Looking for Profitable Growth? You May Need a Map.

Looking for Profitable Growth? You May Need a Map.

Senior executives should be worried. About 40 of the nation's top 200 CEOs were replaced last year - twice the ratio replaced a year earlier - mostly because they failed to deliver satisfactory growth and earnings.

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Looking for Profitable Growth? You May Need a Map.

Senior executives should be worried. About 40 of the nation's top 200 CEOs were replaced last year—twice the ratio replaced a year earlier—mostly because they failed to deliver satisfactory growth and earnings. Indeed, 90% of public companies worldwide failed to achieve sustained, profitable growth over the past decade. Ninety percent. This, despite the fact most CEOs list profitable growth as their No. 1 goal.

The problem is a large percentage of corporate chiefs are looking for growth too far beyond the boundaries of their own business. Our study of growth efforts last decade, across more than 1800 companies, showed many hit trouble straying too far from their core business. They did so despite all the evidence against diversification. The cost of diffusing resources is at least twofold. First, it leaves your core business undefended. Second, it saps management time and resources. And in some cases straying destroys the company's value by confusing investors and hurting stock price. Conversely, 80 percent of companies that achieved profitable growth through the ’90s, did so by focusing on their core business.

That's not to say it's easy. Shareholder expectations have driven the average price-to-earnings ratio in the US stock market to a record, nearly 30 times earnings. That implies that a stock's earnings will grow three or four times faster annually than US gross domestic product, the total value of all goods and services produced within the nation's borders. But according to our analysis of the financial performance of all public companies in the US, Canada, Japan, Germany, France, Italy and the United Kingdom (the Group of Seven industrialized nations) this is unlikely. Over the past ten years, only 240 companies, fewer than 13 percent, achieved growth in income and earnings even close to thrice the GDP's, while also earning their cost of capital.

Straying from the Core

Our work shows that even the most sophisticated management teams can make mistakes in identifying adjacent growth opportunities. They think they are moving into a highly related business, but in fact differences in the new business' cost structure or customer base actually diversify operations. And correcting a strayed course is painful. For example, Gillette just announced a 2,700-person layoff and divestiture of its pens business and some small appliance lines to pare back to shaving products, their core of 80 years. Similarly, Bausch & Lomb, pioneers in contact lens technology, have survived a painful five years of executive turnover and divested interests in ointments, laboratory rats and hearing aids to refocus on being the "eyes of the world."

A classic case of inadvertent diversification is Mattel Inc.'s acquisition of The Learning Company. Mattel was the world's largest maker of traditional dolls and soft toys. The Learning Company was a premier maker of children's interactive software. Mattel was struggling. In the last quarter of 1998 it suffered a $500 million loss.

To Mattel Chief Executive Officer Jill Barad, the $3.6 billion acquisition of The Learning Company enabled Mattel to get into the new market place. It fulfilled Mattel's strategic dream; it would give Mattel "an unparalleled portfolio of branded digital content through one family destination site." But it failed. Mattel misunderstood its core business's relationship to the acquisition. The two companies were so different and incompatible that they couldn't work together. In the middle of a plummeting share price and terrible losses, Barad resigned. Mattel divested The Learning Company for a price of zero and a call on hypothetical future earnings.

So what's the lesson from this and similar stories? Mattel looked too far outside its core for growth. Our research suggests that companies should look for growth by looking inside first. They should start by defining their core business; then they should assess truly related opportunities, or "adjacencies," for organic growth or acquisitions. (Adjacency growth does not preclude acquisitions but it narrows the field.) Finally a company should grow into related businesses in a very careful sequence so each move reinforces the previous move and ultimately the core.

Indeed, chief executives wanting to focus their efforts and analysis around growth strategy, should focus here. It's tough to go back if you move into the wrong business. Mistakes are reversible only at a high, sometimes crippling, cost in company resources and enterprise.

Eighty percent of the 240 publicly quoted companies that achieved sustained, profitable growth over the past decade have expanded through adjacencies1.

Finding the Path to Success

One of these companies, ServiceMaster, a provider of indoor-outdoor maintenance services, has expanded only by entering adjacent businesses for more than 40 years. It has a remarkable growth record.

The US company began in the 1930s as a mothproofing business, and then, riding a post-war wave of wall-to-wall carpet installations, moved into carpet cleaning. From carpet cleaning it expanded into general cleaning for residential and commercial businesses. General cleaning led the company in the 1960s to start cleaning hospitals, where it soon developed a grounds-management business. This new service was then sold back into ServiceMaster's original segments of residential and commercial customers. Cleaning led to laundry services. Grounds management led to pest control. This broad set of services led to a strategy of serving educational institutions, and so on, step-by-step, decade after decade. (See "Top of Mind" chart below)

Over the past forty years, ServiceMaster has grown by a compound annual growth rate of 21 percent and has consistently earned a return on equity of more than 20 percent. In the past decade it provided its investors an average annual return of more than 34 percent. And significantly, more than 75 percent of ServiceMaster's growth has come through organic growth.

Mapping and Evaluating Growth Adjacencies

ServiceMaster got it right, Mattel got it wrong. What distinguishes viable adjacency growth?

First: it's the extent to which a new opportunity draws on relationships, technologies or skills that currently exist in the core business.

Second: it's whether seizing the opportunity will generate a competitive advantage. Does it lower cost? Increase loyalty? Genuinely offer more value to customers? Will it in other words add to and reinforce the existing business?

Mapping adjacencies can sometimes lead to a resurgence of growth in a strong core business. In the mid-1980s, for instance, Grainger, the leading industrial supplies distributor, saw its growth drop from 10% to 2%. As a result, its stock price declined substantially. The company tried to understand whether it had reached the limits of its $3 billion target market. It wasn't even close. When it expanded its market map to include related customer segments, geographies and industrial products, it discovered that its market was closer to $30 billion. The new strategy took advantage of these adjacent opportunities, and re-launched Grainger back to 10% growth for more than the next decade.

Likewise, management teams that develop a full inventory of growth opportunities around their core quickly find themselves awash in interesting and potentially attractive options for investment. But before executives embark on data collection, they should step back and apply their strategic judgment and operating knowledge to rate opportunities along five key dimensions:

  1. How much does this opportunity strengthen our core business franchise?
  2. What are the chances of our becoming a leader in the new segment or business?
  3. Could this move have a defensive benefit, preempting or interdicting our present or future competitors?
  4. Does this investment position our core business strategically for an even stronger future adjacency? Does it hedge against uncertainty or constitute one step in a well-defined sequence of strategic moves?
  5. Can we be certain of superbly executing implementation?

Asking and answering these questions should increase your odds of finding the grail of growth. But they are difficult decisions. They are calls that even excellent managers can misjudge in the chaos of battle.

(Chris Zook directs Bain & Company's strategy practice and is the author, with James Allen, of Profit from the Core: Growth Strategy in an Era of Turbulence, forthcoming from Harvard Business School Press.)

1We define this subset as stock-exchange listed companies in the G7 nations that achieved 5.5% growth in revenue and profits over 10 years, while repaying their cost of capital.

Bain Book

Profit from the Core

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