UTX

February 28th, 2013 / By Robert Rhee

UTX was my moment of epiphany, the “oh my” moment when cogent thought on the legal profession came in a flash. Admittedly, prior to learning of UTX (not that long ago), I didn’t really know much about the economics of the legal profession other than the obvious fact that the financial crisis of 2008-2009 must have inflicted significant pain on the industry, thus my prior assumption of only a cyclical downturn. I write this blog post for the benefit of those colleagues in the academy who may have a sense that the legal profession is having difficulties but can’t quite see the larger picture beyond anecdotes of layoffs and a very difficult hiring market. I hope to provide a concrete example of the economic stress on the legal profession, which obviously has trickle down effects on the economics of law schools and the value of the law degree.

UTX is the stock ticker symbol for United Technology. It is a Fortune 50 company with 2011 revenue of over $58 billion, net profit of about $5 billion, and a market capitalization (market value of outstanding stock) of about $83 billion. UTX is a big company, and it is a big deal.

In spring 2010, I heard a speech by UTX’s associate general counsel. This speech was characterized by an overly aggressive advocacy of a proposition that one ordinarily does not see in staid academic conferences; the associate GC claimed that UTX wanted to “kill[] the hourly rate” and would not pay the fees for junior associates because they “are worthless.” (For more on this presentation, see 70 Md. L. Rev. 310.) If it wasn’t for the presenter’s title and authority, I would have dismissed the polemic as the out–of-turn rant of an overzealous corporate employee. With that said, his provocations were less interesting than the data that substantiated them.

Over a ten-year period (1999-2008), UTX reduced its external legal costs from 33 basis points (bps) to 22 bps of revenue. In financial parlance, 100 bps = 1%. Over a ten-year period, UTX decreased its legal cost ratio by 11 bps (or 0.11%) of revenue on an ongoing basis. One-tenth of one percent does not seem like a large number, but keep in mind that UTX is a large company. In 2011, the company had over $58 billion in revenue, and 11 bps of revenue is $64 million. UTX pays taxes, and so tax-adjusted the cost savings translates to about $45 million accretion to the bottom line profit.

Okay. But isn’t $64 million or $45 million still small relative to other measures? Think about it this way: a single law school that has 800 total students and collects net tuition of $20,000 per student has annual tuition revenue of $16 million—four such laws schools and we would have revenue of $64 million. Keep in mind that law schools produce over 40,000 graduates per year. What’s the big deal over a few million dollars? It would be a mistake to pooh-pooh $45 million in net profit as some rounding error for a company that earns about $5 billion in net profit. The really relevant number is much bigger because it is an ongoing savings. The value implication is significant.

The market value of companies is typically expressed as multiples of some financial measure. As I explain to students, think about buying a house in a particular area. Your real estate agent might tell you that houses in the area are priced around $100 per square foot. That’s a multiple providing a short-cut, approximate value of any given home. If a house is 2,000 s.f., then it should be priced somewhere in the range of $200,000, give or take. Companies also trade on multiples, which reflect their value. One way (of many) to consider the value of a company is the ratio of the market value of stock to net income. This multiple is called “price-to-earnings” or “PE”. UTX’s PE is 16.6 (= $83 billion ÷ $5 billion) as measured by 2011 net income.

Without going into the technical details and at the risk of overgeneralization for the purpose of a blog post (finance types, please spare me your “nits”), the value of a corporation is the discounted value of a going stream of earnings or cash flows the corporation will produce in the future. The multiple expresses a relationship between the value of the company’s stock and the company’s financial data. UTX adds approximately $45 million to the bottom line annually due to legal cost savings. Its PE multiple is 16.6x, which is the expression of the value of UTX for each dollar of earnings it generates on a going basis. Thus, multiply $45 million by 16.6, and the product is about $750 million.

Let me summarize the economic logic as follows: (1) the market values UTX currently at $83 billion; (2) the financial market values the stream of all of UTX’s future earnings at 16.6x earnings, which is the ratio of market value to net profit; (3) a small part of this future earnings is $45 million per year accreted to the bottom line on an ongoing basis due to recurring legal cost savings; (4) therefore, the value added to UTX’s market capitalization of $83 billion from annual legal cost savings of 11 bps is the product of 16.6 times $45 million, which is approximately $750 million.

I don’t know whether a formal valuation study will confirm the value accretion as $750 million (and I no longer do these kinds of studies for a living). I admit that my back-of-the-envelope estimates might be off by several hundred million dollars. The true figure may be only $500 million, or it may be as much as $1 billion, but this sort of imprecision is irrelevant. The relevant point is this: As a matter of financial and economic logic, there can be no doubt whatsoever that whatever is the true number, it is a ginormous number! The board and officers of UTX have great incentive to squeeze every last basis point off legal services. Minute gains in cost efficiency result in large value accretion to the corporation and its shareholders.

Now, think about the broader implication—UTX is only one company in the Fortune 500. The entire Fortune 500 is probably the largest consumer of legal services measured by revenue, and their legal problems constitute the bulk of BigLaw’s business. If we extrapolate from UTX across the entire Fortune 500, the implication on the legal profession is large. Achieve 5 basis point cost reduction across the board and maybe we might add the market value of a McDonalds (about $94 billion); 10 basis points and maybe we might add another Pfizer (about $200 billion).  Why wouldn’t corporations continue to squeeze legal costs? Aren’t the market evaluation of board performance and the bonuses of CEOs, CFOs and GCs in part dependent on achieving these kinds of cost efficiencies?

We shouldn’t be surprised by these developments. Law and Economics has been teaching the nature of transaction costs, agency costs, and their relation to efficiency for decades. Clients understood a long time ago that there is an agency cost problem inherent in a highly leveraged, pyramidal structure in which law firms generate revenue through time billed. But the assumption has been that lawyers and law firms controlled the delivery of legal services. Eventually corporate clients figured out how to leverage technology, knowledge sharing, business processes, and outsourcing in the delivery of legal services.

There are three broader implications. First, once the market finds a method of efficiency, we don’t go back to the old ways. When was the last time you used a typewriter, film-loading camera, or cassette tape? When was the last time you paid a service provider more than you should for the sake of paying more? The changes occurring in the legal profession are structural, and not cyclical.

Second, for the intellectual in us seeking a higher understanding beyond dollars and cents, there are serious social questions that are being resolved through the market process, like it or not and correctly or incorrectly: Who can make better use of $45 million, UTX or its lawyers? Is society better off by having a broader group of wealthier lawyers or by having more corporate funds to deploy in business enterprise? Are these cost efficiencies the inevitable drive of markets toward placing resources in the hands of firms that can maximize production?

Third, if the legal profession is staring in the face of cost efficiency and a large wealth transfer, what is the future for law schools and legal education? Obviously, law schools are currently being squeezed from two sides, making the present situation different from other economic cycles (in the past, the volume of law school applications were countercyclical due to the notion that professional school was a good place to park oneself during a recession). On the output side, corporate consumers of legal services are discounting the value of junior lawyers and many are opting not to buy in the quantities offered at the price point. On the input side, the consumers of legal education are not seeing the value proposition and increasingly are opting not to buy in quantities offered at the price point.

Hopefully this discussion makes concrete the general ether of malaise. These were the questions that came to mind when I thought about the meaning of 11 basis points . . . small number, big implications.