What Makes a Business Great: Abundant Growth Opportunities
This article is part of a series about What Makes a Business Great?
How do businesses grow? Like a Zen koan, it is a simple question that seems to defy a simple response. Businesses pursue myriad different strategies and tactics to grow and create value. However, all of those diverse strategies and tactics ultimately fall under the following seven sources of growth.
Improve existing products and services. Businesses improve existing products and services by enhancing and expanding attributes that users value. Better products and services provide more value to users and should ultimately increase demand.
Netflix provides a great illustration. When Netflix launched its streaming service, the content was limited, dated and generally underwhelming. In response to a question in 2010 about the competitive threat posed by Netflix, Jeff Bewkes, the CEO of Time Warner at the time, famously quipped, “Is the Albanian Army going to take over the world? I don’t think so.” It was actually a fair perspective on the quality of Netflix’s streaming service at that moment. The quote is only humorous now for how devoid it was of foresight about the direction in which the service was headed. No amount of marketing or geographic expansion could have grown the Netflix service of 2010 into the multi-hundred million subscriber base the service has today. Instead, Netflix’s explosive growth since it launched its streaming service has mainly been the result of delivering on a compelling vision and product roadmap for continuously and dramatically improving its service over time, making it ever more desirable to people around the world.
Importantly, most businesses are on a treadmill with respect to the quality of their products and services. Some amount of continuous innovation and improvement is necessary just to stay in the same place. For a business to expand demand for its products and services, it needs to improve its products and services to a greater degree than competitors and substitutes are improving theirs.
Raise awareness and perceived value of existing products and services. New and innovative products may offer substantial value to users, but many potential users may not be aware of them or fully understand and appreciate their benefits. In that case, the bulk of the opportunity to grow rests in driving awareness and perceived value among potential users.
In documents filed related to its IPO in 2019, Peloton indicated that its aided brand awareness in the United States was 67%. While that metric was on a sharply upward trajectory, it still indicated that a lot of potential users were not very familiar with the company and its products. Moreover, being aware of a product is one thing. Fully understanding the benefits it offers is another. The value that Peloton Bikes offer is difficult to completely appreciate without actually trying them out. Many potential users don’t understand how they are different from regular stationary bikes and why they are worth such a high price tag. Although Peloton Interactive certainly has a roadmap for improving its lineup of Peloton Bikes, most of the growth opportunity for those products in existing markets lies in driving awareness and perceived value.
Expand access to existing products and services. The price that a customer pays for a business’s products and services includes not just the sticker price, but all of the costs associated with the transaction, such as search, shipping, assembly, training and transportation costs, among others. By expanding access to its products and services, a business lowers the all-in price that existing and prospective customers must pay resulting in an increase in sales volume. While expanding access can entail incurring incremental costs, those costs often turn out to be an efficient way of lowering the effective price of a business’s products and services.
A business can expand access to its products and services in a variety of ways. One way is to expand its relationships with existing distributors to include more and/or better locations and selling space. Another is to add new distributors operating in existing sales channels. A business can also add entirely new channels of distribution. Finally, a business can expand into new geographies.
Some of the ways in which a business can expand access to its products and services not only lower the all-in price that customers pay but also contribute to increasing demand by raising the awareness and perceived value of those products and services. For example, Apple’s stores both make purchasing Apple products more convenient and raise the awareness and perceived value of Apple products. In fact, the latter may even be the more important function of Apple’s stores.
Enhance pricing effectiveness. Pricing changes that allow a business to capture a greater share of customers’ willingness-to-pay are a powerful and often underappreciated source of growth. A business can enhance its pricing effectiveness in two primary ways.
First, if a business has latent pricing power it can simply raise its prices. A business might have latent pricing power because it historically pursued a penetration pricing strategy. Alternatively, a business may not have fully captured past increases in the real or perceived value of its products and services through price increases.
Second, a business can improve its utilization of price discrimination tactics. Price discrimination involves selling the same or similar products or services to different buyers at different prices. Businesses can implement price discrimination in three general ways. A business can attempt to provide individualized prices to each customer based on its assessment of that particular customer’s willingness-to-pay. Another option is for a business to create different versions and/or bundles of its products and services at different price points in a way that encourages customers to self-select into certain segments. Finally, a business can price discriminate based on some observable customer signal, such as age, industry or location.
Here again, Netflix provides a terrific example. Netflix originally charged $7.99 for its streaming service. Even with the service’s modest initial catalog of titles, it was clear that the initial price point of the service offered a tremendous value to subscribers relative to other video entertainment options. In other words, Netflix initially pursued a penetration pricing strategy that left significant potential for raising its prices down the road. In the same vein, the lone subscription package that Netflix initially offered left substantial opportunity for the company to better implement price discrimination tactics over time. Netflix has since expanded its menu of subscription packages to include three different options: Basic, Standard and Premium at $8.99, $13.99 and $17.99 per month, respectively. The enhancements Netflix has made to its pricing effectiveness over the past ten years have contributed to a near doubling of its average monthly revenue per subscriber in the U.S. and allowed the company to attract a larger subscriber base than otherwise would have been the case.
Reduce costs. Although opportunities to grow profits through cost reductions are always finite, that does not prevent them from being material. Cost reductions come in two general categories, variable and fixed. A business might be able to reduce its variable costs by optimizing it sourcing strategy, reengineering its products and services, exploiting declines in input costs, or implementing more efficient business processes, among other methods. Fixed cost reductions could come in the form of streamlining corporate overhead through zero-based budgeting, restructuring of retail, logistics or manufacturing footprints; or exiting unprofitable lines of business.
Spotify’s experience renegotiating its contracts with major music labels in mid-2017 illustrates how opportunities to reduce costs can be an important source of growth. Spotify’s reported gross margin grew from 13.6% in 2016 to 25.7% in 2018 primarily as a result of lower licensing fees. Those cost reductions were essential in enabling Spotify to achieve attractive unit economics.
Develop new products and services. Every business will exhaust its potential to grow at rates above nominal GDP growth through existing products and services at some point. To have decades of abundant growth ahead, a business needs to have deliberate and successful processes for developing new products and services.
The businesses that are most successful at developing new products and services are methodical about maintaining a strong stock and flow of products and services across three horizons:
Core – established, profitable products and services that define a business’s identity
Emerging – products and services that have achieved product-market fit and attractive unit economics, but are still early in penetrating their addressable markets
Viable – anything from projects to joint ventures to pilots that aims to ultimately deliver a commercial product or service
Creating a map of a company’s three horizons of growth can be revealing. Some companies have an abundant “stock” in each horizon with a strong track record of “flow” from Viable and Emerging to Core. Others have little to speak of outside of their Core and no evidence of flow from one horizon to the next. Ideally, companies will have assets, advantages or competencies in Core products and services that can be leveraged to support Emerging and Viable ones. Companies can successfully maintain their stock of Emerging and Viable products and services either organically or through acquisitions. Businesses with the most abundant growth prospects do both well.
Look no further than Amazon for an example of a company whose ability to successfully develop new products and services seems to provide it a nearly limitless source of growth. Although Amazon was founded as a U.S. online book retailer with a total addressable market of $26 billion at the time of its IPO, its Core now includes a global online retailer offering more than 12 million items on a first-party basis, a marketplace offering more than 350 million items from third party sellers, the Amazon Prime subscription service, Amazon Web Services, Whole Foods and Fulfillment by Amazon just to name a few. Amazingly, most of those now-Core products and services began as internal projects in the Viable horizon. Amazon is not afraid of making bold acquisitions either. Its acquisitions of Whole Foods, Zappos, Twitch and Zoox are just a few examples. For a company like Amazon that has mastered maintaining a strong stock and flow of products and services across the three horizons, offering new products and services represents by far the greatest source of long-term growth.
Allocate capital accretively. Effective capital allocation can contribute to growth in two ways. The first is through acquisitions. While conventional wisdom is that most acquisitions destroy value, successful acquisition strategies do exist. The most common example is the strategy of consolidating an industry in a way that exploits economies of scale.
Publicly-traded companies have a second way of using capital allocation as a source of growth. A publicly-traded company can grow its intrinsic value per share by repurchasing its stock at prices below intrinsic value. Although most companies do a poor job of implementing share repurchase programs, those that do it well are often able to achieve astounding results over time.
These seven sources of growth are the determinants of growth over which a company has control. Exogenous factors, such as population growth, urbanization, disease prevalence and the growth and adoption of complementary products, will also influence demand for a business’s products and services. Businesses that generate exceptional growth over time do so primarily as a result of internal efforts though.
Great businesses have abundant growth opportunities across the seven sources of growth. They will typically have especially profound opportunities from several of the seven sources. A great business should be able to grow its earnings per share at a compound annual rate in the high single digits or more over the next ten years assuming that period includes a full economic cycle.
Conclusion
There are seven ways a business can grow:
Improve existing products and services
Raise awareness and perceived value of existing products and services
Expand access to existing products and services
Enhance pricing effectiveness
Reduce costs
Develop new products and services
Allocate capital accretively
The most noteworthy of the seven sources of growth is developing new products and services, which when done successfully can create the abundant growth opportunities for decades. Great businesses have abundant growth opportunities from multiple sources that should allow them to grow earnings per share at a compound annual rate in the high single digits or more over the next decade.
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