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Finding new ways to grow a company in today's tough climate isn't easy. These CFOs show how it can be done.
Jason Karaian, CFO Europe Magazine
December 30, 2004
"We've become obsessed with the notion of double-digit growth," says CFO Kristen Onken. That's an understatement. Since Logitech brought her on board as finance chief in 1999, the Swiss computer-accessory company has been in pure growth mode. Through some of the worst market conditions that technology companies have ever faced, revenue at the Zurich and Nasdaq-listed firm has grown an average of 23 percent annually in the past five years, to $1.3 billion in fiscal 2004. "What this has done is make me a great believer in growth drivers," notes Onken, having just returned from an annual gathering of Logitech's 60 top finance managers at the company's U.S. base near San Francisco. The theme of the jamboree? "Getting to $3 billion."
That's right — Logitech wants to more than double its size "in the next several years," its executives say. Wishful thinking? Reminiscent of the booming 1990s? Not according to Onken. She says her company can do this through the prudent expansion of distribution centers, customer base and product lines. At a time when much of Europe is still focused on post-bubble restructuring and belt tightening — think ABB, KarstadtQuelle, or Unilever — Logitech's growth vision might strike some companies as audacious. But within the pockets of recovery, not just in Europe but worldwide, there are plenty of other companies that are feeling pressure to dip into the big piles of cash they've been hoarding and ramp up growth.
The challenge for all companies: finding the next new source of growth will be more difficult than ever before. Traditional sources of revenue growth — such as product enhancements, grabbing market share, or acquiring competitors — have been largely tapped out, says Adrian Slywotzky, a managing director at Mercer Management Consulting in the U.S. Slywotzky echoes other management gurus in calling this "a growth crisis."
In the hunt for growth opportunities, failure is rife. (See "Operation Backfire," at the end of this article.) According to research overseen by Chris Zook, head of the global strategy practice at U.S.-based consultancy Bain, only 13 percent of companies worldwide during the 1990s achieved "even a modest level of sustained and profitable growth." In today's hypercompetitive environment, he says he'd be surprised if that figure can reach 10 percent.
Yet that hasn't stopped companies from whipping up investor enthusiasm with magnificently ambitious growth plans. Zook notes that the average company sets a public target of revenue growth at twice its industry's rate, and earnings four times higher. Where will all that growth come from?
In many cases, finance might have the answer. That's why we caught up with the CFOs of three very different companies, all renowned for their ability to tap into new avenues of growth: Logitech, a small start-up founded in 1981, made a name for itself as a maker of computer mice for PC manufacturers before expanding into the retail market to sell a vast range of accessories for computers, gaming consoles and entertainment systems; Giorgio Armani, the Italian fashion house which since its founding in 1975 has grown revenue organically to €1.3 billion ($1.7 billion) through shrewd customer segmentation and brand control; and French hotel group Accor, which revolutionized its industry in the 1980s with a smart investment aimed at budget travelers and today is seeking to rekindle that innovative spirit.
Zook contends that the underlying strength in companies like these is in their ability to 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 consultants offer variations on that theme. Richard Wise, another managing director at Mercer, for example, says that a successful growth strategy in his view is one that adds to, not detracts from, a company's core business. "The idea is not to abandon the pillars of growth, but to add to the playbook," he says.
Logitech has certainly focused on adding to its playbook. It wasn't until the arrival of CEO Guerrino De Luca a year before Onken joined Logitech that the business really began taking off. In 1998, about half of the firm's revenue came from selling mice to the likes of Hewlett-Packard and Dell. That was perilously risky for Logitech. Industry analysts were predicting increasing commoditization of PCs along with a slowdown in demand. What's more, Logitech's executives saw that the company was getting a margin of around 10 percent on business-to-business mice sales, compared with around 60 percent for business-to-consumer sales.
So it was that Logitech's new strategy began calling for a bigger push into B2C, and selling not only mice, but also — as Onken puts it — any product that provides a "bridge between people and technology." That includes everything from keyboards to joysticks to PC speakers, cameras and headsets.
Retail sales today account for more than 80 percent of Logitech's revenue, helping its return on equity reach 33 percent in 2003, compared with the industry average of 23 percent. Meanwhile, analysts expect the company to beat its forecast 11 percent rise in sales and 15 percent rise in operating earnings for fiscal 2005, ending March 31.
And at the moment, "we're right in the sweet spot of growth engines, like webcams and cordlessness," says Onken, noting that in the first six months of the current fiscal year webcam sales grew 53 percent and cordless products jumped 38 percent.
Two factors have worked in the firm's favor, notes Onken. First, there was a useful crossover between the wholesale and retail businesses in a range of areas, from industrial product design to volume manufacturing to logistics to distribution, helping to keep costs low and quality high. Second, the company has invested steadily in infrastructure that can grow alongside the rising demand for its products. It is, in fact, currently replacing the factory it owns in Suzhou, China, with a new one capable of boosting manufacturing capacity by as much as 60 percent.
Finally, Logitech spends around 5 percent of revenue on R&D. "If you look at other hardware companies, it's difficult to find any spending more than 1 percent," says Onken. "During the budgeting process, finance ensures that R&D gets its fair share." That mindset helps to maintain a steady flow of new gadgets wooing customers — like an optical mouse with controls for a computer's CD player on it, or a universal remote control that's configured via the web so that it's always compatible with the latest TV, stereo and other media hardware.
For now, Onken says growth at Logitech doesn't need to be reminiscent of the high-speed M&A activity that many tech companies pursued in the 1990s. "There's a lot of potential for organic growth waiting to be tapped, so we don't have to panic looking for new growth engines. But we're mindful that we'll need other growth drivers two or three years out, so we can plant these seeds leisurely and intelligently."
With or without M&A activity, an oft-neglected source of growth that firms can profit from is intangible assets. "Most of the focus has been on measuring intangibles," says Mercer's Slywotzky. "A good adjacency move leverages them." In particular, he 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 Giorgio Armani, the glamorous Milanese fashion house, adjacency moves have all leveraged a highly valuable asset — its brand. Set up with money raised from the sale of the eponymous fashion designer's Volkswagen car, so the story goes, the privately held company generated an operating profit of €181 million ($240 million) on sales of €1.3 billion ($1.7 billion) in 2003, and ended the year with €260 million ($344 million) in cash. And at 14 percent, its operating margin in the first half of 2004 outshone rivals Hugo Boss (11 percent) and Gucci (10 percent).
Despite its enviable balance sheet, "financial targets are not necessarily Armani's business driver," notes Paolo Fontanelli, CFO of Armani since 2000. "The real driver is always Mr. Armani's vision." As founder, chief designer, CEO and sole shareholder, there's no doubt that Armani the man can do what he pleases with Armani the firm. Behind this broad-brush rhetoric, however, is an appreciation for the value that finance can bring to growth strategies. "Mr. Armani asks me more about business evaluation and assessment rather than financial ratios," says Fontanelli.
Central to Armani's early growth was its decision in the 1980s to divide customers into segments according to their buying power, and designing lines of clothing and shops accordingly. And within each segment — ranging from the haute couture evening gowns and suits to high-street jeans and urban youth fashion — the firm has gradually expanded the types of goods that it sells within each segment to include accessories, perfume, jewelry, and the like.
Armani's licensing has also been important. In an industry that has suffered badly from brand dilution — Pierre Cardin's name, for example, appears on some 900 products — Armani has shown disciplined restraint by jealously guarding its brand. Today, only 8 percent of sales is generated from royalties on a very limited range of license agreements, from scent to sunglasses.
Andrew Campbell, director of the Ashridge Strategic Management Center in London, says Armani's methodical expansion from a solid base business is a good example of how companies can steer themselves down the growth path, more often than not with the help of their CFOs. "Inevitably, it's a screening-out process," he says. "Left to their own devices, the rest of the team are going to be kissing a lot of frogs, and this will not produce a lot of princes. The finance team's job is to point out which ideas will remain frogs."
But having built up a strong base, Armani reckons it's now ready to push the boundaries of its business a little further. In February, it signed an agreement with Dubai-based property developer Emaar to build 14 branded hotels and resorts in major cities including Paris, New York, Tokyo and Shanghai. "Mr. Armani felt that there could be a natural brand extension," Fontanelli explains. It's in deals like this, he adds, that "the CFO becomes part of the company's growth engine," providing advice on the financial strength of outside partners and assessing business cases.
Room to Grow
But what about companies in traditionally low-growth sectors? Zook of Bain says that it's no excuse for complacency. His research suggests that only 20 percent of the difference in profitability between companies has to do with the markets they're in — 80 percent comes from performance relative to competitors and other company-specific factors.
Accor knows a thing or two about that. The French hotelier earned its place in the business school case-study pantheon after the launch of "Formule 1" in the mid-1980s. Formule 1's idea of a chain of budget hotels across France was novel indeed: cheap and cheerful, the hotels served previously neglected travelers who wanted something in between the no- or one-star hotel category and pricier two-star hotels. Accor figured out that it could deliver what travelers value most — like easy check-ins and clean, quiet rooms — while scrapping what they didn't care as much about — like restaurants and ornately decorated lobbies — in order to keep down overheads.
But then, Formule 1's star dimmed. It wasn't long before rivals caught on to its secret and chipped away at its market. Meanwhile, Accor set its sights on the U.S. budget hotel market, but not with the same success. Industry experts say it greatly overpaid for Motel 6, a debt-laden budget chain, in 1990, and to this day, Accor's U.S. budget segment lags its equivalent in Europe in both revenue per available room (in 2003, €27 compared with €34, or $36 compared with $45) and ROCE (7 percent compared with 15 percent). Meanwhile, a bid to conquer other businesses — from theme parks to rental cars — was also failing to deliver value.
As debt grew to nearly twice its equity, Benjamin Cohen was called in as CFO in 1994 to sort out the firm's balance sheet. Sale-and-leaseback deals and outright asset sales ensued to bring in much-needed cash. So did a new financial rigor in the hope of avoiding the costly investment missteps of the past. Today, before a project gets a green light, it must demonstrate, among other things, a 15 percent ROCE three years out. Cohen also insists that gearing remains below 70 percent (it was 67 percent in late 2003). "There is a certain level of risk that cannot be accepted," says Cohen, who was promoted to vice chairman in 2003. "But the financial team also has to be open to growth and not just the 'people who say no.' "
By 2001, the turnaround looked on track — profit before tax was €758 million ($1 billion) on revenue of €7.3 billion ($9.7 billion). Five-year compound annual revenue growth was 11 percent, with profit growth of 27 percent. But then Accor's recovery was dramatically thrown off course following the terrorist attacks of September 11 and the long, harsh downturn of the global economy. And now? Profits in 2003 were €603 million ($799 million) on sales of €6.8 billion ($9 billion).
As for Formule 1, it commands 50 percent of France's no-star market and Accor's one-star Etap chain 55 percent of the one-star market, according to MKG Consulting. As for fresh growth, Cohen says Accor will continue to open new hotels, but with the travel industry still not fully recovered, most of them will be franchised, not owned or leased, so that "we can continue to grow, but with less financial exposure."
Analysts fret, however, that Accor is in danger of losing sight of its core strengths in the quest for growth. In May, Accor announced it would acquire a 30 percent stake, for €252 million ($334 million), in loss-making resort operator Club Méditerranée. Cohen says the "determining factor" in the deal was the €280 million ($371 million) convertible bond issued to finance the purchase, which ultimately satisfied the gearing hurdle set by finance. Fair enough, but only time will tell whether this new investment adds to the company's core hotel business.
Other companies might also find themselves waiting in anticipation to see whether their growth bets are paying off. Many will be disappointed. In his book Beyond the Core, Zook concludes his analysis of adjacencies on a cautionary note, citing 19th-century captain of industry Andrew Carnegie: "It is trying to carry too many baskets that breaks most eggs." Sometimes, Zook says, "many of the best adjacency decisions are the decisions to say no."
Additional reporting by Joseph McCafferty.
Most companies don't really manage top-line growth. They allocate resources to businesses they think will be most productive and hope the economy co-operates. But a growing number are taking a less passive approach, and studying revenue growth more carefully. With the right discipline and analysis, they say, growing revenue can be as straightforward as cutting costs.
"The idea is to bring the same systematic analysis to growing revenue that we have brought to cost cutting," says Franklin Feder, vice president of analysis and planning at U.S. aluminum giant Alcoa.
To that end, Alcoa uses a sources-of-revenue statement (SRS) developed by Michael Treacy, co-founder of consulting firm GEN3 Partners in the US. Compiling an SRS is fairly easy; most of the information needed is readily available.
Alcoa is deploying Treacy's model within all of its 30 business units. The move is the latest in a program started in 2001 to focus on profitable organic growth. Feder says the statements are generated by a team made up of marketing and finance personnel working at the business-unit level, and that some unit managers now use the information on a quarterly basis. Although the program is still in its infancy, Feder says the company already has a better idea of its true sources of growth, and business managers can make better decisions about where to allocate resources.
Treacy envisions a time when companies spend as much time analyzing revenue as they do costs, and when revenue accounting focuses on more than when revenue is recognized. "It's not going to happen overnight. After all, cost accounting has a 100-year head start," he says.
How to Create an SRS
To produce a sources-of-revenue statement, five steps are required in addition to establishing total revenue for comparable periods, as for an income statement or a P&L.
1) Determine revenue from the core business by establishing the revenue gain or loss from entry to or exit from adjacent markets and the revenue gain from new lines of business, and subtracting this from total revenue.
2) Determine growth attributable to market positioning by estimating the market growth rate for the current period and multiplying this by the prior period's core revenue.
3) Determine the revenue not attributable to market growth by subtracting the amount determined in Step 2 from that determined in Step 1.
4) To calculate base retention revenue, estimate the customer churn rate, multiply it by the prior period's core revenue and deduct this from the prior period's core revenue.
5) To determine revenue from market share gain, subtract retention revenue, growth attributable to market positioning, and growth from new lines of business and from adjacent markets from core revenue.
Business books about growth have become something of a growth industry themselves. Here's a selection of recent titles:
Beyond the Core: Expand Your Market Without Abandoning Your Roots (Harvard Business School Press, 2004)
Chris Zook, director of global strategy at consulting firm Bain in the U.S., says a firm 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 its core business.
Blue Ocean Strategy: How to Create Uncontested Market Space and Make the Competition Irrelevant (Harvard Business School Press, 2005)
Insead professors W Chan Kim and Renée Mauborgne challenge companies to break free from their existing markets, or "red oceans" — where blood shed in the battle with competitors over market share obscures the profit pool — and wade into a "blue ocean," where "demand is created rather than fought over."
The Growth Gamble: When Leaders Should Bet Big on New Businesses and How to Avoid Expensive Failures (Nicholas Brealey, 2005)
Andrew Campbell and Robert Park of the Ashridge Strategic Management Center in the U.K. put forth their "strategic business case," a set of criteria (represented as a set of traffic signals) that companies should apply to every new idea.
How to Grow When Markets Don't (Warner Books, 2003)
Adrian Slywotzky and Richard Wise, managing directors of Mercer Management Consulting in the U.S., call on firms to engage in "demand innovation." Growth, comments Slywotzky, comes "not just from providing customers with better products and services, but from providing them better economics."
Attempting to produce new growth via adjacency moves is not without risk. Chris Zook, director of the global strategy practice at Bain, estimates that almost all of history's biggest business blunders were caused or made worse by growth strategies gone awry.
Swissair, for one, built a strong, if unglamorous, reputation for punctuality and efficiency since its founding in 1931. In the mid-1990s, a new management team launched a global growth initiative that involved investments in several regional airlines — Belgium's Sabena, Ukraine International Airlines, and South African Airways, to name a few — and a clutch of travel-related ventures like airline caterer Gate Gourmet and airport retailer Nuance.
Was it distraction that caused Swissair's punctuality and baggage handling to worsen, hurting business, and its investments in the world's more marginal airlines to prove an additional drag on its finances? Hard to say, but in 2000 the company reported a mammoth loss of SFr3 billion ($1.86 billion at the time), and declared bankruptcy shortly after the September 11, 2001, terrorist attacks, SFr17 billion ($10.16 billion) in debt.
Marconi is another example of growth strategy gone awry. A sprawling conglomerate with interests in products from lifts to semiconductors to defense electronics, the U.K.-based company (formerly known as GEC) made a big bet in the booming 1990s on telecoms equipment — a business in which it didn't actually have a toehold at the time. It sold all unrelated businesses and went on a spending spree to buy up telco equipment companies. When the tech bubble burst, the new Marconi was badly exposed and nearly collapsed. It trades as a shadow of its former self today. Adding insult to injury, Marconi's sale of its former "core" defense electronics business to BAE in 1999 turned that company into one of Europe's leading defense contractors.
At any given time, says Zook, a company with a strong core faces between 80 and 110 possible adjacency moves. Of these, "only one in four, maybe fewer, will succeed in creating a stream of growing revenue and earn their cost of capital," he says. Tread carefully.