Bankruptcy

Trouble in Toyland

Finance has been central to Lego's turnaround. So why is it being downgraded?
Janet KersnarMarch 9, 2007

The 2006 reporting season for Lego, the fabled Danish toy maker, was something of a triumph, as its impressive financial results helped cement a period of remarkable profitability from near disaster a few years earlier. Although CFO Søren Lindgaard joined with colleagues in the celebrations, it was a bittersweet moment for him because he also knew that his days at Lego were numbered.

Lindgaard, 40, had been Lego’s CFO only for a few months last year before handing in his notice. The reason? He says it was not the long hours expected of CFOs, nor the high pressure that is part and parcel of grueling turnaround initiatives. Rather, it was the surprising news that came in early summer that the CFO of Lego would no longer be part of the corporate management board. CEO Jørgen Vig Knudstrop was reducing his direct reports from seven to four — the heads of markets and products; community and educational products; supply chain; and a catch-all for corporate centre services, to which the CFO would report.

It’s an unusual move these days for a company the size of Lego, with annual sales of more than €1 billion, to downgrade the CFO position to the second tier of management, especially given the pivotal role the CFO played in the recent turnaround. Perhaps it is the correct structure for the company’s next phase, or it may be a vestige of a family-owned company that remains more wedded to tradition than modern management principles.

For his part, Lindgaard, speaking in his office littered with Lego toy models, including a fort built by his 11-year-old son, downplays any disappointment he may feel. “It’s just a good time for me to move on,” he says.

Part of a new generation of Lego executives recruited from outside the company, Lindgaard has a solid CV, chronicling a rapid progression through the senior ranks of finance at various firms, including CFO roles at Ireland-based FLS Aerospace. In 2002, he moved to Billund, the sleepy Jutland village where Lego — producer of one of Denmark’s most popular exports — has been based since it was founded early last century. After a period as head of corporate finance, Lindgaard succeeded Jesper Ovesen, the CFO since 2003 and now CEO of Kirkbi, Lego’s founding family’s investment trust.

Though only halfway through the turnaround program, Lindgaard leaves Lego this month to become CFO of Tvilum-Scanbirk, a DKr2.7 billion (€362m) Danish furniture manufacturing arm of U.S.-based Masco Corporation.

Christian Iversen, Lego’s former vice president of human resources, is head of the corporate centre services in the new structure. As he explains it, the company has completed its survival phase. “The second part is about building a sustainable platform for growth. The third phase will be about growth and acceleration for the future. For each part, we are applying specific management principles. For the first phase, it was very hands on…a very discipline-driven, financial agenda for the company, about selling assets, optimizing our capital structure and getting cash in hand. That part of the turnaround strategy was dependent on a very heavy hand from the CFO.”

And now? “There are other priorities,” Iversen says. “In order to increase operational excellence, we need to pull two other levers — one is building our people, the other is leveraging IT. So the portfolio under me covers all three of those [HR, IT and finance]. It reflects the company’s agenda.”

Lego’s new structure certainly raises a question about the company’s strategy, given the central role of finance in the turnaround — after crippling losses just a few years earlier, pre-tax profit in 2006 soared, from DKr456m in 2005 to DKr1.6 billion, while sales increased 11 percent to DKr7.8 billion from DKr7 billion. (See table below.) Despite Iversen’s assurances to the contrary, has Lego downgraded financial discipline?

Toy Story

When Lindgaard took on the CFO role last year he certainly reckoned that Lego had put its worst years behind it. In 1998, the toy maker was shaken to the core after reporting a loss — of DKr194m — for the first time in its history. Kjeld Kirk Kristiansen, the founder’s grandson and CEO at the time, cited a long list of problems — from over-investment and haphazard diversification to sinking birth rates and competition from cheap high-tech gadgets. And although the company moved ahead with toy launches and license agreements based on blockbuster Star Wars films and Harry Potter books, worse was to come. In 2003, Lego hit another, more debilitating crisis, reporting an operating loss of DKr1.6 billion on sales of DKr6.8 billion. The next year was just as dismal, with DKr1.2 billion of losses on DKr6.3 billion of revenue.

Radical change was obviously required. As Lindgaard recalls, “Our agenda couldn’t have been clearer: we needed to reduce risk, reduce our fixed-asset base, reduce our breakeven point and we had to rebuild confidence with customers — the Wal-Marts, the Targets and so on.” (In recent surveys, customers had complained that the company “lacked focus,” “was too self-centered” and “was uncooperative.)

Amid all this, Lego also needed to shake a bad habit — relentlessly focusing on growth. “The one question that everyone used to ask over and over at Lego was, ‘Where do we grow next?’” says Lindgaard. “The company was used to just chasing blindly after growth and, with no stockmarket demanding results, there was no pressure to show the hard returns on any investments.”

This “dangerous cocktail” needed to be replaced by financial management predicated on profitability. “You have to remember that we’re in a mature market — flat or slightly negative is the world in which we’re living,” says Lindgaard. (See chart below.) “The only way we can grow is by taking market share from competitors. But we need to ask ourselves, at what price?”

Bricks and Mortar

The turnaround program started in late 2004 with a reshuffle at the top. After 25 years as CEO, Kristiansen resigned in October 2004, moving to deputy chairman, and for the first time, the company tapped a non-family member as CEO, bringing in Knudstrop, a 35-year-old former McKinsey consultant who had been part of Lego’s strategy team since 2001. However, Ovesen, who’d come in from Danske Bank a year earlier as CFO, was already a trusted member of the inner family circle and he remained as part of the top management team. Today he is given credit, both inside and outside the company, for being the mastermind behind Lego’s turnaround.

Asset sales were first on Ovesen’s agenda. Notably, a savvy €375m deal with Merlin Entertainment, of private equity group Blackstone, allowed Lego to extricate itself from running its four theme parks — in Denmark, England, Germany and California — while keeping a 30 percent stake in each. The deal was pivotal on several levels, as Ovesen himself explained to CFO Europe after the deal was closed. “It was not just that we wanted to sell the parks and run away with the highest price,” he said. “The parks are still a very important brand window into Lego and carry a lot of how we live the brand. We needed to be very careful.” What’s more, Ovesen needed to win the confidence of Lego’s owners. “It was important that the family was extremely happy with the partners. I think that has opened up a different universe; opened up the family to the view that it is worthwhile to pursue other strategies with partners.”

Against that backdrop, Lindgaard’s former boss also put his finance department to work on a flurry of ground-breaking agreements with partners in manufacturing and other parts of Lego’s global supply chain. While offshoring and outsourcing has long been a common fixture in the toy industry — China today manufactures nearly 80 percent of all toys sold worldwide, much of them for Mattel, Hasbro and other western toy firms — it was new to Lego.

The biggest outsourcing deal was sealed last year with Flextronics, a Singapore-based electronics company whose other customers include some of the world’s biggest makers of cars, computers and mobile phones. Toys are a new addition to its portfolio. Flextronics has initially begun making about 20 percent of the 15 billion colorful interlocking bricks and other toy parts that Lego sells each year from sites in the Czech Republic and Hungary, soaking up a lot of the work that Lego once did itself from Denmark, as well as production from two sites that have been closed down in Germany and Switzerland . And starting this month, a Flextronics factory in Mexico will take over manufacturing from a Lego site in Connecticut in the U.S. Eventually, it could handle as much as 80 percent of Lego’s production.

As Lego’s finance department ploughed through the next stages of the turnaround, Lindgaard had no illusions about the challenges. While the survival phase of the turnaround galvanized the entire organization, he says, “it’s when you start getting to the heart of the business — doing detailed profit analyses, trying to establish standard tools — that you meet with resistance.”

For Lindgaard, however, there was little choice. “We’d been destroying value since 1993,” he says, pointing incredulously to a chart on his desk chronicling the steep, prolonged drop in returns — and he wanted finance “to be very much in the middle, at the table of management meetings,” developing new tools that draw attention to profitability performance and pushing them out to operations beyond Billund.

An Extreme Eye Opener

One of those tools — a new financial management framework — is the result of a project introduced by Lindgaard called CPP. Short for customer and product profitability, CPP is straightforward: it aims to show which parts of the business are making money and which ones aren’t, something “that was a big black box” before the project was launched, says Torben Nørgaard, CPP’s project leader.

Indeed, when the company needed to trim its bulging product portfolio in the immediate aftermath of the 2003 and 2004 losses, Billund executives didn’t know where to begin. “We had no information about customers or products beyond gross contribution and absolutely no visibility into cost structures,” Nørgaard recalls.

A profit-curve analysis for each product and customer segment — CPP’s inaugural phase — proved to be “an extreme eye opener,” says Nørgaard. “Sixty percent of our turnover was actually giving us 100 percent of our Ebit — in other words, more than a third of our sales were unprofitable.”

As Nørgaard puts it, CPP now needs to “burn” a new P&L-driven culture into every business, emphasizing that turnover must be profitable, that there must be a clear relationship between return on sales and return on invested capital. “This isn’t something that can come out of a financial system. It’s something that has to be installed in the way people think,” he says.

To begin burning CPP into Lego, finance has helped train up 300 non-finance managers over the past year about new standardized budgeting, planning and reporting processes, all now centered on activity-based management. “It’s a totally new language for most of them,” says Nørgaard. While Lego managers aren’t expected to apply these processes formally until later this year when the 2008 budgeting process begins, finance is already providing business unit heads and corporate executives with fewer, but more tailored daily, monthly and quarterly reports than they used to receive, all modeled around CPP-related information.

Could Do Better

As CFO Lindgaard presses for change, how are his own staff coping? After all, he says, “we’ve been managing a heavy project portfolio for the whole organization and at the same time having to cut out more than 25 percent of [finance’s own] costs, which has been pretty tough.” He also questions whether his team is fully capable of providing the high-level insight and analysis that outsourcing, CPP and other projects now demand. These are concerns that Lingaard anticipates another project, World-Class Finance, will address.

One part of the project is intertwined with CPP, focusing on reducing the complexity of planning and reporting. Another homes in on the efficiency of its transactional services, while a third dissects the skills of Lindgaard’s team and then develops training and career management programs for them.

Not that finance at Lego was in such a bad way before these program began, says René Ravn Nielsen of Valcon, a Danish management consultancy that’s worked closely with both Ovesen and Lindgaard on several parts of the turnaround program. Finance was ready working from one chart of accounts. It also had a single ERP system, and financial shared service centers (SSCs) in Denmark, Australia and the U.S. were humming along, having centralized a host of processes from around a dozen or so other sites several years earlier.

But scratching at finance’s veneer revealed the troublesome reality, and probably also provided a good idea of what was going on in other parts of the organization. For example, when Nielsen ran a benchmarking exercise in late 2005, he found that Lego’s SSCs were far less efficient than other large Danish companies it was ranked against. Meanwhile, a painstaking skills-mapping of each of Lindgaard’s 130 finance staffers revealed wide gaps in key technical and leadership competencies. An internal memo listed a number of other shortcomings within finance: too much time (60 percent) was spent on low-end transaction processing and too little (10 percent) on decision support; turnover of permanent staff was high; and the lines of responsibilities were unclear.

It was a wakeup call for Lindgaard. “We were always saying to staff that finance needed to change and provide more business support, but we never actually told them what they needed to do differently,” he says. Since the initial studies, finance has been mobilized on several fronts. Along with more tailored training and performance reviews, for example, a number of his team have been moved out into operations to provide better business support.

But it is commitment and follow-through that Lego seems to struggle with in general. As Nielsen observes, “Lego has a history of initiating hundreds and hundreds of projects and being able to drive them 80 percent, but missing that last 20 percent. They can’t seem to capitalize on their investments.” Under Lindgaard, however, that was not allowed to happen. “Lindgaard brought a lot of focus,” he says.

The New Game Plan

Lindgaard has also focused on areas beyond finance. Addressing the brutally frank feedback that Lego received from its retail customers, “we’ve really professionalized our account manager approach, developing a whole support team for key accounts, with someone from product development, someone from finance and so on,” he explains. “We also started bringing in customer measures into the monthly scorecards that we use at the corporate level.”

The new customer focus hasn’t been lost on one very important constituent for Lego — the big U.S. retailers that account for more than half of its sales. “It was like a light went on,” says toy-industry analyst Sean McGowan of Wedbush Morgan Securities. “They went from the height of arrogance to the height of co-operation, saying, ‘OK, what do we need to do for our customers, how can we work together?’ And it lasted more than just a cup of coffee, it wasn’t just lip service, they’ve been following it through in packaging, marketing, accessibility, sharing information.”

In late August last year — a critical time for toy makers as the major retailers restock their shelves for the holiday season in December — McGowan says, “Lego actually picked up market share, picked up shelf space, the year after a Star Wars movie was out. That’s the first time that’s ever happened. I have to really commend them.”

In the weeks ahead, Lindgaard will be working with his successor — Per Hedegaard Nielsen, from Danish pharmaceuticals company Novo Nordisk — to build on this success. “The biggest challenge [during the turnaround’s next phases] will be ensuring that profit always takes priority,” says Lindgaard.

Finance will face its own issues. One of those is its internal profile. There do appear to be divisions between finance and the rest of the organization. But Nørgaard concedes that some of the biggest resistance to CPP came from within finance, while other business unit heads were receptive and willing to learn. Valcon’s Nielsen, meanwhile, reckons that one of finance’s biggest challenges will be to instigate changes to budgeting and planning processes, because finance lacks clout within the organization.

Lindgaard agrees with these observations, to a point. He concedes that success can breed complacency, “that when you start seeing some positive results, there is a risk that the underlying culture has not really changed and that you can fall back into it…[This] has probably been the toughest challenge, both within finance and the entire business.” But he says the company certainly isn’t the same as it was just two years ago. “People are much more aware that things can go wrong,” he says. “Although the mood around the office was happy when we announced the annual results [on February 21st], there were these ‘buts.’ ‘But what happens now? But what are the risks?’” But these questions are for Lego’s new board members to worry about.