Netflix and Labor

The final accounting issue that is worth discussing here relates to how to think about the cost of talent as an asset, and how to apply that to the aerospace business, part of which really is rocket science, and all of which is all about seriously complicated systems integration challenges involving cutting edge technologies.  

A really fine book by Reed Hastings, the CEO of Netflix that he coauthored with Erin Meyer titled No Rules Rules: Netflix and the Culture of Reinvention provides some great insights into this issue, which is one that Jim McNerney got completely wrong.  Harry also missed the subtleties of the "team versus family" part of this story, which Hastings and Meyer get almost right.  I should hedge that a bit, as they were thinking about a company filled with artistic and creative talent, and they were not yet major percentage of the local economies in the communities where they have a physical presence.  So some of the issues that loom large in aerospace do not apply to them, at least not yet.  But other than that one caution, their discussion is fantastic.

Aerospace work has to be done in the context of a large urban area that has several supporting features.  There has to be a concentration of companies that can provide a variety of specialized services.  These range from unusual custom facilities construction, to emergent manufacturing using exotic materials.  It also helps to have some independent custom electronics shops.  But perhaps the most important piece that is required, is a decent university, both as a place to grow talent, and to serve the needs of some of an aerospace company's employees to be engaged with a university community.   Some of your critical engineering and research talent will invariably end up teaching classes at the local U.

Hastings and Meyer are spot on when they talk about the importance of hiring at the top of the talent pool for certain kinds of work.  Aerospace has that need too.  But, it is much more of a family kind of atmosphere than that of the professional sports team as they describe as their approach at Netflix, which is identical to what Harry Stonecipher tried to impose on Boeing.  That just doesn't work.  You can't have an aerospace high performing A team and avoid building it into a family that is threaded into and bound to the local community.  That's been proven a number of times by companies that tried it, failed, and unfortunately spawned a number of fatal accidents involving their products as a result.

Let's start by looking at one of those failures - the second space shuttle crash.  That was the loss of the Columbia on February 1, 2003.  

Space Transportation System (STS) flight 107 was 113th flight of the program and the 28th flight of the Columbia.  Arguably, this was the first aviation accident with loss of life that resulted from the introduction of the GE value system to Boeing.

Boeing closed a deal to acquire what was left of North American Aviation from Rockwell in December 1996, approximately eight months before the merger with McDonnell Douglas became final.  Harry Stonecipher became Chief Operating Officer at the time of the merger, and the effective chairman of the company in the boardroom coop during the summer of 1998.  He was officially given the title of Vice Chairman in 2001, a position he held until a brief retirement in 2001.

One of the many cost reductions that Harry made by liquidating non-balance sheet assets, was his relocation of the Space Shuttle engineering workforce from the Los Angeles area to Texas in 2001.  This had the intended effect of causing 80% of the engineering workforce to refuse to make the move.  Thus, most of the hard won knowledge and experience of the program's engineering team left, and was replaced by new hires at a fraction of the salaries that had been paid to the legacy team.

An outside consultant name Gerry Hanley was hired to conduct a program called "Knowledge Transfer Through Mentoring."  In his program, the engineers going out the door were given the task of teaching what they knew to their replacements.  The program was hailed by Boeing and Hanley as a success.  An investigative journalism series by the Los Angeles Times came to a different conclusion.

Never-the-less, Hanley got a contract to take his program to Seattle, and as strange as this may sound, Boeing actually got the engineering union SPEEA to split the cost of having Hanley teach his course several times in a Boeing facility in Tukwilla, WA.  I happened to attend one of those class cycles.

Many people in business tend to think of the things that are not reflected in the financial statements as being intangibles.  Whether or not something is tangible or not is beside the point.  What matters is whether or not the equities as described in the work product of the accounts include an ownership interest in them.  One could argue that such things as trade secrets might be subject to ownership claims, especially if there are some obligations associated with those secrets on the part of the employees as stipulated in either written employment agreements or common law.  But things that are beyond those bounds, such as the skills and professional knowledge base of the employees as individuals, and of the firm's so-called "tribal knowledge" when talking about them collectively, well those things are definitely not owned by the stockholders nor subject to liens on the part of the creditors.  There are two problems for accountants when it comes to such things.  One is identification and the other is valuation.

Accountants have a variety of estimating techniques which can be used to assign valuations to many things.  But for those tools to be used, a simple condition must be met.  Two independent accounting teams must reasonably be expected to choose the same estimating methodology given similar circumstances.  And, using those methods, they should be able to come up with reasonably similar results.  If those two conditions cannot be satisfied, then the items in question cannot be included within the scope of the financial statements.

Again, the boundaries of accounting, and the boundaries of an accounting entity are two very different things.  It is even quite common for most of the value that it is believed that a firm has is not disclosed in the financial statements.  For example, as I write this, The Boeing Company has been bankrupt for over three years.  Again, you can see this for yourself here.  Just expand the section titled "Liabilities & Stockholders' Equity."  Despite this fact, during that entire time the stock has been trading in a range between $95 and $440 per share, and has not paid a dividend since February 2020.  Clearly, investors who are willing to pay those prices believe that there is some value there someplace that is not reflected in the audited financials of the company.  In fact, this is to be expected.  

It used to be that accountants were taught that the starting point when placing a valuation on a firm for purposes of a potential merger or acquisition, was to project an expected five years worth of earnings, discount those to their present value, and then adjust for any off-the-books assets or liabilities.  Of course, placing a valuation on those is total guesswork, and not something that is subject to audit or our two requirements for making an accounting estimate.  But that said, virtually no stock that is listed on a public stock exchange ever trades below a price earnings (P/E) ratio of 5:1 unless there is a serious known risk of the company being liquidated to satisfy some liabilities that are being litigated.  Historically, the average P/E ratio of the S&P 500 ranges between 13:1 and 15:1.  That's one heck of a lot of benefit that the investors are expecting from things they do not own.  And yet, in a healthy economy that is growing at a reasonable rate, those valuations will indeed most likely be justified by the next five years of actual earnings.  So how did Jack Welch manage to consistently "beat the street?"

The answer is simple.  He figured out how to monetize in the near term those things that were not on the books.  All that he required was a portfolio of products that had very long lifecycles, and then pull the plug on R&D spending.  He even stretched things out a bit by having his accountants do something illegal with the way they used generally accepted estimating techniques.

Another one of my accounting professors was Dr. John Burke, who as founding chair of the department, and had actually built it into a great part of the Haworth School of Business at Western Michigan University from almost nothing.  Dr. Burke liked to tell a story to explain what was ethical and what was not in accounting.  I'll paraphrase as best as I can.  It feel like I can remember him telling the story as though I was sitting in his class just yesterday.

He said to imagine that the controller of a company is asked into the president's office at the end of the quarter, and asked: "How did we do?  What do the numbers say?"  The controller then closes the door and walks over and draws the blinds, before turning to the president and asks: "What do you want them to say?"

The process of making an accounting estimate starts with an evaluation of the situation.  Then an estimating method is chosen that fits the circumstances.  That's estimating, and it is perfectly ok.  Most of the numbers in a set of financial statements contain at least some estimates.  What is not ok, is to first choose the answer you want, review all possible estimating methods that might exist, and then a pick a method that comes close to the answer that you want.  That is not estimating.  It is fraud.  It may be difficult if not impossible to prove this particular kind of an accounting fraud unless the accountant admits to having done it, but it is fraud none-the-less.  This estimating fraud trick is just one example of the kinds of things accountants can do to misrepresent what has gone on in a business.  The auditors are supposed to catch it, but it can be very hard, if not impossible to detect such things until a whole bunch of such funny numbers have made it into the financials over several years.

And the thing about such a fraud, is that once you have done it with regular accounting data that has been generated by the ongoing activities of the business, it becomes easier to take the next step, and start making business decisions that are bad for the long term health of the company, but which feed raw material to the accountants to inappropriately value based on the estimating fraud trick.  Numbers may not lie, but it is certainly possible to tell lies using numbers.

One can read about several of the accounting frauds that were perpetrated at General Electric under the leadership of Welch in the 2020 book by Thomas Gryta and Tedd Mann titled "Lights Out: Pride, Delusion, and the Fall of General Electric."

This is the kind of thinking and leadership that Harry Stonecipher and Jim McNerney brought to Boeing.  And, they swapped out the old Boeing board of directors for a team that would go along with this chicanery as fast as they possibly could.

When the auditors review the financial condition of a firm, they write a report called an opinion.  The goal of any company is to get a clean opinion, that is, one that doesn't say that their financial statements are not giving a fair picture of what is going on.  The point is, that accountants believe that one can tell a part of the story, that is, the part that is the subject of their trade, and if you add any needed supplemental footnotes or explanations, that the finished report can indeed be fair. 

 

At the end of an audit there is frequently a big debate between the auditors and a company's executives as to what sort of footnotes and supplemental information is required in the report in order to paint a fair picture.  Sometimes this works, and sometimes it doesn't.  Jack Welch basically invented a way to both fool the auditors, con the investment community into believing that he was getting fantastic results, while at the same time, bleeding GE company into collapse.  The key to Welch's discovery or invention, was products which have very long life cycles, large sales prices, large after market support requirements, and no near term competitive threats.

By bleeding GE of its non-accounting assets, and arguably, fabricating some of the valuations for others, he was able to appear to be leading the company to such unusual performance, that paying him an absurdly high salary and providing him with perks one might normally associate with middle eastern royalty, that no one would care.  He was worth it because his stock was doing so well.  All he needed, was a company whose product life cycles were long enough to provide him cover for his tenure as CEO and then well into retirement.  It worked, and he trained a large cadre of followers in his methods.  The Boeing Company has products with some of the longest lifecycles there are, and like the locomotives and power plant turbine generators that GE once made so profitably, jet airplanes and the other defense products that were in Boeing's product portfolio prior to the merger, it was super easy to bleed these businesses dry while making the company look profitable long enough for McNerney to make it into retirement.  Some might argue in McNerney's defense that these are just coincidences, and that he tired hard and things just didn't work out as hoped.  I personally think he is a very smart guy who knew exactly what he was doing, and that he trained with the best and repeated his mentor's performance.

Now, let's cover one specific example of how the Jack Welch company bleeding methodology was applied in Boeing on the 787 Program.

As described in the section on this site about the 20xx Program, in order to achieve that audacious goal of remaking the entire American aerospace industry so as to make the "1 in 10 airplane" possible, the suppliers needed to become more independent.  They needed to shift into a mode of continuous evolution of each of their pieces, and Boeing needed to work very closely with them to evolve the highly standardized interfaces on our planes that would make that possible.

On previous airplane programs, the Supplier Management organization would typically have at least fifty engineers embedded with the suppliers.  But to pull of the transformation required by the goals of the 20xx Program, we were going to need several times that many on airplane #1, which was the 787.  So how many did Stonecipher and McNerney allow?  Exactly two.  The third one was not hired until 2011.  That was enough to sabotage the whole program and guarantee that it would be late, even without the goals of the 20xx Program, or the culture that consistently produced watermelon stop light charts.

Now, you might ask how I know this part of the story.  Well, the third engineer hired into the 787 Supplier Management organization just happened to be the niece of my college roommate.  And after Samantha moved to Seattle to take her new job on the program, she lived in our house for a few months.  Like I said, I really was everywhere, when it came to pulling together the pieces of this story.  McNerney, Stonecipher, and Bair can run, but they can't hide this stuff any more.  It's all coming out.

I could go on for several more pages about the mismanagement and flawed accounting practices of Boeing under the leadership of the Jack Welch trained people that took over the company, but that is enough to provide an insight into the accounting part of what went wrong on the 787 program.

Another accounting issue that was not specific to the 787 program, but which goes into another problem with the Jack Welch and GE approach to business non-leadership will be covered in a separate section.  That is the complete farce that Deborah Chase Hopkins' brought to Boeing with her schtick about RONA, or "return on net assets," which at best, was a poor attempt at a kind of magician's sleight of hand or redirection.

The final accounting issue that is worth discussing here relates to how to think about the cost of talent as an asset, and how to apply that to the aerospace business, part of which really is rocket science, and all of which is all about seriously complicated systems integration challenges involving cutting edge technologies.  A really fine book by Reed Hastings, the CEO of Netflix that he coauthored with Erin Meyer titled No Rules Rules: Netflix and the Culture of Reinvention provides some great insights into this issue, which is one that Jim McNerney got completely wrong.  Harry also missed the subtleties of the "team versus family" part of this story, which Hastings and Meyer get almost right.  I should hedge that a bit, as they were thinking about a company filled with artistic and creative talent, and they were not yet major percentage of the local economies in the communities where they have a physical presence.  So some of the issues that loom large in aerospace do not apply to them, at least not yet.  But other than that one caution, their discussion is fantastic, and is covered on another page linked below.