Navigating the Growth Maze: Challenges & Lessons in Revenue Expansion

A company's value stems from two fundamental variables: its ability to earn a healthy Return on Invested Capital (ROIC) and its ability to grow its earnings, i.e. (NOPAT–Net Operating Profit After Tax). It’s the healthy rate of return & earnings growth that produces future cash flows for the firm which is the ultimate source of value.

This article will primarily focus on earnings growth & how it contributes to the value of a firm. Contrary to common perception not all growth creates value.

Growth creates value only when a company's growth (from new customers, projects, or acquisitions) generates returns that are greater than its cost of capital.

To understand the significance of growth & survival of a firm note that over the last 25 years, most of the companies that have disappeared from the S&P 500 have either been acquired or went private. A vast majority of them were the ones that were struggling to grow!

Growth v Return: Where to Focus

Many companies & leaders struggle to prioritize between growth & profitability because they do not have fundamental clarity which will contribute more to the value of the firm. Company data across multiple industries suggest that:

• For firms with a high ROIC, shareholder returns are affected more by growth in revenues than by further increases in ROIC. If such firms let their returns drop a bit to achieve higher growth, their shareholder's returns will be greater than firms that maintain or improve their already high returns but grow more slowly.
• For firms with a low ROIC increasing ROIC will create more value than growing the company.

It's critical for managers to understand that not all growth is equal or generates equal value for the firm. Hence, they need to clearly decipher which growth opportunities will create the most value for their firms.

Drivers of Revenue Growth:

Revenue growth has 3 main components:

1. Portfolio momentum: The organic revenue growth a firm enjoys because of overall expansion in its market segment.
2. Market share performance: The organic revenue growth or reduction a firm earns by gaining or losing share in any particular market.
3. M&A: The inorganic growth a company achieves when it buys or sells revenues through acquisitions or divestments

The most important source of growth by far comes from portfolio momentum i.e. being in fast-growing markets is the largest driver of growth. The least important growth is the market share growth. Yet we find that managers tend to focus most of their attention on gaining a share in their existing product markets. Firms & businesses that benefit from network effect or increasing returns from scale are exceptions.

?Variation in Revenue Growth by Industry

The exhibit below displays the widely varied range of revenue growth within the industry. It also shows the yawning gap in revenue growth between top-performing firms & bottom ones within the same industry. Over the last decade (2008 to 2017) the fastest-growing sector was Biotech, followed by Pharma, Airlines, Information Services & software, Healthcare equipments, and Telecomm.

If a company's growth depends mainly on the dynamics of the sector in which it operates, why should there be such a big difference in intra-sector growth among different companies??

The main reason is that the median growth rate of companies in any sector masks big differences in growth across the sector's market segments and sub-segments. It makes sense to look at market growth at the level of individual product & geographical segments rather than at the firm, division, or BU level.

Revenue Growth and Value Creation

While managers typically strive for high growth, the highest growth does not necessarily create the most value. The reason is that the drivers of growth mentioned above do not all create value in equal measure. To understand why not, consider who loses under the alternative scenarios for revenue growth & how effectively losers can retaliate in each situation.

• Growth from increases in market share, particularly in slow & moderate growth markets rarely creates much value for long because competitors typically retaliate to protect their market share. Lasting value creation could only occur in situations where smaller competitors are pushed out of the market entirely or when a company introduces differentiated products or services that are hard to copy.
• Growth driven by price increases comes at the expense of customers, who are likely to react by reducing consumption or seeking substitute products so new value created by price increases may not last long.
• Growth driven by general market expansion comes at the expense of companies & other industries that may not even know to whom they are losing market share. This category of victim is the least likely to be able to retaliate & hence product market growth unlikely to create the most value

A Hierarchy of Growth Scenarios

It's possible to rank different growth scenarios that fall within the three overall growth strategies according to their potential for creating value. Refer to the exhibit below, this ranking may not be exactly the same for all industries but it works well as a starting point.

The scenarios with the highest potential to create value are all variations on entering fast-growing product markets that take revenues from distant companies, rather than from direct competitors or customers via price increases.

Developing new products or services that are so innovative as to create entirely new product categories has the highest value-creating potential, the stronger the competitive advantage your company can establish in the new product category the higher will be the ROIC and the value created. For example: The coronary stent commercialized in the 1990s reduced the need for heart surgery. This innovation had an overwhelming competitive advantage over traditional treatments & competitors could not retaliate easily thus creating a large amount of value.

?Next, in the pecking order on value-creation comes from persuading existing customers to buy more of a product or related products. Exp: P&G convinced customers to wash their hands more frequently during COVID-19, the market for hand soap grew faster & direct competitors did not respond because they benefited as well.

Attracting new customers to a market also can create substantial value for firms. Exp: Consumer packaged goods company Beiersdorf Accelerated growth in the sales of skin care products by convincing men to use Nivea products. Competitors didn't retaliate because they also gained from category expansion.

Value a company can create from increasing market share depends on both the market’s rate of growth and the way the company goes about gaining share. The 3 main ways to grow market share:

• ?Gains market share in a fast-growing market?- as the absolute revenue of competitors may still grow strongly too so they may not retaliate. However, gaining a share in a mature market is more likely to provoke retaliation by competitors.
• Gaining share from incremental innovation: Incremental technology improvements that neither fundamentally change our product nor create an entirely new category that is possible to copy- won't create much value or maintain advantage for long. Exp: Hybrid vehicles aren't fundamentally different from gas or diesel so they cannot command much of a price premium to offset higher costs.
• Gaining share through product pricing and promotion?in a mature market rarely creates much value. As Amazon continued expanding in the US consumer electronics retail market in 2008 Walmart reduced prices on key products such as stop selling video games and game consoles, even though Amazon's dollar 20 billion in sales in 2008 was a fraction of Walmart’s 406 billion in sales. Walmart's competitive reaction could not stop Amazon from surpassing Walmart as the largest electronic retailer by 2014 it drove down margins across segment

Choosing a Growth Strategy:

Growth from product market expansion creates greater and more sustainable value than growth from taking a share in a competitive market. Walmart’s innovative approach to retailing in the 1960s & 1970s offered an entirely new shopping experience to its customers who flocked to the company's stores. While mar Walmart was merely taking away customers from small local stores, the fact that its competitors could not retaliate implies Walmart’s approach constituted a truly innovative product. However, if Walmart were to grow by winning customers from Target that would count as market share gain because Target and Walmart offer their retailing products in a similar fashion. The lesson is companies should aim to be in the fastest-growing product market segments.

Why Sustaining Growth is Hard

Sustaining high growth is much more difficult than sustaining a return on invested capital. Sustaining growth is difficult because most product markets have a natural life cycle. The market for a product, which means the market for a narrow product category sold to a specific customer segment in a specific geography typically follows an S curve over its lifecycle until maturity.

The image below shows the growth curve for various real products, scaled to their relative penetration of US households. Some products like autos, & packaged snacks have grown in line with economic growth for half a century while VCRs lasted less than 2 decades & then disappeared. While the pattern of growth is usually the same for every product, the amount & pace of growth varies for each.

Given the natural life cycle of products, the only way to achieve consistently high growth is to consistently find new product markets and enter them successfully in time to enjoy the most profitable growth phase. This is very difficult finding a sizable new source of growth requires more experimentation and a longer time horizon than many companies are willing to invest. For example: Philip's health technology business was a small corporate division in 1998 when are generated around 7% of the total company's revenue it took 15 years of ongoing investment and acquisition to become Philip’s largest business unit generating half of its revenue.

Empirical Analysis of Corporate Growth

• The median rate of revenue growth between 1965 and 2017 was 4.7% in real inflation-adjusted terms
• High growth rates decay very quickly, firms growing faster than 20% in real terms typically grew at only 8% within 5 years & at 5% within 10 years.
• Real Revenue growth of 4.9% is quite high when compared with real GDP growth rate in US which was 3% during the same period (1965-2017).

As we see above, growth rates vary widely across sectors. Unlike ROIC where the industry ranking tends to be stable, the industry revenue growth ranking varies significantly over time. Some of the variations are explained by structural factors such as saturation of the market, the declining growth in hotels and restaurants, & chemicals or the effect of technological innovation in creating entirely new markets for biotech and Information Services, in other cases growth is more cyclical like oil and gas sector.

The Curse of Revenue Decay

McKinsey's research analyzed historical rates of revenue growth decay since 1963, companies were segregated into 5 groups (quintiles), the plots below (left) captures how median revenue progressed for each category over 15 year period. As we see revenue growth decays very quickly; high growth is not sustainable for the typical company

Within 3 years the difference across portfolios narrows considerably, & by Year 5, the highest-growth portfolio outperforms the lowest-growth portfolio by less than 5 percentage points. Within 10 years this difference drops to less than 2 percentage points. Comparing the decay of growth to that of ROIC (right), we see that companies' rates of return on invested capital generally remain fairly stable over time & top companies outperform bottom companies by more than 10 percentage points even after 15 years, such consistent advantage is generally not applicable for rates of growth.

Companies struggle to maintain a high growth rate because product life cycles are finite & growing becomes more difficult as a company gets bigger. Very few companies counter this norm. The exhibit below captures the Revenue Growth Transition across 4 categories: Low (<5%); Moderate (5-10%); Good (10-15%); Excellent (>15%).

The Vast majority (68%) of the companies that started with low (<5%) revenue growth continued to report low revenue growth even after 10 years. By contrast only 1 in 5 (21%) of high-growth (>15%) firms could maintain that level of growth a decade later. But even for high-growth companies, a big majority (58%) had their growth plummet to low (<5%) a decade later.

Conclusion

Achieving & sustaining revenue growth poses a formidable challenge for most businesses, as products inevitably follow a natural lifecycle. The trajectory of a firm's long-term revenue growth is predominantly shaped by the growth of the markets in which it operates. While leaders & managers concentrate their focus on gaining market share to bolster growth, studies show that such gains prove to be less enduring. Also, revenue growth across industries experiences a more rapid decay compared to their returns on invested capital (ROIC).

Lesson for leaders & managers: As the exhibit below shows the key to ensuring sustained revenue growth lies in establishing industry leadership. There is a vast difference in revenue growth among the 4 categories of firms. Those in the 1st quartile (bottom 25%) witnessed a decline from positive 5%?revenue growth to revenue loss (-5%).

Firms in the 2nd quartile also experienced a decline with their revenue growth falling from 7 to 8% to near stagnation (2%). The picture begins to change when we move to the category leaders. Firms in 3rd quartile managed to sustain their revenue growth of around 15%. Note that being an industry leader also helps if we look at the ROIC. For example, the gap in returns between the top & bottom five firms in biotech is enormous, the top 5 Biotech firms have a whopping 287%? return vs a loss of 78% for the bottom 5 firms. In the software industry, the top 5 firms returned at 140% vs a 46% loss for the bottom 5.

Firms at the pinnacle of their respective industries demonstrated resilience against revenue decay, underscoring the significance of being the market leader. Industry data for last 50 years shows that being the top performer in your industry serves as the most effective antidote to revenue decay.