Downsizing as a strategy:effects on profitability and signal value for the capital markets — Finnish evidence 2005–2010

This study concentrates on clarifying the background of downsizing as a strategy, measuring the profitability effects of downsizing and finding out the signal value of downsizing announcements in the capital markets. The research focuses on deriving the effects of downsizing among Finnish large cap companies between 2005 and 2010: what are the effects, what are the main drivers behind the effects and do future profitability development correlate with initial market reaction. The sample of 197 downsizing events consists of stock exchange releases regarding new downsizing actions from Helsinki stock exchange OMX 25 companies. The effects on profitability are measured by market adjusted ROA, ROE, EBIT margin and sales productivity through seven year event window: three years before and three years after the downsizing announcement year. The signal effect in the capital markets is studied with event study methodology through 41 days event window: 20 days before and 20 days after the announcement. Events are categorized in subsamples and cross–sectional analysis is used to derive the effects of downsizing and the main drivers behind the effects. This study shows evidence that downsizing does not have a significant impact on profitability on an aggregate level. Market adjusted return on assets and return on equity improve roughly 1% whereas EBIT margin decreases by the same amount among downsizers during three years after the announcement. Low- and high-profitability subsamples seem to be the most economically and statistically significant factor affecting post-announcement financials; low-profitability subsample clearly outperforms high-profitability subsample in post-announcement financial development. The abnormal return patterns related to the downsizing announcement correlate with post-announcement financial development on subsample level. On aggregate level, the compounded abnormal returns related to the announcements are slightly positive but statistically insignificant. The positive abnormal returns are driven by reactive downsizing strategies, downsizing made during recession and downsizing made by companies with low profitability. The key indications of the research are as follows: 1. Downsizing does not have a significant impact on profitability and signal value for the capital markets is insignificant on an aggregate level 2. Same factors seem to drive both: post-announcement financials and the effect on capital markets 3. Market absorbs the positive or negative information related to the future financial performance correctly and efficiently on subsample level 4. Constant adjustment of resources and reacting to negative demand shocks deliver better future financial performance 5. Market awards companies that react to negative demand shocks and poor financial performance 6. The management of Finnish large cap companies has the ability to inform the market correctly and promptly of the future financial performance and the effects of downsizing; the market reaction is fair compared to the ability to improve efficiency of operations