Profitable Growth PathsPublished: March 01, 2006 in Knowledge@Wharton
What is the best strategy for a company to grow? By increasing the sales of high-margin, best-selling products, right? That sounds like a no-brainer, but it may not always be the smartest move, says John Percival, an adjunct professor of finance at Wharton.
Profitable growth is a not simply a matter of selling more of a company's top products or services -- a business reality that very few chief executives and chief financial officers recognize, notes Percival, who has served as a consultant to major corporations and organizations like AT&T, Bell South and the Federal Trade Commission and teaches courses on company growth strategies for financial executives in Wharton's Executive Education program.
The problem with growing sales of high-margin core products, he says, is that it is not sustainable: As products get bigger and bigger, there are fewer and fewer opportunities for growth. Inevitably, other entrants join the fray, and the market for the product becomes saturated.
Not only do many top executives acknowledge this reality too late in the game, they often make mistakes in tackling the issue subsequently. Among the biggest mistakes they make are expecting the same extraordinary margins in new ventures as they get from their core products, and entering a new market or launching a product in a splashy way without first testing their competitive advantage.
To avoid those mistakes, chief executives and chief financial officers need to ask themselves tough questions, both about the sustainability of high margins in their existing products as well as the wisdom of entering a new market, says Percival. Unfortunately, there are few companies that rigorously question their growth strategies, he adds. "It is very tempting to be opportunistic and structure yourself to get these really high margins, but you have to anticipate that this is going to change, and move in a different direction relatively early on." That, he admits, is a very difficult thing to do at a time when a company is making more money than it ever has before with its highly profitable product.
Growth vs. Margins
Generally speaking, Percival urges executives to recognize that any new opportunities they want to exploit for growth will typically have a lower margin than their core or best-selling products. "The question is, how much margin are you willing to sacrifice to get the growth you are looking for?" he asks. Companies must be willing to accept that extraordinary margins are, in fact, unusual in the first place.
He points to Coca-Cola, the market leader in soft drinks, as an example of a company that has unsuccessfully tried to diversify into areas such as movies and wine, where it has no competitive advantage. "It is one of those companies whose revenue stream is such that it is dominated by one product. So to grow, it really has to grow revenues in that product," he says. The best option for Coca-Cola, he adds, is precisely what it has done -- to find growth opportunities for its core product in new markets overseas. But, he cautions, wherever it goes, the company should not expect to see margins as high as it has had in the past.
Part of the challenge with growth, he says, is that increased sales correspond with an increase in costs for such things as production equipment, labor, and inventory. "Sustainable growth," he notes, "is characterized by increasing profit (as opposed to sales) and retaining the earnings within the company."
Similarly, Kodak has tried unsuccessfully to diversify into several areas, none of which has worked out. "The company has used the huge amount of cash flow generated by its film business to venture into businesses in which it did not have any competitive advantage," Percival says. Recently, Kodak entered into digital imaging, which by definition is the absence of film, the company's core product. "Why would Kodak be any more successful in this business than in the others it has tried?" he asks.
While companies shouldn't give up on potential growth from smaller, newer ventures, Percival emphasizes that top executives have to ask tougher questions about what it is that they are getting into, and why? "It is possible that when you ask those questions, you won't come up with a believable answer about competitive advantage," he says.
Leveraging Real Options
But Percival acknowledges that it is not easy for management to accept that they cannot continue to grow at a fast clip forever. Investors and Wall Street's expectations of high growth don't help either. By the time executives start to realize that they are unlikely to keep up the pace of growth, they also realize that their company is overvalued in the stock market. And because CEOs are afraid of destroying investor confidence in their stock, the last message they want to convey to the capital markets is that they don't have the growth opportunities to justify the high price to earnings multiple that their stock is commanding, says Percival. "So they delay taking the action necessary to be prepared for a different future."
One relatively new approach to valuing growth opportunities that can help companies facing these pressures is the "real options" model, which allows management to put a value on an investment project especially when the outlook is uncertain. Unlike the Net Present Value (NPV) rule for making capital investments, which relies on an expected cash flow, the real options valuation takes into account uncertainties in cash flow and the various courses of action that can be taken in response. The key to real options is to identify the risks associated with a capital investment and the range of options or critical decisions that address those risks. Each of the options is then valued and factored into an overall value for the investment. The option values are typically determined using financial options-pricing models, employing a range of sophisticated equations that might seem daunting for executives trained in the NPV approach. Software companies have stepped into the fray, however, with programs that model the range of options scenarios.
In terms of growth, real options investing is analogous to the purchase of film options in publishing. When a producer or director buys the film rights to a novel, that purchase does not obligate the buyer to make the film; he or she is merely buying the right to do so within a specific time period. Likewise, a real options agreement might allow a company to make an investment in a new project or business opportunity, earning the company the right to increase the investment within a given timeframe, or else to downsize its participation in one project and reallocate resources to another, or to abandon the project (or other associated projects) altogether in light of market changes.
"Often companies want to be the first mover and get in big. That may be exactly the wrong strategy," says Percival. As a broad example, he points to the courier company UPS: Although FedEx invented overnight delivery systems, it turns out that UPS has been very successful without being the first mover. Real options is a tool companies have at their disposal to consider much more than a single course of action. "When companies are going to invest in something new, it may make sense to not go in big but to go in small. The CFO can say, 'Let's make this investment, but make it small, and see if we want to exercise the options later on.' At the very least, the decision makers have to ask tougher questions about the businesses they are going into, and why they would be better at it than others.The job of a CFO is not to say "no" to new investments, but rather "to ask what the believable story is about the competitive advantage that their company would have in the new business," says Percival. "The job of the finance people is to make sure that perspective is part of the decision."