder value.

But that’s where I realised that many of these studies, perhaps all of them I dare say, got it critically wrong. All these abovementioned works suffered a common ailment – the observation window was “limited” to anywhere between -1/+1 (days) and -60/+60 (days) of the recall announcement. What about the longer term effect? The fact is that contrary to what these reports mention, product recalls in fact should have been improving the customer perception about a corporation’s commitment to quality. Especially as the company helps ‘correct’ a past mistake transparently and truthfully. Was this hypothesis of mine correct?

I decided to do a deeper and a wider time window analysis of the fi ve most publicized product recalls in history (considering volumes as well), and see whether these recalls added to or negated from the company’s future performance.

1. TOYOTA’S RECALL OF 8.4 MILLION VEHICLES IN 2010: After posting losses of $4.8 billion in FY2009, the Japanese carmaker had the worst start to the new year amongst all automakers, at least as far as brand image and goodwill were concerned. But that’s where the black suit ceremony ends. The Japanese car manufacturer is extremely confident about a quick recovery and has predicted a net profit of $892 million for FY2010 – a far improved situation as compared to the previously forecasted loss of $2.2 billion by the company. Better still, as per estimates by Thomson Reuters, the automaker is set to

record $1.74 billion in net profits during 2010, a figure which will skyrocket to $8.32 billion by 2011. And here’s a treat for shareholders who have been plagued by hearsays about how recalls lead to value erosion. Even as news of how Toyota planned to exceed its initial recall estimates started doing the rounds on February 5, 2010 (with an additional recall of 270,000 Prius units in US & Japan, to fix their brakes), the company’s share surprisingly rose 4.1% to close at $74.71 on the NYSE. That was a day when even the Nikkei 225 fell by 2.9% to a 60-day closing low. The
five year comparative analysis of the Toyota share performance on NYSE vis-avis the S&P 500 shows that the automaker has beaten the benchmark index consistently over the past half-a-decade, and that the recalls haven’t spoilt Toyota’s game. Lesson learnt – if you’ve earned a goodwill already, even a couple of record-setting recalls won’t hurt, as Bob Johnston, Deputy Dean (Operations and Finance), Professor of Operations Management of Warwick Business Schools puts it in a line: “Companies can get away with recalls once or twice in a period of time!” I should add, “Too profitably!”

2. FORD’S RECALL OF 14.1 MILLION VEHICLES IN 2009-10: Another auto major, another record. Having recalled 4.5 million vehicles in October 2009, Ford Motor Company recorded the highest aggregate number of recalls in history in a single stretch. The record – 14.1 million units. That should have destroyed all hopes for the Detroit carmaker, which was supposedly in the worst shape when 2009 began, having made $17.3 billion in cumulative losses during FY2007 and FY2008. But instead of moving downhill, the figures climbed and share prices shot up. In the past one year, the Ford stock has gained 98% in value, outperforming the S&P 500 by a long way. When FY2009 came to a close, instead of recording a negative bottomline (as was anticipated amidst the recalls), the Alan Mulally led giant got the better of cynics, scoring a positive bottomline of $2.71 billion. Even the first quarter of FY2010 was good news, with the company announcing $2.09 billion in profits. Learning: Having a super dual-role perfoming man on top (CEO & President) like Mulally helps. Recalls do too!

3. JOHNSON & JOHNSON’S RECALL OF 84 MILLION UNITS IN 1982 AND 2010: Within a span of a week in 1982, seven Chicago dwellers died without a serious ailment. Reason: they had consumed the ‘Extra Strength Tylenol pain-and-fever reliever’. The catch? It was cyanide-laced. This forced McNeil Healthcare (Johnson & Johnson’s consumer healthcare subsidiary) to recall 31 million units of Tylenol. The move was made with all haste. By the time the year ended, J&J’s stock had actually gained 38.9% in value to touch $1.75 on the NYSE! The year 2009 and 2010 saw a repeat. The company recalled 53 million units of Tylenol on two occasions – December 18, 2009 and January 15, 2010. The stage was set for the recalls to fracture the first quarter results and share prices of J&J. Worse, unlike eighteen years back, the company had withdrawn the compound after 20 months of complaints. It had acted slowly. Critically, the troublesome consumer healthcare category contributed to 24.12% of total revenues from J&J’s overall portfolio. But the markets chose to move against expectations. There were immediate positive gains. A day following the recall of December 18, 2009, the J&J stock climbed by 0.25%, and following the recall of January 15, 2010, the stock gained 1.23% in the next trading session! As far as financials are concerned, J&J recorded a 29.1% y-o-y increase in quarterly profits, which touched $4.53 billion for Q1, 2010 and a 28.6% increase in EPS which stood at $1.62. Learning: Be truthful to the public, publicise your recalls fervently, and see such moves as invaluable marketing opportunities!

4. MERCK’S RECALL OF ARTHRITIS DRUG VIOXX IN 2004: Within five years of receiving the FDA approval, Merck recalled the Vioxx drug, which had earned it revenues totalling $2.3 billion in 2003. The drug was known to double the risk of sudden cardiac attacks leading to deaths than those who took Celebrex (Vioxx’s main rival). FDA researcher David Graham, who was the lead scientist testing the dangerous side effects of the drug, after an analysis of a database of 1.4 million patients also proved that same year that Vioxx had led to more than 27,000 sudden cardiac- arrest related deaths in US, since it was launched in 1999. On September 30, 2004, Merck was forced to remove the blockbuster drug from the market. When news of this reached the bourses, the stock plunged 26.77% on that fateful Thursday, stripping-off $28 billion of shareholder wealth, leaving Merck’s Mcap battered at $75.41 billion. Three years later, the stock was at a historical high and its Mcap had climbed to $134.22 billion! And for the record, Merck’s revenues for FY2004 rose by an unexpected 2.01% to touch $22.94 billion, with net profits touching $5.81 billion. And these figures have been rising steadily since then. For FY2009, Merck’s revenues touched an all time high of $27.43 billion, with a record of profit margin of $12.90 billion (and all this despite having paid up upto $4.1 billion to settle about 50,000 liability lawsuits in the past five years). Learning: Disbelieve critics who claim that one blockbuster drug recall can kill your future – bet on the long run.

5. MATTEL’S RECALL OF 20 MILLION TOYS IN 2007: In what is by far the largest recall in the history of toy-making, Mattel’s recall of 20 million toys in a span of just two weeks surprised many families who had trusted brands like Barbie, Hot Wheels, He-Man, Dora the Explorer and Elmo for years. The first lot was a 1.5 million units recall on August 1, 2007, which was followed up with an 18.2 million units recall on August 14, 2007. Reason: the extremely harmful toxic lead paint that was used on the toys. So, did it lead to what we call shareholder wealth erosion? Actually, no! In the trading session that followed the first announcement, the Mattel stock gained 1.62% on the NYSE. Similarly, the stock gained 1.83% in the second instance. And if financial performance is some justification that product recalls actually help stem consumer faith, here is one shining example – for FY2007, Mattel recorded a 5.66% increase in revenues to touch $5.97 billion and a 1.2% increase in bottomline that touched the $600 million mark for the first time ever! Talking about the recall, Prof. John A. Quelch, Lincoln Filene Professor of Business Administration at Harvard Business School, praised Mattel to no ends in his August 2007 paper titled, ‘Mattel: Getting a Toy Recall Right’. “Mattel deserves praise for stepping up to its responsibilities as the leading brand in the toy industry. The CEO has taken personal charge of the situation. The CEO knows that Mattel’s brand trust – built up over 62 years – is at stake. Mattel is effectively getting the word out about the recall. Mattel’s recall Web site is a model of excellence,” he wrote.

There are many other product recalls that you can perhaps recollect. Why is it that despite Coca-cola having recalled 30 million cans and bottles of Coca Cola in Europe in 1999 and 2000, it still entered the first ever global valuation ranking by Interbrand a year later on the “number one” spot, a position it holds till date? Why is it that despite tens of thousands of battery recalls by IBM in 2005, 2006 and 2009, it still ends up as being the second most valued brand in the world, a brand valued at $60.21 billion with an Mcap of $167.08 billion? Why is it that Microsoft, despite the Xbox recall fiasco in 2007, is still is the third most valued brand at $57.65 billion, and bears an Mcap of $232.05 billion – the third most valued company on the planet?

Truth is – product recalls actually work to build consumer and investor confi dence in the long run if the company handles it “positively” and acts in favour of the shareholders. It’s also true that simply recalling your faulty product is not a guarantee for future success – as competitive leadership in a cutthroat market can be obtained by well defined strategic plans. But it is an undeniable fact that a significantly larger number of product recalling companies seem to be coming out better off than companies that have been more or less noncontroversial. So does this mean I’m recommending that you should simply start recalling your products, irrespective of whether or not they’re faulty? Obviously not... But then again, why not?

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