This article was originally published in the February 8, 1993 issue of Fortune.
Reporter Associate: John Labate
When Louis Gerstner Jr. swapped the presidency of American Express (AXP) for the top job at RJR Nabisco, he never dreamed events would develop as they have. Henry Kravis chose Gerstner as CEO in 1989 after taking over the maker of Winston cigarettes and Oreo cookies in history’s largest leveraged buyout. As readers of the best-seller Barbarians at the Gate know, Kravis was one of a horde of would-be acquirers who vied savagely to capture RJR. Gerstner recalls that Kravis recruited him with a promise the very opposite of barbaric: “We want to build this company, Lou. We want you to create value. Consider us long-term investors.”
Kravis and Gerstner agreed that RJR’s earlier bosses—including CEO F. Ross Johnson, whom Kravis sent packing—had operated with a nearsightedness that hurt the business. Brands had been starved of capital, acquisitions forgone, and product shipments arranged so that RJR could please Wall Street with a perfectly predictable earnings increase each quarter. Kravis, who is now 49, assured Gerstner, 50, that Kravis’s firm, Kohlberg Kravis Roberts, represented “patient capital” and that Gerstner could run RJR as a private company, sheltered from the demands of the stock market, for five years. Gerstner, in turn, devised a plan of heavy investment to resuscitate RJR’s premium cigarette brands, realize the potential of the food business, and energize international operations. His goal: a rejuvenated RJR that would be ready for a triumphal return to the New York Stock Exchange in 1994. Remembers Gerstner: “Poof! Like a beautiful flower bursting from the ground, we were going to become a public company.”
Oh, how the best-laid plans of buyout artists can end up in ashes. Within a year of Gerstner’s arrival, the collapse of the junk-bond market nearly did in RJR. KKR, faced with the possibility of bankruptcy for RJR, pumped in huge sums of additional capital and took the company public in April 1991, way ahead of schedule. The maneuvering brought in money that RJR has used to cut its crippling $29 billion debt by more than half. Yet it also means that with 50% of the common stock in public hands, Gerstner, the would-be long-term manager, now finds himself answerable to Joe and Judy Shareholder and antsy institutional investors as well as “patient” Henry Kravis.
Gerstner’s grit got tested recently when he hosted a presentation to security analysts in Manhattan, a role he never expected to play so soon. The Wall Streeters asked: “Why don’t you pay a dividend?” “Why not dump some of your marketing outlays to the bottom line and lift the stock price?” Implicit in such questions was skepticism that Gerstner—or anyone—can revive RJR as demand for cigarettes in America ineluctably declines. R.J. Reynolds, the company’s U.S. cigarette unit, accounts for 39% of revenues but fully 58% of operating income. And if profits can’t grow, the analysts wanted to know, shouldn’t the cash flow from the business be returned to shareholders now? Gerstner shot back, again and again, “No. We don’t run the company that way.”
Asking 500,000 owners to hold their horses would not be so dubious a proposition if the stock were doing well. But RJR, which sold for $11.25 in the public offering, lately has been stuck below $9, and dipped to $8.25 in January when the EPA identified secondhand tobacco smoke as a cause of lung cancer. While RJR’s net profits more than doubled to an estimated $800 million in 1992, the improvement comes mostly from reductions in interest expense; operating profits are lousy.
Gerstner blames the recession. “If the Eighties was the era of ‘Shop till you drop,’ the Nineties is the era of ‘Drop shopping,'” he told the analysts, referring to the largest pullback in consumer spending on nondurable products since the mid-1970s. It was no longer possible, he observed, to boost profits simply by raising prices. Profit growth in RJR’s U.S. food business has stagnated, and Reynolds has been even harder hit: Its earnings have fallen for two years running. And while RJR’s estimated 1992 operating income of $2.1 billion on $6.2 billion in U.S. cigarette sales sounds like a bounty, it is not, considering the historical wealth of the tobacco trade. In planning the buyout, KKR anticipated $2.9 billion in U.S. cigarette profits in 1992. The difficulties raise an intriguing issue: How long should a manager keep plowing money into a grand rebuilding scheme when profits lag, when consumers do not respond, when the reward seems out of sight?
Gerstner did not want to answer that or any other question when first approached about this story by Fortune. “You’re catching me in the middle of my five-year plan,” he said. “We’re not ready to tell the world whether we made it or not.” Self-contained and surprisingly shy, Gerstner started his career as a McKinsey consultant and went on to run the travel services division (charge cards, traveler’s checks) at American Express. Product innovations and big investments in marketing produced 18% annual profit growth during his decade at the company. Last fall, when the American Express board decided to oust CEO James D. Robinson III, it approached Gerstner about taking the job. He said no.
Once he gets talking, Gerstner’s reserve disappears. Asked whether his job at RJR has been tougher than expected, the CEO bellows a big “Oh!” throwing his arms up. He says his first shock came the day he reported for work in 1989. “I’d thought there was going to be some management here. But practically no senior people were left. We had to decide, How do you run a $15 billion business?”
Gerstner recruited three executive vice presidents: Karl von der Heyden, 56, from H.J. Heinz, as chief financial officer; Lawrence Ricciardi, 52, a friend from American Express, as general counsel; and Eugene Croisant, 55, from Continental Bank, as administrative boss. None of these executives smokes cigarettes; each juggles many jobs. Croisant serves as chief of personnel, information technology, real estate, and cost cutting. His rule of thumb: Scrimp except where spending directly benefits the brands. At headquarters, four floors of a midtown Manhattan skyscraper, the hallway floors are covered with gray-green industrial carpet. Where the walls are not cheap wood stained to look like mahogany, they are covered with greenish fabric suitable for a rec-room couch. “Even cheaper,” says Croisant proudly.
By eliminating excesses—30 luxury apartments, seven of 11 jets, 30 athletes on retainer, 3,000 unneeded employees—Gerstner and crew reduced total operating costs by 12%, or $550 million annually. In addition, Gerstner raised almost $6 billion by selling low-profit commodity lines and brands that did not dominate their markets—Del Monte, Chun King, Baby Ruth candy bars. He has increased spending on R&D, marketing, and sales to strengthen the brands he kept. Last year alone he paid $500 million for acquisitions, mostly to give RJR a foothold in underdeveloped markets like Mexico and Eastern Europe.
The emphasis on growth has had a powerful effect on morale. In 1992, International Survey Research (ISR), a Chicago firm, tested job satisfaction among 1,400 senior and middle managers at RJR. The scores were much higher than in a 1990 survey and exceeded average company scores on virtually every count—such as management relations, quality, and compensation. Says ISR head John Stanek: “RJR shows the most impressive improvement I’ve seen in 15 years, anywhere in the world.”
Employees rated the company under Gerstner especially high in leadership, strategy, and communication. “We’ve all become better managers,” says Nabisco Biscuit Co. President Ellen Marram, 45, who spent 11 years working under Ross Johnson. Once a month Gerstner travels with his executive vice presidents to Nabisco in Parsippany, New Jersey, and R.J. Reynolds in Winston-Salem, North Carolina, for full-day meetings with senior and middle executives. After spending 15 minutes or so on financial results, the CEO pushes the managers to focus on strategy, posing big-picture questions like “What kind of a business is this?” and “Should we be in it?” Middle managers and hourly workers enjoy occasional lunches and dinners with Gerstner, who likes to ask, “If you had my job, what would you do to perform better?” Says a manager who left Nabisco recently: “Lou’s presence is invigorating. For a man socially not too at ease, he is far more hands-on than Ross was.”
However earnest Gerstner’s commitment to the long term, his misadventures in tobaccoland show that you cannot plan where you cannot predict. Coming into RJR, he was aware of major problems: the 2% to 3% annual decline in the U.S. cigarette market; the fact that R.J. Reynolds, formerly No. 1, “was being hammered by Philip Morris.” The market shares today: 43% for Philip Morris, vs. 29% for RJR. Gerstner did not perceive until too late, however, that the fundamentals of the tobacco business were changing as consumers switched in droves to cheap brands. The tale of Gerstner’s difficulties, he admits, is rich in marketing lessons.
Upon his arrival, Gerstner made bold moves to try to turn Reynolds around. Step one was to snuff plans for launching Premier, RJR’s “smokeless” cigarette. Ross Johnson’s pet project had burned up $400 million in R&D—even as consumers, in tests, judged the product ghastly.
Step two was to abolish what’s called trade loading. This was Reynolds’s practice of inflating quarterly results by shipping extra cigarettes to customers’ already overstocked warehouses. Quitting required RJR to cut production while customers ran down excess inventories; that cost the company $360 million in 1989 pretax earnings. The long-term benefits: fresher cigarettes for consumers and the freeing up of an additional $50 million in cash each year.
Step three was to reverse the old strategy of churning out billions of low-priced, low-profit smokes. RJR had introduced bargain brands like Doral and Century in hopes of stemming the erosion of its market share. They made Reynolds king of the industry’s discount segment but diverted customers from RJR’s most profitable products. Says Gerstner, who has shunned price cutting ever since his days pitching premium charge cards at American Express: “Discounting is too easy. I don’t need marketing people for that.”
Gerstner has relied on James Johnston, a former Reynolds marketer he recruited to run the tobacco operation, to find ways to boost demand for RJR’s premium smokes. Johnston organized a separate team of employees from research, production, and other areas to work on each brand. The Winston team concocted more than 100 improvements, including more puffs per cigarette and a foil-like wrapping around the pack that prevents staleness better than cellophane. Last May, RJR launched Winston Select, which uses milder tobacco and is meant to lure Marlboro smokers from Philip Morris (PM). Salem got repackaged. The Camel team touted its new mascot, Joe Camel, and launched a fat version, Camel Wides, aimed at macho smokers.
Despite the efforts, Winston’s and Salem’s unit volumes and market shares have continued to fall. Meanwhile, the Joe Camel campaign succeeded so well that it set off a furor. Johnston denies antismokers’ charges that the cartoon character, a dapper dromedary who wears a tuxedo and is pictured with fawning women, tempts children to smoke, though Johnston admits to relishing Camel’s new young adult consumers. Last year the brand’s estimated unit volume increased more than 2% even as the industry’s sales of premium cigarettes dropped 8%.
Camel’s gain, however, has been more than offset by another problem. As RJR shifted from selling discount cigarettes, Philip Morris and England’s BAT Industries, owner of Brown & Williamson Tobacco, flooded the market with really cheap smokes. Black and white generics, so named for their plain wrapping, sell for around $1 per pack at retail, half the price of Camel. By last year this cut-rate segment had ballooned to more than 10% of industry volume (from 0% in 1987), yet RJR refused to play. Instead it poured an estimated $2.5 billion in 1992 into marketing, mostly for its high-priced brands. This tactic was so out of touch with the market that many retailers removed RJR’s cigarettes from their displays. With black and whites flying off the shelves, the storekeepers preferred dealing with cigarette companies that offered a complete product line.
Gerstner now admits that RJR blundered in ignoring consumer demand: “We were fools. We were naive. As the guys playing the volume game were rolling out their discount cigarettes, guess who lost? Us.” So, in 1992, RJR got down and dirty with the low-price crowd. It shipped about 18 billion black and white cigarettes—fully 13% of company volume. The moral of the cigarette story, according to Gerstner: “The world is changing so much and so fast that if you don’t modify, shape, adjust the tactics you use to implement your strategy, the strategy becomes useless.”
Investors, however, are still waiting to find out how the story actually ends: Will domestic tobacco profits rise in 1993? That was the first question the analysts posed to Gerstner in November. He replied bluntly: “We don’t know. If the industry can raise prices and avoid chasing volume, we’ll grow our profits.” For now, the industry seems to be doing just that. Reynolds and Philip Morris each increased prices on cheap cigarettes last fall, and their rivals followed.
Gerstner hasn’t given up on his premium brands, but he’s more realistic. This year, RJR will increase the budget for marketing Camel but will delay new ad campaigns for Winston and Salem until smokers show a willingness to pay more for their habit.
Miserly consumers pinched RJR’s North American food business as well. Nabisco Foods, America’s No. 1 cookie and cracker maker, boasts enviable competitive advantages, such as a 43% share of the $6-billion-a-year market and the industry’s best sales force, according to surveys of retailers by the consulting firm Neo Inc. In the first three post-LBO years, President John Greeniaus improved operating earnings 20% annually by paring expenses and serving up teeny versions of best-selling products: Mini Oreos and Mini Chips Ahoy! cookies and Ritz Bits crackers, which appeal to mothers with small kids. But a price war with competitors like United Biscuits’ Keebler unit virtually wiped out profit growth last year. In October, Greeniaus froze the pay of his 8,000 salaried employees, “not so much to save money,” he explains, “as to send a signal that performance is disappointing.” RJR took a fourth-quarter pretax charge of $105 million that will, among other things, enable Greeniaus to cut 200 management jobs.
Greeniaus, 47, is a curious choice to run Nabisco under Gerstner. Before the LBO he was Ross Johnson’s protege and chosen successor, a master at managing for the short term. But early in the battle to buy RJR, Johnson decided he might need to sell off Nabisco. Greeniaus quickly switched sides and leaked crucial information to Kravis. Now, after four years in KKR’s camp, he pledges allegiance to long-term growth: “We view our brands as strategic assets, which no one ever did before. Thou must preserve the health of assets and maximize their return.”
Nabisco’s challenge is to rationalize its non-biscuit businesses, which account for about half of RJR’s North American food sales. The mix includes Fleischmann’s margarine, Ortega Mexican foods, Grey Poupon mustard, Milk-Bone dog biscuits, and Life Savers candies. Each is strong in a category that RJR, in Gerstner’s view, had neglected to expand: The Johnson regime had lumped most of the products into one business unit, skimping on development and allocating advertising money mainly to keep profits smoothly growing.
Greeniaus reorganized in 1992, adding marketers from PepsiCo (PEP) and McKinsey and giving each brand more autonomy in marketing and R&D. To rouse Ortega from its siesta, Nabisco is forgoing profits in 1992 and 1993, doubling the marketing budget, and launching such new items as tacos and bean dips. In five years Greeniaus expects Ortega will quintuple annual sales, to $500 million. He also wants to expand recent acquisitions: Stella D’oro, a famous East Coast baker of breadsticks; New York Style Bagel Chips; and Plush Pippin, a piemaker in Kent, Washington.
Gerstner, meanwhile, has moved to capitalize on food opportunities abroad, taking Nabisco International from Greeniaus’s charge and spinning it out as a separate operating company. To run it, Gerstner recruited Richard Thoman, 48, who had become co-CEO of the travel business at American Express after Gerstner left. Thoman has to make up lost ground: RJR was forced to sell its European and Asian food operations in 1989 to help reduce debt, and today the food business abroad accounts for only $750 million a year in sales, mostly in Latin America. He aims to increase profits (some $100 million in 1992) by more than 20% annually, partly through acquisitions, and says he is evaluating 15 possible deals.
In international tobacco, Gerstner envisions king-size growth. Reynolds sells about $3 billion a year abroad, vs. $13.2 billion for Philip Morris. With demand for mild American-blend cigarettes rising 5% annually outside the U.S., RJR hopes to match strides with the Marlboro man in taking market share from local producers.
RJR only recently arrived in a position to indulge Gerstner’s appetite for growth abroad. Until just over a year ago, the company’s load of junk debt had caused banks to turn down financing requests. RJR made a slew of deals as soon as additional stock offerings restored it to investment grade. It bought cigarette factories in Turkey, Poland, and Hungary, and is setting up joint ventures in Spain, the Dominican Republic, Russia, and Ukraine.
Ambitious though Gerstner’s expansion plans may be, they don’t come anywhere near sopping up the company’s gargantuan cash flow. After operating expenses, interest payments, and taxes in 1992, says CFO von der Heyden, the business had $1.5 billion left over. RJR will use that money to retire or refinance its remaining $4 billion of LBO debt, which carries an annual interest rate of some 15%. Cuts in interest expense should help boost earnings per share 25% in both 1993 and 1994. For that reason, security analysts such as Emanuel Goldman of Paine Webber rate RJR one of the best bargains among packaged goods industry stocks.
All the same, the common stock is still stuck below what most people paid for it. For the price to rise, contends analyst Goldman, Wall Street must be convinced that tobacco earnings will grow. Alternatively, RJR can up the stock price by returning cash to the shareholders through dividends or stock buybacks—something Gerstner keeps resisting. He insists: “The stock price is derivative of performance in the marketplace and not something you act on with financial engineering.”
The heat the CEO feels is only going to increase; by next year, some of it may emanate from within RJR. The company’s 450 most senior managers were required to buy RJR shares at about $5 each when they joined the Gerstner brigade after the LBO, so an executive with an annual salary of $125,000 owns some $400,000 worth of stock. Most of those shares, along with generous stock options, will vest in April 1994. Ownership can motivate even the most farsighted executive to shorten his focus. Gerstner, who has put in $6.5 million of his own, assured the analysts: “We care about the stock price. We’re not running RJR Nabisco for our grandchildren.”
The heat the CEO feels will only increase; by next year, some of it could come from within RJR.
Investors may also be encouraged to know that Kravis, while insisting he is unequivocally pleased with Gerstner’s performance, puts enormous pressure on management. Consider a remarkable fact: KKR’s investment in RJR represents 53% of the total amount the firm has invested in all companies it owns. Eight KKR executives sit on RJR’s 15-member board; the KKR brass visits RJR each month for a formal review; Kravis speaks with Gerstner by phone two or three times a month.
Remember also that while Kravis is famous as an acquirer, he gets his biggest kicks from cashing out. He said in an interview for this story: “People call me up and congratulate me when I buy a company. I tell them, ‘Don’t congratulate me now. Congratulate me the day I sell it.'” Kravis also says he is not worried about RJR—then, with a smile, admits that he never reveals a worry. He refuses to discuss the prospects of the tobacco business, and insists, “If I had it to do the RJR Nabisco deal over again, I’d do exactly the same thing.”
And the outlook for the stock? Perhaps tellingly, Kravis asks, “Is 25% a good rate of return in this environment?” Well, Henry, KKR enjoyed returns of more than 30% during the 1980s, so answer, please. “It’s a terrific rate of return!” he declares. For KKR to hit that mark by, say, Gerstner’s fifth anniversary as CEO in April 1994, the stock would have to be selling for $15, almost double where it is today. It’s a good thing that Henry Kravis is a patient man.