Wednesday, April 04, 2007

Growing Your Way to a Flawed Strategy

In 2001, Carol Loomis wrote an article for Fortune magazine, which was titled "The 15% Delusion." She described the dangers that companies encounter when their CEOs publicly proclaim aggressive growth targets. In particular, she pointed that many companies set a goal of 15% growth in earnings per share, yet few large firms can sustain this rate of growth over a lengthy period of time. She cited several studies to support this conclusion. Growing earning at 15% per year means that a firm is doubling its earnings every five years. That type of growth becomes very difficult as a company becomes quite large.

Companies continue to set such targets though, and they continue to get themselves in trouble pursuing the ever-elusive 15% growth year after year. Some executives undoubtedly will disappoint Wall Street when they fail to meet these targets. A few might cross the ethical line trying to avoid public acknowledgement of missed earnings goals. The larger problem, however, is that many firms will undermine a once quite effective competitive strategy in search of rapid growth. They often undermine their strategy by expanding their product and service offerings in an undisciplined manner. They begin trying to be all things to all people, instead of focusing intently on a particular segment of consumers. In short, many companies simply grow themselves into a troubled strategy.

In a 1996 Harvard Business Review article, Michael Porter argued that "the essence of strategy is choosing what not to do." In other words, creating a distinctive strategy is all about making good tradeoffs. Southwest Airlines, for instance, does not offer first class seating, nice meals, and assigned seats. By refusing to offer such services to customers, they have created a unique low-cost position in a very tough industry. Southwest isn't for everyone. That's ok. They don't try to cater to all flyers.

As many companies get large, and try to sustain 15%+ growth, they begin violating the tradeoffs that made them unique and great. That leads them into trouble. Porter called this the "growth trap." Do we have some examples recently? One might be The Home Depot. When Bob Nardelli took over, the company generated $45 billion in annual revenue. He spoke boldly of more than doubling revenue in five years, to achieve $100 billion in sales. That translates into roughly 15% growth per year. You see the trouble. 15% growth at a company of that size means adding more than $50 billion in revenue in 5 years - a breathtaking pace. It had taken the company more than 20 years to grow to $45 billion sales. Now, they wanted to generate that same amount of new revenue in less than 1/4 of the time. Five years later, of course, Nardelli was pushed out at The Home Depot, and many investors want new CEO Frank Blake to fundamentally re-think the strategy. Under Nardelli, the company had expanded aggressively into businesses catering to professional contractors. The firm began as a company totally focused on the do-it-yourselfer. By 2006, it had become a firm trying to cater very different kinds of customers, ranging from the buy-it-yourselfer who wanted someone else to do the work to the professional contractor who wanted to buy in bulk. Those very different customers had very different needs. It operated multiple businesses ranging from EXPO Design to Home Depot Supply. Through it all, the original "orange box" could not keep up with the same-store sales growth generated by Lowe's - a much more focused competitor.

Are there other companies today in danger because of the "15% delusion" described by Loomis? One company to watch is Starbucks. In their last Annual Report, they set out goals of achieving 20% sales growth per year and 20-25% earnings growth per year over the next 3-5 years. 25% earnings growth means doubling net income every 3 years! Can they do it? Perhaps. It has been a remarkable company. However, Starbucks is now a Fortune 500 firm. It generated nearly $8 billion in revenue last year. Sustaining such rapid growth, without undermining its distinctive competitive positioning, will be a challenge. Investors recognize this, which is why so much was made of founder Howard Schultz's recent letter to senior managers. In that letter, he warned of the possible "watering down" of the Starbucks brand and experience. He speaks, for instance, of the loss of the coffee aroma in the stores. I notice this now that Starbucks offers breakfast sandwiches... the shops don't smell like coffee any more; they smell like eggs. It's not the same experience. As Starbucks continues to try to grow aggressively, one wonders if they will violate many of the tradeoffs that made them so distinctive. What exactly will Starbucks not do these days? Are they trying to be all things to all people? Will they be more like Southwest Airlines or The Home Depot five years from now?