General Dynamics Strategy

Anders’ strategy creates value. Some of the value created is obvious: Shareholders benefit from increased share price and dividends. This includes any employees who own stock or stock options. And of course, the twenty-five executives in the gain sharing program receive value from their incentive payments.

Less obvious is the value to society created by downsizing. Any excess capacity GD has, including human resources, is not creating value. (By definition, otherwise it would not be “excess.”) When GD sells assets or releases employees, other companies can put them to use in value-creating activities. If the cash that GD receives from selling assets or reducing payroll is paid to shareholders then that money is available to invest elsewhere. This is the Coase theorem in action: resources are allocated to their highest-valued use, and society benefits overall.

But not everyone benefits. Employees who are released lose value if they are not able to find another job offering the same utility. If these employees had specific knowledge that was valuable to GD, it may not be as valuable to other employers. While GD probably paid them for both their time and training, that will be small comfort to those facing lower wages.

However, the 90,000+ employees who remain with GD enjoy better long-term security because their employer is in better financial health. If GD had kept employees to do work that did not add value, many more employees would likely have lost their jobs in the long run.

GD should retain the gain sharing program, though it may opt to make cosmetic alterations to make it more palatable to employees, shareholders, the public and the government.
Gain sharing appears to be a successful incentive: the executives created value for shareholders by making difficult and unpopular decisions to downsize the company. If the gain sharing program were eliminated now, it would damage trust, and reduce incentives to make difficult value-adding decision in the future.

Critics of the program claim that the executives can manipulate the stock price by exploiting information asymmetries, or that it provides incentives to make short term gains at the expense of long term company health, or that such large payouts are unfair given that many employees are losing their jobs. Strangely, these same critics did not complain about the even larger gains executives had from appreciation of their stock and stock options. ($2.7M in appreciation for each $10 rise on Anders’ options alone, according to exhibit 7)

It seems unlikely that short-term stock price manipulation occurred. Given that the incentive program is public knowledge, the market should discount the GD stock price somewhat to account for overly positive communications from GD executives. Short-term manipulation of gain sharing would not benefit executives who had more at stake in stock or stock options. (Unless they sold out at the peak, which would certainly be a tip off to the market and might garner rather unfavorable attention from some serious-minded people at the SEC.) And future gain sharing payments depend on maintaining any gains to reach the next hurdle.

To improve appearances, GD could extend the 10-day window to make short term manipulation of the stock price less likely. They could also smooth out the bonus formula to reduce arbitrary levels and make timing less important. For example, the payments could be 10% (or 20% after the first $10) of base salary for each one dollar increase of the average closing price over each quarter. This may work out about the same for the executives, but unfortunately may be a less compelling incentive simply because it is more complicated and less immediate.

Another option is to grant new stock options that exactly duplicate the performance of the gain sharing program. (Basically, set the option price equal to the last gain sharing hurdle reached and grant a number of options equal to 1/10 of the dollar value of the executive’s salary.) The drawback to options is that executives must exercise the options (in effect, selling stock) to get cash, whereas gain sharing provides cash (or at least half of it) up front. Since the executives have no other cash bonus, this could mean that executives sell stock more often to raise cash for themselves, which might have a negative effect on stock price.

Of the two alternatives, stock options would probably be the least controversial (it gets rid of “gain sharing,” and nobody has complained much about existing options) and would be the easiest to implement. Our preference would be to keep the gain sharing program intact. But if the compensation committee believes that public and employee relations would improve enough to offset the disadvantages, then options are probably the best choice.

3) Assuming that the twenty-five executives who participated in gain sharing were the people who would face decisions about downsizing, it was appropriate to limit the incentive to these people. Twenty-five seems like a small number of executives for a company the size of GD. We would expect there to be a larger number of people who would be faced with difficult decisions about reducing employment. But without more detailed knowledge of the organizational structure, we cannot more specifically assess who should have been included.

Perhaps the GD model was that only very top executives made decisions about selling assets or reducing employment. Still, to be effective, these executive would need to rely on their subordinates to provide suggestions and information and to execute the decisions. Therefore, some kind of value-based incentive for these “rank and file” employees seems appropriate. Lower level managers did benefit from stock options, and most employees were encouraged to participate in a stock purchase program. These seem inadequate, but apparently were enough, given GD’s success.
Executives should be rewarded for selling assets and reducing employment when it adds value, as described in our response to question one. The rewards should be based on specific and measurable results that clearly demonstrate value added. Stock price, while not perfect, is the collective determination of what a company’s future cash flows are worth, and it is the best long-term measure of a value available for a public company. Measures based on sales, earnings or other accounting measures are short-term, narrow, and open to manipulation through unscrupulous accounting practices, as recent events have shown. Temporary information asymmetries (like cooking the books) may exist, but eventually the market catches up.

The extent of the reward should be enough to motivate the managers to make the necessary decisions, and no more. There is an information asymmetry problem here in that managers might be willing to do the same job for less. (For those of us who do not make millions of dollars each year, it is hard to imagine how a couple million here or there make a big difference.) Furthermore, the number of qualified executives for a given position is often small, so creating a self-selection scenario can be problematic. The best that companies can do is to be very clear on what is expected and then negotiate for the best price.

So, it is possible that GD could have paid less to their executives and gotten the same results. We have no way to tell for certain. But note that the gain sharing bonuses paid to GD executives seem relatively cheap compared to the overall value added: $17.8 million for $1.2 billion, or about 1.5 cents per dollar.

There may have been viable alternatives to the downsizing strategy pursued by Anders at GD. For example, the company might try to produce its way out of trouble, as Lincoln Electric did in the previous case. It might enter other markets and retrain its workers. The company might also pursue total liquidation or sale: if a company is more valuable to shareholders dead than alive, managers are obligated to end it.

But none of these alternatives seems likely to be more successful. Unlike Lincoln, GD faces declining demand in a very uncertain market, and is not already focused on a core competency. GD and its competitors have a history of poor performance in diversification efforts, and there is nothing to indicate that this will change. While GD could theoretically attempt to restructure itself to be more efficient in serving its current markets, what new structure would offer it the “critical mass” necessary to compete more effectively in those markets?

In short, if GD cannot find a strategy to compete in a market, it is better off exiting that market and returning any residual value to shareholders or reinvesting it where a promising strategy exists. One could argue that Anders and the executives were not good enough at developing better strategies, but given that they fared better than their competitors, it seems likely that they judged correctly.

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