The most visible example to the general public of this principle is when opening a new retail store in an additional town gives access to consumers who we could not previously reach. We constantly hear of new outlets opening for Starbucks, Wal-Mart, IKEA, etc., and many of us change our shopping habits when an appealing new store appears in our neighborhood. Behind this expansion lie sophisticated procedures for assessing the likely customer-base, sales and profitability of each new unit.

But gaining access to potential customers is not the same as actually winning those customers. Having opened a new store, we must of course offer products and services that its target consumers want at prices that offer good value. Then there is the question of how far to push that expansion. Early in the life of a retail chain, every new store can be opened in a locality that is new for that chain, and where there are large numbers of potential consumers. As expansion continues, however, two things change:

• locations for new stores reach only smaller numbers of potential consumers
• each new store’s catchment area increasingly overlaps with existing units, so much of its sales only arise by taking sales from neighbors.

In the figure below, an initially successful retailer expands its network of stores over a 10-year period. With its first stores able to reach 20 000 consumers who each spend $500/year on its goods, management believes there is potential for over 200 stores reaching up to five million consumers. For the first five years, plans go well, but as expansion passes the target number of stores, consumer numbers and sales fall short of expectations. Nevertheless, with each new store seeming to win enough consumers to be worthwhile, and sales continuing to grow, the company presses on with expansion.

New retail stores bring access to ever-fewer new potential customers

Unfortunately, hidden beneath the reasonable top-line indicators there is a sharp fall in the true number of new consumers won with each new opening, and new stores increasingly succeed only by taking sales from others. Furthermore, the later consumers turn out to spend less with the stores than those captured from around the initial locations. The costs of operating these later stores is not covered by the incremental revenues and gross profit from the sharply reducing rate of new consumers, and profits go into decline.

The generic structure this example illustrates consists of:

• The in-flow of new stores (the primary resource) brings with it an attribute co-flow or new potential customers (the secondary resource)
• That growing potential of the attribute resource is then converted into an active resource, in this case consumers who really use the stores
• The secondary resource (customers) drives revenue, and costs are incurred
  [a] adding the primary resource (stores)
  [b] operating that resource (running the stores) and
  [c] converting potential customers into active ones.

Had this company cut its expansion rate when the additional numbers of consumers with each new store dropped sharply (e.g. as shown in grey text about half way through its expansion in year six), it would have attracted most of the potential market, kept profits at $32m/year, and only had to invest $240million of capital rather than the $385million it eventually spent.

You (or your students!) can explore this strategic management of market saturation in the Beefeater Restaurants business game. In addition to this issue, the game includes the impact of product development on expanding market potential, the pressure to accelerate progress when a competitor is pursuing the same opportunity, and the need to satisfy investors’ requirements in order to attract the capital to continue expansion.

This is not to say that management should give up at the first sign of having “used up” their business opportunity. It is often possible to find ways to serve smaller markets profitably. Second, many retail chains have expanded the potential market, and thus lifted the ceiling on viable growth by extending the range of products and services offered in the same space. Many have also developed slimmed-down units, offering limited product-ranges and incurring much reduced operating costs precisely to enable them to reach smaller local markets.

These principles can readily be adopted with suitable adjustment by businesses in other sectors and applied to other kinds of resource. We have featured the low-fare airline Ryanair in early briefings – a company that has relentlessly opened large numbers of new airports and routes over many years. Each new airport gives access to new potential travelers, and additional routes are one important means of developing those people into active customers. This issue is explored in another business game – the LoFare Airline microworld

Product-range extension can also give access to additional potential customers, but again can be over-done. In one country market, a confectionery company sold over 30 distinct products, but still had lower sales than Mars, who offered only 18. The competitor kept adding new products in the hope of winning new consumers, but each new line took more sales from its own range than from Mars.

Until next time…

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Real-world examples

Even world-leading retailers fall into this trap. Starbucks, for example, had to close over 500 stores during 2008, and more in 2009 because of inadequate sales, at a very high cost and having spent hundreds of millions of wasted dollars to open them in the first place, just a few years earlier (see my video presentation ” Lessons from the crisis ” (Note: Duration is 72 mins)

This strategic error can lead to further difficulties, such as damage to the firm’s reputation in the market as it is seen to operate second-rate units, diversion of management attention onto solving the problem they themselves created, damage to investor confidence, and poor morale amongst middle – and front-line management. It is worth recalling that McDonalds’ too once got into this difficulty. In its 2002Annual Report letter to shareholders, the new Chairman stated that the business was “in transition from a company that emphasizes adding restaurants to customers to one that emphasizes adding customers to restaurants.” The company also cut its target annual profit growth rate. Result? – a subsequent increase in profit growth and a strong recovery in its stock price.

This briefing summarises material from chapter 5 of Strategic Management Dynamics, pages 274-280.

Read more about the book on our website

It rather looks like the love-affair with flying everywhere for nothing – no matter the inconveniece involved - is fading, so both routes and service frequency might have to fall. The parallel with Starbucks over-expansion of stores is uncanny.

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.

This is a great principle, since investors are of course a critical constituency – along with customers and staff – whose loyalty is valuable. And as for any ‘product’ loyalty to a firm more likely if investors know and understand that product. Public companies have been obliged for some time to include in their annual returns a ‘discussion’ about their strategy and prospects [called the Management Discussion and Analysis in the U.S.], so with all this required transparency, how come investors get so misled by simple strategic issues [like the Starbucks’ pushy pricing and over-expansion I've posted on before, or the many, many banks who stupidly over-sold high-risk loans]?

The headline answer is that we still – after half a century of trying – don’t know how to work out the link from strategy to performance, and the academics and consultants are fully aware of this problem. [As you probably know, I think there's a way to do this, even if it's not yet widely known or practised]. Just one part of the problem, for example, is that we know intangible items like staff skills and market reputation ‘matter’, but don’t know how to build these into our analysis – see Invisible Ink previously published in Business Strategy Review, outlining briefly how to make the link from intangible factors to performance – more detail in chapters 9 and 10 of Strategic Management Dynamics [UK link].

To see the 6-year path that brought them to this point , see their 07 Annual Report. Store numbers and revenues multiplied by ~2.5 – operating profits and earnings more than tripled ! How do you do that? – by squeezing more margin out, so operating margins up from 9.5>11.2% [but hit 12.3% in 05] .. and how do you do that by pushing prices or squeezing costs.

To understand how they came to be so successful, it’s worth a look at Preserving the Starbucks Counter Culture by Gretchen Weber in Workforce Management Feb’05 [great article!]. Which closely matches the reasoning in many business school case studies. In summary, it’s this:

Background

The fast food industry may not so admired for success in retaining people – staff satisfaction ratings of 50-60% are common, and staff turnover can hit 300% per year, people need to be productive fast. Starbucks turned this industry norm on its head, devoting considerable effort to staff satisfaction and retention in the belief that this was essential to retaining customers and winning their spending. From the start, generous benefits and stock options  even for new employees – called as ‘partners’ – pushed satisfaction levels to over 80%. Starbucks hit 2nd place amongst large US companies in the Fortune 2005 ranking of best places to work. Result - turnover rates way below industry averages at 70%-80% per year. And it’s not just direct staff benefits – the company spends more on employee training and development than on marketing.

It’s when these advantages impact on customers, though, that the real benefits show up. Staff get to know their customers, so visits to the company’s stores become a regular part of their lives. Some simple numbers show just what all this is worth. The company captured $10.4bn in revenue in 2008, so if the most loyal customer used a store only 10 times a month rather than the 18 times it often hits, then revenue would only have been $5.7bn. But then, with lower customer usage, many of the stores that have been opened over the years would never have been viable. So instead of the 15,000 outlets operating at the end of 2007, it would have been operating many fewer, and revenue would have been way less than that $5bn.

Think too about the impact on hiring and training itself. With 170,000 employees, 80% turnover means hiring and training over 130,000 new people each year. If turnover were a more typical 200% each year, that hiring rate would rise to 340,000 per year. And that’s on top of the need to find some 30,000 extra people each year to staff their newly opened stores, often in new geographic markets. A further advantage arising from strong staff retention, then, is that it ‘breeds’ people with experience, who become available to support the opening of further stores.

Response to ’08 profit problems

So how has Starbucks responded to the difficulties this year? – here’s extracts from their results announcement, as above … revenues increased 10 percent to $10.4 billion, vs $9.4 billion for 07.  … the U.S. posted comparable store sales of negative 5 percent.   Operating income decreased to $504 million, vs $1.1 billion for fiscal 2007. Margin contracted to 4.9 percent from 11.2 percent … primarily due to lower revenues. Excluding restructuring charges [and other exceptionals], margin was 8.1 percent.

The response:

• “  A re-architected cost structure to allow for long-term operating margin expansion
• A healthier store portfolio achieved through closure of underperforming stores
• A stronger value and rewards platform – consistent with Starbucks premium brand   “

I argued in a previous post that they had been foolish [in spite of McKinsey's endorsement!] to over-expand their store network [investors might ponder how their fortunes might have differed had that error not been made], so I can hardly argue that rationalising over 600 ‘underperforming’ stores is anything but unavoidable. And ‘a stronger value and rewards program’ is presumably code for cutting prices, however it’s wrapped up for public consumption – again unavoidable. The killer is on the staffing issue - “… in the 4th quarter, general and administrative expenses … improved to 3.8 percent, from 5.1 percent for 2007. The favorability was primarily due to lower payroll-related expenses.” [emphasis added]

Now read again the Gretchen article above, and ask what this will likely do to the very special staff culture in the stores, and what that might then do to customers’ experience, and what that might then do to sales in FY 2009? I don’t have time to do the numbers in detail, but those savings would be worth about +$130m in operating profits for a full year. You can do a heck of a lot of training and staff development with that kind of money, even with Starbucks’ staff numbers.

The question for investors [and the pesky analysts who keep pushing companies to do these kinds of stupid things!] is – would you rather have $130m less profit this year, and stand a good chance of having better profits next year, or keep the $130m now, and risk having no profits at all next year?

To track the gossip on Starbucks and watch how staff and customers seem to be responding to all this, by the way, starbucksgossip.typepad.com is great fun and very informative.