CM: You've recently compared the current business climate to weather conditions that gave birth to the Perfect Storm. What exactly do you mean?
Zook: Well, I don't know if you saw the movie, but it's the convergence of three weather forces that had not converged before. And it strikes me that one reason we're experiencing what we are is the convergence of three forces. Number one, I can't find a time, going back into the early 1900s, when the price/earning ratios were over 20 — which is a measure of expected profitable growth — this far into a slowdown period in all the major western economies. P/Es are over 22 in the United States, 20 in Canada, 21 in the U.K., 20 in France, and so on. So I think there's enormous expectation for continued sustained profitable growth on the part of shareholders and boards, even though we're in a slowdown period, which everybody agrees.
The second force is, I don't think the penalties for a shortfall have ever been greater. Some of the numbers are really astounding. 1.2, 1.3 years is how long the average share is held, it used to be about 2.5 years in 1990 both in the U.S. and the U.K. and in France. It was about four years about two decades before that, and about eight years a decade or so before that. So it's gone from eight to 1.2 years — how quickly people are now willing to dump stocks. And of course CEOs were replaced in the U.S. at a 22 percent rate last year, and the U.K., which is usually slower to act on these things, was at a 25 percent rate.
I think the third force, which is what a lot of the book is focused on, is that the odds of sustained profitable growth are low. That is lower than most people think, and it seems to be getting lower over time. So if you put those three forces together, the combination is causing companies and management teams to say, "What are the most reliable, high-probability ways of finding sustained, profitable growth and meeting my objectives?"
CM: The penalty is really impatience.
Zook: Three quarters of CEOs who were replaced last year were not replaced because of age or change of lifestyle. They were replaced because of performance. In the last three to four months in the United States, we've seen a record number of CFOs being turned over by their CEOs, who are feeling pressure from stockholders in turning over their shares at a record rate, so I think it's rippling throughout the whole organization. But what that does, of course, is to create a much shorter-term focus because you're worried about three months, you're worried about six months, you're worried so much about the quarter that the long run almost becomes a series of short runs. Which is counterproductive for longer-term customers.
CM: You charge that too many companies diversify their businesses before having a true understanding of their core business, but not diversifying quick enough can be harmful as well?
Zook: I think that in every successive decade the world is rewarding more and more an expertise and focus around a core. I think we're seeing a continuation of a long-term trend in a sense, but it may pick up speed after going from a fast period and calming into a slow-down period. There's a drumbeat in every newspaper you pick up. I was just looking yesterday and saw an article about how Polaroid stock is down to $4, and of course that's a company that lost track of what was going on around its core and stayed with film photography and didn't expand its core into digital. … Or you see cases like Lucent, which set up nine small technology businesses and sapped resources from the core and overcomplicated their company. Recently, there was the announcement that they are returning to become a simpler, more focused company again.
CM: Why do companies continue to struggle with what should be obvious — to expand, you first need a bedrock of core profitability?
Zook: I think it's an issue of relative priority. The first priority for every company has to be to define its core in the right way and then to make growth investments that reinforce the core business, that extend the core strength in a really powerful way above all else. The second priority has to be to experiment on the fringes with new ideas, to make sure you're aware of what a few small competitors might be doing in relation to your business. But that cannot dominate your thoughts, and it's so easy to become fascinated by new initiatives on the fringe. … I think that companies have so many growth initiatives around the core business, some close in, some far away. It's very difficult to keep them all in mind at once. We often find that companies that asked us to get involved in growth have never actually written all the initiatives down on a piece of paper, let alone written them down on which extend products, which extend customer groups, which are close to the core, which are far from the core.
CM: Why do companies often overreach when they look to diversify?
Zook: I think one reason for overreaching is an exaggerated definition of what your core really is. The second reason is the myth that it's better to buy a weak position in a hot industry than to build a strong position in a more mediocre industry. And we find that it is three times more valuable per dollar on average to seek out growth, and strong positions in weaker industries, than to go into a weak position in a hot industry. … I think there are still a lot of people who believe they should invest in the next hot industry — that's why so many people invested in Internet ventures.
The third reason is just the trap of false enthusiasm. People who believe a business relates to their core may not have done all the homework or rushed into a decision to invest. I think those are three distinct reasons why people overreach from their core, sap resources away from their core business, and leave it undefended and put less attention on it, and then when they return back to the core in search of profitable growth, they find it's weaker than it has once been.
CM: You've been quoted as saying that Compaq overreached when it looked to expand past its core business of PC-making into services. Some would argue that services are a very complementary business to Compaq's core. Do you see this differently?
Zook: My feeling on Compaq is that their strategic priorities were questionable. Looking from the outside, it appeared that their strategic priorities were, number one, buy the DEC service business, number two, buy Tandem Computers, number three, look for other investments like biotech where they invested $100 million last October, and number four, fix the illness in their core PC and server business, which they were unable to do for a very long period of time. I would think that at least from the outside, an alternative ordering of priorities would be, number one, fix the core. Number two, buy the DEC service business perhaps and integrate it in for the large companies. Three, four, and five, do nothing else — do the above, just stay focused.
And so I see a company that got lost in its identity and tried to do too many things at once. It sapped resources away from its core — its core is still sick.
CM: IBM has gone from computer hardware into services over the last decade, and it looks like a successful expansion for them. They've enjoyed healthy profits through services.
Zook: Yes, and that's a company that has done a series of small service acquisitions. Most of the growth in the service business has been organic, most of it has been step-by-step. They've reinforced their core. It's a service that was desperately desired by their core customers, large enterprises, and has also been brilliantly executed. I think it's been a textbook case of adjacency expansion off of a strong core in a very strong way, step-by-step, building dominance.
CM: How does your premise of core profitability apply to Internet companies?
Zook: We looked at 1,500 Internet companies that were funded over three years. Of those 1,500, only 157 of them performed well enough to go public. Of the 157, only about seven or eight of them had maintained profitability. Of those eight, we would say only four or five of them have a strong, dominant core and very good growth prospects for the future, and one of those is eBay.
You'll find that eBay has made a series of small and medium-size acquisitions to extend their technology and their franchise internationally, for example. But they've really been very careful about avoiding large, complex acquisitions or joint ventures. As a result, they've been very successful at improving their business model. Whereas an opposite company, like WebVan, before even proving profitability in one neighborhood, one product line, in one core to build upon, was doing acquisitions of competitors with somewhat different business models in the grocery business. I think eBay is an example of a company that has done a series of small acquisitions, but has just done a great job with them.
CM: Amazon recently announced plans to sell computers. Any thoughts?
Zook: I don't know the details of what Amazon is planning to do. Certainly, if what Amazon is doing is putting a link onto their home page, which then goes to somebody that's in the business of distributing computers, that might be relatively undistracting from their core business and not that important of an announcement. If what they're actually doing is intending to set up warehouses to handle computer products themselves, they're going into one of the toughest businesses in the world — against some of the toughest, most expert competitors the world has ever seen — in a time when the margins are going down. And you have to say to yourself, "What's up with that?" So I think it depends on the details.
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