1.

Analyze the changes that Paul Land initiated at Solrayo after being hired from a strategic
perspective. Do these changes make sense? Individually? Collectively?

After being hired, Paul Land initiated a host of changes primarily focusing on aggressive cost
cutting and shareholder value maximation (through M&A and divestitures). To analyze his
decisions from a strategic perspective, I will employ Porter ideology, whereby firms can choose
between two generic competitive strategies: Cost leadership and Differentiation.
Below is a discussion of his various changes and their analysis from a strategic standpoint:
Strategic Analysis
Change
(Cost leadership/Differentiation)
Redefinition of company’s core business and Cost Leadership – This move would create
divestiture of non-core business lines efficiencies in the business operations and
closure of non-core business line would
enable the company to focus on the main
operations (assuming the non-core
operations were inefficient from a business
operations standpoint)
Consolidation of divisional and regional Cost Leadership - This move would have been
headquarters to single worldwide an attempt to streamline the headcount and
headquarter reduce overlapping personnel. Overall
companywide headcount was reduced by
50% (12,000 to 6,000 employees).
Divestiture of non-core business lines and Cost Leadership – Production facilities were
reduction in Capital Spending and Working reduced from 26 to 8 by eliminating non-core
Capital requirements businesses and optimizing the capacity of the
core businesses.
Introduction of new innovative product lines Differentiation - Introduced 35 new U.S.
and move towards globalized operations products and 54 new international products
Substantially reducing different product pack Cost Leadership – Lower amount of product
offerings pack offering would have create more
standardization across the product
processes, thereby increasing the margins
and reducing costs. This step would also
reduce the product differentiation since the
variety of products offered would be
reduced.
Implementing 3-year growth plan to Differentiation – Brand image is important
strengthen main brand names factor for a successful differentiation strategy
since it creates brand loyalty and provide
broad market appeal. Strengthening of the
 main brands, therefore, is a differentiation
strategy. Further, I understand, the company
was targeting to become a successful
category leader by strengthening its main
brands.
Growth from acquisitions Both – Growth from acquisitions could be
used for both Cost Leadership (by increasing
the scale of operations, and hence better
economies of scale) and for differentiation
(by increasing the variety of offering and
gaining capabilities for innovation or
acquiring IP).

As explained above, these changes make sense individually, however, collectively, it is not
perfectly clear whether the company, through these changes, is pursuing a cost leadership
strategy or a differentiation strategy. While the company is extensively undertaking cost
optimizations, the medium that Paul has employed is by reducing the production capabilities
and employee headcount. This would surely impact the overall capability of the human capital
at the firm (some great employees would have been fired as well, since the employee
headcount was reduced 50%) and hence would impact the innovation at the firm, something
that it critical to pursue a differentiation strategy. Further, cost leadership and differentiation
are opposing strategies, with cost leadership focusing on the serving a broad market with the
lowest cost possible, vs. differentiation, which focuses on innovation and brand image building,
attributes that require costs that must be recouped though higher prices. Hence in my view,
pursuing both the strategies, that are conflicting in nature, does not make sound business and
financial sense to me.

2. Now analyze the changes made by Land from an “earnings management perspective”. How
do these changes allow him opportunities to manage earnings?

To analyze the changes made by Mr. Paul Land from an earnings management perspective, we
first have to analyze the potential motivations behind those actions. As stated in the case, it is
clear that Mr. Land’s renumeration was directly linked to the stock price performance, since
within the first 3 years of his appointment, he was expected to be the owner of 4% of the total
stock of the company. Another distinction must be made here, that performance of the stock
and financial performance of the company may not always be directly linked (due to various
behavioral biases). An example of this is the fact that generally company’s share price shoots up
if the company outperforms the street expectations (and usually has very little to do with the
actual, absolute financial performance of the company, Source: “How to manage earnings
management?” ,Partha S. Mohanram). Further, the case mentions that Mr. Lands
compensation contract underwent a restructuring in 2019, whereby his fixed salary component
was raised and all his options underwent accelerated vesting (as compared to a 3 year vesting
horizon initially). One of the reasons organizations generally have delayed vesting of the
options is to make sure the managers have long term sustainable growth in the mind, and to
reduce the impact of artificially inflating the financials in the short term. This can be understood
by appreciating that the inter-temporal transfer of income between periods does not matter as
much in a steady state due to the reversals in accruals and maturing of the company. In the
context of the above background, I now analyze changes made by Land from an earnings
management perspective:
 Given the heavy component of options as Mr. Lands remuneration, volatility in earnings
would actually be beneficial, since this volatility would increase the value of the options
that Mr. Land held (Vega component of options pricing). This volatility was clearly
evident in the financials, particularly the EPS (2016: $0.61, 2018: $1.25, 2019: -2.75)
 Another change that could be a red flag in terms of earnings management was the fact
that Mr. Land brought in the team of managers who worked with him at the Welsh
Paper turnaround and appointed his close lieutenant Mr. Kersh as Vice-Chairman of
finance, human resources, MIS and purchasing functions. The problem with this move is,
there is no oversight, hence could be a possible route to poor governance. If Mr. Land
were to manage earnings, it could be easily done by partnering up with his close
lieutenant, who oversaw critical functions like finance, HR, MIS and purchase (all of
which coincidentally form a close loop for financial earnings management)
 In November 2017, the company announced massive restricting changes ($337.6
million). As explained in a Speech Entitled “The Numbers Game” by Chairman Arthur
Levitt of the SEC at the NYU Center for Law and Business, these large charges associated
with the company’s restructuring could potentially help the companies in cleaning up
their balance sheets, a tactic known as “big bath”. The big bath would allow Mr. Land an
opportunity to initially overstate the charges and theoretically get away with it (since
the Wall St. overlooks these one-time big hits and focuses on the future potential
earnings). And this overstated charge would then be used to pump up whenever the
future earnings would be inadequate.
 The company undertook intense M&A and Divestiture activity under Mr. Land’s reign,
and these activities involve substantial managerial judgement. Purchase price allocation
(and thereby goodwill) are subjective exercises since they involve valuation assumptions
and would enable a substantial leeway to manage earnings. Of course, these aggressive
assumptions would later be reversed in form of impairments, however, the time horizon
of that impairment may or may not match Mr. Land’s tenure (and subsequent options
vesting) at the company. Further, these activities substantially change the Asset Block of
a company, and hence create more opportunities for managerial judgement on the
grounds of useful live of assets and hence depreciation (although this could be a small
factor given that there are strict accounting guidelines)
3. Briefly peruse the financial statements provided for Solrayo for the fiscal year 2018 and
2017.

a) Highlight the most dramatic improvements in performance that you see.

 The gross margin improved from 9% in 2017 to 28% in 2018
 SGNA went down from 22% of sales in 2017 to 11% of sales in 2018
 There were no impairment or restricting expenses in 2018 (vs a substantial 154,869 in
2017)
 Operating Margin went from -29% in 2017 to 17% in 2018. If one time restricting costs
are excluded from 2017 income, the normalized margin was still -13%
 Earnings Margins (from continuing operations) went up from -20% in 2017 to 11% in
2018 while net earnings margin (inclusive of discontinued operations) went from -23%
in 2017 to 9% in 2018
 Prima facie, the D/E ratio went down substantially from 0.51x in 2017 to 0.37x in 2018
 Net receivables went up from 22% of sales in 2017 to 25% in 2018
 Retained earnings went up by 302% from 35,118 in 2017 to 141,134 in 2018

b) Are there any aspects of the financial statements that appear to be discordant with the
strategic changes initiated by Land?
 Given that the company adopted a growth by acquisition strategy, it seems highly
unlikely that the synergies from those acquisitions would be realized so soon, so as to
make such enormous changes in the cost structures of the firm. This is clearly evident in
the gross and net margin improvements, but is incongruent with the empirical evidence
of realization of synergies after M&A activity
 Strategically the company strived to create a international presence and launch new
lines of products, these activities require enormous upfront investment and have a lead-
lag cycle whereby the product offering uptake takes a couple of years. However, this is
not evident in the extremely rosy financials presented.
 The company took a strategic direction to create brand value for leading brands of the
firm. That involves greater marketing budgets and consequently higher SGNA in the
initial periods. This should initially worse the SGNA as a % of sales (since sales uptake
take time), however, we observe the exact opposite, whereby the SGNA has halved
from 22% to 11% in 2018
 Since only condensed financials are provided, I would like to analyze and read notes for
various accounts, for e.g. why has retained earnings increased 300% even though the
company was not as profitable in the previous year, how has the net asset block
changed, how has the M&A activity been funded (since the debt is not rising) etc.

c) Can you identify any potential red flags?

 Firstly, I observe a large increase in the inventory of the firm, going up from 16% of total
sales in 2017 to 22% of total sales in 2018. This unexplained buildup of inventory is a
possible red flag, since this could be inventory returned from previous fiscal years’
channel stuffing.
 Another potential red flag is that Mr. Land’s new compensation plan announced just
before new acquisitions were announced (reference: Figure 1, Solray stock price chart),
and as explained above, Mr. Land’s compensation depended heavily on the price
performance, and his options were immediately vesting under the new compensation
plan. This could simply be a coincidence, but investigation is warranted.