Companies With Successful Growth Strategies

Is a company worth the expected growth premium wired into its stock price? Beyond the Core, a new book by Chris Zook, who leads the global strategy practice at Bain & Co., tells investors how to choose stocks with the right growth strategies.

In his search for factors that underlie successful growth strategies, Zook compared 12 pairs of companies. Each pair consisted of two companies in the same industry which started off the decade (1990 to 2001) with similar revenue and earnings, but ended up with very different financial trajectories due to their contrasting growth strategies.

One set of companies saw their stock prices increase almost tenfold, while another one by only threefold. What were the main differences in the new business initiatives between the slow and fast value creators?

One key factor, according to Zook: When a company moves into a new line of business, it should closely relate to the firm's core operations.

In seven out of the 12 pairs of companies Zook studied, the companies that lagged in creating value for shareholders did so because they moved too far away from their area of expertise. Consider the example of two British grocers: Tesco (otc: TSCDY ) and Sainsbury (otc: JSNSY).

The two grocery chains followed divergent growth strategies: Sainsbury's foray into new lines of business included acquisitions of retail chains in Egypt and Texas. Tesco, on the other hand, decided not to stray far away from its core business; instead, it added new products and services--such as eyeglasses and coffee shops--in its existing stores.

"We knew we were a supermarket and only invested in things that we could prove our customers really wanted," said Lord Ian McLaurin, who is now chairman of Tesco.

Over the last decade, Tesco's stock price grew 291%, while Sainsbury's stock only grew by 38%.

Zook writes that another factor to consider in analyzing growth initiatives is whether new lines of business are concentrated in profit pools--areas in the industry that generate the highest profits. Sometimes new profit pools can be created by going up-market, as when Starbucks (nasdaq: SBUX ) introduced premium-priced coffees. Most of the time, however, profit pools are created by sharply lowering costs.

Five out of 12 company pairs analyzed by Zook were influenced by the correlation of their new business lines to profit pools. This was apparent in Zook's study of two drug different drug wholesalers: Cardinal Health (nyse: CAH - news - people ) and McKesson (nyse: MCK ).

Cardinal grew by buying businesses that were in services which helped Cardinal's clients or vendors manage pharmacies or help package drugs. In this way, Cardinal created profit pools for itself, by helping its suppliers cut costs. Its main rival, McKesson, acquired a health care software business, HBO & Co., which was disastrous.

Cardinal's stock price grew at an annual rate of 30% over the decade ending in 2001, and McKesson by only 7%.

Zook also claims that in order to be a winner, a company must be willing and able to match the investments made by the leaders in its industries. This, writes Zook, is why Walgreen (nyse: WAG) and Eckerd Drugs had very different outcomes at the end of a decade.

Eckerd grew faster than Walgreen but spread itself too thin nationally and lost it leadership position in regional markets. Walgreen grew more organically and achieved high market shares regionally. Walgreen's high local-market shares resulted in higher returns on investment than its competitors. Eckerd was purchased by J.C. Penney (nyse: JCP) in 1997; Walgreen continues to be a strong performer.

The table below lists five of the 12 pairs of companies analyzed by Zook, in which he feels that the fast value creator (first set of companies) is still on the correct growth track for investors.

Different Growth Strategies Can Drastically Affect Stock Performance
Company	Industry	Price	Estimated EPS Growth*	Historic Earnings Growth**	Historic Stock Growth***
Fast Growers
Nike (nyse: NKE )	Athletic footwear and apparel	$70.73	14%	8%	21%
Cardinal Health (nyse: CAH )	Medical distributors	64.12	16	43	30
Walgreen (nyse: WAG )	Drugstore chain	33.75	15	16	27
Tesco (otc: TSCDY )	Grocery store chain	13.65	13	10	13
Jacobs Engineering Group (nyse: JEC )	Engineering and construction	44.05	15	18	19
Slow Growers
Reebok International (nyse: RBK)	Athletic footwear and apparel	38.49	15	-5	3
McKesson (nyse: MCK)	Medical distributors	28.99	16	14	7
Eckerd****	Drugstore chain	NA	NA	NA	NA
Sainsbury (otc: JSNSY)	Grocery store chain	21.55	6	-1	3
Fluor (nyse: FLR)	Engineering and construction	40.73	13	NA	NA

Apple well poised in Living Room 2005 battlefield

Bertrand Russell once said—and I'm paraphrasing here—that genius is to present a problem in a way which allows a solution. And that's exactly what is needed in Apple's current situation, which is both highly encouraging and somewhat preoccupying in terms of midterm perspective.

Phenomenal as it may be, the success of the iPod will not suffice on its own to pull Apple out of the "über-stylish, niche innovator" role the industry has typecast the company in. It is also quite clear that the Macintosh platform on its own will not be able to grow significantly if it continues its course at the current rhythm of market penetration.

Sure, iPods may drive iMac sales, and growing concerns about security also may erode confidence in the Windows platform, but the chances for the Macintosh to go from current levels of market penetration to double-digit numbers remain fairly slim.

In terms of technology development, on the other hand, genius is about seeing beyond the obvious, and about anticipating constructive disruptions in the making. In short, it is about coming up with an idea or a product that nobody has thought of, but which has the potential to "click" with a majority of people.

These days, the key area of interest for Apple is boringly commonplace, yet it is supremely challenging. I am of course alluding to the most coveted spot of consumer technology today, what one might call "The Great Living-Room Conundrum": the convergence of digital media with lifestyle and entertainment. The company that ends up dominating this space will be very enviable indeed.

Yet Apple may have a better chance than others at cracking the way in which entertainment, the Internet and computing come together. There's one simple reason: Unlike most other players in this field, Apple is not fueled by technology, but it is clearly vision-driven.

The company owes its biggest successes to the capacity of spotting an emerging need and then delivering a superior product to cover it. (And conversely, Apple's failures often can be traced back to its incapacity to act like the "normal" technology provider.)

In particular, Apple manages to succeed in one area where most technology-centric companies (and Microsoft in particular) almost systematically fail: in making products desirable.

Logical reasoning may govern mainstream PC purchases, but truly remarkable successes in the market are founded on objects so desirable that they defy reasoning. Sure, the Ipod is pricey, but millions of consumers want one anyway.

The keys to cracking the "living-room conundrum"

The mistake many technology companies make when it comes to product strategies is that they attack the problem from the technology side. This does not work in the consumer market, because Joe and Jane Average don't buy technology. They are generally not interested in technology for its own sake, nor do they want to find out more about it.

Truly successful products do not start from the technology, but from the problem they want to solve. Take the iPod: Apple did not set out to sell an MP3 player. Apple convinced the market that the iPod was a cool, convenient way of listening to music.

So, here are Apple's core issues in conquering the living room:

1) Find the magic formula. The problem with the living-room conundrum is that all of the ingredients are pretty well-known; it's the magic formula that will make them work together in a harmonious, easy way that is the problem.

We know that television, personal computing and digital media are converging, and it's also quite clear that wireless networking and broadband Internet access will play a crucial role. What we haven't figured out is which combination of these features will have the capacity to support the emergence of widespread new usage patterns in the mainstream consumer space.

2) Take it one step at a time. It is likely that it will take many iterations and mistakes to edge toward true integration of all of these elements. One of the biggest mistakes companies can make in this space is trying to go too fast: The main problem with current attempts such as Media Center PCs is that they try to do far too much at the same time.

3) Overcome the iPod. The first thing Apple has to do right now is to surpass the iPod. Build on its strengths—yes, by all means—and expand it as far as it can go, but go well beyond it. While it lasts, a mega-craze like the iPod is a wonderful thing. Once it has peaked, it becomes a significant burden to overcome. Coco Chanel used to say: Fashion is what becomes unfashionable. It will happen to the iPod eventually.

4) Continue to surprise. In order to survive the iPod craze, Apple needs to do more than expand: It needs to surprise. And it needs to do this more than ever before. From a market perspective, all Apple needs now is another successful consumer product. On the grander scale of things, Apple not only needs to find one more consumer success—but also one it can tie into its overall vision of the digital home. And that's where it becomes tough.

The Niche Approach

What are Apple's assets in this battle? So far, the company has a rock-solid position in the music market; it has a credible offering in wireless networking, and it has the iMac, which begs to be considered as the ideal home computer.

But Apple knows very well that it's too early to sell the iMac as the digital hub for the home to a mass-market audience, and being too early is as bad as being too late.

Even worse, Apple has no footing in the gaming market. As for video, consumer usage patterns for viewing video are far too fragmented to allow for a single device to become an iPod-like success in the near future.

Yet Apple clearly has understood one important (though often overlooked) lesson: True revolutions start at the fringe, not at the center. Before becoming a vast consumer hit, the iPod was the perfect stylish, niche product.

Since Apple has no chance at the Microsoft-style "we've got the money, let's just do it" juggernaut technique of product marketing, it has to go for the smart, viral marketing approach.

Whatever comes next from Apple will probably resemble the iPod in terms of approach rather than in terms of product. There is one additional problem, though: Any future foray into the consumer space needs to be sufficiently close to Apple's core business to avoid alienating the extremely loyal Macintosh user base.

So, to get back at our initial question: Yes, Apple could well crack the living-room conundrum. But don't expect Steve Jobs to do it in a predictable way ...