Warning – its an academic paper, but get it here. And .. it’s another finding based on answering the wrong question. It’s entirely possible that these divestitures decrease profitability, but increase growth in free cash flow, which is what investors actually value, because the firms immediately start spending to exploit growth opportunities that will deliver future cash flows whilst holding down short-term profitability. It is even probable that the divested core business was making OK returns [ROIC] because it was mature and [a] didn’t justify any spending on growth and [b] could be sold at a good price in a consolidating industry.

Nevertheless, it should give cause to think carefully before buying into a transformation. Remember, strategic transformations are very rare, and even more rarely successful.

The first is easily dealt with – stronger cash flow ‘growth’ than rivals can of course imply less decline when everyone is going backwards .. would you rather cash-flows fell by 50% or only 20%? We just need to add the check that this is sustainable – as I have argued with the Starbucks case, slashing costs to sustain immediate cash-flows [and support ROIC] is hardly welcome if it damages future cash flow.

I find the second response intriguing – that strategic management is all about survival, and anything extra management may achieve is just a welcome bonus. First, this does not seem to have been the primary concern of CEOs for most firms during reasonable economic conditions [at least after the high infant mortality of start-up!]. Maybe it should have been.

But there’s a bigger question as to whether survival should be the aim in any case. It is easy to see situations in which it would be in everyone’s interests for a firm not to survive, but to be acquired – both in positive and negative circumstances.

• In my time practising strategy, we constantly sought out promising smaller businesses to acquire and develop. This was good for their owners, who got good cash returns for their investment – good for customers, who got faster and wider access to the good products and services of those businesses – good for employees, who got more job and career opportunities – good for suppliers, who got a stronger, faster-growing  customer to supply – good for their management, who often had access to bigger jobs or else also left with a nice cash handout. Apart from competitors, I can’t think of any group who suffered. Indeed, many smaller businesses start up with the deliberate intent of being acquired in this way. For a big-scale example of a serial-acquiror who has exploited this phenomenon, it’s worth checking out Cisco – here’s an interview with their head of business development and just one case study on the story .. you will find a ton more case studies at European Case Clearing House.
• It’s not even clear that death necessarily does harm when it’s the final outcome of business failure. If death = acquisition by another company, investors can get value that would otherwise have disappeared, customers can get continued provision of products and services that may otherwise have discontinued, suppliers get a continuing sales opportunity, and employees get the chance of a continued job rather than redundancy.

Unfortunately, even when others would benefit hugely from a business being absorbed by another, one small group likely to suffer unfortunately dominates whether it happens or not – management themselves. So I find myself wondering how many firms are currently strugging to survive when it would be best if management spent their time seeking a buyer instead.

The only form of survival I can see that might be a reasonable aim for strategic management is the avoidance of bankruptcy – but that’s the extreme case, and responsible management should be able to find better solutions in almost all cases, well before that becomes unavoidable.

Perhaps my original post to them was not clear enough.  I meant to say that, as I understand it, investors are interested in the present value of future cash-flows – not growth per se. There is no point in simply growing market share or revenues if it does not ultimately improve future cash flows [the error that followed misuse of the growth-share notions from BCG in the 70s]. But as we speak, companies are understandably trying hard to maintain revenues In the current recession [i.e. minimise negative growth] as well as hold up profitability.

If this is right, the recession makes no difference to the fundamental point. If cash flows with poor or average strategy would likely decline sharply, and good strategic management would lead to a better cash-flow trajectory, then that is what will be best for investors and what management should be pursuing. Profitability [ROIC or similar] is but one lever to achieve that – and one that comes with big dangers. If your ROIC was previously 10% and recession hits it down to -5%, then investors would no doubt like to see it back up to, say, 5% … unless 5% and no subsequent growth was all they would ever see thereafter.

Percentages are not at all helpful in all this. If this scenario meant that your 10% ROIC corresponded to profits [or more strictly free cash-flows] of $10m/year, investors should prefer you to accept the minus-$5m if it meant that next year you get back to say, zero, then $10m, then $15m etc rather than $5m/year for ever.

Maybe the main reason firms pursue dangerous cost-cutting in a desperate attempt to prop up profitability is precisely because the naïve analysts who comment on their performance understand so little about the link from good strategic management to a firm’s value, and constantly bully management for ‘poor profitability’, rather than asking whether current profitability is actually in investors’ best interests. For an example, see my blog-post on what looks like a big strategic error by Starbucks, who are trying to sustain profitability by cutting costs sharply – including the costs of supporting exactly the ‘sustained competitive advantage’ that drove their historic strong growth in cash flows .. their unique investment in staff rewards and training which features in so many great case studies on the company.

To see a powerful and lucid explanation of why growth in free cash-flow is the right measure for investors and executives [and strategy researchers!] to focus on, see the statement from Jeff Bezos, founder and CEO of Amazon.com that opens the company’s 2004 Annual Report . Prior to founding Amazon.com, Jeff was a star Wall St analyst .. to be distinguished from the more average folk in that world.

Professional guidance on the same issue features in many finance reference books, e.g. Copeland, Koller, and Murrin, Valuation—Measuring and Managing the Value of Companies, Wiley, Chichester .. . It’s not perfect – e.g. the section on forecasting growth is way off, but as regards how firm performance is valued, it looks like essential reading for anyone planning to teach strategy.

” …

Have had many useful answers on this. There seems little dissent that:

• we have a problem with current strategy methods not being valued by the people who are supposed to use them,

• … which implies we have little useful theory [notably that seeking explanations for profitability is the wrong question], and
• existing strategy tools focus on the rare issue of choosing strategic position, rather than what management actually does to steer strategy and performance continually through time.

If this is all about right, perhaps any firm’s ‘sustained competitive advantage’  shows up not in persistent higher profitability, but in stronger sustained growth in cash-flows. Perhaps this implies that the question strategy should be asking [in business cases at least] is ‘what does management actually do to deliver sustained growth of cash flows ahead of others?’ On this measure, performance of strong firms might be tens or hundreds of times greater than that of weaker ones, so an answer would seem to be of more interest to our customers .. executives, consultants, students .. than a few percentage points of ROIC or ‘rent’.
It would be useful to hear more from the senior figures in the strategy field as to whether this is all way off-target – I would not want to stand accused of encouraging colleagues down a long, deep and dark blind alley. Maybe there is no problem with the reputation of Strategy in its market-place, with basic strategy theory, or with the utility of the tools and methods that are recommended and taught?

…”

Kim

One very common result is that firms may be less profitable, or even unprofitable, for many years, but still enjoy investors’ confidence and a strong share price. This support reflects the expectation that earnings will grow, even if they are not doing so yet. So I’ve asked now in 3 sessions here in Cologne why empirical research in academia hypothesises that ‘performance’ reflects some factor X, and then sets out to confirm that hypothesis correlation between factor X and profitability [ROS, ROA etc]. So far, I don’t get an answer that makes sense. The only attempt I heard was that “We are trying to explain ‘sustained competitive advantage’, and that is indicated by superior profitability.”

To illustrate the nonsense this gets us into – Amazon.com was loss-making for many years, and still generates rather modest profitability. Every time they could have become more profitable, they found further opportunities for growth. So if you took the academic logic, you would be trying to explain why Amazon.com has been an unsuccessful business !

‘Sustainable competitive advantage’ is important of course – if only we knew what it was. I’d go for ‘the ability to sustain stronger growth in earnings than other firms’, which is what managers seem to seek and investors value.

[ Strictly, investors value 'free cash flow' - the cash flow generated after the business has spent what it needs to grow - which is why they can be reasonably upset when firms with limited growth opportunities throw their cash away on ill-advised acquisitions. ]

And to really do it properly, you would want to segment this analysis by product, geography, customer segment – and also track the gains and losses vs. all other rivals.  My friends at Vanguard Strategy are the real experts in this, having transformed product strategy at some of the largest global brand companies.