Look at a handful of corporate earnings releases in a down economy, and you're bound to see the phrase 'cost-cutting'. Cutting costs is a set of actions a company takes to lower expenses. Usually, the goals of cost-cutting are to improve profitability and conserve cash.
How companies cut costs
Companies can approach cost-cutting in various ways. Much like you might try to lower your household spending, a company may address its highest spending categories first. For example, companies with high labour costs may lay off employees, eliminate shifts, or reduce salaries. Other strategies include:
- Renegotiating supply chain contracts
- Changing internal policies, for example, pausing business travel
- Downsizing facilities
- Closing or selling unprofitable units or divisions
- Pausing costly growth initiatives.
Why companies cut costs
Different circumstances can prompt companies to initiate cost-cutting efforts. The economy, however, is a common culprit.
Economies expand and contract in cycles. When the economy is expanding, businesses will often experience higher demand for their products and services. In response to higher demand, the business increases its capacity — and its costs.
Later, when the economy contracts, demand can moderate, and revenues can drop. At lower revenues, the same business model may lose some cost advantages. As a result, the company would produce smaller profits on every $1 of sales.
The ratio of profits to sales is called the profit margin. Shareholders and prospective investors watch profit margins carefully. When a company's margin is low compared to its competitors, the business is generally less profitable but also less appealing as an investment.
What do to when companies you own cut costs
When a company you're invested in announces a cost-reduction plan, pay attention to the details. You can usually find the highlights in earnings releases. These highlights should include the reason for cutting costs and the areas of the business the plan will affect.
You can also listen to the earnings call for a deeper understanding. Analysts are likely to question the nuances of any cost-cutting plan, and the questions and answers can provide a ton of insight. Ideally, you'll want to find out if the company is working toward a stated goal, such as a specific profit margin and its timeline.
You'll also want to know how the new cost focus will affect shareholder programs and growth initiatives. Companies that need to conserve cash, for example, may cut back on things such as:
- Share repurchases
- Shareholder dividends
- New product launches
- Geographic expansion
- Acquisitions
- Capital spending
When a company reduces investment in these programs, it usually changes the outlook for shareholder returns. If that change is negative and likely to be long-term, you may need to rethink your position in that stock.
Real-world examples: Harley Davidson and Kraft Heinz
In the first quarter of 2020, Harley Davidson (NYSE: HOG) reported an operating profit margin in its motorcycle division of 7.7%, down from 9.1% in the first quarter of 2019. (The company also makes money on financial services.)
Motorcycle division sales in the same quarter were down about $95 million. The stock price had also fallen more than 50%, from about $35 per share in January down to $15 per share in March.
At the time, the pandemic was raging around the world, and Harley Davidson had paused production. When it published quarterly results, the company announced a massive cost restructuring. Its primary strategies included a hiring freeze, temporary salary reductions, a pause on merit increases, and a more conservative product launch calendar.
The company also suspended share repurchases and slashed its dividend from 38 cents to 2 cents per share. The program's goal was to preserve approximately $250 million in cash in 2020.
Fast-forward one year, and Harley Davidson's motorcycle operating margin had increased to 18.5%, more than double the 7.7% from the first quarter of 2020. Also, in the first quarter of 2021, the company raised its dividend from 2 cents to 15 cents per share and stepped up its share repurchase activity. The stock price benefited from the improvements, climbing back into the mid-$30s.
One year later, in the first quarter of 2022, the company's motorcycle operating margin had moderated down to 15.6%. Even with the step back, it was still well above the single-digit performance it had experienced in earlier years.
In this case, the cost restructuring efforts positioned the company for improved profitability going forward. But such efforts don't always go according to plan.
Packaged food maker Kraft Heinz (NASDAQ: KHC) had a different experience with cost restructuring. Between 2017 and 2019, the company followed an aggressive cost-cutting strategy before abruptly changing course.
The shift happened after the company wrote down the value of two major brands by billions and cut its dividend. Kraft Heinz also restated three years of financial results after an accounting investigation by the US Securities and Exchange Commission (SEC).
Kraft Heinz installed CEO Miguel Patricio in 2019 to implement the strategy change. In an interview with Reuters at that time, Patricio said, "Cost cutting should be a priority for any company. However, you cannot cut costs every year."
Cost cutting: Sometimes good, sometimes bad
At the end of the day, cost-cutting can be good or bad. Changes that a company makes should either be sustainable or temporary. You don't want to see permanent cuts that degrade the company's ability to grow, compete, or return value to shareholders.
