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). Th us, 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 Marketing Science Institute Working Paper Series 3 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 Marketing Science Institute Working Paper Series 4 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