Business

In a world where tastes and habits are changing faster than ever, businesses, products and services are under constant threat. But companies can protect themselves from slow obsolescence if they are vigilant and follow some strategic rules.

Moving on

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For all his successes as the former chief executive of Procter & Gamble, one missed opportunity always stuck in Alan Lafley’s mind. Back in the noughties, a popular drug was about to change from prescription to over-the-counter (OTC). P&G was on the verge of acquiring the rights, in exchange for a prescription drug it had been developing, when, at the eleventh hour, leading figures in the fast-moving consumer goods giant’s healthcare business raised opposition.   

 

“It was perfectly rational behaviour on their part,” Lafley later told the Harvard Business Review. “The leaders of the P&G healthcare business wanted to keep the assets and business they had – the head of R&D had put a lot of time, money and personal effort into developing the drug we were about to swap.”  

 

Human nature

He hesitated, the deal never happened, and the OTC drug ended up becoming one of the most successful in US history. P&G, meanwhile, exited the prescription sector entirely a few years later.

 

Inertia can be an existential threat to every organisation, but particularly the successful ones. If something gets results, it’s human nature – not to mention financially prudent – to keep doing it. In time, it even becomes part of a company’s identity. But as Lafley realised, a rigid attachment to the status quo ultimately leads to strategic myopia. That’s why many once-great companies come to be defined by yesterday’s innovations and find themselves unfit to compete in tomorrow’s markets.

 

Eliminating waste  

Management thinker Peter Drucker proposed a drastic solution to this problem. Every few years, he wrote in Innovation and Entrepreneurship: Principles and Practices, an enterprise should put every single product it makes and every single market where it operates on trial. Executives should ask one leading question: “Would we now go into this product, this market, this distributive channel, this technology, today?”

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Every few years an enterprise should put every single product it makes and every single market where it operates on trial

If the answer to that question was no, then the company should immediately look at retreating from the product or activity, where possible abandoning it altogether. Only such ruthlessness would allow it to break free of inertia and truly embrace innovation as though its very survival depended on it. As Drucker put it: “Every organism needs to eliminate its waste products or else it poisons itself.”

 

Core weakness 

Drucker was writing 35 years ago, but his logic appears to be borne out by company performance, particularly during a downturn.

 

After the global financial crisis, analysts at management consultancy McKinsey & Co looked at the total return to shareholders of 1,000 publicly traded US firms with revenues of more than $1 billion, between 2007 and 2011. They wanted to know why, when the average return was zero, the top quintile averaged returns of 20 per cent. 

 

These firms were not simply in recession-proof industries; indeed, performance diverged mainly during the recovery, not the downturn. 

 

McKinsey’s conclusion was twofold: first, these resilient companies cut costs much faster and more effectively during the recession; second, they had “noticeably stronger divestitures” and “acquired far more than non-resilients did during the recovery period”.

 

The last two are not unrelated. Take the example of Eleco, which used to be a UK maker of precast concrete, metal roofing and other components for the construction industry. 

 

When the financial crisis hit, orders almost completely dried up. Executive chairman John Ketteley made the decision to divest Eleco’s core businesses in their entirety in order to focus on its smaller but highly promising construction software division. 

 

Survival mode 

These had accounted for the vast majority of group revenues, so the decision was radical. But it was a matter of survival – there simply wasn’t enough time and money to keep doing everything. As Ketteley explains: “The only businesses we had with any assets were our concrete construction components and metal roofing arms, which were making losses and haemorrhaging cash, and our software businesses, which were making profits and generating cash. So, it was not rocket science. We had to survive.”

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When a new business model threatens to disrupt an old one, for example, the answer on paper may be for the incumbent to abandon the old and invest in the new

By 2014, the company had completely exited its original trade in favour of a software business, which has since grown both organically and through acquisitions. Eleco’s share price has risen 12-fold since its post-crisis low – a recovery that would not have been possible had Ketteley tried to hold on to the old core.

 

Strategic vision

In many respects, a downturn can act as a catalyst for making strategic divestment decisions that firms should be considering anyway. The nascent World Wide Web, for example, was still decades away from being a material threat to trade magazine and academic journal publisher Reed Elsevier (now RELX) when, in the mid-1990s, it started a concerted programme of abandoning its core print operations in favour of digital business analytics. RELX had identified a strategic vision of the future that put it on the right side of history, in this case as a technology and information company, now worth more than £33 billion.

The question that RELX and all companies that successfully divest ask themselves is whether businesses fit their strategic vision of how they can grow and compete sustainably and coherently years down the line. It’s not always a straightforward question. In his book Playing to Win, P&G’s Lafley recalled how, on the surface, the company’s fine fragrances division was a natural choice to divest, as it didn’t leverage the group’s competitive strengths in R&D and branding. 

If something gets results, it’s human nature – not to mention financially prudent – to keep doing it. But a rigid attachment to the status quo ultimately leads to strategic myopia

Competitive advantage

However, a closer investigation revealed that fragrances were not only essential for establishing credibility for P&G’s core skincare and haircare brands, they also provided a way of maintaining competitive advantage in the household and personal care sectors – put crudely, people like these products to smell nice. “This little fine-fragrance business was important well beyond its existing size; it was crucial to building core capabilities and systems that could differentiate and create competitive advantage for brands and products across the entire corporation,” Lafley said.

 

Swift action

If on examination a business does not fit the wider company’s strategic vision, then divestment becomes the rational course of action, even – perhaps especially – if the business to be sold is still profitable. 

 

Once the decision to divest has been made, it’s imperative to act swiftly. According to a report earlier this year by management consultancy Bain & Co, 60 per cent of businesses find that divestments end up taking longer than other strategic decisions, often with delays of months or even years. These delays “not only stop a company from fully focusing on its strategic growth businesses, but also weaken the non-strategic businesses” that are up for sale, largely because they are persistently starved of funds and lose value over time. 

 

While it’s wise not to hold on to assets for too long in a gambler’s hope that the market will improve, it’s also important not to settle for a bad price out of sheer panic. “If you start hanging ‘for sale’ signs outside, you will only drive the price down,” says Ketteley. 

 

Bain advocates that businesses appoint a dedicated divestment team and build a convincing exit story, both for potential buyers and for employees, who may be anxious about the sale. As such, company managers need to be very clear about the strategic rationale for divestment, explaining why the business will be better off with a new owner, and incentivising key staff to stay on for a smooth transition.

 

Drucker’s doctrine of strategic abandonment does not just refer to entire businesses. It can – and should – apply to portfolios of products, too. 

 

Multifaceted manufacturing giant 3M relies on a stream of new products to maintain its margins in the face of competition from lower-cost, generic competitors. If the group kept inventing new products but never discontinued old ones, it would sprawl out of control.  

 

Product vitality

In order to focus management efforts on innovation, 3M has a target that 33 per cent of revenues must come from products released in the past five years.

 

“You have to remember that all companies are dying,” explained former CEO George Buckley, who introduced the metric, which he called the new product vitality index. “The core is attriting, losing products because they’re at the end of their life, being nibbled away by competition, or being cannibalised by your own new products. 

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Every few years an enterprise should put every single product it makes and every single market where it operates on trial

At 3M, this attrition rate was 3 per cent to 4 per cent a year… which means you needed to sustain new products with a vitality index of 15 per cent just to replace the core.”

 

Whether a company is replacing specific products or whole businesses, it’s important not to take a cookie-cutter approach. Some products will have a much longer shelf life than others, some companies will have different attrition rates, and some industries don’t afford the same flexibility to divest. 

 

Strategic partnerships

When a new business model threatens to disrupt an old one, for example, the answer on paper may be for the incumbent to abandon the old and invest in the new. But researchers have found that in industries with high levels of competition and high asset values sunk into the existing model or technology, such as electricity generation and distribution, incumbents that try to pivot end up with lower valuations than those that plough on.  

 

“Ironically, those… potentially most threatened by the change seem to be least rewarded for their efforts to renew themselves,” wrote John Eklund and Rahul Kapoor in the journal Organization Science, suggesting instead that for incumbents in such industries, strategic partnerships with newcomers may be the smarter bet. 

 

Even if the answer is rarely straightforward, Drucker’s question remains as pressing today as it did in the 1980s. Effective strategy requires tough choices, and if companies do not want to fall victim to inertia, imprisoned by decisions made years or decades ago, these are the choices that need to be made n

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