Managing Growth

1. Managing Growth

2. Introduction • It is possible for companies to grow too quickly. • It is possible for companies to grow too slowly. • Growth needs to be managed.

3. Sustainable 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?

4. Phases • Startup (usually with losses) • Rapid growth (with infusions of outside financing) • Maturity (generating cash) • Decline (marginally profitable, with cash to search for new products, investments)

5. The 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.

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

7. 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.

8. Plowback • 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.

9. Levers 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.

10. Balanced 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.

11. FIGURE 4-2 A Graphical Representation of Sustainable Growth

12. Unbalanced Growth • A company with unbalanced growth has 3 choices: • Change its growth rate. • Change its ROA. • 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.

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

14. Respond 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?

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

16. What If? • Let’s come back to some What If questions. • Check the bottom of the next slide.

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

18. 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”

19. Sell New Equity • Get cash. • Increase borrowing capacity. • Difficult to do in most countries.

20. Increase Leverage • Raises cash. • Also raises risk of bankruptcy.

21. Reduce 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.

22. Profitable 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.

23. Outsourcing • Increase asset turnover and therefore ROA.

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

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

26. Too 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.

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

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

29. 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?

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

31. 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.

32. Ignore the Problem? • Accumulate cash and slow growth attracts corporate raiders. • Why? • What do raiders believe?

33. 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.

34. Buy Growth • Buy other businesses, especially ones that need cash because they are growing rapidly. • History suggests that returning the money is the better option.

35. Sustainable 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.

36. New Equity Financing • The next slide illustrates the value of new equity issues over time. • What happened before and after 1983?

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

38. 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.

39. Acquisitions • 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.

40. Gross 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.

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

42. FIGURE 4-6 (Concluded) 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.

43. 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.