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Notes and musings from a Value investor

Recovery, brick by brick

31 August 2017
Author: Alastair MundyPortfolio Manager

I am a sucker for a good recovery story. At heart, Value investors have a great belief in the powers of mean reversion and there is nothing like a well told anecdote to illustrate that not all declines need be terminal.

Brick by Brick, by David Robertson, details the history of Lego and in particular the travails and the astonishing recovery of the last twenty years.

LEGO (the name provided by using the first two letters of the Danish words leggodt, or ‘play well’) was founded by Ole Kirk Christiansen in Billund, Denmark in1932. The early years of the company covered the Great Depression, Germany’s occupation of Denmark, a fire that destroyed the factory and the death of the founder’s wife. Christensen somehow persevered, driven by a desire to produce high-quality wooden toys. However, in 1946 he purchased a plastic injection moulding machine (costing twice the previous year’s profits) and then spent the best part of a decade working out how to make a LEGO brick, the design of which was finally patented in 1958.

As Ole Kirk’s health deteriorated, he handed over operational control to his son Godtfred, who having set some ‘principles of play’, such as the desire to make products which were affordable, simple, durable and offering rich variation, concluded that the LEGO brick offered far more attractions than the other two hundred plus products that the company made.

Godtfred’s enthusiasm ran somewhat ahead of the market. A buyer at the Nurembourg Toy Fair in 1955 commented that, ‘The product has nothing at all to offer the German toy market’. But Godtfred was a believer, so he dumped his company’s other products and focused on the brick. By the early 1970s Godtfred’s laser focus had paid off and the LEGO group employed over 1,000 people at Billund and was responsible for nearly 1% of Denmark’s exports. The business then slowed with Godtfred reluctant to hand over to his young son Kjeld Kirk Kristiansen. This eventually happened in 1979 and catalysed a period of extraordinary growth (sales doubling every 5 years for fifteen years reaching over DKK 7 billion by 1993 having stood at just DKK 1 billion in 1978).

Even during the extraordinary years of growth the company had experienced its fair share of failures, but these were outnumbered by the many successes. However, by the 1990s, sales had flattened, the company’s innovation rate had slowed and the core LEGO player had been seduced by a number of exciting technological alternatives such as VCRs, video games and computers. LEGO managed one last successful role of the dice by agreeing a licensing deal with Lucas film to create products in conjunction with the Star Wars films. Indeed, The Phantom Menace release accounted for more than one-sixth of Lego’s annual sales. This success further papered over some significant structural issues which finally became apparent when there was a pause in new Star Wars films.

Robertson highlights the pertinent issues:

  1. The introduction of significant levels of low-priced competition as LEGO’s patents expired
  2. An apparent maturity in sales as LEGO reached worldwide saturation
  3. Uncontrolled new product development as the company tried to deal with this maturity
  4. Kids having moved on to the digital world

If LEGO had been listed on the stock market it is a fair bet that analysts would have claimed that it was a value trap in structural decline.

LEGO dealt with this malaise by recruiting Poul Plougmann, a turnaround expert, previously at Bang & Olufsen.
The Plougmann strategy reads like classic MBA stuff:

  1. Hire diverse people
  2. Head for blue-ocean markets
  3. Be customer driven
  4. Practice disruptive innovation
  5. Foster open innovation
  6. Explore the full spectrum of innovation
  7. Build an innovation culture

Having won the buzzword bingo competition, Plougmann then executed and in the process lead LEGO headfirst into almost complete destruction. With sales falling quickly, senior management asked the head of strategic development Jorgen Vig Knudstorp, to diagnose the problem.

Knudstrop, despite his McKinsey background, provided a far simpler conclusion identifying profitable innovation as a key missing link (the author highlights that Plougmann was incentivised to double sales, with no mention of profits, so perhaps perverse incentives were largely to blame for LEGO’s woes) but also highlighted dysfunctional silo-type management, and low quality financial controls. Plougmann’s desire for turbo-charged growth (in new areas) had clearly trumped every other business decision. Growth opportunities had taken the company into software, education, fashion, girls’ toys, media, theme parks and retail stores. Once again, you can imagine the analyst notes that would have greeted these growth plans.

As a Professor of Innovation Robertson is unlikely to disagree with Plougmann’s to do list. In fact, he claims that it was these ‘Seven Truths of Innovation’ which Knudstorp (placed in charge post Plougmann’s departure) eventually focused on post saving the company which drove LEGO’s elongated recovery. But first Knudstorp had to improve the balance sheet and make LEGO profitable again.

Knudstorp and his finance director Jesper Ovesen took Lego back to its core. Relationships with the retailers selling the company’s products had deteriorated dramatically as a result of stuffing the retailers with unsaleable inventory and then under-supplying them with the winners. These relationships were improved. Back to the core also saw the end of the diversification efforts and this was implanted by simply focusing on just one number – an operating margin hurdle of 13.5% (maybe a bit crude but much better than Plougmann’s sales obsession). This led to 30% of the product portfolio being cut, curtailment of the stores roll-out and sales and closures of the theme parks and computer games business respectively. The DUPLO brand, dropped by previous management and much loved by the customer and staff, was restored. Manufacturing was also greatly simplified as the company at its peak was making 14,200 separate LEGO components in more than fifty different colours. Many of these components were used in just one set making the cost of production extraordinarily high. The restructuring was far from pain-free with nearly a third of the company’s workforce leaving. All very dull stuff, but key to taking the company from shocking losses to very high levels of profitability.

The remainder of the story of LEGO’s remarkable re-birth, and the huge growth in sales and profits that ensued, is of more interest to an innovation junkie than a value investor, but the success of Knudstorp compared with Plougmann – from a far inferior starting position is interesting. The stock market is always fascinated by the arrival of new management at a previously high-flying company and is typically supportive of new growth strategies. Knudstorp delivered more growth than anyone could have imagined, but only having first put the LEGO house on firm foundations.

Alastair Mundy
Alastair Mundy Portfolio Manager

Important information

This communication is provided for general information only should not be construed as advice.

All the information in is believed to be reliable but may be inaccurate or incomplete. The views are those of the contributor at the time of publication and do not necessary reflect those of Investec Asset Management.

Any opinions stated are honestly held but are not guaranteed and should not be relied upon.

All rights reserved. Issued by Investec Asset Management, issued August 2017.

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