Chapter One: The Growth Imperative

Chapter One: The Growth Imperative


Chapter One: The Growth Imperative

Overview

Financial markets relentlessly pressure executives to grow and keep growing faster and faster. Is it possible to succeed with this mandate? Don’t the innovations that can satisfy investors’ demands for growth require taking risks that are unacceptable to those same investors? Is there a way out of this dilemma?

This is a book about how to create new growth in business. Growth is important because companies create shareholder value through profitable growth. Yet there is powerful evidence that once a company’s core business has matured, the pursuit of new platforms for growth entails daunting risk. Roughly one company in ten is able to sustain the kind of growth that translates into an above-average increase in shareholder returns over more than a few years.[1] Too often the very attempt to grow causes the entire corporation to crash. Consequently, most executives are in a no-win situation: equity markets demand that they grow, but it’s hard to know how to grow. Pursuing growth the wrong way can be worse than no growth at all.

Consider AT&T. In the wake of the government-mandated divestiture of its local telephony services in 1984, AT&T became primarily a long distance telecommunications services provider. The break-up agreement freed the company to invest in new businesses, so management almost immediately began seeking avenues for growth and the shareholder value that growth creates.

The first such attempt arose from a widely shared view that computer systems and telephone networks were going to converge. AT&T first tried to build its own computer division in order to position itself at that intersection, but was able to do no better than annual losses of $200 million. Rather than retreat from a business that had proved to be unassailable from the outside, the company decided in 1991 to bet bigger still, acquiring NCR, at the time the world’s fifth-largest computer maker, for $7.4 billion. That proved only to be a down payment: AT&T lost another $2 billion trying to make the acquisition work. AT&T finally abandoned this growth vision in 1996, selling NCR for $3.4 billion, about a third of what it had invested in the opportunity.

But the company had to grow. So even as the NCR acquisition was failing, AT&T was seeking growth opportunities in technologies closer to its core. In light of the success of the wireless services that several of its spun-off local telephone companies had achieved, in 1994 the company bought McCaw Cellular, at the time the largest national wireless carrier in the United States, for $11.6 billion, eventually spending $15 billion in total on its own wireless business. When Wall Street analysts subsequently complained that they were unable to properly value the combined higher-growth wireless business within the lower-growth wireline company, AT&T decided to create a separately traded stock for the wireless business in 2000. This valued the business at $10.6 billion, about two-thirds of the investment AT&T had made in the venture.

But that move left the AT&T wireline stock right where it had started, and the company had to grow. So in 1998 it embarked upon a strategy to enter and reinvent the local telephony business with broadband technology. Acquiring TCI and MediaOne for a combined price of $112 billion made AT&T Broadband the largest cable operator in the United States. Then, more quickly than anyone could have foreseen, the difficulties in implementation and integration proved insurmountable. In 2000, AT&T agreed to sell its cable assets to Comcast for $72 billion.[2]

In the space of a little over ten years, AT&T had wasted about $50 billion and destroyed even more in shareholder value—all in the hope of creating shareholder value through growth.

The bad news is that AT&T is not a special case. Consider Cabot Corporation, the world’s major producer of carbon black, a compound that imparts to products such as tires many of their most important properties. This business has long been very strong, but the core markets haven’t grown rapidly. To create the growth that builds shareholder value, Cabot’s executives in the early 1980s launched several aggressive growth initiatives in advanced materials, acquiring a set of promising specialty metals and high-tech ceramics businesses. These constituted operating platforms into which the company would infuse new process and materials technology that was emerging from its own research laboratories and work it had sponsored at MIT.

Wall Street greeted these investments to accelerate Cabot’s growth trajectory with enthusiasm and drove the company’s share price to triple the level at which it had languished prior to these initiatives. But as the losses created by Cabot’s investments in these businesses began to drag the entire corporation’s earnings down, Wall Street hammered the stock. While the overall market appreciated at a robust rate between 1988 and 1991, Cabot’s shares dropped by more than half. In the early 1990s, feeling pressure to boost earnings, Cabot’s board brought in new management whose mandate was to shut down the new businesses and refocus on the core. As Cabot’s profitability rebounded, Wall Street enthusiastically doubled the company’s share price. The problem, of course, was that this turnaround left the new management team no better off than their predecessors: desperately seeking growth opportunities for mature businesses with limited prospects.[3]

We could cite many cases of companies’ similar attempts to create new-growth platforms after the core business had matured. They follow an all-too-similar pattern. When the core business approaches maturity and investors demand new growth, executives develop seemingly sensible strategies to generate it. Although they invest aggressively, their plans fail to create the needed growth fast enough; investors hammer the stock; management is sacked; and Wall Street rewards the new executive team for simply restoring the status quo ante: a profitable but low-growth core business.[4]

Even expanding firms face a variant of the growth imperative. No matter how fast the growth treadmill is going, it is not fast enough. The reason: Investors have a pesky tendency to discount into the present value of a company’s stock price whatever rate of growth they foresee the company achieving. Thus, even if a company’s core business is growing vigorously, the only way its managers can deliver a rate of return to shareholders in the future that exceeds the risk-adjusted market average is to grow faster than shareholders expect. Changes in stock prices are driven not by simply the direction of growth, but largely by unexpected changes in the rate of change in a company’s earnings and cash flows. Hence, one company that is projected to grow at 5 percent and in fact keeps growing at 5 percent and another company that is projected to grow at 25 percent and delivers 25 percent growth will both produce for future investors a market-average risk-adjusted rate of return in the future.[5] A company must deliver the rate of growth that the market is projecting just to keep its stock price from falling. It must exceed the consensus forecast rate of growth in order to boost its share price. This is a heavy, omnipresent burden on every executive who is sensitive to enhancing shareholder value.[6]

It’s actually even harder than this. That canny horde of investors not only discounts the expected rate of growth of a company’s existing businesses into the present value of its stock price, but also discounts the growth from new, yet-to-be-established lines of business that they expect the management team to be able to create in the future. The magnitude of the market’s bet on growth from unknown sources is, in general, based on the company’s track record. If the market has been impressed with a company’s historical ability to leverage its strengths to generate new lines of business, then the component of its stock price based on growth from unknown sources will be large. If a company’s past efforts to create new-growth businesses have not borne fruit, then its market valuation will be dominated by the projected cash flow from known, established businesses.

Table 1-1 presents one consulting firm’s analysis of the share prices of a select number of Fortune 500 companies, showing the proportion of each firm’s share price on August 21, 2002, that was attributable to cash generated by existing assets, versus cash that investors expected to be generated by new investments.[7] Of this sample, the company that was on the hook at that time to generate the largest percentage of its total growth from future investments was Dell Computer. Only 22 percent of its share price of $28.05 was justified by cash thrown off by the company’s present assets, whereas 78 percent of Dell’s valuation reflected investors’ confidence that the company would be able to invest in new assets that would generate whopping amounts of cash. Sixty-six percent of Johnson & Johnson’s market valuation and 37 percent of Home Depot’s valuation were grounded in expectations of growth from yet-to-be-made investments. These companies were on the hook for big numbers. On the other hand, only 5 percent of General Motors’s stock price on that date was predicated on future investments. Although that’s a chilling reflection of the track record of GM’s former management in creating new-growth businesses, it means that if the present management team does a better job, the company’s share price could respond handsomely.

Table 1-1: Portion of Selected Firms’ Market Value That Was Based on Expected Returns from New Investments on August 21, 2002

Percent of Valuation That Was Based On:

Fortune 500 rank

Company Name

Share Price

New Investments

Existing Assets

53

Dell Computer

$28.05

78%

22%

47

Johnson & Johnson

$56.20

66%

34%

35

Procter & Gamble

$90.76

62%

38%

6

General Electric

$32.80

60%

40%

77

Lockheed Martin

$62.16

59%

41%

1

Wal-Mart Stores

$53.88

50%

50%

65

Intel

$19.15

49%

51%

49

Pfizer

$34.92

48%

52%

9

IBM

$81.93

46%

54%

24

Merck

$53.80

44%

56%

92

Cisco Systems

$15.00

42%

58%

18

Home Depot

$33.86

37%

63%

16

Boeing

$28.36

30%

70%

11

Verizon

$31.80

21%

79%

22

Kroger

$22.20

13%

87%

32

Sears Roebuck

$36.94

8%

92%

37

AOL Time Warner

$35.00

8%

92%

3

General Motors

$49.40

5%

95%

81

Phillips Petroleum

$35.00

3%

97%

Source: CSFB/HOLT; Deloitte Consulting analysis.

Probably the most daunting challenge in delivering growth is that if you fail once to deliver it, the odds that you ever will be able to deliver in the future are very low. This is the conclusion of a remarkable study, Stall Points, that the Corporate Strategy Board published in 1998.[8] It examined the 172 companies that had spent time on Fortune’s list of the 50 largest companies between 1955 and 1995. Only 5 percent of these companies were able to sustain a real, inflation-adjusted growth rate of more than 6 percent across their entire tenure in this group. The other 95 percent reached a point at which their growth simply stalled, to rates at or below the rate of growth of the gross national product (GNP). Stalling is understandable, given our expectations that all growth markets become saturated and mature. What is scary is that of all these companies whose growth had stalled, only 4 percent were able to successfully reignite their growth even to a rate of 1 percent above GNP growth. Once growth had stalled, in other words, it proved nearly impossible to restart it.

The equity markets brutally punished those companies that allowed their growth to stall. Twenty-eight percent of them lost more than 75 percent of their market capitalization. Forty-one percent of the companies saw their market value drop by between 50 and 75 percent when they stalled, and 26 percent of the firms lost between 25 and 50 percent of their value. The remaining 5 percent lost less than 25 percent of their market capitalization. This, of course, increased pressure on management to regenerate growth, and to do so quickly—which made it all the more difficult to succeed. Managers cannot escape the mandate to grow.[9] Yet the odds of success, if history is any guide, are frighteningly low.

[1]Although we have not performed a true meta-analysis, there are four recently published studies that seem to converge on this estimate that roughly one company in ten succeeds at sustaining growth. Chris Zook and James Allen found in their 2001 study Profit from the Core (Boston: Harvard Business School Press) that only 13 percent of their sample of 1,854 companies were able to grow consistently over a ten-year period. Richard Foster and Sarah Kaplan published a study that same year, Creative Destruction (New York: Currency/Doubleday), in which they followed 1,008 companies from 1962 to 1998. They learned that only 160, or about 16 percent of these firms, were able merely to survive this time frame, and concluded that the perennially outperforming company is a chimera, something that has never existed at all. Jim Collins also published his Good to Great (New York: HarperBusiness) in 2001, in which he examined a universe of 1,435 companies over thirty years (1965–1995). Collins found only 126, or about 9 percent, that had managed to outperform equity market averages for a decade or more. The Corporate Strategy Board’s findings in Stall Points (Washington, DC: Corporate Strategy Board, 1988), which are summarized in detail in the text, show that 5 percent of companies in the Fortune 50 successfully maintained their growth, and another 4 percent were able to reignite some degree of growth after they had stalled. The studies all support our assertion that a 10 percent probability of succeeding in a quest for sustained growth is, if anything, a generous estimate.

[2]Because all of these transactions included stock, “true” measures of the value of the different deals are ambiguous. Although when a deal actually closes, a definitive value can be fixed, the implied value of the transaction at the time a deal is announced can be useful: It signals what the relevant parties were willing to pay and accept at a point in time. Stock price changes subsequent to the deal’s announcement are often a function of other, exogenous events having little to do with the deal itself. Where possible, we have used the value of the deals at announcement, rather than upon closing. Sources of data on these various transactions include the following:
NCR
“Fatal Attraction (AT&T’s Failed Merger with NCR),” The Economist, 23
March 1996. “NCR Spinoff Completes AT&T Restructure Plan,” Bloomberg Business News, 1 January 1997.
McCaw and AT&T Wireless Sale
The Wall Street Journal, 21 September 1994.
“AT&T Splits Off AT&T Wireless,” AT&T news release, 9 July 2001.
AT&T, TCI, and MediaOne
“AT&T Plans Mailing to Sell TCI Customers Phone, Web Services,” The Wall Street Journal, 10 March 1999.
“The AT&T-Mediaone Deal: What the FCC Missed,” Business Week, 19 June 2000.
“AT&T Broadband to Merge with Comcast Corporation in $72 Billion Transaction,” AT&T news release, 19 December 2001.
“Consumer Groups Still Questioning Comcast-AT&T Cable Merger,” Associated Press Newswires, 21 October 2002.

[3]Cabot’s stock price outperformed the market between 1991 and 1995 as it refocused on its core business, for two reasons. On one side of the equation, demand for carbon black increased in Asia and North America as car sales surged, thereby increasing the demand for tires. On the supply side, two other American-based producers of carbon black exited the industry because they were unwilling to make the requisite investment in environmental controls, thereby increasing Cabot’s pricing power. Increased demand and reduced supply translated into a tremendous increase in the profitability of Cabot’s traditional carbon black operations, which was reflected in the company’s stock price. Between 1996 and 2000, however, its stock price deteriorated again, reflecting the dearth of growth prospects.

[4]An important study of companies’ tendency to make investments that fail to create growth was done by Professor Michael C. Jensen: “The Modern Industrial Revolution, Exit, and the Failure of Internal Control Systems,” Journal of Finance (July 1993): 831–880. Professor Jensen also delivered this paper as his presidential address to the American Finance Association. Interestingly, many of the firms that Jensen cites as having productively reaped growth from their investments were disruptive innovators—a key concept in this book.
Our unit of analysis in this book, as in Jensen’s work, is the individual firm, not the larger system of growth creation made manifest in a free market, capitalist economy. Works such as Joseph Schumpeter’s Theory of Economic Development (Cambridge, MA: Harvard University Press, 1934) and Capitalism, Socialism, and Democracy (New York: London, Harper & Brothers, 1942) are seminal, landmark works that address the environment in which firms function. Our assertion here is that whatever the track record of free market economies in generating growth at the macro level, the track record of individual firms is quite poor. It is the performance of firms within a competitive market to which we hope to contribute.

[5]This simple story is complicated somewhat by the market’s apparent incorporation of an expected “fade” in any company’s growth rate. Empirical analysis suggests that the market does not expect any company to grow, or even survive, forever. It therefore seems to incorporate into current prices a foreseen decline in growth rates from current levels and the eventual dissolution of the firm. This is the reason for the importance of terminal values in most valuation models. This fade period is estimated using regression analysis, and estimates vary widely. So, strictly speaking, if a company is expected to grow at 5 percent with a fade period of forty years, and five years into that forty-year period it is still growing at 5 percent, the stock price would rise at rates that generated economic returns for shareholders, because the forty-year fade period would start over. However, because this qualification applies to companies growing at 5 percent as well as those growing at 25 percent, it does not change the point we wish to make; that is, that the market is a harsh taskmaster, and merely meeting expectations does not generate meaningful reward.

[6]On average over their long histories, of course, faster-growing firms yield higher returns. However, the faster-growing firm will have produced higher returns than the slower-growing firm only for investors in the past. If markets discount efficiently, then the investors who reap above-average returns are those who were fortunate enough to have bought shares in the past when the future growth rate had not been fully discounted into the price of the stock. Those who bought when the future growth potential already had been discounted into the share price would not receive an above-market return. An excellent reference for this argument can be found in Alfred Rappaport and Michael J. Mauboussin, Expectations Investing: Reading Stock Prices for Better Returns (Boston: Harvard Business School Press, 2001). Rappaport and Mauboussin guide investors in methods to detect when a market’s expectations for a company’s growth might be incorrect.

[7]These were the closing market prices for these companies’ common shares on August 21, 2002. There is no significance to that particular date: It is simply the time when the analysis was done. HOLT Associates, a unit of Credit Suisse First Boston (CSFB), performed these calculations using proprietary methodology applied to publicly available financial data. The percent future is a measure of how much a company’s current stock price can be attributed to current cash flows and how much is due to investors’ expectations of future growth and performance. As CSFB/HOLT defines it,
The percent future is the percentage of the total market value that the market assigns to the company’s expected future investment. Percent future begins with the total market value (debt plus equity) less that portion attributed to the present value of existing assets and investments and divides this by the total market value of debt and equity.
CSFB/Holt calculates the present value of existing assets as the present value of the cash flows associated with the assets’ wind down and the release of the associated nondepreciating working capital. The HOLT CFROI valuation methodology includes a forty-year fade of returns equal to the total market’s average returns.
Percent Future = [Total Debt and Equity (market) – Present Value Existing Assets]/[Total Debt and Equity (market)]
The companies listed in table 1-1 are not a sequential ranking of Fortune 500 companies, because some of the data required to perform these calculations were not available for some companies. The companies listed in this table were chosen only for illustrative purposes, and were not chosen in any way to suggest that any company’s share price is likely to increase or decline. For more information on the methodology that HOLT used, see <http://www.holtvalue.com>.

[8]See Stall Points (Washington, DC: Corporate Strategy Board, 1998).

[9]In the text we have focused only on the pressure that equity markets impose on companies to grow, but there are many other sources of intense pressure. We’ll mention just a couple here. First, when a company is growing, there are increased opportunities for employees to be promoted into new management positions that are opening up above them. Hence, the potential for growth in managerial responsibility and capability is much greater in a growing firm than in a stagnant one. When growth slows, managers sense that their possibilities for advancement will be constrained not by their personal talent and performance, but rather by how many years must pass before the more senior managers above them will retire. When this happens, many of the most capable employees tend to leave the company, affecting the company’s abilities to regenerate growth.
Investment in new technologies also becomes difficult. When a growing firm runs out of capacity and must build a new plant or store, it is easy to employ the latest technology. When a company has stopped growing and has excess manufacturing capacity, proposals to invest in new technology typically do not fare well, since the full capital cost and the average manufacturing cost of producing with the new technology are compared against the marginal cost of producing in a fully depreciated plant. As a result, growing firms typically have a technology edge over slow-growth competitors. But that advantage is not rooted so much in the visionary wisdom of the managers as it is in the difference in the circumstances of growth versus no growth.




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