Article

Inertia is the enemy

Gaining a much sought-after footing in the list of S&P/ASX100 companies is one thing. Staying there is quite another.

By Paul Calthrop

Published on January 18, 2007
min read


Gaining a much sought-after footing in the list of S&P/ASX100 companies is one thing. Staying there is quite another. Nearly six out of EVERY 10 companies that made up the S&P/ASX100 in 2000 are no longer there. A few went broke, some lost control of their destiny and were taken over, and the rest simply drifted out of the S&P/ASX100 towards irrelevance—good companies that were not able to grow as fast as the market demanded. This "mortality" rate has been rising steadily, from 40 per cent in the 1970s, to 50 per cent in the 1980s, to 60 per cent in the 1990s. We're halfway through this decade, with a projected mortality rate of 73 per cent. What is behind this disappearing act? Two factors: for one, the base of the S&P/ASX100 is rising at a surprisingly fast rate, pushed by a strong supply of companies entering the index. Between 2001 and 2005, the market capitalisation of the number 100 company on the index rose an average of 20 per cent a year. Add a representative dividend increase of about 3 per cent, and a company has to deliver total returns to shareholders of about 23 per cent a year to avoid sliding closer to the exit door—a sobering challenge. But there is a second factor, especially daunting for incumbents within the index: commoditisation. This is the process by which any given product or service in a competitive economy trends towards a lower net price over time, in real, inflation-adjusted terms. Left unfixed, it undermines companies' prospects of revenue and profit growth inch by inch, year by year, until they drop out of the index. The only cure for commoditisation is innovation. Done well, it results in a higher net price per equivalent unit, and if it doesn't, under this definition it is not an innovation. The trouble is, most companies confuse innovation with growth. As a result, they break the golden rule of innovation—that it must yield a higher net price per equivalent unit.Companies chase revenue, not "higher margin revenue". It is the equivalent of walking under the bar in a high-jump competition—no prize. More revenue at the same, or lower, price per unit builds complexity, as companies introduce new products and proliferate stock-keeping units. Complexity creates cost and compounds with commoditisation to create mortal risk to companies. Here is the acid test: what does the net price per equivalent unit look like over time, in a business? If it is not going up, the business is headed for trouble. And how do the best companies keep prices heading north, without artificially inflating them? Colgate-Palmolive, for example, in China began substituting local raw materials of acceptable quality in its toothpaste instead of importing them. That way it was able to improve margins while lowering the price of its toothpaste to just 44 per cent above local brands, a price point that appealed to consumers looking to trade up. The company also diverted cost savings into marketing and launched new products such as Colgate Herbal. While Colgate's strategy in China is still being refined, its market share there has increased from 10 per cent in 1996 to more than 30 per cent in 2004. In a similar way, Colgate has brought its approach to continuous innovation to Australia's toothbrush market, in this case offering a constant but controlled flow of new products that justify higher price points. Consumers think the new toothbrushes are worth it, so they comply. All companies face the toothbrush challenge—to develop and manage an innovation system that keeps real prices inching forward. The first task is to measure net price over time. Most companies do not do this, in any formal way that actually weights its average price by number of units sold at each price. The second task is to set a simple yet powerful innovation rule—no innovation project should take up space in the system if it does not aim for a higher net price. Applying this rule with any sort of discipline cause the cancellation of many projects. Taking the initiative is essential. To add to former Gillette chief executive Jim Kilts's quote—"the opposite of success is not failure but inertia"—standing still, in a commoditising world, is suicide. Paul Calthrop is a partner with Bain & Co in Melbourne.

Gaining a much sought-after footing in the list of S&P/ASX100 companies is one thing. Staying there is quite another.

Nearly six out of EVERY 10 companies that made up the S&P/ASX100 in 2000 are no longer there. A few went broke, some lost control of their destiny and were taken over, and the rest simply drifted out of the S&P/ASX100 towards irrelevance—good companies that were not able to grow as fast as the market demanded.

This "mortality" rate has been rising steadily, from 40 per cent in the 1970s, to 50 per cent in the 1980s, to 60 per cent in the 1990s. We're halfway through this decade, with a projected mortality rate of 73 per cent.

What is behind this disappearing act? Two factors: for one, the base of the S&P/ASX100 is rising at a surprisingly fast rate, pushed by a strong supply of companies entering the index. Between 2001 and 2005, the market capitalisation of the number 100 company on the index rose an average of 20 per cent a year. Add a representative dividend increase of about 3 per cent, and a company has to deliver total returns to shareholders of about 23 per cent a year to avoid sliding closer to the exit door—a sobering challenge.

But there is a second factor, especially daunting for incumbents within the index: commoditisation. This is the process by which any given product or service in a competitive economy trends towards a lower net price over time, in real, inflation-adjusted terms.

Left unfixed, it undermines companies' prospects of revenue and profit growth inch by inch, year by year, until they drop out of the index.

The only cure for commoditisation is innovation. Done well, it results in a higher net price per equivalent unit, and if it doesn't, under this definition it is not an innovation.

The trouble is, most companies confuse innovation with growth. As a result, they break the golden rule of innovation—that it must yield a higher net price per equivalent unit.Companies chase revenue, not "higher margin revenue". It is the equivalent of walking under the bar in a high-jump competition—no prize.

More revenue at the same, or lower, price per unit builds complexity, as companies introduce new products and proliferate stock-keeping units. Complexity creates cost and compounds with commoditisation to create mortal risk to companies.

Here is the acid test: what does the net price per equivalent unit look like over time, in a business? If it is not going up, the business is headed for trouble. And how do the best companies keep prices heading north, without artificially inflating them?

Colgate-Palmolive, for example, in China began substituting local raw materials of acceptable quality in its toothpaste instead of importing them. That way it was able to improve margins while lowering the price of its toothpaste to just 44 per cent above local brands, a price point that appealed to consumers looking to trade up. The company also diverted cost savings into marketing and launched new products such as Colgate Herbal.

While Colgate's strategy in China is still being refined, its market share there has increased from 10 per cent in 1996 to more than 30 per cent in 2004.

In a similar way, Colgate has brought its approach to continuous innovation to Australia's toothbrush market, in this case offering a constant but controlled flow of new products that justify higher price points. Consumers think the new toothbrushes are worth it, so they comply.

All companies face the toothbrush challenge—to develop and manage an innovation system that keeps real prices inching forward.

The first task is to measure net price over time. Most companies do not do this, in any formal way that actually weights its average price by number of units sold at each price.

The second task is to set a simple yet powerful innovation rule—no innovation project should take up space in the system if it does not aim for a higher net price. Applying this rule with any sort of discipline cause the cancellation of many projects.

Taking the initiative is essential. To add to former Gillette chief executive Jim Kilts's quote—"the opposite of success is not failure but inertia"—standing still, in a commoditising world, is suicide.

Paul Calthrop is a partner with Bain & Co in Melbourne.