The Granularity of Growth

When we ask executives from other telecom companies to explain Telefónica’s growth, they often point to its activities in South America. Although this region has clearly contributed to Telefónica’s overall growth, as a deeper analysis of its performance between 1999 and 2005 reveals, it is not the only growth driver (Figure 2.1). In particular, Telefónica did very well in Spain.

So why aren’t the underlying drivers of Telefónica’s growth better understood? The problem is that even when we are looking at a single company there is no easy way to make a like-for-like comparison of top-line growth performance over a period of years. To benchmark growth properly, we would have to dig deeply into segment-level data in company annual reports to establish the real sources of revenue growth. We are not the first to say this; indeed, some commentators have gone so far as to propose a new form of reporting—a “sources of revenue” statement—that tracks customer revenue back to five sources.¹

Fig 2.1 Where Telefónica grew

€ billion, 1999-2005

Source: Dealogic; Hoovers; company reports; McKinsey analysis

For a proper comparison to be made, overall growth performance needs to be broken down into organic growth and inorganic M&A-driven growth, as the two are quite different in nature. In turn, organic growth needs to be broken down into its two components: the momentum of the portfolio a company starts with (by which we mean the growth rate of the underlying market segments) and the company’s relative market-share performance (the difference between company growth rates and relevant segment growth rates). For the aggregate numbers to be accurate, these breakdowns need to be done at the segment level.

We believe that the only way to reach a full understanding of your own current and past growth and draw accurate comparisons with competitors’ performance is to break growth down into these three components of portfolio momentum, share gain, and M&A—or growth “cylinders,” as we call them. This is what we have done in a new form of analysis that we call granular growth decomposition, or simply “decomp” (see the box “Introducing granular growth decomposition”).

Company A grew by 4.3 percent a year between 1999 and 2005. To understand where this growth came from, we need to break it down into the three cylinders, as illustrated in the left-hand column in Figure 2.2. This reveals that most of company A’s growth is driven by portfolio momentum. The M&A cylinder, which represents net inorganic growth over the period, shows a negative result, meaning that the company divested more businesses than it acquired. As for share gain, this made a positive contribution to company A’s overall growth, albeit a modest one. So the granular growth decomposition has shown us that company A’s business segments are in growing markets and are gaining market share.

Understanding one company’s performance by unraveling its real sources of growth is interesting, but drawing comparisons between peers or benchmarking a company against its industry can yield more valuable insights. Consider a second hypothetical company. Company B competes in the same markets as company A, and is similar in size. Its growth performance is shown in the right-hand column of Figure 2.2.

Fig 2.2 Contrasting growth trajectories

Revenue CAGR breakdown based on local currency, 1999-2005, percent

Source: Global Insight; company reports; SDC; Dealogic; Hoovers; analyst reports; McKinsey analysis

At first glance, company B appears to be outperforming company A: in terms of top-line growth, it has delivered a compound annual growth rate of 7.9 percent, as against company A’s 4.3 percent. But a closer look reveals a more complex picture. Company B is actually losing market share. The strong contribution made by the M&A cylinder to its revenue growth—4.7 percent—is perhaps masking issues with execution elsewhere in the business. Look again at company A; in the same markets and over the same time period, it managed to gain market share. Now that we are comparing apples with apples, we are able to draw a much more accurate comparison of the two companies’ individual strengths and weaknesses.

Fig 2.3 Comparing telecom players

Revenue CAGR breakdown based on local currency, 1999-2005, percent

Source: Global Insight; company reports; SDC; Dealogic; Hoovers; analyst reports; McKinsey analysis

Now that we’ve seen how the granular growth decomposition works in a hypothetical case, let’s see how it applies to the real world. Our team of analysts worked for more than two months to make a detailed comparison between ten telecom companies with headquarters in Europe over the period 1999 to 2005. The results of the analysis are fascinating: they partly confirm our intuitive understanding, but hold surprises too.

As Figure 2.3 reveals, the telecom companies’ collective growth was driven by portfolio momentum and M&A. As a group, the companies did not gain market share; on the contrary, they lost it to attackers. But these averages conceal quite startling differences in the performance of individual players. Take inorganic growth: the top performer managed to notch up a CAGR of 13 percent, while its weakest peer turned in a negative CAGR of -2 percent. Similarly, companies varied widely in terms of portfolio momentum (a range of 2 to 18 percent) and share gain (from -6 to 5 percent).

These numbers are all very well, you might think, but what do they tell us? Let’s now look at the companies in our granular growth database to see if we can reach any useful conclusions about where companies tend to get most of their growth. To find out, we took our database of 416 companies and broke down their average performance over the period 1999-2006 into the three cylinders of growth.³ We found some of the results surprising—and so did many of the executives with whom we shared them.

Fig 2.4 Where large companies got their growth

Average revenue CAGR breakdown, 1999-2006, percentage points

The average large company grew at 10.1 percent per year over the period (Figure 2.4). Portfolio momentum accounted for 6.6 percent of this growth, M&A for 3.1 percent, and share gain for 0.4 percent. This means that virtually all the growth for an average company could be explained by the underlying growth rates in its market segments, coupled with its own M&A activity. We’ll take each of these cylinders in turn.

Across all the companies in our sample, the level of M&A activity is surprisingly high. We’ll look at this in more depth in chapter 6; suffice to say here that M&A is important for growth giants and challenged companies alike. As Figure 2.4 shows, M&A activity contributes on average 3.1 percent per year in revenue growth. In other words, a company with $10 billion in revenue is acquiring, on average, companies with $310 million in revenue that year. To understand why, we can look back at some of the companies that are featured in our “grow or go” analysis in the Introduction.

Take Schlumberger and General Dynamics, both of which made the transition from the challenged category in the first business cycle (1984-94) to the growth giant category in the second (1994-2004). General Dynamics made the leap by divesting heavily in the early 1990s as the defense market deteriorated, and then going into acquisition mode once the market offered better prospects. Schlumberger also worked its way up by actively trading its portfolio. On the one hand, it strengthened its operations in the fast-growing market of oilfield products and services by making a series of acquisitions, including Camco’s drilling products and services and Baker Hughes’ seismic services. On the other hand, it divested businesses that didn’t fit with its growth goals, such as metering, chip-testing, and IT services outside the oil industry.

If we now turn to the companies that managed to retain their growth giant status through two business cycles, we find that many of them did so by making extensive use of M&A. Some, such as GE, are renowned for the effectiveness of their M&A machine; others, such as Pfizer, are leading the consolidation of their industry. Between 1994 and 2004, when the compound annual growth rate of the pharmaceutical industry was running at 9 percent, Pfizer made several key acquisitions, buying Warner-Lambert (at that time about two-thirds its size in terms of sales) for $112 billion in 2000, and Pharmacia in 2003—a purchase that made it the world’s largest research-based pharmaceutical company.

To answer this question we need to go back to the decomp database, this time to understand what drives the differences among the growth rates of different companies. Using a multivariate regression, we looked at the contribution of the three growth elements to differences in company growth. As Figure 2.5 reveals, 79 percent of what differentiates leading companies from the rest in terms of growth performance is explained by portfolio momentum and M&A—factors determined by where a company chooses to compete. Just as in real estate, then, location matters.

In terms of the individual cylinders, portfolio momentum or market growth explains 46 percent of the difference in growth performance between large companies, highlighting the importance of market selection in driving growth.

Fig 2.5 Performance differentiation by growth component^*

Percent

M&A is responsible for 33 percent of the performance difference. That is, active acquirers grow a lot faster than companies that rely on organic growth. (We discuss whether this creates value in chapter 6.)

Share gain explains on average only about 21 percent of differential growth performance,⁴ so it’s hard to escape the conclusion that the effort companies put into hard work and smart execution doesn’t get them very far relative to competitors.

Put another way, a company’s choice of where to compete is almost four times more important than outperforming within its market.

At this point you may be wondering whether the relative unimportance of market share in explaining differences in growth performance applies only to certain market sectors. To find out, we compared a cross-section of industries.

Not surprisingly, the eight sectors we examined show some variation (Figure 2.6). However, the overall message remains the same: market share outperformance doesn’t play a significant part in the growth differences between leading companies and average performers. In most sectors it is responsible for less than a quarter of the differential. The only major exception is the high-tech sector, at 36 percent. Here, the disruptive nature of the market and the brevity of product life cycles facilitate new entry, so allowing young upstarts to challenge the market share of established players a bit more frequently than in other sectors.

Fig 2.6 Differentiation by growth cylinder and for selected sectors

Percent (number of companies)

To explore further the part played by favorable markets—or what we call “tailwinds”—in differentiating growth performance, let’s now return to the four categories we looked at in the Introduction and apply them to a set of companies from our growth decomposition database (Figure 2.7).⁵

The companies with growth giant performance are helped by favorable tailwinds and substantial M&A, which together drive their performance. On average, a growth giant with revenue growth of 16.8 percent receives 10 percent from portfolio momentum and 5 percent from M&A. The remaining 1.8 percent growth comes from market-share gains.

Unrewarded companies also benefit from tailwinds. On average, they receive just over half (6.7 percent) of their total annual growth of 12.9 percent from market momentum, and slightly less (5.3 percent) from M&A. Growth in market share contributes just 0.9 percent.

The performers are in the doldrums. In fact, their portfolio momentum is below the GDP growth rate and is in some cases even negative.

Fig 2.7 Decomposition by quadrant

Average revenue CAGR breakdown, 1999-2005, percent

The challenged companies, far from receiving favorable tailwinds, are in fact being buffeted by multiple headwinds in the markets where they operate. At 3.3 percent, their portfolio momentum is below GDP. In addition, these companies are losing market share at the rate of 1.6 percent a year.

What lessons can we draw from this? One obvious observation is that growth giants deliver, on average, more growth both overall and in each one of their cylinders—portfolio momentum, M&A, and share gain—than any other group, performers included.

It’s abundantly clear from this analysis that a company’s granular growth performance depends heavily on the markets in which it operates. So the next time a company announces stellar performance, it’s worth taking a closer look to see how much of its growth came from better steering, and how much from a favorable tailwind. What is driving performance: execution or strategic choices?

In much the same way, it’s a good idea to ask questions about your own company’s performance. Do you know your numbers on growth, and your peers’, both by segment and overall? Do you use them in your planning, performance appraisals, and external presentations? Are your plans consistent with your real sources of growth? Or are they based on possibly unrealistic hopes of gaining market share?

In the next chapter, we draw on the insights we’ve developed from the decompositions to explore the different ways in which companies have grown.

Getting to the sources of growth

Peer comparisons

Growth for the average large company

Portfolio momentum: Thank your predecessor

M&A: More important than you think

Market share: Seldom a growth driver

Location, location, location

Tailwinds or headwinds?

NOTES