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Managing GrowthManaging Growth

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McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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IntroductionIntroduction

• It is possible for companies to grow too quickly.

• It is possible for companies to grow too slowly.

• Growth needs to be managed.

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Sustainable GrowthSustainable Growth

• A company’s sustainable growth rate is the maximum rate it can grow without depleting financial resources.

• How to compute a company’s sustainable growth rate?

• How to respond when growth veers off the sustainable trajectory?

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PhasesPhases

1. Startup (usually with losses)

2. Rapid growth (with infusions of outside financing)

3. Maturity (generating cash)

4. Decline (marginally profitable, with cash to search for new products, investments)

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The Sustainable Growth EquationThe Sustainable Growth Equation

• Consider a situation when a company has a target dividend payout policy, target capital structure, and does not wish to issue new shares or repurchase existing shares.

• Consider a firm whose sales are growing rapidly.

• Sales growth requires investment in AR, inventory, and productive capacity.

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FIGURE 4-1 New Sales Require New Assets, Which Must Be FinancedFIGURE 4-1 New Sales Require New Assets, Which Must Be Financed

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g*g*

• What limits the rate at which this company can increase sales, or more generally its overall expansion?

• From the previous figure, the limit to growth is the rate at which equity expands.

• Therefore, g* is the ratio of the Change in equity to Equity at the beginning of the period.

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PlowbackPlowback• If the firm pays out all of its earnings as

dividends, it cannot grow equity.• If R stands for the plowback ratio, then g*

is the product of R and Earnings over Equity.

• g* = R x ROE.• g* = R x P x A x T or PRAT,

where T (T-hat) is Assets/Equity based on beginning of period Equity, A is asset turnover, and P is profit margin.

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Levers of GrowthLevers of Growth

• The levers of growth here are PRAT.• g* is the only sustainable growth rate

consistent with these ratios.• A company that grows too quickly might

not be able to increase operating efficiency, and therefore resort to increased leverage.

• Sometimes that is like playing Russian roulette.

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Balanced GrowthBalanced Growth

• ROA is Net income / Assets.

• With this definition, g* is the product of (RT) and ROA, where RT reflects financial policy and ROA reflects operating performance.

• Look at Figure 4-2 in the next slide, where sales growth off the line with slope RT generate either cash deficits or surpluses.

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FIGURE 4-2 A Graphical Representation of Sustainable GrowthFIGURE 4-2 A Graphical Representation of Sustainable Growth

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Unbalanced GrowthUnbalanced Growth

• A company with unbalanced growth has 3 choices:

1. Change its growth rate.2. Change its ROA.3. Change its financial policy, meaning the

slope of the line.• Let’s look at Genentech, Inc. and

compare their actual growth rates to their g*-estimates.

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TABLE 4-1 A Sustainable Growth Analysis of Genentech, Inc., 2003 – 2007*TABLE 4-1 A Sustainable Growth Analysis of Genentech, Inc., 2003 – 2007*

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Respond to GapRespond to Gap

• Compare 2007 against prior years.

• R stayed at 100%.

• With some exceptions, P, A, and T all rose.

• Look at Figure 4-3.

• In 2007, was Genentech still in cash deficit mode?

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FIGURE 4-3 Genentech’s Sustainable Growth Challenges, 2003-2007FIGURE 4-3 Genentech’s Sustainable Growth Challenges, 2003-2007

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What If?What If?

• Let’s come back to some What If questions.

• Check the bottom of the next slide.

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TABLE 4-1 A Sustainable Growth Analysis of Genentech Inc., 2003 – 2007*TABLE 4-1 A Sustainable Growth Analysis of Genentech Inc., 2003 – 2007*

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What To Do When Actual Growth Exceeds Sustainable Growth?

What To Do When Actual Growth Exceeds Sustainable Growth?

• If growth is temporarily too fast, just borrow and wait for it to slow down.

• If not, then there is a laundry list.– Sell new equity– Increase financial leverage– Reduce dividend payout– Prune marginal activities – Increase prices – Merge with a “cash cow”

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Sell New EquitySell New Equity

• Get cash.

• Increase borrowing capacity.

• Difficult to do in most countries.

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Increase LeverageIncrease Leverage

• Raises cash.

• Also raises risk of bankruptcy.

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Reduce the Payout RatioReduce the Payout Ratio

• Saves cash that can be used to build up equity.

• Can anger shareholders who respond by selling their stock, thereby driving down stock price.

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Profitable PruningProfitable Pruning

• Raises ROE, and therefore earnings, and therefore retained earnings.

• Retained earnings are part of equity.• Prune by un-diversifying unrelated product

lines with no synergy.– Who benefits from corporate diversification,

shareholders or managers?

• Un-diversifying generates cash from the sale of assets.

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OutsourcingOutsourcing

• Increase asset turnover and therefore ROA.

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PricingPricing

• Increases ROE, if %-demand doesn’t fall by more than the %-price increase.

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MergerMerger

• Find a cash cow (white knight, if threatened) with deep pockets.

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Too Little GrowthToo Little Growth

• What to do with the profits?

• In a couple of slides, examine Table 4-3 (Scotts Miracle-Gro).

• Before that, the next slide displays the overall pattern in respect to how companies finance themselves.

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TABLE 4-2 Sources of Capital to U. S. Nonfinancial Corporations, 1998-2007TABLE 4-2 Sources of Capital to U. S. Nonfinancial Corporations, 1998-2007

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TABLE 4-3 A Sustainable Growth Analysis of Scotts Miracle-Gro Company, 2003-2007*TABLE 4-3 A Sustainable Growth Analysis of Scotts Miracle-Gro Company, 2003-2007*

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What Did Scotts Do?What Did Scotts Do?

• Paid dividends.

• Reduced financial leverage.

• Leveraged recap in 2007!

• See Figure 4-4, and ask whether Scotts will need the cash?

• Looking forward, new products, targets to acquire?

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FIGURE 4-4 Scotts Miracle-Gro Company’s Sustainable Growth Challenges, 2003-2007FIGURE 4-4 Scotts Miracle-Gro Company’s Sustainable Growth Challenges, 2003-2007

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What To Do When Sustainable Growth Exceeds Actual Growth?What To Do When Sustainable

Growth Exceeds Actual Growth?• Ask if situation is temporary.

• If yes, build up cash.

• If no, ask if phenomenon is industry-wide, or within the firm.

• If within the firm, look for new product lines, improvements, etc.

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Ignore the Problem?Ignore the Problem?

• Accumulate cash and slow growth attracts corporate raiders.

• Why?

• What do raiders believe?

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Return The Money To The Shareholders

Return The Money To The Shareholders

• Increase dividends.

• Repurchase shares.

• Temptation is to invest in assets that reduce corporate value but increase management’s empire.

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Buy GrowthBuy Growth

• Buy other businesses, especially ones that need cash because they are growing rapidly.

• History suggests that returning the money is the better option.

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Sustainable Growth and InflationSustainable Growth and Inflation

• Inflation increases the nominal value of assets such as AR, inventory, and fixed assets (with a lag).

• These still need to be financed, and the problem is acute if prices are difficult to raise quickly.

• The issue is important if banks miss the connection.

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New Equity FinancingNew Equity Financing

• The next slide illustrates the value of new equity issues over time.

• What happened before and after 1983?

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FIGURE 4-5 Net New Equity Issues 1971-2007FIGURE 4-5 Net New Equity Issues 1971-2007

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FIGURE 4-5 (Continued)FIGURE 4-5 (Continued)

Sources. Federal Reserve System, Flow of Funds Accounts of the United States, http://www.federalreserve.gov/releases/z1/Current/data.htm. Bank of Japan, Flow of Funds, Non-financial Corporations, www.boj.or.jp/. U. K. Office of National Statistics, Financial Account: Non-financial Corporations, www.statistics.gov.uk/.

Note: $169.4 billion of equity issued by Vodafone to acquire Mannesmann in 2000 are omitted from U.K. figures because German equity falls by equal amount.

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AcquisitionsAcquisitions

• In the last slide, what happened in 1998?

• Companies reduce their shares by repurchasing them or by acquiring the stock of another firm for cash or debt.

• Was the situation different in the U.K. and Japan?

• The numbers suggest that companies sell new shares about once every 20 years.

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Gross ProceedsGross Proceeds

• Check the graph on the next slide.• Gross proceeds from new stock equaled

9% of total sources of capital.• Relative to external sources, the number

was 22%.• Check the graph of IPOs relative to gross

public equity issues.• In 2000, IPOs contributed 5% of total

external capital.

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FIGURE 4-6 Gross Public Equity Issues and Initial Public Offerings, 1970-2006FIGURE 4-6 Gross Public Equity Issues and Initial Public Offerings, 1970-2006

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Note: New equity is publicly issued stock including preferred stock. IPOs exclude over allotment options but include the international tranche, if any.

Sources: Federal Reserve Bulletin, Table 1.46, "New Security Issues U.S. Corporations," various issues for gross public equity issues; Securities Data Corporation as cited in Jay R. Ritter, "Some Factoids About the 2004 IPO Market," http://bear.cba.ufl.edu/ritter.

FIGURE 4-6 (Concluded)FIGURE 4-6 (Concluded)

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Why Don’t US Companies Issue More Equity?

Why Don’t US Companies Issue More Equity?

• Other sources generated sufficient cash.

• Equity is expensive to issue (flotation).

• Fear of diluting EPS in the short-run.

• Concern that their stock is undervalued in the market.

• Windows close.