Reference no: EM132108415
The second fundamental task of a general manager is to lay the groundwork for long-term growth by creating new ways of doing business, since the value of existing business models fades as competition and technological progress erode their profit potential. RBM acquisitions help managers tackle that task.
Investors’ expectations give executives a strong incentive to embrace the work of reinvention. As Alfred Rappaport and Michael Mauboussin point out in their book Expectations Investing (Harvard Business Review Press, 2003), managers quickly learn that it is not earnings growth per se that determines growth in their company’s share price—it’s growth relative to investors’ expectations. A firm’s share price represents myriad pieces of information about its predicted performance, synthesized into a single number and discounted into its present value. If managers grow cash flows at the rate the market expects, the firm’s share price will grow only at its cost of capital, because those expectations have already been factored into its current share price. To persistently create shareholder value at a greater rate, managers must do something that investors haven’t already taken into account—and they must do it again and again.
Acquiring a disruptive business model.
The most reliable sources of unexpected growth in revenues and margins are disruptive products and business models. Disruptive companies are those whose initial products are simpler and more affordable than the established players’ offerings. They secure their foothold in the low end of the market and then move to higher-performance, higher-margin products, market tier by market tier. Although investment analysts can see a company’s potential in the market tier where it’s currently positioned, they fail to foresee how a disruptor will move upmarket as its offerings improve. So they persistently underestimate the growth potential of disruptive companies.
To understand how that works, consider Nucor, an operator of steel minimills, which back in the 1970s developed a radically simpler and less costly way to make steel than the big integrated steel-makers of the day. Initially, Nucor made only concrete reinforcing bar (rebar), the simplest and lowest-margin of all steel products. Analysts valued Nucor according to the size of the rebar market and the profits Nucor could earn in it. But the pursuit of profit drove Nucor to develop further capabilities, and as it invaded subsequent product tiers, commanding higher and higher margins from its low-cost manufacturing technique, analysts kept having to revisit their estimates of the company’s addressable market—and hence its growth.
As a result, Nucor’s share price fairly exploded, as the exhibit “Why Disruptive Businesses Are Worth So Much” demonstrates. From 1983 to 1994, Nucor’s stock appreciated at a 27% compounded annual rate, as analysts continually realized that they had underestimated the markets the company could address. By 1994, Nucor was in the top market tier, and analysts caught up with its growth potential. Even though sales continued to increase handsomely, that accurate understanding, or “discountability,” caused Nucor’s share price to level off. If executives had wanted the company’s share price to keep appreciating at rates in excess of analysts’ expectations, they would have had to continue to create or acquire disruptive businesses.
A company that acquires a disruptive business model can achieve spectacular results. Take, for example, information technology giant EMC’s acquisition of VMware, whose software enabled IT departments to run multiple “virtual servers” on a single machine, replacing server vendors’ pricey hardware solution with a lower-cost software one. Although this offering was disruptive to server vendors, it was complementary to EMC, giving the storage hardware vendor greater reach into its customers’ data rooms. When EMC acquired VMware, for $635 million in cash, VMware’s revenues were just $218 million. With a disruptive wind at its back, VMware’s growth exploded: Annual revenues reached $2.6 billion in 2010. Currently, EMC’s stake in VMware is worth more than $28 billion, a stunning 44-fold increase of its initial investment.
Johnson & Johnson’s Medical Devices & Diagnostics division provides another example of how reinventing a business model through acquisition can boost growth from average to exceptional. From 1992 through 2001, the division’s portfolio of products performed adequately, growing revenues at an annual rate of 3%. But during the same period, the division acquired four small but disruptive business models that ignited outsize growth. Together these RBM acquisitions grew 41% annually over this period, fundamentally changing the division’s growth trajectory. (See the sidebar “ Can This Acquisition Change Your Company’s Growth Trajectory?”)
Why do you think reinventing your business model would have bearing from a strategy standpoint? Think of a company or two that this strategy makes sense for. Make your case.