Growth Traps:Lessons from the Go-Go '90s
by: Michael C. Mankins
For most of the late 1990s, revenue growth was the be-all and end-all on Wall Street. Profitability mattered, but top-line growth grabbed all of the headlines. Back then, companies did anything and everything to grow. They proliferated products, entered new markets, made costly acquisitions and reorganised themselves all in the name of growth.
But that all changed. Starting in late 2000, economic growth slowed and investor optimism turned decidedly sour. By mid-2001, the major stock market indices were down some 25% to 50% from their highs and the gogo '90s seemed to be over. As investor sentiment abruptly shifted, so did top management's focus - profitability moved back to centre stage and executives everywhere struggled to boost bottom-line returns.
|Well, it's beginning to look like we've come full circle. Indeed, as the U.S. economy begins to show signs of recovery, many executives are now wondering whether (and how) to get back on the growth bandwagon. But after more than two years of "belt-tightening" and "rightsizing," few senior managers are anxious to repeat the boom-and-bust cycle of the last few years. Accordingly, executives are asking: "How can I avoid the growth traps of the late 1990s and manage my company for the kind of growth that leads to steadily increasing shareholder value?"
Avoiding the pitfalls of the last half-decade requires that managers think about growth in a fundamentally different way. Executives should recognise that, while sales growth is important to investors, growth alone won't generate superior stock market performance. Likewise, they should realize that an exclusive focus on rate of return measures (be it return on sales, assets, or capital) won't produce sustained value growth either. Investors will consistently reward only economically profitable growth - that is, growth in profits that account for all costs, including capital.
Thus, before executives rush out and begin devising new strategies to accelerate top-line growth in their companies, they should take time to reflect on the events of the last few years and see if there are any lessons to be learned from the go-go '90s. Only by studying the mistakes of the last half-decade can companies avoid being snagged in the same growth traps in the years ahead.
Our Misguided Growth Obsession
Why did so many companies fall into growth traps? One answer appears to be "mischievous markets." In the last 1990s, any CEO who objectively scrutinised the market data could easily have concluded that investors were using a growth-focused model to value their company's stock. After all, companies with the highest revenue growth rates (or touted revenue growth rates) had the highest market values. In fact, a number of companies that had no profits - but sky-high revenue growth - had huge market capitalisations. In the midst of this growth frenzy, what was a shareholder-loving CEO to do? He or she had to look for ways to grow.
Academics, consultants and investment bankers didn't help the situation. In 1999 and 2000, many academics attempted to explain how the inflated values attached to many high-growth companies could be explained by "real options" or other "nondiscrete" valuation schemes. These scholars maintained that discounted cash flows and other traditional valuation models simply did not capture the full benefits of growth.
Consulting firms were quick to chime in - advancing the notion that a company had to generate high rates of revenue growth to produce superior shareholder returns. Finally, investment bankers contributed their fair share to the growth hysteria as well. Making claims of a "new paradigm," many banks advised clients to pursue rapid growth in order to become Wall Street's next highflier. With all of the so-called "experts" saying the same thing, it is easy to see how so many companies went so wrong.
There was some truth in the experts' contentions. Traditional valuation approaches do short-change growth, and profitable growth can fuel share price appreciation. Nevertheless, these observations don't explain stock price movements between 1998 and 2000. You see, what few scholars took the time to ask was whether it was the models or the markets that were wrongly valuing so many companies. At the time, we all presumed that our models were broken. As it turns out, the markets were.
Fortunately, the capital markets came to their senses towards the end of 2000. Investors began to realize that the values being placed on many companies simply could not be justified by the underlying economics. In fact, between March 2000 and March 2001, more than 500 companies listed on the NASDAQ experienced declines of greater than 90% in market value (a group affectionately referred to as "the 90% Club"). Across a vast array of fast-growing industries, managers felt the impact of the market's abrupt shift in mindset. It was painful but necessary in order to burst the stock market "bubble" and focus investors on business fundamentals. Today, stock prices once again reflect values that can be linked to reasonable expectations of future economic profits and cash flows.
Lessons from the 90% Club
The market's fixation on growth in the late 1990s encouraged many executives to prioritise growth above all else. While there is nothing inherently wrong with the idea of becoming larger, in many cases, growth came at the expense of good management practice. In hindsight, companies fell victim to six common growth traps:
1. Proliferating products without real competitive advantage.
If top-line growth is all that matters, more products is a must - or so goes the logic. Unfortunately, adding profitable products is difficult (it requires unique skills and real competitive advantage), whereas adding unprofitable products is relatively easy. In the 1990s, many companies attempted to introduce new products and services only to find out that these new offerings failed to add meaningfully to the bottom line. In 1996, for example, Amazon.com carried nothing but books. By the end of 1999, Amazon had expanded into 25 online businesses – ranging from DVDs to power tools. Only after investors began pressuring the company to deliver nearer-term earnings did Amazon scale back on its new product introductions.
Amazon is not unique. Many companies added new products and services to fuel growth. There is no question that these product additions created significant value for customers - after all, who wouldn't want more products at lower prices - but most of these new products created very little real value for shareholders. The lesson to be learned is clear: without real competitive advantage, product proliferation will not support value growth.
2. Adding new customers at the expense of profitably penetrating existing ones.
In many cases, it is easier to add new customers than to expand relationships with existing, profitable customers. When management takes the easy way out and emphasises customer breadth over customer depth, it usually does so at the expense of economic profit. Telecommunications equipment makers are a case in point. In the late 1990s, the market for telecommunications equipment was growing at more than 20% per year. Not wanting to fall behind the market's torrid growth, many traditional equipment makers did anything and everything to attract new Competitive Local Exchange Carrier (CLEC) and Internet Service Provider (ISP) customers - such as providing favorable financing and offering attractive credit terms.
In 2001, when the telecommunications market abruptly slowed, many equipment makers found
themselves with bloated balance sheets and unprofitable customer relationships. At the same time, many of these companies' preexisting and highly profitable) Regional Bell Operating Company (RBOC) customers complained of poor sales and service support. The result: many existing profitable customers fled, leaving equipment makers with a portfolio of unprofitable customer relationships and burgeoning debt.
3. Ignoring the profitability of new "highgrowth" markets.
Expanding a company's reach into new markets is a popular means of fuelling growth in good times and bad. Like the addition of new products and customers, however, new market entry is difficult to accomplish profitably. For example, in the late 1990s, many companies tried to enter the Digital Subscriber Line (DSL) business, where revenues were growing at more than 35% per year. At least 50 firms entered the DSL market (both on the equipment and service side) in the 12 months between March 1999 to March 2000.
Unfortunately, the standards they applied to these investments were light on profitability measures. By our count, not a single provider has successfully earned its cost of capital in this industry. The lesson from the DSL experience is clear. In many cases, "highgrowth" markets and "high-profitability" markets are not the same. Executives should focus on entering economically profitable markets where their companies' unique skills and capabilities can be used to create competitive advantage.
4. Unprofitably battling for market share in low-growth markets.
When the world around you is promising to grow revenues at 15%, it is difficult to stand proud at 8%. Yet, some markets - such as consumer products, packaged goods, and commercial aviation - won't support double-digit growth rates. Companies in these sectors must battle for market share if they aspire to grow at doubledigit rates. All too often, however, the company that wins the share battle loses the value war.
Consider the case of Airbus Industries. For years, Airbus had been considered an "alsoran" in commercial aviation, with The Boeing Company controlling nearly two-thirds of the commercial jet market. Faced with the need to increase sales in a slow-growth industry - commercial jets orders are linked to air passenger and cargo miles which are growing at only 5% per year - Airbus cut prices to gain market share.
On one level, the strategy worked: between 1998 and 2001, Airbus' share of aircraft orders grew significantly. But from the shareholders’ perspective, the strategy was very disappointing. Indeed, we estimate that Airbus has never generated a return in excess of its capital costs. In short, revenues have grown, but shareholder value has not. While this sort of price-for-share strategy is not always a loser, in most cases the strategy's net effect is to transfer value from the company's shareholders to its consumers.
5. Organising to maximise revenue growth, not profit growth.
In the 1990s, the practice of creating organisational structures ostensibly to get closer to the customer, track market trends or create better products reached a new high. More and more companies shifted from business unit structures - where P&L responsibility rested with one general manager - to matrix-based organisations, with customer and product teams "sharing" responsibility for performance. While these new structures may have facilitated coordination, new product development and revenue growth, they blurred accountability for bottom-line performance.
In our view, the shared responsibility models employed by Xerox, Lucent, HP and so many others tend to put the growth cart in front of the profitability horse. These organizational structures limit management's line-of-sight into bottom-line performance and make it difficult for managers to trade-off returns and growth. Thus, to produce the level of profitability the markets are expecting, executives should make sure that their organisational structures make clear who is accountable for generating superior economic profitability over time - not just higher revenues.
6. Pursuing value-destroying acquisitions.
Nothing illustrates the excesses of the growthfirst era more clearly than the number (and poor track record) of acquisitions. In the late 1990s, executives who were fixated on growth in revenues, EBITDA or other measures that exclude investment costs naturally gravitated towards acquisitions as the easiest vehicle for expansion. But acquisitions take capital, and capital costs the shareholders money. So unless management has a clear means for recouping the acquisition premium - something more than "woolly" descriptions of potential "synergies" - acquisitions do little to create value (and can destroy prodigious amounts of it).
The final lesson from the gogo' 90s is simple and straightforward: a company can't typically "buy" revenues or earnings at bargain-basement prices. Acquisitions only create value if the target (or portions of the target) are worth significantly more to the buyer than they are to the seller - a test that few acquisitions pass today and even fewer passed in the last decade.
Avoiding Growth Traps
It is possible to avoid the growth traps that plagued so many companies in the late 1990s. But it requires a fundamentally different view of growth. Namely, only economically profitable growth creates shareholder value. If executives focus on developing, selecting, and executing strategies that grow economic profits - that is, after-tax operating profits less the dollar cost of capital employed - then they stand a much better chance of seeing their actions rewarded in the stock market. Of course, changing management's focus isn't easy. In our experience, focusing management on growing economic profits has at least three prerequisites:
1. Better information on the sources of economic profit by product and customer.
In order to grow economic profits, managers must have a clear understanding of where economic profits reside within their existing businesses and markets. For example, managers need market information that incorporates profitability - not just market size (in revenues), growth, and share - in order to determine whether further penetration will create value. Furthermore, executives need financial information that goes beyond Line of Business (LOB) reporting and sheds light on the profitability of individual products and customer relationships. By modifying the strategic and financial information used to inform strategic planning, resource allocation, and performance management, companies can provide executives with clearer signals about where and how to grow profitably.
2. Seamless integration of strategic planning with resource allocation.
Once companies have identified the most profitable product and customer segments of their businesses, they should quickly move resources into those businesses - and out of the unprofitable ones. Unfortunately, this is not always easy since the process used to identify profitable markets and customers (strategic planning) and the process used to allocate capital to those businesses (resource allocation) are frequently out of sync with each other. Strategic planning is done annually, according to a redetermined "planning calendar." Resource allocation and capital approval, on the other hand, is done continuously, typically by project or by investment opportunity.
Since growing economic profits requires the judicious use of capital, strategic planning and resource allocation must be integrated such that management: 1) continually assesses the current and future profitability of markets and customers; 2) continually creates strategies to exploit those opportunities; and 3) continually reallocates capital based on those assessments. The end result is a set of integrated management processes capable of supporting managers in their efforts to develop, select, and execute profitable growth strategies.
3. Profit-focused organisational structures.
In order to develop, select, and execute profitable growth strategies, a company should be organised around "economically independent" business units, as opposed to functional, matrix or other organizational structures. The sole purpose of these independent units should be to sustain and exploit opportunities for economically profitable growth - whether product-, market-, or customer-focused. (This should be done without negatively affecting the ability of other units to do the same.) Each business unit should have one - and only one – manager who is accountable for growing economic profits and for developing, selecting, and executing the business unit's growth strategy. Dow Chemical's shift from a functional organisation to this type of profit-focused structure helped the company generate the highest levels of profitability and growth in its industry for most of the late 1990s.
These are exciting times. The economy is turning and the growth engine seems to be restarting. Executives are understandably anxious to "get on with it" and re-ignite growth in their companies. But unless some important steps are taken to change management's mindset about growth - focusing on economically profitable growth rather than revenue growth per se – many companies are doomed to repeat the mistakes of the last half-decade. Fortunately, by focusing managers on developing, selecting, and executing strategies to grow economic profits and making the necessary changes in information, processes, and structure to support this new approach, companies can avoid the growth traps of the go-go '90s and prosper in this new growth era.
Content is copyrighted, reproduced with kind permission ©2002 Marakon
Michael C. Mankins