Marketing Science Institute Working Paper Series 2017 Report No. 17-121
Crisis Management Strategies and the Long-term Effects of Product Recalls on Firm Value
Yan Liu, Venkatesh Shankar, and Wonjoo Yun
“Crisis Management Strategies and the Long-term Effects of Product Recalls on Firm Value” © 2017 Yan Liu, Venkatesh Shankar, and Wonjoo Yun ; Report Summary © 2017 Marketing Science Institute
MSI working papers are distributed for the benefit of MSI corporate and academic members and the general public. Reports are not to be reproduced or published in any form or by any means, electronic or mechanical, without written permission. Report Summary
Companies increasingly face product harm crises (e.g., Toyota car, Samsung Galaxy Note phablet, Blue Bell ice cream), resulting in product recalls that often have a negative impact on shareholder value. While we know something about the short-term effects of product recalls on shareholder value, not much is known about the long-term effects of recall volume and the moderating effects of crisis management strategies on the relationship between recall volume and long-term firm value.
Here, Yan Liu, Venkatesh Shankar, and Wonjoo Yun undertake the first study to investigate the effects of crisis management strategies on long-term shareholder returns to product recalls. They develop a conceptual framework and hypotheses about the main effect of recall volume and the moderating effects of crisis management strategies on the relationship between recall volume and long-term firm value.
They empirically test their hypotheses in the auto industry context using both short-term abnormal returns analysis and long-term calendar-time portfolio analysis of 280 product recalls during 2005-2015.
Findings Overall, they find that brand advertising, voluntary initiation, and post-recall remedy mitigate the negative effects of recall on long-term returns and promotional advertising exacerbates recall effects on long-term returns.
Specifically, contrary to short-term effects, brand (promotional [e.g., rebate, financing deal, discount]) advertising has a significant positive (negative) effect on the relationship between recall volume and long-term abnormal returns. Furthermore, both voluntary recall initiation and post-recall remedial efforts positively moderate the impact of recall volume on long-term returns.
Implications These results suggest that managers should use different advertising types during and after a recall, strategically initiate recalls, and diligently execute post-recall remedy. To ameliorate the negative effects of recall volume on long-term abnormal returns, the firm should first voluntarily initiate the recall. It should next spend its resources fixing the defects and then focus on brand advertising. These findings are general to all industries but apply in particular to automobiles and durables.
Overall, this study suggests that managers and researchers should focus on the long term, rather than focus on short-term strategies, as proposed by prior research. The authors’ findings demonstrate that morally correct strategies such as voluntary initiation, post-recall remedial efforts, and demonstration of brand commitment are best for long-term shareholder value as well as for consumers who face a significant number of recalls of foods, toys, electronic devices, and automobiles.
Yan Liu is Assistant Professor of Marketing, Department of Marketing, and Venkatesh Shankar is Professor of Marketing, Coleman Chair in Marketing, and Director of Research, Center for
Marketing Science Institute Working Paper Series 1 Retailing Studies, both at Mays Business School, Texas A&M University. Wonjoo Yun is Assistant Professor of Marketing, Oakland University. The lead authors, Venkatesh Shankar and Yan Liu, contributed equally.
Marketing Science Institute Working Paper Series 2 Companies increasingly face product harm crises, resulting in recalls of related products.
Such recalls are frequent in many industries such as automobiles, toys, pharmaceuticals and food items. For instance, according to the National Highway Traffic Safety Administration
(NHTSA), the auto industry experienced an average of 122 recalls per firm over 1997-2010.
The volume of recalled units affects investor response to a recall announcement. For example, in 2010, Toyota’s market capitalization declined by 8.8% on the day it announced the recall of two million vehicles due to unintended acceleration, sticky braking, and poor vehicle handling (MarketWatch 2010).
Recall volume impacts both short- and long-term firm value by affecting short- and long- term revenues and costs. In the short-run, sales revenues of the volume of affected of products decline. The short-term costs relate to investigation, notification, repairs and replacement of defective products (Bromiley and Marcus 1989). Investors typically anticipate such revenue loss and costs and their effects on the recalling firm’s cash flow in the short run.
Thus, these effects are reflected in the short-term returns to product recall announcements.
However, recall volume also affects potential long-term revenues through damage to intangible assets, such as customer equity, brand equity, corporate reputation (Rhee and
Haunschild 2006), and marketing effectiveness (Liu and Shankar 2015; van Heerde, Helsen, and Dekimpe 2007). Recalls also entail long-run costs, which include unpredictable fines from regulatory authority, future liability claims, and other unexpected marketing costs
(Bromiley and Marcus 1989; Govindaraj et al. 2004). Thus, recall volume can have a long- term impact on cash flows, which may be difficult for investors to ascertain at the time of announcement.
Over a period of time after the announcement, the recalling firm and the regulatory authority disseminate to investors value-relevant information ranging from costs of the recall to the firm’s actions to alleviate the adverse financial impact (Govindaraj et al. 2004), helping
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investors update their beliefs about future cash flows and resulting in a change to the long- term firm value (Brav and Heaton 2002; Brennan and Xia 2001). For instance, over a period of at least 18 months after the announcement of recall of Ford Explorer SUV due to defective
Firestone tires in August 2000, Ford Motors, Bridgestone, and NHTSA shared several pieces of value-relevant information about the recall with the investors, including lawsuit settlement, government fines, updated number of deaths and injuries, and CEO change (see Web
Appendix for a chronology of these updates). The market capitalization of Ford decreased by
27.9% one year after August 2000 (Reuters 2001). Table 1 summarizes the differences between the short- and long-term effects of recalls on revenues, costs, and investor responses.
(Tables follow References.) To mitigate these negative short- and long-term effects of recall volume on firm value, firms have at their disposal three key crisis management strategies; advertising, recall initiation, and post-recall remedy strategies, which correspond to the three critical components of crisis management: (1) communicate to the stakeholders, (2) be responsive, and (3) repair damage, respectively (Seeger et al. 1988; Tang 2008). These elements are consistent with the communication, policy planning, and product development and logistics functions delineated by Smith, Thomas, and Quelch (1996) in their proposed strategic product recall management approach. These strategies offer additional information to consumers and investors about the firm’s belief in the recalled brand, its commitment to fix the problem, and its efforts to rectify the defect. These information and thereby these strategies moderate the effects of recall volume on firm value.
Firms could use different advertising types such as brand (e.g., Toyota) advertising, and promotional (e.g., zero-percent finance) advertising to inform consumers and investors and communicate their faith in the recalled brand. By understanding the effects of these different
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advertising types on the relationship between recall volume and short- and long-term returns to recall, firms can decide the advertising type to use during and after recall.
Firms could also voluntarily initiate a recall or issue a recall upon an order from the regulatory authority. Over the long-term, a voluntary recall might signal the firm’s commitment to fix the problem, but in the short-term, it can also acknowledge blame.
Through a better understanding of how recall initiation strategy moderates the long-term effects of recall volume on firm value, firms make an appropriate recall initiation decision.
To rectify the defect(s) in the product recalled, firms engage in post-recall remedial efforts. This process occurs after recall and does not affect short-term returns. However, consumers and investors evaluate the firm’s recovery efforts over several months after the recall. By knowing how these efforts affect the relationship between recall volume and firm value in the long-run, firms can better allocate their resources to post-recall remedy.
While the short-term effects of such crises or recalls on firm value have been researched
(e.g., Chen, Ganesan, and Liu 2009; Gao et al. 2015; Thirumalai and Sinha 2011), the long- term effects of such recalls on firm value are not well understood. Furthermore, the findings from extant literature may not adequately inform firms on using crisis management strategies to improve long-term shareholder value.
A key challenge in analyzing the effects of recalls on long-term returns in industries characterized by frequent events is to control for cross-correlations across the events over a long period. We surmount this challenge and fill a key research gap by addressing important research questions: (1) How does recall volume impact firm value in the long-term after a recall? (2) How do crisis management strategies mitigate the potential negative effects of recall volume on long-term abnormal returns? (3) How do the moderating effects of crisis strategies on the relationships between recall volume and long-term returns differ from those of the short-term?
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The answers to these questions are important from both theoretical and practitioner viewpoints. From a theoretical standpoint, it is key for researchers to understand why crisis management strategies affect the relationship between recall volume and long-term firm value. From a practitioner perspective, managers require guidance on strategies to minimize the negative impact of recalls on long-term abnormal returns. For example, they could benefit from knowing the pros and cons of voluntarily initiating product recalls. Moreover, they need to decide the advertising type to use during and after a recall. Finally, managers should know how worthwhile post-recall remedial efforts are in the long run.
We develop hypotheses about the main effects of recall volume, and the moderating effects of crisis management strategies, formulate models of short- and long-term abnormal stock returns, and test the hypotheses using the auto industry as the context with data on 280 product recalls during 2005-2015. Our results reveal important new insights. Recall volume’s negative impact on firm value lingers over the long term. Brand (promotion) advertising has a significant positive (negative) effect on the relationship between recall volume and long-term abnormal returns. Furthermore, when a firm voluntarily initiates a product recall, recall volume has a less negative effect on long-term returns. These effects are contrary to the short- term effects. Finally, a diligent post-recall remedy positively moderates the impact of recall volume on long-term returns. Our results suggest that managers should use different advertising types during and after a recall, strategically initiate recalls, and diligently execute post-recall remedy.
Our research differs from and contributes to related research (e.g., Borah and Tellis 2016;
Chen et al. 2009; Cleeren et al. 2013; Eilert, Jayachandran, Kalaignanam and Swartz 2017;
Gao et al. 2015; Liu and Shankar 2015; Xiong and Bharadwaj 2013; Yun 2014) in important ways (see Table 2). First, our research offers robust insights on long-term returns to product recall. Second, it makes valuable theoretical and managerial contributions about the
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moderating effects of key crisis management strategies. Third, it cogently explains how and why the long-term effects differ from the short-term effects. Fourth, it differentiates the effects of brand advertising and promotional advertising on abnormal returns to recalls, providing valuable theoretical and managerial implications. Finally, our research is the first to study the effects of post-recall remedy on long-term firm value, offering useful insights.
Conceptual Development and Hypotheses
Because the size of the recall has a key bearing on the financial outcome of a recall, we focus on the recall volume-abnormal returns link. The premise of ‘complete and immediate investor response’ underlies the use of short-term abnormal returns as an appropriate measure for the effect of a firm’s announcement on its value. In the long-term, investors update their beliefs about the firm’s future cash flows based on snowballing of short-term effect and additional value-relevant information provided by the firm, regulatory authority and related entities (Barberis, Schliefer, and Vishny 1998; Brown, Harlow, and Tinic 1988).
In developing our hypotheses, consistent with prior research (Xiong and Bharadwaj
2013), we examine two types of effects; the cash flow effect and the investor behavior effect.
The cash flow effect refers to the focal variable’s effect on the cash flows of the firm, while the investor behavior effect refers to the variable’s direct effect on investor attention and response, over and above the cash flow effect (Field and Lowry 2009).
Main Effect of Recall Volume on Firm Value
Recall volume has a direct and main effect on firm value in both the short- and the long-term.
Its impact on short-term abnormal returns is straightforward. It negatively affects consumer preference for the brand and thus the future sales and cash flow (Liu and Shankar 2015). We focus on its impact on long-term abnormal returns through both the cash flow effect and the investor behavior effect.
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Recall volume directly affects unexpected cash flows in the long-run. Fixing the product defect for a large number of units typically takes longer and the costs last over a longer period. Therefore, a recall with greater volume is more likely to involve unexpected costs, such as increased law suits and regulatory fines (Govindaraj et. al. 2004). Moreover, the greater the size of the recall, the more affected owners may spread greater negative word of mouth both online and offline, resulting in further loss in sales over the long-term (Borah and
Tellis 2016). Therefore, a recall with a high volume is more likely to result in long-term cash flow loss which is difficult for investors to forecast at the time of recall announcement.
Recall volume also has a negative effect on investor behavior post recall. Prior research in finance suggests that bad news may influence investor’s trading behavior and the stock may display a negative drift over the long- term (e.g., Barberis et. al. 1998; Chan 2003). Investors respond slowly to news. In the case of negative news, since shorting stocks is more expensive than buying stocks investors may delay trading in the long-term (e.g., Chan 2003). Moreover, a recall involving a large number of units sends a strong adverse signal about the recalled brand’s equity and the recalling firm’s health to investors. Over the long-term, the negative signal compounds investors’ pessimism about the firm’s brand value and future prospects. As a result, investors’ negative reactions to an announcement persist over the long-term with high recall volume. For example, Hasbro’s recall of 1 million units of Easy Bake Oven, an electric toy for children, in February 2007 had significant long-term negative effects on its market capitalization, which started recovering only in 2008 (O’Brien 2014). These arguments lead to our first hypothesis.
H1: Product recall volume has a negative relationship with long-term abnormal returns to a product recall announcement.
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The recalling firm’s crisis management strategies might moderate the relationships between recall volume and abnormal returns in both the short- and long-term.1 A large stream of research in finance has shown that investors learn about a firm’s anticipated financial performance from its actions (e.g., Daniel et al. 1997), including crisis management actions.
In the context of product recall, investors may evaluate the impact of the recall volume based on the firm’s crisis management strategies to reduce financial loss (Chen et al. 2009).
Prior research suggests that the responsiveness and recovery (or remedy), representing the recalling firm’s actions during and after, respectively, a product recall, are crucial to the outcomes of the recall management process (Etayankara and Bapuji 2009; Tang 2008).
During a product recall, a firm could show its responsiveness by quickly acknowledging problems and adopting voluntary recall initiation strategy (Laufer and Coombs 2006;
Siomkos and Kurzbard 1994). After a recall announcement, the recalling firm needs to recover in its business by providing remedy to affected customers. During the recall remedy process, the defective products are fixed, returned or exchanged (Kramer et al. 2005;
Siomkos and Kurzbard 1994). A firm’s efforts on remedy can increase the effectiveness of a recall and restore its reputation (Berman 1999). Both during and after a recall, the recalling firm communicates its responsiveness and efforts in recovery through advertising (Reynolds and Seeger 2005; Seeger et al. 1998). Thus, we focus on the three moderator variables: advertising, recall initiation strategy, and recall remedy. These variables represent firm actions, connecting them causally to outcomes and providing a theoretical basis, consistent with Sutton and Staw (1995).
Because firms spend most of their marketing budget on brand and promotional
1 Recall severity may also affect abnormal returns to a recall. In the subsequent empirical analysis, we have done a robustness check and our key findings are unchanged even after incorporating the effect of recall severity in the short-term (Table A11 of the Web Appendix).
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advertising, we focus on the moderating effects of brand and promotional advertising. Brand advertising refers to advertising that highlights the brand and is also sometimes referred to as image advertising. Promotional advertising communicates information about the brand’s promotional offers or customer incentives. Our conceptual model capturing the main effect of recall volume and moderating effects of crisis management strategies appears in Figure 1.
(Figure follows References.) Moderating Effect of Brand Advertising on Recall Volume-Firm Value Link
Firms often use brand advertising to alleviate the damage caused by a recall (Cleeren,
Dekimpe, and Helsen 2008; Cleeren, van Heerde, and Dekimpe 2013; van Heerde, Helsen, and Dekimpe 2007). In the short-term, high levels of brand advertising spending may amplify the recall volume’s negative effect on the firm’s short-term value through both the cash flow effects and the investor behavior effect. During a recall, greater exposure to the affected brand may attract unwanted attention from consumers and lead to greater negative salience of the recalling firm (Sparkman and Locander 1980), less responsiveness to brand advertising
(Liu and Shankar 2015; van Heerde, Helsen, and Dekimpe 2007), and lower expected future cash flows (Xiong and Bharadwaj 2013). Moreover, increased brand advertising during recall could also heighten investors’ unwanted attention to the recall, lower their confidence in the firm, and enhance their likelihood of selling the firm’s stock, leading to further negative impact on its stock price (Xiong and Bharadwaj 2013).
In contrast, the effect of brand advertising on the recall volume--long-run firm value link may be positive. We first discuss the long-term cash flow effect of brand advertising. When the affected firm places a steady emphasis on brand advertising over a long period post recall, it displays its serious commitment to enhance brand equity. Post-recall, brand advertising’s positive effect on consumer attitudes increases (Rubel, Naik, and Srinivasan 2011). Thus, spending more on post-recall brand advertising will likely help firms arrest the dilution of
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brand reputation, regain consumer trust in the brand, and decelerate revenue declines after a large recall (Bruce et al. 2012). It can also lift stock returns by raising customer lifetime value and cash flows (Kumar and Shah 2011). When consumers are uncertain about a brand or when there is incomplete brand information, advertising tends to be more persuasive by helping consumers learn (Assmus et al. 1984). Thus, increased brand advertising post recall can enhance brand attitude, making customers more loyal and mitigating the negative effect of recall volume on long-term cash flows (Xiong and Bharadwaj 2013).2
We now discuss investors’ direct response in the long-term to brand advertising over and above the cash flow effect through spillover and signaling. Investors may favor stocks with strong brand names and high brand quality (Frieder and Subrahmanyam 2005). In the long- term, increased brand advertising could buttress brand equity, potentially spilling over to the demand for stocks of the recalled firms (Joshi and Hanssens 2010). Moreover, sustained brand advertising after the recall can signal the firm’s confidence in its financial well-being and future earning potential, influencing investor behavior (Joshi and Hanssens 2010). As the recalling firm spends more on brand advertising, investors are less likely to expect a prolonged negative impact of recall volume on the firm’s cash flow and are more likely to hold the firm’s stocks. Therefore, we hypothesize:
H2: The negative relationship between product recall volume and long-term abnormal returns to a product recall announcement will be weaker when firms spend more on brand advertising post recall announcement.
Moderating Effect of Promotional Advertising on Recall Volume-Firm Value Link
Unlike brand advertising, promotional advertising informs consumers about offers such as price reduction, rebates and attractive financing plans. Promotional advertising may influence the effect of recall volume on long-term returns differently than on short-term returns.
2 Note that such positive effect exists regardless of whether the recall volume is high or low.
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In the short-term, promotional advertising disseminates information on price promotion activities, temporarily raising customer value by lowering the net price paid (Blattberg and
Neslin 1990). This increase in value arrests declines in preference and sales revenues vulnerable to the recall, mitigating the negative effect of recall volume on short-term cash flow (Pauwels et al. 2004). Therefore, investors will anticipate that the short-term abnormal returns to a recall will decline less when firms spend more on promotional advertising.
Over time, however, repetitive promotions may increase consumer price sensitivity and diminish brand value, resulting in lower anticipated future cash flow (Chen, Ganesan, and Liu
2009; Dodson, Tybout, and Sternthal 1978). Consumers may use price promotion as a quality cue and associate it with inferior quality of the promoting brand (Raghubir and Corfman
1999). Since recalls of defective products also degrade consumers’ quality perception (Rhee and Hauschild 2006), repeated promotions will only serve to dilute quality perception. As a result, investors will anticipate that brand value will decline by a greater amount, further damaging customer base and potential future revenues (Xiong and Bharadwaj 2013).
Therefore, investors will anticipate that customer preferences and average price will decline more, long-term marketing costs will rise, and cash flows will fall due to higher promotional advertising for recalls, i.e., a cash flow effect. Thus, we hypothesize:
H3: The negative relationship between product recall volume and long-term abnormal returns to a product recall announcement will be stronger when firms spend more on promotional advertising post recall announcement.
Moderating Effect of Recall Initiation Strategy on Recall Volume-Firm Value Link
Firms can chose to either voluntarily initiate a product recall or wait for the regulatory authority to mandate a recall. Some firms may choose to recall a product early rather than wait for the regulatory body to mandate it (Eilert et al. 2017). In the short-term, investors may perceive a voluntary recall as the firm’s admission of guilt about its product defects and expect lower future cash flows (Chen, Ganesan, and Liu 2009). As a result, voluntary recall
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initiation will aggravate the negative relationship between recall volume and short-run returns.
Unlike in the short-run, in the long-run, a proactive initiation strategy might soften the negative impact of a large recall through both cash flow effect and investor behavior effect.
Voluntary recall initiation may decrease the likelihood and extent of regulatory fines and potential long-term costs associated with product recalls, improving cash flows (Govindaraj et al. 2004). Moreover, consumers may treat the recall as an exception to the brand’s normal behavior, softening the negative effect of recall on cash flows (Lei, Dawar, and Gürhan-Canli
2012), leading to a cash flow effect.
Investors may interpret a proactive recall initiation as a commitment by the firm to improve the value of the affected products. Over time, investors interpret this commitment as a strong signal of the firm’s ability to bounce back from crisis. Thus, investors will view the firm’s actions favorably and adjust their assessment of the negative effect of the recall announcement on its long-run abnormal return, yielding an investor behavior effect.
Considering both the cash flow and the investor behavior effects, we argue that a proactive recall initiation strategy will lead to a less negative effect of recall volume on long-term shareholder value. These arguments lead to our next hypothesis.
H4: The negative relationship between product volume and long-term abnormal returns to a product recall announcement will be weaker for firms recalling voluntarily than for firms recalling mandatorily.
Moderating Effect of Post-recall Remedy on Recall Volume-Firm Value Link
Firms need to manage the post-recall remedial process, which can have an effect on firm value only in the long-run. A firm’s post-recall remedy refers to the firm’s efforts in addressing the crisis by appropriately mobilizing its resources and rectifying the defects
(Shrivastava and Siomkos 1989). For instance, in industries such as auto, electronics, toys, durables, and medical devices, once a firm makes a recall announcement, it has to follow a
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multistep process that includes informing affected product owners, developing remedial procedures, distributing repair parts and kits to dealers, training its dealers to repair the affected products, and monitoring the repairs to customers’ satisfaction.
Post-recall remedy can moderate the effect of recall volume on long-term returns to a recall, similar to service recovery (e.g., Maxham and Netemeyer 2002). In general, strong remedial efforts for the recall procedures can reduce customer and investor uncertainty associated with the quality of repairs and proper completion of the recall process. It evokes greater trust in the firm’s thoroughness to overcome the adverse effects of a recall and improve product quality and customer value as in the case of recovery of a failed service
(Maxham and Netemeyer 2002). Therefore, we expect the firm’s post-recall remedial efforts to weaken the negative effects of recall volume on the value of intangible assets, such as perceived product quality and firm reputation. The strengthened intangible assets help retain more consumers and stem revenue losses. Furthermore, a thorough remedy and implementation process may reduce any future product liability costs. As a result, any cash flow losses anticipated over the long-term can be significantly mitigated, reducing the likelihood of investor devaluation of the firm. These arguments lead to H5.
H5: The negative relationship between recall volume and long-term abnormal returns to a product recall announcement will be weaker when firms expend more efforts on post- recall remedy.
Empirical Context and Data
We test the hypotheses in the United States (U.S.) automobile industry context. Using data from this industry is advantageous for key reasons. First, it obviates the need for including a wide array of cross-industry factors to control for potential heterogeneity present in multi- industry studies. Second, data on strategic variables such as post-recall remedy are available as firms in this industry are required to report the recall remedy completion rate (percentage
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of defective products fixed) on a quarterly basis. Third, because industry factors are common for all the firms within the industry, the internal validity of the results is strong.
The external validity is also strong because recalls in many other industries are similar to those in the automotive industry in many ways. First, firms in the food, toy and pharmaceutical industries also experience multiple recalls over time (Dawar and Pillutla
2000). Second, as in the auto industry, the consequences of product failure in many industries can be very severe and even life threatening. Third, similar to the auto industry, recalls in many industries are regulated by government agencies. Fourth, post-recall remedy is common in industries such as auto, electronics, toys, consumer durables, and medical devices. Thus, crisis management strategies, such as advertising, voluntary initiation and post-recall remedy, are similar in many industries.
The data for our empirical analysis come from nine major sources: NHTSA for product recall attributes data, LexisNexis and Factiva databases for recall announcement, social media and conventional media data, Center for Research in Security Prices (CRSP) and
COMPUSTAT for firm performance and firm attributes, Automotive News Market Data
Book for auto vehicle sales and dealer size, Ward’s Automotive Yearbook for auto characteristics, Kantar Media for weekly advertising spending, and Consumer Reports for product reliability. A summary of the data sources of key variables appears in Table 3.
In the first step of data collection, we collected product recall data from the NHTSA database for all the U.S. automobile industry’s manufacturers listed on the New York Stock
Exchange (NYSE) during January 2005 to June 2015. The NHTSA recall database is the
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official data source that provides information about product defects in the automobile industry (Rhee and Haunschild 2006).3
For this study, it is critical to identify the true date when the product recall was first announced to the public, allowing us to get a clean estimation window for event studies
(MacKinlay 1997; McWilliams and Siegel 1997). Although the NHTSA provides information on the date of owner notification, the actual announcement date released to the public could be much earlier (e.g., Chen, Ganesan, and Liu 2009; Davidson and Worrell
1992). Following prior work (Sood and Tellis 2009), we searched all news sources in
LexisNexis and Factiva databases for the earliest date when information about the recall became publicly available. We consider this date as the announcement date.
In the automobile industry, the coverage of product recalls by a press release may be incomplete (Barber and Darrough 1996). All recalls documented by NHTSA may not be reported as news releases (Rupp and Taylor 2002). Therefore, we diligently collected data on all recalls from multiple sources. We obtained a usable sample of 280 product recall announcements made by all the publicly listed auto firms between 2005 and 2015.
Variables, Measures, and Models
Dependent Variables: Abnormal Stock Returns
Our dependent variables are abnormal stock returns in the short- and long-term windows. To minimize potential confounding effects, consistent with prior research, we examine short- term abnormal returns over a relatively short period surrounding the event (Brown and
Warner 1985; Srinivasan and Bharadwaj 2004). Based on the Patell’s test (Patell 1976), we
3 In the empirical context and data section, we provide brief details of the recall process in the auto industry that we subsequently analyze (NHTSA 2006). Greater details are available in the Web Appendix.
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use a typical five-day window centered on the recall announcement (-2, 2).4 The long-term abnormal return is measured monthly starting the month after the short-term window. The long-term window typically extends for a year (e.g., Sorescu, Shankar, and Kushwaha 2007).5
Focal Independent Variables
Recall volume. We operationalize product recall volume by the number of defective vehicles recalled. To control for scale effects, we normalize a firm’s recall volume by its unit sales in the previous year (Kalaignanam, Kushwaha, and Eilert 2013).
Advertising. We operationalize short-term advertising as the spending during the week of the recall announcement, consistent with the five-day (business day) window for computing short-term abnormal return. We operationalize long-term advertising as each month’s advertising spending over a one-year period after recall. Brand advertising refers to spending on the brand theme, while promotional advertising refers to spending on promotional offers such as annual percentage rate (APR) financing, manufacturer rebates, and extended warranty. Following prior research that considers only unexpected changes in advertising to which investors respond (e.g., Joshi and Hanssens 2010; Kim and McAlister 2011; Tirunillai and Tellis 2012), we operationalize unexpected advertising as the residual from an autoregressive model of advertising, consistent with Jacobson and Mizik (2009). Investors are rational and only surprises can change their expectations of future cash flow, and thus stock prices (Daniel et al. 1997, Mizik and Jacobson 2004). As a result, only when a firm’s advertising spending increases faster or slower than what investors expected based on the firm’s past advertising spending, will the firm’s value (Kim and McAlister 2011).
4 In our data, the average abnormal return is significantly negative in the short time windows both before and after the announcement day, suggesting possible information leakage before the recall announcement, consistent with Gokalp et al. (2016), who find evidence of insider trading before the auto recall announcement. 5 The results from analyses using various other short- and long-term windows (e.g., two years) are largely consistent with those of our proposed model and are available in the Web Appendix.
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Recall initiation strategy. The recall initiation strategy variable is a binary variable denoting whether the firm voluntarily or involuntarily initiates the recall. Consistent with advertising, we use unexpected level of recall initiation probability operationalized as the observed recall initiation strategy (1=voluntary recall) minus the expected probability of voluntary recall computed from a binary autoregressive model of recall initiation (Wang and
Li 2011). Investors form expectations of the affected firm’s recall initiation strategy based on the firm’s past recall initiation strategies. If investors anticipate the firm to follow an initiation strategy (voluntary or mandated) based on their expectations and if the recalling firm does not deviate from that, there will not be any abnormal stock returns. However, if the observed recall initiation strategy differs from investors’ expected probability of the firm’s recall initiation, the firm will experience abnormal returns.
Post-recall remedy. The ultimate goal of a recall is to fix the defected products. The more effort a firm puts on post recall remedy, the more likely consumers respond to the recall and bring the defected product to the dealers. Consistent with prior research (e.g., Hoffer, Pruitt, and Reilly 1994), we use owner response rate, or the remedy completion rate (percentage of defective products fixed) as a direct measure of the firm’s post recall remedial efforts on fixing the defective product, collected from www.safercar.org.6 As in the cases of advertising and recall initiation, we use unexpected post-recall remedy obtained from the residual of an autoregressive model. Similar to advertising and recall initiation, investors form expectations of the recalling firm’s remedial efforts to a recall based on the firm’s prior remedial efforts.
The firm will likely experience abnormal returns commensurate with the gap between the observed and expected remedial efforts.
6 Although the completion rate is a well-accepted measure of post remedial efforts, it can be argued that it is the result of the recalling firm’s post recall remedial efforts. To ensure that the results are robust to the measure of post remedial efforts, we estimate our models with an alternative measure and report the results in the subsequent robustness check section.
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Control Variables
Following prior research (Chen et al. 2009; Thirumalai and Sinha 2011), we include control variables: other advertising types, their interactions with recall volume, social media volume, conventional media volume, recall frequency, product reliability, labor intensity, R&D intensity, sales, product scope, dealer size, leverage, market-to-book ratio, and year trend.
Car model advertising refers to advertising spent on specific car models (e.g., advertising spending on Toyota Camry). Following prior research, we use the number of blogs on product recalls from 33 popular blog sites as the measure of social media volume (Babic et al.
2016: Li, Lai, and Chen 2011; Luo 2009; Luo, Zhang, and Duan 2013; Tirunillai and Tellis
2012; Stephen and Galak 2012). Investors may find conventional media volume, the number of articles about the recall in print media (Liu and Shankar 2015) more trustworthy than firm- generated information (Jolly and Mowen 1984). Investor response to a recall may be shaped by recall frequency (Wynne and Hoffer 1976), the number of recalls experienced by the firm in the past six years (Liu and Shankar 2015). Product reliability, the sales-weighted average of both the brand and model level product reliability ratings measured on a five-point scale
(Rhee and Haunschild 2006), may impact the abnormal returns to recall.
We expect labor intensity, number of employees/sales revenue, to negatively affect the short-term returns to a recall because it reflects the cost to train or retain employees
(Thirumalai and Sinha 2011). Innovation ability, measured by R&D intensity or R&D spending/sales revenue, might influence investors’ assessment of a firm’s ability to overcome a failure in quality. The level of sales in the year prior to the recall signals to investors the firm’s capabilities to absorb the negative impact of a crisis, fix the faulty product(s), and to recapture share (Kalaignanam, Kushwaha, and Eilert 2013).
The recalling firm’s distribution intensity, measured by dealer size or the number of dealers in the firm’s distribution network, may influence short-term abnormal returns to a
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recall. Firms with a boarder or deeper product scope, measured by the breadth and depth of products in the model, may be able to better withstand the negative impact of a recall
(Thirumalai and Sinha 2011). We anticipate financial leverage, measured by debt-to-equity ratio, to negatively affect short-term returns to a recall as the shareholder’s burden during the crisis is lower for firms with higher leverage (Thirumalai and Sinha 2011). We include the market-to-book ratio to capture the firm’s growth prospects, which can impact the short-term returns to a recall (Thirumalai and Sinha 2011). Finally, we include a time variable
(Yeartrend) to capture the potential impact of trend (Chen, Ganesan, and Liu 2009).
The operationalization of key variables in the data appears in Table 3. The summary statistics and the correlation matrix of short- and long-term variables appear in Tables 4A and
4B, respectively. The average recall involves about 418,580 cars. The average firm initiates
71% of its recalls. On average, firms spend more on brand advertising than on promotional advertising. The average post-recall remedy completion rate is 68.55% after one year. None of the correlations among the short-term independent variables is high with the Variance
Inflation Factors (VIFs) smaller than four. Therefore, multicollinearity is not an issue.
Short-term Effects Analysis
To analyze the short-term effects of recalls on firm value, we adopt the widely used event study methodology (e.g., Agrawal and Kamakura 1995; Chen et al. 2009) as follows.
CARi RVi 2 ADi 3 INITi 4 RVi AD i 5 RVi INIT (1) ( 2,2) 0 1 6 SMi + 7X i ( AD i , INIT , SM i ,1)* * i i where CARi is cumulative abnormal returns (CAR) for event i, and RVi is recall volume. ADi is a vector of three types of advertising, including brand advertising, promotional advertising, and car model advertising. INITi is a dummy variable representing recall initiation strategy (1 if voluntary and 0 otherwise). SMi is social media volume and Xi is a vector of other control
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variables. i is a vector of endogeneity correction terms (i.e., estimated error terms from the first stage regressions) from the Control Function (CF) approach we use. β and Λ are
parameters to be estimated and i is an error term (See Appendix D in Web Appendix).
We estimate the model by controlling for the endogeneity of advertising spending, recall initiation strategy, and social media volume. To control for intercept and slope endogeneity of the advertising types that occur because econometrically unobserved factors affect advertising and manufacturers having private information on market response to advertising during a recall, we use a CF approach (Liu and Shankar 2015; Petrin and Train 2010).7
Following prior advertising research (e.g., Liu and Shankar 2015), we use advertising costs across media (cable TV, network TV, magazines, and newspapers) and own and competitor’s product attributes as instruments for advertising. Following Chen et al. (2009), we use sell time, the number of months the recalled products were in the market before the recall and the manufacturer suggested retail price (MSRP) of the recalled car as instruments for recall initiation strategy. Sell time captures how long the recalled products have been sold in the market before the recall. Investors don’t usually respond to expected information such as sell time. Moreover, the longer the product is on the market, the higher the costs associated with a recall, reducing the likelihood of the firm initiating a recall of the product. MSRP is determined on an annual basis, so it is reasonable to assume that such a long-term measure is uncorrelated wit short-term abnormal return. However, MSRP is correlated with the recall initiation strategy, making it a valid instrument because firms might be more reluctant to initiate a recall when fixing the product defect is more expensive. To control for the endogeneity of social media volume, we follow a widely used approach where lagged
7 To control for the endogeneity of recall initiation, unlike Chen et al. (2009) who use observed recall initiation, which takes dichotomous values, we use unexpected recall initiation probability that is a continuous measure. Therefore, we do not use the Heckman (1979) two-step selection approach.
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endogenous variables serve as instruments (e.g., Ataman, van Heerde, and Mela 2010). The
R-square of the first-stage regression ranges from .37 to .78, underscoring the validity of these instruments.
In addition, we performed a Staiger and Stock (1997) instrument quality test using the first stage F-statistic value. The results show that these values (F-test results of Model 2 in
Table A1 of Web Appendix) are all significant and greater than 10, a threshold for strong instruments and 2SLS to be reliable (p. 522, Stock, Wright, and Yogo 2002). Moreover, we compare the first stage model with and without instruments and find the comparison F-tests significant (Table A1 of the Web Appendix), suggesting that including the instrumental variables significantly improves the model fit of the first stage regression. We also performed the Stock and Yogo (2005) test used with multiple endogenous variables. The result again rejects the null hypothesis that the instruments are weak (see Table A1 in Web Appendix).
Long-term Effects Analysis
Two methods are commonly used for analyzing long-term abnormal returns: the Buy-and-
Hold Abnormal Returns (BHAR) and the Calendar Time Portfolio Abnormal Returns
(CTAR). When there are considerable cross-correlations among abnormal returns of multiple events in a long period, that is, when the long-term abnormal returns for subsets of the sample firms overlap in a common calendar year, statistical inferences on the event portfolio’s
BHAR can be difficult. In particular, major corporate actions are not random events and are clustered through time by industry. For example, in the auto recall context, manufacturers suffer from recurring recall events rather than experience a one-time event, such as an initial public offering (IPO). Therefore, ignoring the cross-correlation problem may lead to a serious misspecification of the model (see Kothari and Warner 2007 for details).
The most conservative approach to overcome cross-correlation is the Calendar Time
Portfolio Abnormal Returns (CTAR) approach (Fama 1998; Sorescu, Shankar, and
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Kushwaha 2007). It is particularly appropriate for calculating long-term abnormal returns to events that are clustered in time, automatically accounting for dependency among the events
(Mitchell and Stafford 2000). We use the CTAR approach to test the proposed moderating effects on long-term firm value. It starts from portfolio formation and categorization of recall events into various portfolios based on whether a key variable is above or below its median value in that period. For example, the two portfolios based on recall volume are: (1) recall events with volumes greater than the medium value and (2) recall events with volumes smaller than the medium value. After creating the calendar-time portfolio, we compute the abnormal returns using the four-factor model, which controls for risk and momentum
(Carhart 1997) as follows:
(2) RR(RR)pt ft p p mt ft pSMB t p HML t p UMD t pt , where Rpt is the rate of return of the calendar time portfolio p during month t, Rft is the risk- free rate or the 1-month T-bill yield, Rmt is the average rate return on the CRSP equal- weighted index, SMBt is the return on a portfolio of small stocks minus the return on a portfolio of large stocks, HMLt is the return on a portfolio of high book-to-market stocks minus the return on a portfolio of low book-to-market stocks, UMDt is the return on a portfolio of high prior return stocks minus the return on a portfolio of low prior return stocks, and εpt is the residual. The intercept (αp) reflects the average monthly abnormal returns of the portfolio. When the estimated intercept is zero, the portfolio’s post event stock performance is “normal,” so there is no adjustment to the stock price in the long term. However, when the intercept is positive (negative), there exists overreaction (underreaction) to the negative event in the short-run and this mispricing is corrected in the long-term when additional information is introduced post event. Moreover, the intercept (αp) in the long-term analysis is computed from inter-temporal variation of portfolio returns rather than from cross-sectional variance as
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in short-term analysis. As a result, it helps to account for cross-sectional correlation of returns, a major advantage of CTAR over BHAR method (Sorescu et al. 2007).
We estimate Equation (2) using the weighted least square (WLS) method that corrects for heteroscedasticity induced by changes in the number of firms in each month. To test the interaction effects of crisis management strategies and recall volume, we classify events into subgroups. For example, to test H2, we form four subgroups, events with high-low, high-high, low-low and low-high of recall volume and brand advertising. We obtain separate regression intercepts for each subgroup using Equation (2). We then test differences among the subgroup intercepts pairwise (see Sorescu, Shankar, and Kushwaha 2007 for more details).
Note that CTAR analysis differs from the regression model in that the effect of each factor is estimated through separate analyses.
Results
Main Effects of Product Recall Volume on Shareholder Returns
Table 5 presents mean value of the short-term abnormal return (CAR). On average, the short- term abnormal returns to product recall events are negative and significant (p < .01).
Table 6 shows the results of the long-term calendar time abnormal returns for the 12- month holding period using the four-factor model. The calendar-time long-term abnormal returns for the entire sample are significantly positive, suggesting that the negative short-term abnormal returns to product recall announcements do not present a complete picture and the negative impact of product recall on firm value is reversed post recall announcement.
Table 5 presents the results of the short-term abnormal return models with three approaches (OLS, 2SLS and CF). While the results are consistent across the three methods, we focus on the results using CF approach since it has the best model fit based on R2. The
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results show that recall volume has a significant (p < .10) main effect on short-term abnormal return. However, our focus is on the long-term. Recall volume has a significant negative main effect on long-term abnormal returns (p < .10), supporting H1 (Table 6). To better understand the total impact of recall volume on firm value, we examine the coefficients of the moderating effects of the crisis management strategy variables.
Moderating Effects of Crisis Management Strategies on Recall Volume-Returns Link
We first discuss the moderating effects of brand advertising on recall volume’s impact on firm value in the short- and long-term. The results of the short-term analysis (Table 5) show that the coefficient of the brand advertising-recall volume interaction term is negative and significant (p < .05), consistent with expectation. Increased brand advertising makes the recalled brand more salient around the time of recall announcement, aggravating the negative effect of recall volume on the firm’s short-term returns. In contrast, the interaction of brand advertising and product recall volume has a significant and positive effect on long-term abnormal returns (p < .05), supporting H2. The firm’s continued investment on brand advertising after the recall announcements shows its serious commitment to enhance brand equity and sends favorable signals to investors in the long-run.
We now examine the results relating to H3. As expected, the results of the short-term analysis show that the coefficient of the interaction of promotional advertising and recall volume is positive and significant (p < .05). In contrast, Table 6 shows negative and significant interaction effects between promotional advertising and recall volume on the long- term abnormal returns (p < .01), consistent with H3. Thus, promotional advertising, which facilitates the dissemination of offers, temporarily increases customer value, retaining customers and alleviating the negative impact of recall volume on firm value in the short- term. However, post-recall, a firm’s high investment in promotional advertising diminishes brand value, intensifying the negative impact of recall volume on long-term firm value.
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We now test H4. The recall initiation and recall volume interaction coefficient in the short-term analysis is not significant (p >.10). In contrast, the long-term abnormal returns for recall initiation are positive and significant (p < .05), supporting H4. These results indicate that investors respond to unexpected voluntary recall initiation in the long-term. They value the firm’s social responsiveness and commitment to fix the problem, which alleviates the negative effect of recall volume on long-term firm value.
Consider H5. Table 6 shows that the interaction between recall volume and post-recall remedy has a significant and positive effect in the long-term (p < .05), supporting H5. This result suggests that when firms put more efforts into addressing the crisis after the announcement, investors become less uncertain about the quality of the firm’s repair efforts and the completion of the recall process. Such trust in the firm positively moderates the negative relationship between recall volume and long-term firm value. We present a summary of the expected signs and the results of the key hypotheses tests in Table 7. All the hypotheses are supported.
Other Results
We discuss the remaining effects from Tables 5 and 6. In the short-term, brand advertising has a significant and negative main effect (p < .05), while the coefficient of all other crisis management strategies are insignificant (p > .10). However, in the long-term, both voluntary recall initiation and post-recall remedy have positive main effects on firm value (p <.10), suggesting that a recalling firm could benefit over the long-term when voluntarily initiating a recall and diligently providing remedy to the consumers. Among the control variables in the short-term analysis, only sales revenue and financial leverage have a positive and significant (p < .10) effect. These results suggest that firms with lower sales
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revenue or higher equity-to debt ratio stand to lose more, consistent with prior research
(Thirumalai and Sinha 2011).
Additional Analysis on the Interaction of Social Media and Crisis Management Strategies
We tested for both short- and long-term effects of social media volume and its interactions with crisis management strategies on firm value. The results appear in Table 8.
The short-term effects are all insignificant (p > .10). In the announcement window, social media volume may not be substantial and may not add much to the already negative news of the recall. However, social media volume has a negative main effect and a positive interaction effect with brand advertising in the long-term (p < .10). Over time, social media chatter gathers a strong negative momentum, dampening expected future cash flows. Brand advertising mitigates this negative effect by continuing to show the firm’s commitment and by arresting the spread of negative sentiments among investors.
Robustness Checks
Mediating effect of recall initiation. To check if recall initialization could mediate the effect of recall volume on abnormal returns, we performed a mediation test. We first estimated a probit model of recall initiation on recall volume and other covariates. The results suggest that while recall volume has a significant impact on recall initiation (p < .01), the link between recall initiation and short term abnormal returns is not significant (p > .10) with or without controlling for recall volume. Thus, recall initiation does not mediate the relationship between recall volume and short-term abnormal returns (Tables A3a-A3b of
Web Appendix). A possible reason for mediation being insignificant in the short-term is that recall volume announcement and recall initiation occur on the same day, making it hard to temporally separate them. Exploration of a possible long-term mediating effect is not feasible
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because we analyze long-term returns using the CTAR model for which a regression type mediation analysis is not relevant.
Differential effects across country of origin and product segments. Because country of origin and product segment may be related to quality perceptions, we tested to see if the moderating effects of crisis strategies on the recall volume-firm value relationships differed across these groups. The results showed that the effects are not significantly different across the U.S. and non-U.S. brands and across the luxury and popular car segments (p > .10).
Serial correlation of recall events. Because each firm may have multiple recalls in the sample, some recalls may be related to others (Borah and Tellis 2016) and there might be serial correlation among the events. We re-estimated the model by allowing the error term in the short-term analysis to be auto-correlated (Wooldridge 2010). The results showed no significant autocorrelation among the events (p > .10).
Alternative measure of post remedial efforts. To ensure that our results are robust to the operationalization of post remedial efforts, we estimated our models using an alternative measure, namely, the time elapsed between the recall announcement date and the date the remedy is first available to consumers, i.e., the date of customer notification. The reasoning is that a longer time lag corresponds to a greater degree of remedial efforts and a greater number of products repaired. The results of the models for this alternative measure were substantively similar, underscoring the strength of recall completion rate as the measure of post remedial efforts.
Implications
Theoretical Implications
Our study makes important theoretical contributions to product-harm crisis research. First, we extend the product recall literature by examining the long-term effects of recalls on firm value. We extend prior research on the determinants of the impact of product-harm crisis on
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short-term abnormal returns (Chen, Ganesan, and Liu 2009; Gao et al. 2015; Thirumalai and
Sinha 2011) by identifying the key moderating effects of crisis management strategies on both short- and long-term firm value. Our results reveal novel long-run moderating effects of recall volume on firm value, contrasting with the short-term effects.
Second, our study extends the literature on advertising and shareholder value (e.g., Joshi and Hanssens 2010; Kim and McAlister 2011; McAlister et al. 2007; Xiong and Bharadwaj
2013) by proposing a moderating framework for advertising’s role in the effects of recall volume on long-term returns. It also extends prior research on product recall and brand equity
(Dawar and Pillutla 2000), recall and reputation (Rhee and Haunschild 2006), pre-recall advertising (Gao et al. 2015), and advertising’s effect on sales or market share post recall
(e.g., Cleeren, Dekimpe, and Helsen 2008; Cleeren, van Heerde, and Dekimpe 2013; Liu and
Shankar 2015; Rubel, Naik, and Srinivasan 2011; van Heerde, Helsen, and Dekimpe 2007) by focusing on the moderating role of advertising in the recall volume-shareholder value link.
Although conventional wisdom suggests that advertising after a product recall should lead to positive shareholder returns, our findings imply different conclusions about different advertising types in the short- and long-term. Not all advertising types result in similar effects in the short- or long-term. In particular, brand advertising ameliorates the negative effect on long-term returns, reversing an exacerbation of recall volume’s effect on short-term returns.
Importantly, although promotional advertising mitigates the negative effect of recall volume on firm value in the short-run, if it is sustained over the long-term, it exacerbates recall volume’s adverse effect on firm value. These findings show that valuable insights will be lost if all advertising types are pooled under a single advertising banner as in previous studies.
The asymmetric results for different advertising types call for a deeper investigation into the mechanisms through which advertising types have effects on shareholder value.
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Our work also adds to the discussion on recall initiation (Rupp and Taylor 2002) by revealing a positive effect of unexpected voluntary recall initiation on the recall volume- shareholder value link in the long-term. Although recall initiation has no significant impact on the link between recall volume and abnormal returns in the short-run, in the long-run, it might weaken the negative relationship, thanks to investors’ acceptance of the firm’s commitment and reduced risk of regulatory fines. Our result is consistent with Eilert et al.
(2017) who show that the stock market punishes recall delays. Thus, voluntary recall initiation has a favorable impact on the investors in the long run.
Our study extends our knowledge of product-harm crises and long-term firm value by studying the under-researched role of post-recall remedy efforts. Greater post-recall remedy reduces the detrimental effect of recall volume on long-term returns. It provides greater comfort to investors about improved product quality and lower long-term liability costs, dampening the negative effect of recall volume on long-term returns.
Managerial Implications
The results have important managerial implications. With the growing number of product recalls in recent years, managers need clear guidelines for product-harm crisis management strategies. The results provide a more complete substantive picture than prior studies.
Although the empirical results are based on one industry, the principles apply to multiple industries.
First, investors may over-react negatively to product recalls at the time of announcement.
Such negative reactions may be corrected over the long-term if the recalling firm provides new information about the recall. By signaling to the investors about their responsiveness and their efforts to recover from the crisis over the long-term, recalling firms can effectively overcome the initial negative reactions of investors.
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Second, because recall volume has a negative impact on firm value even in the long-run, firms should try and limit the damage by starting the recall with smaller recall volumes when they discover the problem. Firms can follow up with additional recalls if they identify additional affected units. Such a practice will mitigate the negative impact on long-term abnormal returns. For example, by announcing periodically separate recalls for gas pedal problems for different affected vehicles, Toyota was able to control the damage to its stock valuation over a long period.
Third, managers should invest in brand advertising over the long-term to create a strong buffer against negative incidents. For example, Toyota substantially increased recalled model and brand advertising for a sustained period of time after the crisis to refurbish its tarnished image (Nielsen 2010). Such a practice is consistent with the normative model result of Rubel,
Naik, and Srinivasan (2011). However, at the time of crisis, managers should avoid allocating dollars to advertising the brand. This guideline applies to all brands across categories. For example, McNeil Consumer Healthcare, a division of parent company, Johnson & Johnson, reduced Tylenol brand advertising during the recall of Tylenol OTC products in January 2010
(Edwards 2010).
Fourth, managers should be wary of promotional advertising during product harm crisis.
They should use promotional advertising only to arrest a steep decline in short-term returns, especially for high volume recalls. For example, Toyota offered incentives such as no-interest financing and low lease rates during its massive recall in 2010 (Bunkley 2010). However, to prevent long-term attrition of brand equity and firm value due to high recall volume, they should stop promotional advertising once the sales decline is under control.
Fifth, managers choosing a voluntary recall initiation strategy can arrest a decline in shareholder value to recall volume in the long-run. Our results reveal significantly positive moderating effects on recall volume’s impact on shareholder value from voluntary product
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recalls in the long-run but not in the short-run. For example, Chrysler was reluctant to voluntarily initiate a recall regarding potential engine fires in Jeep vehicles (USA Today
2013). It might have not anticipated the potential benefit of a voluntary initiation in the long- run. Our results suggest that Chrysler’s recall initiation strategy will likely backfire in the long-term. Our results apply to other industries as well. For example, in 1994, when a few customers alerted Intel to a computing flaw in its Pentium microprocessor, Intel decided not to voluntarily recall the defective units. There was no immediate adverse effect on its revenues and market value (which might have occurred had it voluntarily recalled its products). However, over the long-run, Intel lost orders from big clients such as IBM, resulting in a cash flow loss of $500 million (Smith, Thomas, and Quelch 1996). Intel had to publicly acknowledge the problem before it could begin the path to the long-term recovery of its business.
Sixth, managers of products should focus on post-recall remedy to fix defects. After the recall announcement, they should expend efforts to successfully rectify the defect and complete product repairs. Such thorough efforts confer benefits to shareholders in the long- run. Again, this result applies to multiple industries. For example, Dell did a good job of recalling and fixing 4.1 million batteries that were found to pose fire hazard (Baseline 2006).
As a result, Dell’s stock price recovered in the long-run. Similarly, in 1995, when a user of
Intuit’s tax management software reported bugs in it, Intuit rectified the defect and mailed the corrected software to its vast customer base of 1.65 million affected users, bouncing back to business as usual (Smith, Thomas, and Quelch 1996).
Seventh, the relative effects of the three crisis management strategies on long-term abnormal returns help managers dial up or down on their crisis management strategies by highlighting the relative degrees of emphasis to be placed on these strategies. Because the
CTAR approach requires these strategies to be measured as high or low levels, we can
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directly compare their effects on long-term firm value. The results suggest that recall remedy is the most effective strategy in mitigating the negative effect of recall volume, followed by recall initiation and brand advertising strategies, in that order. Recall remedy (recall initiation) is about eight (5.5) times more effective than brand advertising. However, both recall remedy and brand advertising are much more expensive to implement than recall initiation. Therefore, to ameliorate the effects of recall volume on long-term abnormal returns, a recalling firm should first voluntarily announce initiation. It should next spend its resources fixing the defects and then focus on brand advertising. Interestingly, promotional advertising exacerbates the negative effect of recall volume on long-term firm value by about
3.5 times more than the extent to which brand advertising softens the negative effect. This result highlights the danger of over-promoting the affected products despite the positive effect of promotional advertising on the recall volume-abnormal returns link in the short- term.
Finally, managers of recalled products should be wary of the creeping effect of social media over time and use brand advertising to counter it. Social media volume does not cause more damage than what is already caused by the news of the recall in the short-run. However, left unchecked, negative chatter can gather steam and dent long-term firm value. By investing in brand advertising, managers of recalling firms can control and limit the damage to their brands and firm value.
Taken together, the results offer key pointers for resource allocation to maximize shareholder value. At the time of a product recall, firms should move their dollars from brand advertising to promotional advertising. However, after the recall, firms should shift their allocation toward brand advertising and post-recall remedy efforts. While advertising the recalled brands, firms could also sharpen its messaging and create a positive affect for its brands so as to negate the potential adverse effect of social media volume on firm value.
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Limitations, Further Research, and Conclusions
Limitations and Further Research
Our research is not without limitations. First, we apply our framework to a very important industry, the automobile industry with around $70 billion gross output in 2015
(https://www.statista.com/statistics/258075/us-motor-vehicle-and-parts-manufacturing-gross- output/). While data on recalls can be obtained for other consumer industries from such sources as the Consumer Product Safety Commission (CPSC), data on moderator variables such as post recall remedy are not readily available to the researcher. To enhance the generalizability of results, future research can extend the analysis to other industries where data on moderator variables may be available.
Second, the crisis management strategies that moderate recall volume’s effects are similar in other industries such as toys, electronics, and other consumer durable products. However, for frequently purchased food and drug categories, other crisis management strategies such as providing compensation to affected consumers and obtaining recertification for product manufacturing and quality may also moderate the effects of recall volume on short- and long- term abnormal returns. Such moderating effects could be studied if data are available.
Third, we showed how managers could use the CTAR approach results to understand the relative degrees to which they could focus on the different crisis management strategies.
However, because the approach examines the difference in long-term abnormal returns between high and low levels of the focal crisis management variable, it cannot inform the exact amount by which managers may need to dial up or down their crisis management strategies for achieving desired changes in long-term abnormal returns.
Fourth, our focus is on abnormal returns to recall announcements. Additional insights on the trade-off between product quality and innovation can be gleaned by extending our
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research to study abnormal returns to new product preannouncements in the presence of product recalls.
Conclusion
Before this study, not much was known about the long-term impact of recalls on firm value and how firms should strategically manage the crisis. Our empirical analysis in the auto industry context reveals novel findings about the long-term effects of recalls. The negative impact of recall volume lingers over time. Brand (promotion) advertising and voluntary recall have a significant positive (negative) effect on the relationship between recall volume and long-term abnormal returns. A voluntary recall initiation strategy mitigates the negative effect of recall volume on long-term firm value. These effects are contrary to the short-term effects.
A diligent post-recall remedy positively moderates the impact of recall volume on long-term returns. Our results suggest that managers should use different advertising types during and after a recall, strategically initiate recalls, and diligently prepare post-recall response.
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Marketing Science Institute Working Paper Series 42 TABLE 1 Product Recall: Short-term vs. Long-term Effects Short-term (ST) Long-term (LT) Costs of o Opportunity cost of sales loss due o Costs of recalling and replacing/fixing the defected product Recall to defected product pulled off the o Regulatory fines market o Consumer liability claim o Opportunity cost of LT sales loss due to damaged brand equity Information o Recall characteristics o Recall characteristics Available o Recall volume o Actual LT costs o Recall severity o Effectiveness of the recall process o Firm’s ST response o Firm’s LT response o Recall initiation strategy o Recall remedy effort (to ensure easy repair and replacement) o ST advertising o LT advertising (to restore brand equity) Investor o Immediate reaction based on ST information o Update beliefs on future cash flows with new information response o May overreact or underreact in the ST o Underreaction or overreaction corrected in the LT
TABLE 2 Our Study Relative to Selected Related Studies in Product Recall Crisis Management Strategy Study Short-term Long-term ST vs. LT Brand ad vs. Recall Post-recall Advertising Value Value Comparison Promotional ad Initiation Remedy Cleeren et al. (2013) Liu and Shankar (2015) Borah and Tellis (2016) Jarrel and Peltzman (1985) Hoffer et al. (1988) Davidson and Worrell (1992) Thomsen and McKenzie (2001) Chen et al. (2009) Thirumalai and Sinha (2011) Xiong and Bharadwaj (2013) Gao et al. (2015) Pre-recall ad Eilert et al. (2017) Our Study (2017)
Marketing Science Institute Working Paper Series 43 TABLE 3 Variables, Operationalization, and Data Sources Variable Reference Operationalization Data Source Dependent Variable Financial returns Chen et al. (2009); Thirumalai and Shinha Short-term abnormal returns (-2, 2), five days around product recall Center for Research in (2011) announcement date Security Prices Sorescu et al. (2007) Long-term calendar-time portfolio-level returns (after announcement) Center for Research in Security Prices Fama and French (1993); Carhart (1997) Fama and French’s (1993) and Carhart’s (1997) momentum factors Ken French’s Web site Focal Independent Variable Product recall volume Chen et al. (2009); Thirumalai and Sinha The number of units recalled normalized by sales in the previous year NHTSA, Automotive (2011) News Brand ad Srinivasan et al. (2009) The residual from an autoregressive model of brand ad spending Kantar Media Promotional ad Rajiv et al. (2002); The residual from an autoregressive model of promotional ad spending Kantar Media Recall initiation strategy Chen et al. (2009) 퐼푁퐼푇푖 − 퐼푁퐼푇̂푖 , 퐼푁퐼푇푖 is the voluntary initiation dummy and 퐼푁퐼푇̂푖 is the NHTSA, LexisNexis estimated probability of voluntary initiation from an discrete autoregressive model of recall initiation strategy Post recall remedy This study The residual from an autoregressive model of recall remedy completion rate Safercar.gov completion rate Control Variables Car model ad Liu and Shankar (2015) The residual from an autoregressive model of car model ad spending Kantar Media Social media volume Luo et al. (2013) Number of Web blogs about the product recall event LexisNexis Conventional media volume Liu and Shankar (2015) Number of news article about the product recall event LexisNexis Recall frequency Liu and Shankar (2015) Number of recalls in the last 6 months NHTSA, LexisNexis Product reliability Kalaignanam et al. (2013); Liu and Shankar Unit sales-weighted average of brand reliability ratings + unit sales-weighted Consumer Report (2015) average of reliability ratings of the recalled-models Labor intensity Thirumalai and Sinha (2011) Number of employees / Sales revenues COMPUSTAT R&D intensity Thirumalai and Sinha (2011) R&D expenditures / Sales revenues COMPUSTAT Sales Thirumalai and Sinha (2011) Log of unit sales Automotive News Dealer size This study Log of the number of franchises in the U.S.A. Automotive News Product scope Thirumalai and Sinha (2011) p p p , pi is number of product within brand i. p is the firm’s total Ward's Automotive n iiln( / ) Yearbook number of product. Financial leverage Thirumalai and Sinha (2011) Debt-to-equity ratio: (Long-term debt / Shareholder equity) COMPUSTAT Market-to-book ratio Thirumalai and Sinha (2011) (Total number of shares outstanding times quarter-end / Common equity) COMPUSTAT Year trend Chen et al. (2009) The number of years between 2005 and the year when the recall occurred COMPUSTAT
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TABLE 4A Summary Statistics and Correlation Matrix of Short-term Variables Variable M SD Min Max 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 1. CAR (-2; 2) (%) -.0069 .0350 -.1338 .1035 1 2.Recall volume 418.58 814.63 .07 6281.04 -.02 1 (000) 3. ST brand ad($106) 8.80 0.81 0 74.56 -.08 .03 1 4. ST promotional 2.32 0.29 0 32.27 .05 .09* .56*** 1 ad ($106) 5. Recall initiation 1 .71 .45 0 1 -.06 -.21*** .18*** -.10 strategy 6. ST car model 19.11 0.821 0 59.34 -.07 -.06 .36*** .39*** -.10* 1 ad($106) 7. ST social media 3.46 4.21 0 28 -.06 .15*** .13** -.02 -.10* -.02 1 volume 8. ST conventional 5.36 4.83 0 32 .04 .03 -.06 -.08 -.06 .04 -.01 1 media 9. Recall frequency 6.26 2.25 1 15 .05 -.06 -.11 -.12** -.11** .04 .04 -.01 1 10. Product 3.28 .89 2.20 4.91 .14** .05 -.16*** .07 -.16*** -.05 .05 -.09* .03 1 reliability 11. Labor intensity .02 .02 .01 .09 .11* -.04 .05 -.09* .05 .08 -.12** .01 -.09* -.11* 1 12. R&D intensity .09 .07 .01 .47 .07 -.02 .03 -.01 .03 .07 -.05 0 -.07 -.06 .01 1 13. Sales ($1012) 9.13 .85 .03 25.69 -.06 .14** .25*** -.13** -.05 .07 .04 .14** .10* .01 -.19*** -.18*** 1 14. Dealer size(103) 4.38 3.75 1.01 13.97 -.09* -.05 .03 -.11** -.02 .07 -.12** .11* .02 -.04 .22*** .12*** .21*** 1 15. Product scope 12.70 11.27 2.51 47.62 -.09* .00 -.12** -.12** .25*** .06 .10* .05 .18*** -.04 -.11* -.01 .01 .36*** 1 16. Financial -.03 .10 -.25 .19 .10* -.04 .11 -.17*** .03 .09* -.10* .02 .01 -.13** 0 -.18*** .09* .22*** .11** 1 Leverage 17. Market-to-book 1.20 7.23 -94.37 47.62 -.06 -.02 .03 -.07 -.15*** .09* -.07 -.03 -.04 -.17*** .11* .13** -.03 .09* .04 -.07 1 ratio 18. Year trend 6.63 3.37 1 11 -.10* .12** -.15*** .09* .03 .01 .11* .03 -.04 -.05 -.16*** .04 -.04 -.03 -.06 .01 .07 Notes: Advertising is measured as the residual from an autoregressive model of advertising spending. *p < .10; **p < .05; ***p < .01.
TABLE 4B Summary Statistics and Correlation Matrix of Long-term Variables Variable M SD Min Max 1 2 3 4 5 6 7 8 9 1. Monthly return (%) .33 2.62 -12.51 14.06 1 2. Recall volume (000) 418.58 814.63 .07 6281.04 -.07** 1 3. LT brand ad ($106 monthly) 30.12 2.99 0 197.58 .09** .07** 1 4. LT promotional ad ($106 monthly) 15.59 2.93 0 266.80 -.03 .11*** .41*** 1 5. Recall initiation strategy .71 .45 0 1 .03 .03 -.10*** .02 1 6. Post-recall remedy completion rate (First Quarter) 31.19% 0.01 0 99.90% .07** -.22*** -.07** .01 .08** 1 7. Post-recall remedy completion rate (Second Quarter) 51.92% 0.01 0.06% 99.91% .05* -.21*** -.05* .00 .16*** .81*** 1 8. Post-recall remedy completion rate (Third Quarter) 62.88% 0.02 0.19% 99.91% .01 -.24*** -.07** -.03 .21*** .75*** .91*** 1 9. Post-recall remedy completion rate (Fourth Quarter) 68.55% 0.02 0.51% 99.93% .04 -.23*** -.02 -.05* .21*** .67*** .85*** .96*** 1 Notes: Advertising is measured as the residual from an autoregressive model of advertising spending *p < .10; **p < .05; ***p < .01.
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TABLE 5 Cross-sectional Short-term Abnormal Returns Model Results Mean CAR Positive: Dependent Variable: CAR[-2; 2] Patell Z Negative -.0069 100:180 4.20*** Control Regression Results OLS IV (2SLS) Function Focal Variables Intercept -.1803*** -.1748** -.1834*** Recall volume -.0002* -.0002* -.0002* Brand advertising -.0511** -.04416** -.0461** Promotional advertising -.2147 .1036 .1116 Recall initiation strategy -.0001 -.0001 -.0001 Interaction Variables Recall volume × Brand ad -.0027** -.0031** -.0030** Recall volume × Promotional ad .0051** .0071** .0064** Recall volume × Recall initiation -.0014 -.0012 -.0012 Control Variables Car model advertising -.0102 -.0132 -.0167 Social Media -.0017 -.0026 -0.0064 Conventional media -.0018 .0019 .0016 Recall frequency .0003 .0006 .0006 Product reliability .0022 .0012 .00013 Labor intensity .2355 .1879 .1708 R&D intensity -.0096 -.0066 -.0054 Sales revenues .0184*** .0187** .0196** Product scope .0002 .0002 .0002 Dealer size -.0210 -.0106 -.0046 Financial leverage .0518* .0484* .0456* Market-to-book ratio -.0001 -.0001 -.0002 Year trend .0009 .0008 .0012 Recall volume × Car model ad -.0808* -.0943 -.0838 Error Correction Variables¥ Intercept: Brand ad .0003* Intercept: Promotional ad -.0011** Intercept: Recall initiation .0026 Intercept: Car model ad .0092* Intercept: Social Media -.0017* Slope: Brand ad on effectiveness of -.0066** promotional ad Slope: Car model ad on effectiveness of .0078* brand ad R2 .1302 .1317 .1360 Notes: N=280. Robust standard errors are in parentheses: corrected for heteroscedasticity. *p < .10; **p < .05; ***p < .01. ¥: There are 9 slope correction variables. However, only the ones shown in the table are significant. We don’t report the other 7 coefficients of slope correction variables to save space.
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TABLE 6 Results from Long-term Analysis of Abnormal Returns to Recall Main Effect Entire Recall Brand Ad Promotional Ad Recall Initiation Post-recall Remedy Sample Volume (H1) .0041*** -.0009* .0019 -.0002 .0003* .0002* Moderating Effects Recall Volume × Recall Volume × Recall Volume × Recall Volume × Brand Ad Promotional Ad Recall Initiation Post-recall Remedy (H2) (H3) (H4) (H5) .0002** -.0007*** .0011** .0016** Notes: This table shows the results of the long-term abnormal returns measured by the intercept p, using the calendar-time portfolio approach with 12 months holding period after the product recall announcement. The data are presented as monthly abnormal returns estimated using the four-factor model. We used the weighted least squares (WLS) method to account for the number of firms within the calendar month portfolio. The effects are independently estimated. *p < .10; **p < .05; ***p < .01.
TABLE 7 Summary of Hypotheses and Results Short-term Returns Long-term Returns Factor/Variable Expectation Result Hypothesis Result Recall volume - - H1 - - Recall volume × Brand advertising - - H2 + + Recall volume × Promotional advertising + + H3 - - Recall volume × Recall initiation strategy - N.S. H4 + + Recall volume × Post-recall remedy N.A. H5 + + Note: N.A.: Not Applicable. N.S.: Not significant.
TABLE 8 Short-term and Long-term Effects of Social Media Short-term Long-term Social media -.0091 -.0005* Social media volume × Brand ad -.0006 .0001* Social media volume × Promotional ad .0002 -.0003 Social media volume × Recall initiation -.0015 .0003 Social media volume × Post-recall remedy N.A. -.0025 Notes: To save space, the estimates of all other variables are not shown in this Table and are available in the Web Appendix. Our expectation on short-term effects are again supported when incorporating the interaction effects of social media and recall strategies.
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FIGURE 1 A Conceptual Model of the Moderating Effects of Crisis Management Strategies on Recall Volume on Long-term Firm Value
Brand Promotional Advertising Advertising H2(+) ■ Cash flow effects (+). Sustained brand ad post recall arrests brand equity H3 (-) ■ Cash flow effects (-). Sustained erosion. promotional ad enhances the low H (-) ■ Cash flow effects (-). Greater recall ■ Investor behavior effects (+). 1 quality perception and further Continued brand ad after recall signals volume results in great costs of fixing damages brand equity, lowering confident future outlook and financial the defective product units. future cash flow. well-being. ■ Investor behavior effects (-). Greater . recall volume signals brand equity erosion and investors may lose confidence in the firm’s financial well- being. Abnormal Recall Volume Returns to Recall
H5 (+) Cash flow effects (+). Post-recall Cash flow effects . H4(+) ■ (+) Voluntary recall remedy efforts weaken the negative can decrease the likelihood of future fines effects of product recall on intangible and LT recall cost. assets by evoking greater trust in the Investor behavior effects ■ (+).Voluntary Recall firm’s ability to improve product recall can improve investor perception of Post-recall quality. the firm as a proactive firm with a strong commitment to improve product and firm Initiation Remedy value.
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