Defying Gravity: Preparing for the Inevitable Downturn in Your Core Business

Posted on March 15, 2012

Nearly every successful middle-market company eventually faces a swarm of competition. When their core business contracts, single-product companies can find themselves fighting for their lives. But the companies which plan highly-related diversifications before such downturns grow in good times and bad.

Many middle-market companies have one core business and tend to it well. They are often the first to market and enjoy tremendous growth before any competitors are able to catch up. But as the business matures and the competition becomes entrenched, growth slows. So when the economy turns south, mature middle-market companies get squeezed and performance drops.

Here’s an example:  syrup flavoring company Torani’s core market was the café industry. When this business was young, the market supported phenomenal growth rates in the 50 percent range. But in the late 1990s, the growth slowed down to the 20 percent range, then to single digits by 2005. By the time the 2007 downturn hit, Torani’s growth was flat.

Obviously, mid-market companies would love to maintain a high growth rate in all economic conditions and side-step the inevitable waning of their core business. But how?

Most companies address this problem through conventional strategies – finding new customers for existing products, creating new products for existing customers, adjusting prices, or ramping up sales and marketing. These are all valid tactics and ought to be considered at all times, yet they usually deliver only incremental improvements that produce less impact over time.

In addition, merely tweaking existing products and services leaves companies vulnerable to cheaper or better innovations. For example, improvements to the fax machine during the 1980s and 1990s helped extend its lifecycle. But thanks to fresh Internet-based alternatives, no one is pouring resources into new fax machines today.

Something else happens to many mid-market companies that experience healthy growth: they get too comfortable with it. They devote all of their resources to maximizing the core product and do nothing to prepare for the day when it will no longer be competitive.

The optimal solution is to find new or adjacent markets long before a company’s growth rate starts to wane, when times are good. Large companies often do this by developing a portfolio of business units—some with stable positions in mature markets, and others focused on new, high-growth markets. Through this approach, a company like General Electric is able to generate strong growth year after year.

Of course, middle market companies do not have the bandwidth GE does—but they can utilize the same thinking. While growth in their core business is still healthy, they can start pilot programs.  These may explore new or adjacent markets, new market needs, or frankly anything that leverages their core competencies into a new business with the potential for long-term growth.

For mid-market companies, the key is to focus on core competencies. Large companies have the cash and bandwidth to jump into areas in which they have not yet developed or acquired a core competency. But mid-market firms do not have this luxury. For them, building a new core competency takes an enormous amount of effort and is fraught with risk. On the other hand, leveraging existing expertise on a pilot program keeps the expense of pursuing new products, services or markets within budget, simultaneously allowing enough time to do it right until the new opportunity proves itself.

In 2008, 20-year software veteran Pete Daffern took the helm of Clairmail, a seven-figure company which connected mobile technology to back office software in multiple markets. One year later, having experimented with many verticals, Pete shifted Clairmail’s focus to retail banks—a segment that had undergone enormous pain due to the collapse of capital markets and the accompanying economic downturn.

The move seemed risky. Yet Clairmail had something the retail banks really needed, and it turned out to be the firm’s next big thing. Today, Clairmail’s revenues approach $100 million. Moreover, the company recently won the Bank Administration Institute’s MobileLink Pace Setter Award for increasing mobile usage and furthering mobile innovation in retail banking.

Building the Future into the Present

Keep in mind that when you really, really need a green field—a new business with big potential—it’s usually too late. The idea is to consistently look for the next big thing, or at least start five years before your core business peaks. You need to bake this into your strategic priorities with a separate budget and a team which is completely detached from the one assigned to your core products/ services.

Here are some key elements of this effort:

Allocate time from your best strategic thinkers. From great minds come great ideas. But those great minds must be committed to finding the next big thing, and must set aside time specifically for working on this task. Torani, for example, hired strategic sales experts to supplement the CEO’s years of experience, then ran a disciplined process of ideation, including regular meetings and discussions.

Conduct market research every year to assess competitors and markets. While purchased research can help, many mid-market businesses are in niches that are not heavily studied and reported on. Their executives need to leave the office and get intimate with customers, products and consumer behaviors. Forget about selling. Instead focus on what the customer needs but isn’t getting, or why the customer buys from a competitor. This job-to-be-done approach is being studied and popularized by Harvard Business School professor Clay Christensen (you can find his recent Harvard Business Review case study here).

Consider Flexstar Technology, a private equity-based company with revenues of about $40 million. Flexstar sold quality assurance test equipment for computer hard drive manufacturers, but as CEO Tony Lavia explains, the company’s sales were constrained by a small number of large manufacturers buying new test equipment only when they changed form factors. By 2008, Flexstar’s top line was growing slowly, in the single digits.

Every year, Tony went to industry conferences and listened to the growing debate between mechanical hard drives and newer, solid-state drives (SSDs). In 2009, he took a gamble and developed test equipment for high-volume production of SSDs.  Flexstar now has the lead in this new adjacent market, which is fueling growth dramatically. Revenue from SSD test equipment in just three years has surpassed 50% of total sales, and the product is delivering a growth rate more than five times the company’s conventional hard drive test equipment product line. Since 2009, SSD test equipment sales have doubled or more every year.

Give it a budget every year. This is especially difficult during a downturn because money is tight all around. In fact, it is very easy to cut the budget for the next big thing, and many companies do. This must be resisted. Making this component of your budget sacrosanct not only presents the initiative as doable, it establishes it as a priority in the minds of your team.

Develop and test a set of hypotheses about the “next hot area.” You may see several avenues for growth, but not know which is best. You can find out by creating quick, low-cost tests to get feedback. These might be small region market tests, or “bubble gum and tape” prototypes to demo in front of key customers, or outsourcing manufacturing of a short-run product to get a quick test completed. Torani, for example, created a three-year, “test and invest” program, which included new organic food products and vegetable-based flavors, as well as new distribution channels, such as consumer retailers and restaurants. Ultimately, they chose to sell their core flavorings products through retail channels, and it has been driving double-digit growth for the past three years.

“Winning” ideas advance to a second test. There may be five concepts worth considering, and among them, three really good ones. Ditch the other two. Then test those three until you find the one that can drive you forward.

Scale the winner. Testing the new product or service carefully will give you a much higher probability of success. Scaling the operations that support a new offering is always costly, but doing it when the core business is robust can help cushion the expense.

Obstacles to Expect and How to Address Them

CEOs should expect internal resistance to exploring a new business avenue. Here’s how I’ve seen it play out, and ideas on how to address it:

Complacency. The management teams of fast-growing mid-market companies never seem to have the time, bandwidth or urgency to look for the next big opportunity. They know intellectually that it is important, but nothing ever happens. Set up a dedicated team with a clear mission and its own budget to drive this process forward. (It may mean pulling some talent out of the core business, which of course will need to be backfilled.)

Fear. Many companies find that looking so far into the future is a distraction for their teams. Confusion erupts as to what the “core” of the business is, and why the firm is “abandoning” the core. Let your people know that you’re not abandoning the core business, but in fact are trying to ensure the future health of the company. Care and effort should be put into communicating to the entire organization the message that innovation is an important part of assuring your company’s long-term growth. Meanwhile, having pilot programs and tests contained within a diversification team helps keep the core team focused on today’s business but aware of tomorrow’s business.

Perception of waste. Long-term planning is often derailed by short-sighted shareholders who are used to strong dividends and high profit margins. To them, a new budget with an uncertain, long-term payoff seems like a waste. To offset this perception, it’s important to communicate the realities of your maturing market and show a clear, measurable plan for your diversification efforts. If you start the process early enough, the budget will feel small and will be more likely to gain approval.

For companies facing imminent insolvency, it may be too late to begin these efforts. When survival is truly at stake, cutting away non-core expenses is usually advisable. Yet many companies with tight cash and declining growth are years away from insolvency. In some cases, it is better to stop tinkering with incremental improvements that aren’t moving the needle in favor of more dramatic changes.

Even for healthy, growing companies, finding an adjacent market with big potential is hard work with uncertain results. It usually takes years of sorting through many potential opportunities to find one with proven potential. Torani worked for two to three years before it became clear the retail channel would be its next big growth area. Since no one knows at the outset when the new business will be ready to scale, starting immediately is paramount.

But in spite of this uncertainty, not looking for the next big thing represents the greatest danger to a mid-market company’s long-term future. No one knows for sure when the current core business will begin to decline and no one can foresee the severity of that decline. In the absence of change, gravity takes over, and the time that any existing business remains viable decreases with each passing day. This gravitational process accelerates when the economy turns south or when new, aggressive competition emerges from the pack.

It takes real discipline on an ongoing basis to identify, prepare and explore new opportunities beyond your core business. But the potential payoff is nothing less than the ability to defy gravity by constantly generating new growth – in good times and bad.

So how is this actually put into practice?

Two Illustrative Case Studies Follow.

Melanie Dulbecco, CEO of Torani

Melanie Dulbecco, CEO of Torani, the flavored syrup company, joined the company 20 years ago after graduating from Stanford Business School. When the café sector—the company’s core business —was hot and growing in the mid-1990s, Torani experienced hyper growth rates of around 50% per year.

But by the time growth fell flat four years ago, Dulbecco and her team were looking for new ideas.

Finding the next big thing starts with mindset. Dulbecco says, “Our attitude was , ‘We’re going to do this. We’re going to figure it out.’”

She realized it would be necessary to overhaul Torani’s executive team. “That was a really, really hard thing,” Dulbecco says. “We had people who were very skilled in the café market who weren’t ready to do new things.” But some people stayed and took on new roles and Torani attracted new talent. “That was critical to us, to have new talent to combine with people who had know-how in our categories,” she says.

Dulbecco  developed a three-year plan for strategic planning, rooted in measured risk taking, which she calls the “test and invest” model. She made sure everybody in the company was on board with the risk and the goal of developing the next big thing by sharing the ultimate objectives.

Ultimately what “popped” was retail, but they had a short misfire along the way,  attempting an organic product line. “We used the ‘test and invest’ model, not going whole hog,” Dulbecco recalled. “Ultimately when the product didn’t make it, we learned a lot from it so we’d know what to do next.” Several other areas for growth also took second place to retail.

Just four years after investing heavily in retail, it represents over 30% of Torani’s top line – plus it’s growing at over four times the rate of their café sector.  Torani’s products are now found in Cost Plus/World Market, Safeway, Wal-Mart, BevMo, Smart & Final, Raley’s, and many other retail stores.

“It feels very sensible and rational when we look back on it, but it felt a little scary and daunting,” she adds. “When we’re in a tough situation in our own market, or in the economy, we tend to get a ‘hunker down’ attitude. I find that that’s something that we really have to fight.”

 

Tony Lavia

President & CEO, Flexstar Technology

Tony Lavia’s company, Flexstar Technology, focused on selling QA test equipment for hard drive manufacturers, but sales were constrained by the small number of large manufacturers who bought new equipment only when they changed form factors. Growth remained in the single digits until 2009, when Flexstar began developing test equipment for high-volume production of solid-state drives (SSDs). The move totally revitalized the company’s growth rate, as the majority of sales now comes from this new adjacent market.

Flexstar took chances on product development. “We do as much analysis as possible, but then instead of building a few and trying them out, we essentially design them up to a point where real money is required,” Lavia says. Once the company knows what it can build and when it can deliver, it shelves them and heavily advertises them. “We say, ‘Hey, they’re here, come and buy them.’” he says. “As soon as we get our first real customer, we finish off development.”

In just three short years, the sales of SSD have doubled each year, recently surpassing 50% of total sales. It’s also delivering a growth rate that is five times higher than Flexstar’s traditional product line. But how did Tony know the SSD market was the right thing?

Lavia recalls the debates in the technology industry between “upstart Silicon Valley people” and “hard drive veterans with  forty years experience” about where the industry was headed. For the latter group, the “next big thing” was not obvious at all. And yet Lavia’s own experience was precisely the reason why he recognized the next big thing when he did.

“Having been in this business such a long time, I have never seen an example where solid state lost against mechanical. Never,” he says. “But we didn’t want to risk a lot of capital. So we bastardized one of our standard machines, modifying it just enough to prove that we could make it work. It wasn’t elegant or even efficient, but it did the job. We showed what we could do, got an order, then fine-tuned the process. One order led to another, and soon it became clear that we had made the right move.”