Is Cost Cutting by Companies A Curse or A Blessing?

In the last 24 hours, stock in two high profile companies has reacted positively to earnings, and in both cases, news of cost cutting measure was, at least in part, responsible for the reaction. Both Google (GOOG) and Schlumberger (SLB) beat expectations, results that no doubt were the principal reasons for their shares trading higher, but both also mentioned cost saving measures in their reports to shareholders and conference calls.

In Google’s case it was the promise of things to come, while Schlumberger talked of things that had already happened. In both cases, though, some age old questions remain: Is cost cutting a positive sign for a business, or is it a one-off improvement in EPS that means little going forward? Could it even be seen as a negative in some cases?

On the surface the answer is obvious. After all, isn’t free market capitalism supposed to be about survival of the fittest? Isn’t “lean and mean” what companies are supposed to be? Cost cutting is at the heart of efficiency, and we all know that efficiency is what the profit motive, at least in theory, delivers. In a brave, new, Randian world that is what corporations should always be doing, right?

In the real world, however, and in the forward-discounting world of the stock market in particular, it isn’t that simple. Cutting costs in the way that Schlumberger has done, essentially reducing capacity as a response to a huge downturn in revenue, is necessary and gives an immediate boost to margins. It therefore goes some way towards limiting the negative effects of tough times on bottom line earnings. In theory the cost conscious culture that results stands a company in good stead for the future

There is only so much that can be cut, however, so it would be reasonable to expect the effects to be short lived, maybe a boost for one or two quarters. After that, the danger for a company like Schlumberger is that the cuts made now could make them slower to respond when the market picks up. In the extremely cyclical world of oil that is a legitimate concern.

Some may say that a better approach would be that of Schlumberger’s competitor, Halliburton (HAL). Sure, they made attempts to cut costs following the downturn (they really had no choice), but they also saw the collapse in all things oil as an opportunity. They searched for, and found, a major merger or acquisition; in this case Baker Hughes (BHI). It may be that in this case Halliburton bit off a little more than they can chew (the merger is hung up with regulators and far from the certainty it looked a while ago), but it is the principle of expanding, rather than contracting, in tough times that is the point here.

As an investor I would rather a company in which I am a shareholder follow the advice of The Sage of Omaha, Warren Buffett, and be greedy when others are fearful than see them retreat. Cost-consciousness is one thing but ultimately aggression is what I look for from a long term investment.

That said, though, there are times when costs get out of hand and cutting is a long term blessing for shareholders. At some point in our lives, most of us have probably enjoyed working for a company in that situation; I know I have.

When I started work in a dealing room it was at the height of business for live interbank forex brokers. Information was expensive and hard to come by back then, and that is what we had. That information gave us power, including pricing power, and the banks and institutions that were our clients were happy to pay exorbitant amounts for our services. Inevitably that led to an almost incredible profligacy.

At the firm where I started everybody was given membership to a dining club, for example, and if you stayed in at lunch time rather than take a client out, you could order lunch from them to be delivered. Because those lunches were paid for by the company, there were no prices on the menu we saw, but the regular items that appeared everyday were fillet mignon and Dover sole, so I can only guess how much the average meal cost.

Of course if you went out, then Laurent Perrier Rosé champagne was the normal drink, not beer, and everything went on expenses. If you were out with colleagues rather than clients then it was “teambuilding” and still expensable.

I am not saying that Google had reached the “fat and happy” levels that we did, but the company has dominated its market and eschewed a dividend, and as a result been hugely cash rich for a long time. It has gained a deserved reputation as a firm with “money is no object” working conditions and policies. As they have pursued rapid growth and made several key acquisitions, reigning in costs has not been a priority.

Sooner or later, something had to be done. As a result, Ruth Porat, who is known for being extremely cost conscious, was brought in as CFO. In her comments yesterday she delivered what many investors had been looking for, the promise to make cost management a priority at the company.

Unlike at SLB, where cuts were forced and could conceivably have long term negative effects, cuts at Google are a sign of maturity and will serve simply to make the company leaner, meaner and more efficient in the long term. The answer, then to the question of whether cost cutting by companies is good or bad is the one that is so often true, even if somewhat unsatisfying. That answer, it seems is “It depends...”

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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Martin Tillier

Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.

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