The New Math of Profitable Growth

The New Math of Profitable Growth

There will growth come from in 2004 and beyond? For most CEOs, finding the next wave of profitable growth is at the top of their agenda, along with global sourcing, cost cutting and dealing with Sarbanes-Oxley

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The New Math of Profitable Growth

There will growth come from in 2004 and beyond? For most CEOs, finding the next wave of profitable growth is at the top of their agenda, along with global sourcing, cost cutting and dealing with Sarbanes-Oxley. Yet, like Olympic athletes preparing for the next Games, many CEOs are finding that their growth muscles are a bit out of shape.

Two-thirds of senior executives believe growth is much harder to achieve today than it was five years ago, according to a Bain survey. These same executives feel more pressure than ever to grow. The average company sets revenue targets at more than two times its market growth rate, with earnings targets four times as high.

The penalties for missing growth targets have rarely been so severe. Shareholders, on average, hold shares of common stock for less than a year, down from eight years several decades ago. Even the innuendo of slowing growth can cause shares to dive. The Gap lost 78 percent of its market value in 19 months, despite a l0-year run in which it delivered compound annual revenue growth of 22 percent. None of that seemed to matter to investors when The Gap's growth slowed.

So, how can companies find sources of new, profitable growth? Our analysis indicates that most new growth will come from pushing the boundaries of a strong core business into "adjacent" territory. This is different from the past, when companies typically sought growth from either expanding their core businesses or improving their weaker businesses or from diversifying and pursuing hot markets.

When we examined the growth records of several hundred companies, six basic types of "adjacency moves" emerged. There are geographic adjacencies (such as Vodafone's acquisition of Mannesmann to enter the German cellular-phone market); channel adjacencies (Carter's creation of a new brand and logistics system for baby sleepers); and product adjacencies (IBM's shift from hardware to services). In addition, there are customer adjacencies (Schwab's pursuit of higher-wealth customers); value-chain moves (Nike's decision to open its own retail stores); and new businesses based on core competencies (American Airlines' creation of Sabre).

Each of these moves is inherently strategic, and therefore the domain of the CEO. Each entails a high degree of risk by moving a company into unfamiliar territory on at least one dimension, and often on several dimensions at once. Each usually requires significant investment of time and money that could otherwise be reinvested in the core.

Yet only one in four of these initiatives succeeds at generating profitable growth, our analysis shows. Adjacency moves gone awry account for most of the 25 major non-dot-com business disasters of the past l0 years—including the Enron implosion and the collapse of Kmart. The shareholder value lost by these 25 failures totaled $1.3 trillion. What's more, more than 40 percent of non-retirement-related CEO departures followed a failed or controversial adjacency move.

Still, some companies defy the odds and manage to outgrow their competitors by a factor of two or more through successful adjacency moves. What allows one company to succeed where most fail? Why do smart management teams armed with quality research falter so often? The answers vary by industry and circumstance. But a few key themes shine through:

Develop a repeatable formula. The company that comes up with a formula to find and execute adjacency moves can bury its competitors. Nike is a case in point. In 1988, Nike's earnings and market value were smaller than Reebok's. Both companies made athletic shoes; Reebok had the better-known brand. Yet, Reebok's profits have grown only 10 percent in the past 10 years, and its market value is roughly one-eighth the size of Nike's. Why? Nike hit upon a formula for adjacency moves, refined and applied to one sport after another, from basketball to volleyball to tennis to soccer and golf. The formula involved a product sequence from shoes to soft goods to hard goods, and an overlay of celebrity endorsements and brand building. Reebok had a chance at the same prize, but never found the combination, hunting and pecking at the periphery of its business across a range of adjacency moves to no avail.

Repeatability enables a company to build an organization around its growth program. A repeatable formula creates the confidence to invest quickly, provides a method by which to find the next opportunity and makes it possible to handle more adjacencies faster and execute them better. Together, these factors constitute a new math of profitable growth.

Keep adjacency moves closely related to a strong core business. Though it sounds obvious, many companies stumble by either misdefining their core businesses or misjudging how an adjacency relates to the core. Anheuser-Busch's foray into snack foods, Mattel's purchase of the Learning Company and Bausch & Lomb's moves into hearing aids and dental products all demonstrate the heavy costs of such miscalculations.

Relatedness is not a matter of intuition or guesswork. Executives can measure the "number of steps from the core" by looking at the key areas where an adjacency overlaps with the core, such as target customers, the channel, the infrastructure, a key brand or shared technology. Some CEOs will invest only in adjacencies that are one step away from the core, and restrict their companies to moves that vary only a single parameter at a time—geography, for instance, or channels.

Many successful adjacency moves involve extensive advance work to confirm the linkage between the adjacency and the core business. The CEO's challenge is to reconcile the tension between the independence of a new growth initiative and its life-giving linkage to the core. In 1998, for example, UPS purchased a relatively small business called Sonic Air that delivered critical parts to businesses within a few hours, such as key computer components to an online brokerage. UPS CEO Mike Eskew deployed 60 employees, some of whom spent their time mapping out the linkages to the core. How would this business relate to the main package delivery system? Should it carry the UPS brand? Which IT systems and what tracking software would be used? The results speak for themselves: In five years, UPS has created a profitable business with $1 billion in revenue.

Seek out detailed customer insight. During the 1980s, American Express turned to an acquisition strategy predicated on the idea of assembling a "financial supermarket." The company made a host of acquisitions, but these moves proved to have little relationship to Amex's core business, and the company's stock price declined by half. A new management team under Harvey Golub and Ken Chenault spent the early '90s reducing operating costs and divesting six of the seven new businesses. But where would they find growth?

The answer came from looking deep within the customer base. Amex segmented its customers more and more finely to offer tailored products, services and rewards programs. Employing this strategy, Amex drove the revenues in its Travel Related Services business from $12 billion in 1996 to $18 billion in 2002, while earnings grew from $1.1 billion to $2.1 billion.

As CEOs confront the growth challenge, they will need success stories like these—and the calculus behind them.

Bain Book

Beyond the Core

Learn more about how how powerful, repeatable methods for moving into new adjacencies can dramatically increase the odds of success.


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