Comeback to the Future

Comeback to the Future

The management of Minnesota Diversified Industries—a nonprofit that provides useful work for the disabled—was spending big money on perks while the business nearly fell off a cliff. Here's how it got turned around.

To Pat Marso, the vistas of artwork, rich mahogany, and fancy electronics that he found in the executive offices on the upper floor of a St. Paul warehouse were a perfect symbol of what went wrong at Minnesota Diversified Industries, Inc.

MDI is a 45-year-old nonprofit organization with a mission to provide employment for disabled and disadvantaged people. In 2007, it suffered a near-death experience. Marso insists that the painful reorganization he helped engineer to rescue MDI should never have been necessary. The enterprise’s woes “didn’t come from the usual causes,” he says. “It wasn’t competitive pressures or imports from China or product evolution. It was just an example of poor leadership at its worst.”

Marso is a turnaround specialist, a principal with Manchester Companies, a Minneapolis-based management advisory and investment banking firm. In June 2007, MDI’s volunteer board of directors asked Manchester to look into the nonprofit’s operations and finances. Manchester’s investigation confirmed that MDI was losing $1 million a month on projected 2007 revenue of $22 million. It also revealed a business model so deeply flawed that things could only decline further. The situation was an “utter disaster—way worse than anyone anticipated,” says Marso, who became interim CEO a month into Manchester’s intervention. James Geiser, another Manchester principal, became assistant treasurer and later interim CFO.

The drastic steps they took saved the enterprise from oblivion. A year later, Manchester’s work at MDI won the 2008 Turnaround of the Year award from the Upper Midwest Chapter of the Turnaround Management Association.

Marso still gets angry at the thought of the partial second floor of MDI’s warehouse, which was security protected and off limits to most employees. The management crew that went out the door as Manchester came in spent untold sums on those lavish offices; the cost was buried within a $4 million renovation of the building in 2004, Marso says: “Then they loaded up [the offices] with executives. And it was all to position themselves as something they weren’t.”

The leadership group, he asserts, lost sight of the organization’s mission. “I think they saw MDI’s nonprofit status as a stigma, and it went up their craw,” he says. “It wasn’t as sexy [as the for-profit sector.] So they were going to build an empire.”

If so, they went about it in a distinctly unprofitable way.

 

Stamps and Totes

MDI was founded in 1964 as the Occupational Training Center, an offshoot of a St. Paul school for children with disabilities. It took its current name in 1978 and officially defined its mission: “to serve people with disabilities and disadvantages by offering progressive development and job opportunities in a competitive business enterprise.”

In 1992, MDI opened a second facility—a packaging and assembly plant in Hibbing. The following year, it built a bar-coding facility in Grand Rapids that it later converted to a plant to extrude corrugated plastics. At its peak in 2000, MDI had revenues of almost $50 million and employed more than 600 people.

For decades, MDI’s largest client has been the U.S. Postal Service, for which its workers package bulk stamps into units for retail sale under a set-aside contract for companies that employ disabled people. MDI also produces plastic totes, the boxlike cartons used by the Postal Service to sort mail. The corrugated plastic comes from the Grand Rapids plant; the totes are assembled mainly in Hibbing.

In the 1990s, concerned about its heavy reliance on a single customer, MDI sought to diversify. In 1999, it greatly expanded its St. Paul operation by buying a 320,000-square-foot warehouse to offer warehousing and product-fulfillment services to commercial customers. This business involved warehousing, packaging, and shipping smaller promotional and direct-response products for its customers, including well-known local firms such as 3M, Best Buy, Medtronic, and Caldrea.

In 2004, the Postal Service encouraged MDI to increase its corrugated-plastics output to become the sole supplier of its totes. Despite the continuing desire for diversification, MDI spent $8.5 million to triple the capacity of the Grand Rapids plant.

Not long after the expansion was completed, however, the Postal Service began to reduce its orders for plastic totes as it took on a just-in-time inventory campaign and other streamlining measures. Its business with MDI fell significantly in 2006, then was nearly eliminated as the Postal Service entered 2007 with a sufficient inventory of totes. The expanded Grand Rapids plant, with few other customers, was left functioning at 30 percent capacity. Meanwhile, printed adhesive postage at local post offices, and online downloading and printing of consumer postage, not to mention electronic funds transfers, had been steadily reducing demand for stamp packaging.

At the same time, MDI took on an additional $5 million in mortgages against the property appreciation of the St. Paul warehouse. That added to $16 million in remaining debt on the original purchase of the warehouse and the Grand Rapids plant expansion.

MDI finished 2006 in the red, with a loss of $3.8 million on total sales of $42 million. But the fat began to hit the fire in late January 2007, when Twin Cities media outlets reported that MDI executives had treated themselves the previous fall to an $8,000 golf outing at a resort on Gull Lake, near Brainerd. The getaway’s purpose? To plan layoffs that began shortly afterward.

Newspaper and television reports also revealed that such outings were not unusual for CEO Mark de Naray and MDI’s vice presidents. Since de Naray arrived in 2003, executive retreats had occurred once or twice a year. In a side trip to the Mystic Lake Casino during a 2004 retreat at the Hotel Sofitel in Bloomington, de Naray gave $100 in gambling money to each of the five vice presidents and their spouses. All of this went on MDI’s tab. (De Naray is now interim CEO of St. Cloud Window. He declined to comment for this story.)

The papers also reported that de Naray made $340,000 in 2005, including a bonus, and that compensation for him and the VPs totaled $1.14 million. In 2006, de Naray got $263,000. Citing the Economic Research Institute in Redmond, Washington, the Star Tribune reported that the national average salary for top executives in the nonprofit sector that year was $230,000.

 

“It Never Worked”

The MDI board first learned about the executive outings “when we read about them in the newspaper,” says Rob Tracy, principal at Minneapolis-based accounting and consulting firm LarsonAllen, who joined the nonprofit’s board in 2005 and has been its chairman since January 2008. That added to a growing sense that the transparency inside the organization “wasn’t what we’d hoped.”

In the spring of 2007, Tracy notes, revenue projections weren’t being met: “We started to get a sense that [management’s] plans to diversify outside the Postal Service were overly aggressive and not achievable.” And management had “spent money” assuming those plans would work out.

“As a board member, the CEO and the management team are your lens into the organization,” Tracy says. “You can do skip-levels [i.e., talk with people below the C-level] to try to get closer, but at the end of the day, you depend on them. We brought in Manchester because we didn’t feel like we were getting the straight picture.”

When Manchester entered the picture in July 2007, it found that with the Postal Service business on life support, 2007 revenue would drop by nearly half, to about $22 million. What’s more, with the real estate bubble having burst, the value of the St. Paul warehouse plummeted, and MDI was upside down on $21 million in debt. The company’s primary secured lender, Associated Bank in Minneapolis, placed its credit in a controlled loan portfolio and demanded an exit plan.

MDI’s remaining activities, most notably the packaging, assembly, and fulfillment business, were losing $1 million a month.

Should the MDI board have acted sooner? “If you do a postmortem, there’s plenty of blame to go around,” Tracy says. Some of it attaches to the Postal Service for urging MDI to expand its plastics operation—then cutting back its orders. “But we on the board have to take some responsibility, because the organization was under our watch. Could we have smelled the smoke sooner? Certainly.” De Naray resigned when the board asked Manchester for an initial six-week study.

In less time than that, the study found not just smoke but a raging fire.

MDI’s problems were “deeper and wider” than the board feared, says Manchester Companies CEO Mark Sheffert. “The place was in a dire financial condition.” (Sheffert writes the “Corner Office” management column for Twin Cities Business.)

The core dilemma dated back to 1999, before de Naray’s time, when MDI diversified into the warehouse and fulfillment business to serve private- sector companies. Manchester discovered that the fulfillment and warehouse operations “weren’t making money, and they never did,” Sheffert says. Indeed, they were operating at a loss. But that had been disguised by revenue from the Postal Service.

MDI’s management had been right to worry about having so many of its eggs in the Postal Service basket, and right to seek ways to diversify, Sheffert says. But the execution of the diversification strategy had been a disaster from the start.

Pat Marso couldn’t believe his eyes when he examined the warehouse and fulfillment operation. In the first place, he says, “nothing about the fulfillment business supports the type of employees MDI is supposed to serve.” Most competitors in the field have highly automated facilities and very efficient systems. MDI was using hand trucks to move merchandise. “So they had limited-mobility people in this 320,000-square-foot warehouse—some employees who have a tough time walking to their car, if they have a car—and they were selling fulfillment against automated [competitors].”

In the second place, Marso says, MDI was charging so little for its fulfillment services that it didn’t even cover direct costs. “They were bidding projects at a third of what a market-based contract would be,” he recalls. “3M, an outstanding corporate citizen, even asked MDI, ‘Are you sure you can charge us this little?’”

Even after the Postal Service revenues that were hiding the problem largely evaporated in 2007, management appeared not to recognize its mistake, Marso says. As MDI’s financial crisis deepened, managers had assured the board that a solution was at hand. What they promised—and evidently believed—would save the day, Marso says, was a major new fulfillment client scheduled to come on board shortly after he arrived in August.

“But the contract was so severely underpriced that it would have just exacerbated the beating they were taking,” Marso says. “I said: ‘How are you going to make this up with volume? The more volume you take in, the more money you lose.’”

There was no way to save the fulfillment business, Marso says. Manchester basically shut it down, though 3M and a few other companies remain as clients, on a much smaller scale and at more competitive rates.

Turning It Around

Given that the fulfillment business couldn’t be made to work, Manchester told MDI’s board, the company’s expenses were wildly out of line with reality. The 320,000-square-foot warehouse in St. Paul made no sense. And MDI’s management structure, built in the expectation that those operations would thrive and expand, was top heavy.

With Marso and Geiger installed as interim CEO and CFO, major surgery began. The head count of 26 executives was cut to four, including the CEO. In early 2007, MDI employed about 360 people at its Hibbing and Grand Rapids plants. Layoffs begun before Manchester arrived already had reduced those numbers. But for a month, Manchester cut the Grand Rapids work force down to 30 people and temporarily closed the Hibbing facility.

Meanwhile, Sheffert says, Manchester representatives went to Washington to iron out problems with the Postal Service and convince it to start ordering again. MDI’s stamp packaging and tote business soon picked up, and some of the laid-off employees were called back.

By October 2007, two months after the interim Manchester executives were installed, MDI was a smaller company—and almost all of its remaining business was with the Postal Service. But at least it was in the black, and it has remained modestly profitable every month since.

MDI still posted a $6.6 million loss for 2007 on $21.6 million in sales. Added to the $3.8 million loss in 2006, the company lost more than $10 million in two years. But without the intervention, Marso says, the 2007 losses might have been worse.

Having applied a tourniquet to stop the bleeding, Manchester turned to MDI’s $26 million in mortgage and vendor debt. The St. Paul warehouse was listed for sale, with MDI intending to lease back about 30,000 square feet—one-tenth of the space—for its remaining operations. A deal expected to close last summer would have paid down some mortgage debt. That sale fell through. On December 1, after a new deal was put together, the building was finally sold.

Also in late 2008, Manchester was still helping to renegotiate payment terms for the $1 million in debts owed to vendors.

As of November, MDI expected to show a 2008 surplus from operations of $1 million. On an EBITDA basis (earnings before interest, taxes, depreciation, and amortization), MDI’s 2007 loss was $3.2 million, before the loss of $2 million on the sale of the St. Paul facilities. For 2008, it projected positive EBITDA of $3.5 million on $26.7 million in sales. That’s almost a $7 million swing, or 28 percent, on consistent sales.

Manchester enlisted the support of Minnesota Congressman James Oberstar in an effort to refinance the remainder of the mortgage debt through a United States Department of Agriculture program that supports economic development in rural America. MDI qualifies as rural because the majority of its remaining operations and tangible assets are in Grand Rapids and Hibbing. Under the program, the USDA would guarantee 70 percent of a loan from a new bank. Those negotiations were successfully completed in December.

Peter McDermott, formerly president of the nonprofit Itasca Economic Development Corporation in Grand Rapids, took over from Manchester as MDI’s new president and CEO in August. “Manchester did what they had to do to save the company,” McDermott says. His job now is to build MDI up—and better fulfill the “diversified” in its name.

As of November, the company employed 255 people, divided about equally among the St. Paul, Grand Rapids, and Hibbing facilities. Sixty percent of those workers have disabilities and 15 percent are disadvantaged, a classification that can include poverty, limited English, and other factors, McDermott says. Federal Express and UPS buy some plastic totes, and a few fulfillment clients remain, but more than 90 percent of MDI’s business is still with the Postal Service. McDermott is working on new strategies to diversify the client base—this time in what he calls a “back to basics” manner: both profitable and in line with MDI’s mission.

“Call me back in six months,” he says, “and we can talk more definitively about the future.”

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