The Dangers of Product-Driven Success: What’s the Next Growth Act?

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The Dangers of Product-Driven Success: What’s the Next Growth Act?

Adrain Slywotzky and Richard Wise are vice presidents of Mercer Management Consulting

When we discuss growth problems with managers, investment analysts, fund managers, and others, they frequently hold out a favorite industry or handful of companies as being exceptions. The common refrain is that this particular sector or company has posted consistent growth and has bright prospects for strong demand and further growth.

There is a kernel of truth to many of these proposed exceptions. They may be healthy companies with seemingly strong revenue growth. Often, these companies or industries are blessed with high degrees of technological innovation creating seemingly boundless opportunities to sell lots of new products. That’s why investors flock to them.

And that can be a most dangerous situation. Time after time, managers at successful companies become complacent about the amount of growth left in their current strategy and underestimate the long-term importance of building more customer-centric businesses. They are unprepared to address the next generation of growth. If they do come to recognize the danger, it is often too late to regain their advantage.

In our consulting work and research, we have observed three patterns in which successful product-oriented companies can fall into growth crises:

• Becoming a high-technology "bottle rocket." Some companies are propelled to success by a breakout technical innovation. Heady growth follows. But success is typically short-lived, as the product or service is copied by tenacious competitors or surpassed by the next wave of innovation within a couple of years. The company's performance deteriorates, and the stock plummets as quickly as it rose.
• Failing to manage a shift in investor expectations. Another group of companies performs well for an extended period. Investors project a straight line into the future, according high multiples to these stocks. Eventually, signs emerge that the true growth potential of these companies is far lower than expectations as market dynamics being to change. The result is deflating market value as investors dump the stocks. The pharmaceuticals industry, for example, has had two decades of strong growth but is now seeing the "blockbuster" drug innovation model begin to run out of steam.
• Failing to anticipate the end of the growth runway. Some companies such as Wal-Mart, Dell, and Southwest Airlines have reaped decades of growth from an outstanding business design. But all good things come to an end. When a company's business design is flush, it's very easy to become content, bask in glory, and focus on incremental improvements. The challenge is to anticipate when the current strategy will falter and to invest in next-generation growth while there is still adequate time and resources.

Fortunately, most established companies possess the means to renew growth through the gold mine of hidden assets that are naturally generated as a byproduct of a company’s core business. When skillfully deployed, these assets enable a company to deliver an array of related offerings, with unusually high margins, that benefit the customer in ways beyond the functionality of the core product itself.

Hidden assets that can be exploited range from a large installed base (Boeing’s 13,000 commercial jetliners in the air) to technical know-how (IBM is a leading expert on the implementation of SAP software) to a user community that shares information and experiences (Harley-Davidson’s motorcycle enthusiasts). Once created, hidden assets can usually be applied, reused, and extended at little or no cost. And these assets can enable offerings that strengthen the core business that has spawned them.

For example, an industrial products company might help customers improve their operating efficiency by offering maintenance support, remote monitoring, bundled products, or complete operations outsourcing. It might help customers reduce their risk, by offering insurance coverage or performance or output guarantees. In consumer markets, companies can improve the ease and efficiency with which products and services are purchased and consumed – what might be called “time-and-hassle economics.”

Hidden-asset thinking can enhance a strong product position and prepare you in advance for harder times down the road. It can close an investor expectations gap and can uncover new growth moves to build on today’s success. Now, let’s look at these three patterns in detail.

The Trouble with Technology

While technological innovation will be a source of growth for some companies and is clearly a major contributor to macroeconomic growth, relying on innovation as a source of revenue growth is a highly risky proposition.

The vast majority of companies founded on technological innovation fail to get off the ground. Think of Iridium’s satellite phone venture or Sprint’s ION enterprise-wide communications platform.

A tiny portion of high-tech launches do lead to wide product sales and some even earn profits. But for even the big winners in technology, product-driven success has typically been brutally short. Most experience three to four years of spectacular growth and stellar financial performance followed by equally spectacular declines in revenues, profits, and then collapse of the stock.

We analyzed the stock market performance of successive technology leaders over the past two decades. We tracked the time elapsed from the day the stock achieved 50 percent of its peak value, then reached its peak, and then lost 50 percent of its peak. As shown in Figure 1, in every case, the bottle rocket pattern lasted less than five years.

Each company’s stock circuit correlated with the saturation of its product market, attacks by competitors, or a shift in customer priorities that left it vulnerable. DEC failed to anticipate the shift away from proprietary minicomputer systems to distributed networks and PCs. Palm has had difficulty capitalizing on the success of its personal organizer as strong competitors such as Handspring and RIM entered the market. In each case, revenue growth faltered and then declined, bringing market value down with it.

Relying on product technology innovation – betting on your ability to develop a better mousetrap – turns out to be a dramatically unstable business. A few high-tech companies, however, have managed to achieve sustained growth and strong market positions. What these companies have in common is that they have leveraged their hidden assets to profitably address higher-order customer needs and deliver value beyond the next wave of products.

Applied Materials: The Economics of Making Chips

One interesting example is Applied Materials of Santa Clara, CA, which is shifting its focus from producing individual pieces of manufacturing equipment to delivering integrated manufacturing solutions to its customers.

For microchip makers who have to spend billions of dollars to build a fabrication plant, there are two key concerns: First, reduce the time it takes to build the plant, start production, and work out the bugs. And second, increase the production yield of high-quality chips during the short lifespan of each generation of chips. Applied Materials has found opportunities in this market by improving on the customer’s overall fabrication efficiency rather than on the performance of any one piece of equipment.

While no supplier is yet capable of providing all the tools needed to create a state-of-the-art fabrication system, Applied Materials comes close. It has expanded from making tools for one stage to serving 13 stages and is now the leading company in most of its product markets. Applied Materials clusters its offerings into process modules – integrated sets of equipment that work together as a highly automated unit.

In an industry where product lifecycles are very short, Applied Materials’ integrated system is carefully tuned to helping the customer improve its overall economics. The company helps to improve the efficiency of production lines and ancillary operations. By deploying integrated process modules, Applied’s customers can decrease the time it takes them to ramp up production and can increase the yield and throughput of their factories.

Applied Materials guarantees quality levels for the output of a process module including electrical performance, defect levels, thickness of films, and throughput. To increase further the value it delivers to customers, the company now offers integrated service, where it owns and manages all the spare parts required for equipment at customer sites and helps with the hook-up phase of installation. This reduces set-up time and headaches for the customer.

To make this new offering work, Applied Materials leaned on a critical hidden asset: the insight gained from designing and installing equipment in hundreds of factories around the world and interacting with customers across the value chain. This gave Applied Materials the knowledge it needed to build integrated solutions.

As a result, Applied Materials has posted superior financial results relative to its competitors. Revenue has shown a 24 percent CAGR from 1990 through fiscal 2002, while EBIT growth was 14 percent over the same period. The company's stock market valuation, meanwhile, showed a 40 percent CAGR during that period.

Like Applied Materials, high-tech companies hoping to achieve sustained revenue and market-value growth should consider expanding their business from a product-centric focus to more diversified offerings that meet customers’ higher-order needs, stabilize the business, and generate more sustainable growth. Promising moves include services and support around the product lifecycle, bundled product/service solutions, subscription services and annuity revenue streams, and acting as a switchboard to connect customers with disparate suppliers.

Profit Zones in Pharmaceuticals: The Expectations Challenge

In the pharmaceuticals industry, companies and investors have for many years cultivated faith in the power of the blockbuster model – a reliance on drugs that generate more than $1 billion in global sales – as the primary means of driving growth in revenue and profits. For the past two decades, pharmaceutical manufacturers demonstrated a consistent ability to bring new drugs to market and find new customers, as worldwide sales for U.S. manufacturers grew from a 1980 base of roughly $22 billion to $149 billion in 2000 – a 10 percent annual growth rate.

Investors continue to have great expectations for the future, with valuation multiples for the industry still at high levels (Figure 2). Industry executives are feeling the pressure of these expectations, as revenue and earnings growth of 15 percent or even 20 percent is seen as merely meeting targets.

A closer analysis suggests that these high expectations are out of line with the realities of and risks to industry performance. Let’s start with the many cracks weakening the blockbuster model. The drug companies have been consolidating and are now much larger than they were five or 10 years ago. So to meet current expectations for growth through the blockbuster model, they would need to introduce new blockbuster drugs at a far higher rate than they have typically done in the past, given their larger revenue base. For the average drug firm to meet an 18 percent growth target, it would need to introduce between one and three new blockbuster drugs per year for the next five years. However, over that period, the entire industry is expected to introduce just 20 new blockbusters.

Any revenues from a new drug, moreover, must be offset by the sharply rising cost of drug discovery and development: A Tufts University study estimated that the inflation-adjusted cost was about $802 million in 2001, roughly two and a half times what it cost in 1987. At the same time, the potential target markets for new drugs are becoming smaller or saturated. Drug makers once could target large markets such as depression or cholesterol, which supported more than one blockbuster. Today, the number of remaining large markets has declined, reducing the potential for any given manufacturer to earn high rates of return on its entire portfolio of drugs in the R&D pipeline.

At the same time, an array of broader health care issues has emerged to which companies must respond. For example, many older patients are having trouble taking so many different prescriptions, so frequently. Some companies are working to limit the number of individual therapies a patient must administer; others are trying to extend the time between dosages to as long as a month.

But improving the properties of particular products is only a start. Pharmaceutical companies will also need to gain a deeper understanding of their customers’ entire economics. Development teams will have to consider how a new drug fits into the patient’s existing therapeutic regimen. For existing therapies that address chronic conditions, marketing teams will need to shift their focus from creating awareness to ensuring ongoing compliance. Moreover, none of these issues will be addressed effectively by considering consumers as a single group. Segmenting customers according to their medical needs and other priorities will increasingly be a key capability for drug firms.

Southwest Airlines: When Is the Beginning of the End?

The most difficult time to think about future growth is when you’re flying high. When customers are buying your product or service faster than you can produce it, be worried about what they will want next. When investors are singing your praises the loudest, be thinking about your next act.

Southwest Airlines is a classic case of the challenge of anticipating the end of a growth strategy. Formed in 1971, Southwest has consistently outperformed its airline peers and built a stellar record. In every year but one from 1982 through 2000, Southwest achieved double-digit revenue growth. Core revenue, after stripping away the short-term incremental moves, has posted a strong 12.8 percent CAGR since 1995. And in an industry where carriers have been profitable for an average 1.5 years in a row, Southwest was the only airline to be profitable for 19 years consecutively.

The company has achieved this superb record in part by crafting and focusing narrowly on a differentiated value proposition targeted mostly to leisure travelers. Southwest emphasizes convenience, relying on smaller, less congested airports than its competitors, offering relatively shorter flights, and dispensing with physical tickets. It also offers lower prices than its competitors. But it does so while maintaining an upbeat spirit for both the passengers and crew, which holds appeal for customers.

The operating strategy delivers on this unique customer promise. Southwest focuses primarily on short flights at airports in smaller metro areas or secondary airports in large metro markets. This allows Southwest to fly more sorties per day, improve turnaround time, and pay lower slotting fees relative to those at large airports. It uses just one type of plane to cut down on maintenance and training and to maximize equipment flexibility. And it works hard to fill seats on each plane; capacity utilization rose by roughly 2 percent per year from 1995 through 2000, largely through stimulating new demand in the markets Southwest serves.

What’s not clear is how much growth remains in the current way of doing business. Questions can be raised about the growth potential of the current strategy.

Is there enough capacity at secondary U.S. airports to allow Southwest to continue adding new markets? Over the past five years, Southwest has averaged 10 percent annual revenue growth by adding two new airports per year to reach its current nationwide total of 59. However, there are only seven mid-size airports remaining that Southwest does not serve. So at the rate of two additional airports per year, and assuming a goal of 10 percent revenue growth, Southwest has three years of growth remaining through this move.

Are there any viable, traditional routes to new growth that Southwest has yet to try? Attacking the major airlines in their primary hubs might improve Southwest’s access to some markets and lure new customer segments, but it would potentially create operational problems such as slower turnaround times and higher costs, so this move is unlikely. International expansion also presents major obstacles, such as different equipment requirements, and is unlikely. The company has added more long-haul flights; ramping up this tactic would add new customers at potentially higher fares, but might eventually require a different fleet of planes and modified operating procedures. This move could yield one to two years of growth. And strategic acquisitions of WestJet, JetBlue, or other airlines with similar operating philosophies would provide the opportunity to quickly add additional routes, yielding an additional one to two years of growth.

Our analysis suggests that adding cities to the core business, plus making a set of traditional incremental moves, would give Southwest three to five years of double-digit growth. This would still put Southwest at or near the head of the airline class in terms of growth potential, and our analysis may be too pessimistic, but the company should not rest on its laurels. Growth could vary depending on how much Southwest can continue to gain share from the traditional carriers and pick up new classes of customers, such as business customers looking to cut costs, and whether competitors such as JetBlue make significant inroads on Southwest’s turf.

If its managers can act while the company is still flush, Southwest has valuable hidden assets that could be deployed to create new offerings on several fronts: travel offerings such as rental cars, boat cruises, or an air taxi service; fleet management in railroads or trucking; and sales of information on the characteristics and desires of leisure travelers.

The logical path forward for Southwest will contain a portfolio of traditional moves as well as a set of moves focused on higher-order customer needs. The challenge is to continue its history of excellent operations and customer-focused innovation, while at the same time preparing for the inevitable end of growth from the current strategy.

Paranoid Enough

Skepticism about the growth crisis is a natural reaction for managers and investors in healthy companies. However, even though they do not feel the heat of a crisis today, there are benefits to incorporating this new way of thinking into their plans and operations.

Indeed, successful companies that recognize the constraints of their current strategies are well positioned to develop and implement strategies that address next-generation demand. Their current success provides a relatively stable environment in which to analyze potential options. Their financial strength provides resources to invest in growth. Recognition of the problem before it becomes a crisis enables managers to make careful, thoughtful decisions in an organized fashion. They need to become paranoid enough in good times to think differently, shift direction, and generate the next wave of growth.

Adrian Slywotzky and Richard Wise are both based in Boston. Their new book, How to Grow When Markets Don’t, was published in April by Warner Business Books. For more information on new-growth initiatives, visit www.DemandInnovation.com.