Tuesday, May 3, 2011

Is Bigger Better?

imageBigger may not necessarily be better: Not when it comes to companies’ ability to grow and make money. So says the CFO magazine (Too Big to Succeed, Gregory V. Milano, CFO magazine, April 29, 2011). But what is a big corporation to do, when the conventional growth strategies fail? Innovate!  

The conclusion is based on the research on the 1,000 largest public nonfinancial U.S. companies for the full decade of the 2000s. The companies were categorized based on their size and assessed for several performance metrics. The summary of results is reproduced here from the original CFO article. The highlights:

  • Total Shareholder Returns showed the greatest variance with 9.7% for the smallest companies (less than 2 billion in size defined using EBIDTA) and 2.7% for the largest companies with size more than 10 billion dollars. TSR (Total Shareholder Returns) is defined as the change in a company’s stock price for a given period, plus its free cash flow over the same period, as a percentage of the beginning stock price. (For a more detailed view of the metric and  examples, see this article from strategy+business).
  • Conversely, then, the biggest companies seem to have not much opportunities or inclination in terms of reinvestments back into the business – since the Distribution Rate for the largest companies is 30.5% as against only 18.3% for the smallest group. Distribution rate is a measure of the dividends paid to the shareholders.
  • imageThe author also points out that the bigger companies have trouble growing as fast as the smaller companies, reflected in their revenue growth numbers (7% versus 11.3%). 
While higher dividends to shareholders appear appealing, is that the best use of money to provide shareholder returns? Gregory’s research suggests otherwise, he says: “While those distributions are often labeled "shareholder friendly," our research shows that reinvestment yields strong share-price performance benefits”. See his other article on CFO magazine, “Are You Reinvesting Enough?” for details of his research on the impact of reinvestments on TSR.
Again, the summary of the results is reproduced here for a quick review: Companies that reinvested between 0-50% of their cash-flow generated a median TSR of only 18% compared to a TSR of 193% for companies that reinvested above 150% of their cash-flow.  This, of course, directly aligns with the other finding that the growth rate of bigger companies is smaller than the smaller corporations.
Why are the bigger companies not inclined to reinvest and grow faster? Part of this can be explained by reviewing how conventional growth  happens at companies. In their book, “The Granularity of Growth”, the authors, Sumit Dora, Sven Smit, and Patrick Viguerie contend that the growth results from one of the three, “portfolio momentum, or the market growth of the segments in a company’s portfolio; M&A; and market share gains”. All of these opportunities get limited in mature industry segments where larger companies are most likely to operate – reflecting the trends confirmed above by the research by Gregory’s company. 
So what is a large company in a mature industry to do? Innovate. P&G remains one of the best examples for such innovation driven growth. Between 2002 and 2008, P&G’s revenues almost doubled in spite of it being in one of the most mature industry segments. While some part of the expansion was acquisitions (Gillette, for example), a lot of growth came from products that were simply part of the P&G’s push to innovate when Lafley arrived in 2000. In his book, The Game Changer, co-written with Ram Charan, Lafley describes the case of their fragrance business. P&G acquired the Max Factor and Ellen Betrix cosmetic and fragrance lines from Revlon Inc. in early 90s. At the time, the fine fragrance industry was characterized by slow growth of 2 to 3 percent a year, low margins, and weak cash flow. But P&G wanted to change the game. P&G focused on the innovation that was meaningful to their consumers, including fresh new scents, distinctive packaging, provocative marketing, and delightful in-store experiences and leveraged their global scale and supply chain to reduce complexity and cost. As a result in 2007, P&G became the largest fine fragrance company in the world, with more than $2.5 billion in sales — a 25-fold increase in 15 years.
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© Vivek Sehgal, 2011, All Rights Reserved.

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