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Finding new sources of revenue is harder than ever. Here's how to grow without damaging your roots.
Joseph McCafferty, CFO Magazine
March 1, 2004
For the past three years, Corporate America has been nothing if not stingy. Stalled by sluggish demand, companies have slashed spending on new factories and equipment, salaries and bonuses, technology, benefits, and travel. They have exited unprofitable businesses and sold off nonstrategic assets. They have downsized, outsourced, and offshored.
Now, as the economy finally springs back to life, CEOs are ready to start spending again. But for many companies, investments in growth will produce disappointing results, predict a handful of prominent management consultants. The main reason: traditional sources of revenue growth—such as product enhancements, grabbing market share, or acquiring competitors—have been largely tapped out.
"When you look at a lot of markets, the functionality needs of those markets have pretty well been met," says Adrian Slywotzky, a leading management guru and a managing director at Mercer Management Consulting Inc., in Boston. Where does a shaving company go, for example, when it has already packed four blades on its razors? How do automakers or steel companies grow when the markets for their core products are flat? Slywotzky, for one, thinks that many companies are facing a growth crisis.
So does Chris Zook, director of the global strategy practice at Boston-based consulting giant Bain & Co. Zook says research shows that during the booming 1990s, only 13 percent of companies worldwide achieved "even a modest level of sustained and profitable growth." And he predicts that far fewer companies will be able to sustain that level of growth over the next five years.
Meanwhile, investors are bullish, coming off a year where earnings for the S&P 500 grew 18.2 percent, according to Thomson First Call. For 2004, says Thomson, analysts are predicting earnings growth will slow to 12.6 percent—but that's still a challenging goal. Based on his research, Zook says the average company plans to grow revenue at an annual clip of two times the rate of its core markets, and earnings at four times that rate. Where is all that growth going to come from?
Fortunately, consultants rarely identify problems without offering solutions—and books. (Business books on growth have become something of a growth industry themselves.) In his latest book, How to Grow When Markets Don't, Slywotzky and co-author Richard Wise, also a Mercer managing director, call on companies to engage in "demand innovation." This means that instead of focusing on improving products incrementally, companies should create new growth and value by addressing issues that surround products. IBM successfully followed this strategy in the 1990s, moving from primarily making low-margin PCs and servers to becoming a one-stop shop for high-margin IT services. Growth, comments Slywotzky, comes "not just from providing customers with better products and services, but from providing them better economics."
Zook, who advised companies to perfect their knitting in his previous book, Profit from the Core, explains how to expand into new markets in his new book, Beyond the Core. He says a company can combine high growth and low risk by moving systematically into "adjacencies"—products, services, geographies, or customer segments that are highly related, or adjacent, to the company's core business.
Other books published in the last year, also by well-known consultants, offer more or less similar answers to the growth conundrum"—books like The Innovator's Solution: Creating and Sustaining Successful Growth, Profitable Growth Is Everyone's Business, and Stretch!: How Great Companies Grow in Good Times and Bad.
Believing that experience is the best teacher, we decided not to review books but rather find out whether what the consultants preach actually works in the real world. Accordingly, we examined four companies that have adopted variants of the strategies promoted by Slywotzky and Wise, Zook, et al. They are United Parcel Service (UPS), which wants to embrace the whole spectrum of logistics services; Cardinal Health Inc., which went from $2 billion to $50 billion in 10 years; Reynolds & Reynolds Co., which was incorporated in the era of buggy whips and now offers Internet tools for its auto-dealership customers; and General Motors Co., which has leveraged intangible assets to create a brand-new technology.
Seeing the Big Picture
A key principle of successful growth is that it should add to, not detract from, a company's core business, says Wise. "The idea is not to abandon the pillars of growth, but to add to the playbook." For Zook, UPS is a stellar example of a company that has strengthened its core by exploiting adjacencies—here, new, high-growth business opportunities that also create greater demand for shipping.
Not that UPS was a slouch to begin with. From 1981 to 1991, the Atlanta-based company tripled revenues, from $4.9 billion to $15 billion. That was achieved by building on a solid brand, expanding overseas, and acquiring competitors. Along the way, the company built a network that serves more than 200 countries and millions of customers. By the mid-1990s, however, UPS was failing to deliver on its growth goals. From 1994 to 1997, revenues grew at less than 5 percent annually, as growth in the U.S. package-delivery business slowed to the single digits. Clearly, UPS needed a new source of revenue.
The source was sitting right under its nose. A few big customers had already asked UPS to warehouse goods near its main U.S. air hub in Louisville. Those customers wanted to be able to take orders up until the last minute and still have the goods shipped overnight. At the same time, other companies were asking UPS to keep equipment parts on hand, which they could then ship to facilities in a matter of hours if repairs were needed. UPS realized that it could provide these services—and more—to other companies around the world.
In 1995, the company started UPS Supply Chain Solutions. Through a series of acquisitions and organic growth, it built out the business along its existing shipping network, leveraging existing capabilities and making acquisitions to plug holes. "At the time, other companies were doing small parts of the supply-chain logistics puzzle," says David Mounts, CFO of UPS Supply Chain Solutions. "But no one had put the whole picture together globally." Today, UPS Supply Chain Solutions can do just about anything under the logistics umbrella. The company has 750 distribution centers in 120 countries, where they manage inventory, prepare orders, and deliver goods via truck, ship, rail, or air. It will handle returns and even repair and ship some products back to customers on behalf of the vendor.
In 1998, the company started UPS Capital, a financial-services firm. "All transactions involve the movement of goods, information, and funds," says Mounts. "We were already doing the first two very well." By adding the third capability, the company could complete the circle of transaction settlement. With all three, says Mounts, "a company can outsource its whole supply chain to us, and focus on what it does best." The bottom line for customers, he says, includes better inventory management, accelerated cash flow, and lower working capital. "We help them run their businesses better."
And the bottom line for UPS? The new business units, with $2.9 billion in 2003 revenue, accounted for more than half of the company's new growth from 1998 to 2003, says Mounts, who adds that the supply chain outsourcing market is growing in the double digits. In the last quarter of 2003, operating profit for the nonpackage-delivery segment of UPS rose 27 percent, to $121 million. "Our fourth-quarter performance underscores how effectively our strategies are working," noted UPS CFO Scott Davis at the company's quarterly earnings call in late January. "All three of our business segments are showing expanded margins."
Rx for Growth
Key to UPS's growth is the way the company came to see opportunities: not just in terms of what new products and services it can sell, but also in terms of how it can help customers improve their businesses. The same shift in perception helped Cardinal Health, a Dublin, Ohio-based provider of health-care products and services, embark on a sensational growth spurt over the past decade.
Before 1995, Cardinal was primarily a pharmaceutical- distribution company. In the mid-1990s, while the health-care sector enjoyed robust growth, distributors like Cardinal were increasingly squeezed; average net margins plummeted to around 1 percent. Like other companies in the industry, Cardinal had grown mostly through acquisitions, but with just three major players left, it faced pricing pressure and slowing growth.
The company decided to look elsewhere for new opportunities. But being a middleman, it looked not only to its customers, but also to its suppliers. "They ran the play both ways," says Mercer's Wise. "By looking at suppliers as a potential customer, they hit on a whole new business model""—one that enabled Cardinal to take a wider view of its business without losing focus on what it does best.
Thus, in 1998, Cardinal leveraged its relationship with pharmaceutical companies to move into contract manufacturing. It acquired RP Scherer, a drug manufacturer that held a patent for making gel-cap pills. Now, a pharmaceutical maker can provide Cardinal with the raw active ingredients for a drug, and Cardinal will manufacture it in gel caps, package it, and distribute it to pharmacies and hospitals. By expanding these capabilities, the company now manufactures, packages, and distributes all major over-the-counter and prescription dosage forms for its pharmaceutical and biotech customers. The business segment now represents more than $2 billion in annual revenue. What's more, the segment grew a whopping 44 percent last year and contributed 15 percent of the company's operating earnings.
Meanwhile, Cardinal also moved downstream. For example, it leveraged its relationship with hospitals to sell them medical and surgical products in addition to drugs. With the acquisition of Pyxis Corp., in 1996, it acquired machines that dispense pharmaceuticals in the hospital. Since the acquisition, Cardinal has broadened the Pyxis line to automate other functions within hospitals and pharmacies, enabling them to boost efficiency and improve patient care.
Cardinal's long-term guidance for growth is midteens or better EPS growth, according to CFO Richard Miller. But "Cardinal has always looked at growth as a strategy more than an outcome," he says. Miller, who joined the company in 1994 and became CFO in 1999, says any new market opportunity must pass four tests. One is the fit with the existing business. "We are not going to go for wild diversification outside health care or into 'just anything health care,'" he says. "It has to be a complementary business that makes one or both of the businesses better to justify it." Another test is whether it helps Cardinal establish a leadership position in the new market. A third relates to the quality of acquired companies, a key determinant in achieving a successful merger. Finally, Miller says, the financial model has to be sound, leading to the creation of shareholder value.
Acquisitions have been an important part of Cardinal's strategy; the company has made 27 deals since 2000. "We purchase a company for scale or expertise, and then we build out breadth systematically," says James Mazzola, a Cardinal spokesperson.
The willingness to take a broader view of itself has helped make Cardinal one of the fastest-growing large companies in the nation. Over the past decade, since it started to diversify, the company's revenues have ballooned from $2 billion to more than $50 billion, and operating earnings have grown from $60 million to $2.5 billion.
Redefining the Core
Taking too broad a view of a company may result in growth initiatives that stray too far from the core business (see "Growing Pains," at the end of this article). Sometimes it's better instead to redefine the core and grow from there. That's essentially what Reynolds & Reynolds did in 1998, when it sold off part of its printing business. The roots of that business reach all the way back to the 19th century, to Reynolds's founding in 1866 as a business-forms company.
Over the years, Dayton-based Reynolds became the top supplier of business forms to auto dealerships. When computerization took hold, the company branched into back-office systems for dealerships. By the late 1990s, Reynolds had become an $800 million company, but neither of its main businesses was growing much. "We did a few acquisitions, but not a lot of organic growth at all," says CFO Dale Medford, who has been at Reynolds since 1974.
So Reynolds decided to focus its growth efforts exclusively on its automotive-related customers. The company sold off the nonautomotive part of its printing business in 1998. Through acquisition and internal development, it assembled a host of CRM (customer relationship management) solutions that would seamlessly connect with Reynolds's existing back-office applications. Medford says its CRM applications can increase the number of sales a dealer can close on the showroom floor by 2 or 3 percent. "That doesn't seem like much, but in the auto business, that is a lot of money," he says.
And Reynolds has a sizable installed base of potential customers for its new products. Now the company is moving into handling Internet sites for dealers through its acquisitions of Web services companies Automark and Third Coast Media. "We buy the expertise and make some improvements, and then we scale it out over our customer base," says Medford.
Today, Reynolds sees itself as an "information services company" whose mission is to "enable car companies and automotive retailers to work together to build the lifetime value of their customers." The company will grow by helping its customers grow. It's a compelling vision, one that the consultants would surely applaud.
But significant growth from that vision hasn't materialized yet, thanks in part to the economy. The company's sales in fiscal 2003 barely topped $1 billion, only a 16 percent increase over 1999 revenues of $868 million. And in January's Q1 2004 earnings call, Medford lowered expectations of 6 to 10 percent revenue growth for the year to 2 to 4 percent. But the CFO added, "We're setting the table for stronger top-line growth in fiscal 2005 with our investments in new solutions and continued solid earnings and cash flow." Stay tuned.
A Star Is Born
Another, frequently neglected source of growth that companies can profit from is intangible assets. "Most of the focus has been on measuring intangibles," says Slywotzky. "A good adjacency move leverages them." In particular, Slywotzky tells companies to look in four areas: customer relationships; strategic real estate, such as market position or value-chain position; networks, such as an installed base; and information.
At GM, the world's largest automaker, a successful adjacency move started with a focus on hard assets, but ultimately it was the company's intangible assets that made for its success.
In 1995, Chet Huber, then president of GM Mobile Communications Services, and a team of GM employees were given the task of brainstorming ways to leverage GM's technology properties. The company wanted to put its two big tech divisions, Hughes Electronics (satellite communications) and EDS (computer services), to work for the vehicle side of the business. Huber's team began by focusing on the customer—the driver. "We had an erector set of sorts," he recalls, referring to the technologies and capabilities of Hughes and EDS. "We took the pieces apart and looked at ways they could address the needs of the customer." The team identified safety, security, and convenience as needs that were not being completely met, and it set out to provide a service to address them.
The result was OnStar, an in-vehicle global positioning system combined with a wireless telephone. The user pays a monthly subscription fee that gives him or her access to a network of trained operators who can give directions, handle emergencies, or even make a reservation at a restaurant.
GM made OnStar part of a popular factory-installed option package, thus providing an instant, and sizable, base of customers. "GM created a market that didn't exist before," says Huber, now president of the OnStar unit. And the parent's network of relationships has led to other opportunities for the fledgling unit. "Our attachment to GM enabled us to get attention from partners that we wouldn't have had access to as a pure start-up," says Huber. For example, when OnStar wanted to look at ways the system might be able to provide entertainment features, it used GM's relationship as a big advertiser with Disney's ABC network and tapped into its expertise.
The introduction of OnStar does highlight a chief difficulty of growing into an adjacency: How much flexibility do you give the new unit to do things its own way? The OnStar unit more closely resembles a consumer-electronics business than a division of an automaker. "We knew that we had to do some things differently," says Huber. "But we didn't have a 'Get out of Jail Free' card. We couldn't run away from every business process and policy." At the same time, OnStar brought in talent from outside the auto industry and used different metrics such as subscription and renewal rates to measure growth and provide employee incentives.
Although OnStar is a wholly owned subsidiary and doesn't disclose financial-performance information, GM CFO John Devine announced in the second half of 2002 that OnStar was making a profit. To be sure, the unit is too small to have an appreciable effect on the giant automaker's revenue growth, which is currently about 5 percent. Still, the crossover value is undeniable. And the system creates a way for GM to communicate with its customers every day, instead of every few years or so. Who knows what kind of growth could ultimately result from that?
Joseph McCafferty is news editor of CFO.
Attempting to produce new growth via adjacency moves, demand innovation, or other strategies is not without risk. In 1998, Ford Motor Co. tried to reinvent the sales wheel by launching a Website where customers could comparison-shop for used and off-lease Ford vehicles. The move infuriated dealers, and the Texas Department of Transportation sued Ford on the grounds that it was violating a law that prohibits automakers from selling directly to the public. Ford lost the case and was forced to shut down the service. It had succeeded only in damaging its relationship with dealers.
Xerox is another demand-innovation casualty. Despite the company's attempt to move from the declining copier business into the document-management business, revenues grew at just under 2 percent from 1996 to 2000, and have declined ever since. Mercer Management Consulting Inc.'s Richard Wise says that Xerox thought about its customers too narrowly, while its position in the copier business didn't give it the authority to be in the document-management business. "I'm not sure they had the right mix of skills to play in that space," he says.
Chris Zook, director of the global strategy practice at Bain & Co., estimates that 75 percent of history's biggest business blunders were either caused or made worse by growth strategies gone awry. One of the most common mistakes has been that companies look too far afield for adjacencies. They assemble a patchwork of businesses that seem related but don't provide real synergies, then are forced to sell off their new purchases, usually at a steep discount.
"During the euphoria of the late 1990s, a lot of companies got caught up in all the dealmaking," says Zook. "Their risk profile was extended beyond their comfort level." Mattel, for example, acquired The Learning Co., only to sell off the business later on. Bausch & Lomb diversified into hearing aids and other medical equipment, even as its position in its core market, contact lenses, slipped from first to fourth. "The farther you get from the core, the greater the chances are for failure," says Zook.
Indeed, new sources of growth can't be simply bolted on to a weak business. Says Mercer's Adrian Slywotzky: "The tricky thing about creating new growth is that you don't get to do it unless you get an A or an A+ in what you already do."