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Tuesday, 29 May 2012

James Murdoch...when the agent was the principal

James Murdoch has given us much to write about this year, but in my view his most important contribution to economics teaching was eight years ago, when one of the most important speeches he ever gave as Chief Executive of BSkyB resulted in shares falling 24% whilst he was giving it despite it being generally regarded as a masterstroke in business strategy.

It is rare that within such a large company the principal-agent problem is temporarily solved and there is so little divorce between ownership and control but the story of Sky under Murdoch's stewardship gave us a chance to see what happens if a company is managed with the long-term in mind, despite the pressures of the short-term demands of the investment community, compared to a period in which the company was managed with short-term objectives in mind, not necessarily in the best long-term interests of the owners.

The divorce between ownership and control occurs because the majority of shareholders in a quoted company (plc) cannot exercise day-to-day control over the decisions of managers. Managers employed by a business may have different motivations than owners and may want to maximise their own "utility" (read: rewards, both monetary and not) from being in charge of a business. This may lead to decisions that are not consistent with profit maximisation or maximising shareholder value over time.

The Principal Agent problem is caused by the principal (the owner/s of a company), needing to hire an agent (managers) to perform tasks on theirbehalf but not being able to ensure that the agent performs them in exactly the way the principal would like. The efforts of the agent are expensive and time-consuming to monitor and the incentives of the agent may differ from those of the principal leading to a conflict of objectives.

¢A good example of this was how Sky had been run before Murdoch took over in 2004. Tony Ball had been Chief Executive and had generally been regarded as excellent. Profits had risen as customer numbers rose. The trouble was that Murdoch quickly spotted that this had been achieved through a series of short-term decisions which had kept costs down at the expense of the future of BSkyB's ability to serve their customers. This was most likely to have happened because Sky's investors demanded short-term profits (and no doubt Ball had a pay package that was linked to that too).

Murdoch's speech promised two things. One was that Sky would have 10 million customers by the end of the decade (2010) and the other was that to achieve this they would need to spend £450million on upgrading their infrastructure, including its call centres and headquarters, in order to meet customer demand with a high enough quality service.

The response to this speech was that shares fell by 24%. Eventually they fell by 50%. The reason was this. Financial analysts and journalists agreed without doubt that what Murdoch was doing was absolutely correct in terms of what Sky needed in the long term. But given that the increase in costs would cause them to take a short-term hit in profits, investors should sell their shares.

Anyone who wants to understand the problems that the financial community have caused themselves in the 8 years since should think back to that day. I thought at the time it was a dark day for the long term future of those businesses interested in investing in the long-term health of their company. To mark down the value of a company like that on such short term views is simply an incentive for companies to pursue strategies that do not make business sense in the long-term.

The fact that in November 2010 Sky reached 10 million customers. The fact that they are regarded as an excellent company to work for. The fact that they are now in a position where the company is so highly cash generative - given the need now only to retain customers (which costs one fifth of what it costs to acquire new ones) is a testament to what happens sometimes when someone is hired to manage a company who has the same objectives as the owners...because he was an owner.

No wonder News International have been so desparate to acquire the whole of BSkyB - although that's another story.......

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