Chapter 4

1. Chapter 4 Instructors: Please do not post raw PowerPoint files on public website. Thank you! Return on Invested Capital

2. Why is ROIC Important? An Introduction to ROIC: • In 1999, eBay’s market capitalization was $23 billion, while Webvan’s was $8 billion. Both were high-flying Internet startups with little financial history, so why such a difference in market values? • The difference in market value can be traced to capital intensity: • Webvan was an online grocery-delivery business and its business model required substantial warehouses, trucks, and inventory. • eBay’s featured an easily scalable online auction business model which required no inventories or receivables and very little invested capital. • Eventually, Webvan burned through its cash and eBay continued to prosper. We can trace this difference to the increasing returns to scale that each company’s business model exhibited—and this is the dimension that ROIC attempts to capture.

3. Sustainable Competitive Advantage • The efficient use of capital will improve short-term ROICs, but to maintain long-term ROICs above the cost of capital, the company also needs a sustainable competitive advantage. • For instance, pharmaceutical companies tend to have high ROICs (ranging between 20-30% between 1998 and 2008) because cost of production is low and barriers to entry (R&D and patent protection) are high. Company Profitability: Industry Matters

4. A Deeper Look at ROIC • Return on invested capital equals the company’s after-tax operating profit divided by the amount of operating capital the company requires to run operations: • Divide both sides by the number of units the company produces: • Finally, separate operating profit into price minus cost. A superior ROIC results from either a price premium relative to peers or a lower cost or capital per unit (or both):

5. Sources of Competitive Advantage • As shown on the previous slide, A superior ROIC results from either a price premium relative to peers, a better cost structure or less capital required per unit (or both). Example: Quality: Customers willing to pay a premium for a real or perceived difference in quality over and above competing products or services. Cost: Innovative business method: Difficult-to-copy business method that contrasts with established industry practice Scalable product/process: Ability to add customers and capacity at negligible marginal cost/capital. Price premium Better cost structure Superior ROIC More efficient use of capital

6. Price Premiums • Unique Products through Innovation: Innovative good and services yield high returns on capital if they are protected by patents, difficult to copy, or both. • Pharmaceutical companies typically gain patents on new products, giving them 20 years with a market monopoly. • Apple’s iPod is an example of a non-patent protected product which is difficult to copy because of its appealing design and branding, not necessarily its technology. • Real (or perceived) Quality: Quality refers to any real or perceived difference between one product or service and another for which consumers are willing to pay a higher price. • In the car business, for example, BMW enjoys a price premium because customers perceive that its cars handle and drive better than comparable products that cost less. Price To sell a product at a price premium, a company must find a way to differentiate its products from those of competitors. Let’s examine five sources of price premiums: Cost ROIC Capital

7. Price Premiums • Brand: A factor highly correlated and difficult to distinguish with “Quality,” Brand is especially important when no particular quality difference is present and customer loyalty to brands in a particular industry allows companies to charge higher prices for their products. • Strong brands allow cereal companies to earn ROIC of roughly 30%, while a lack of brand strength relegates meat processors to an ROIC of 15%. • Customer Lock-In: Making the replacement costs expensive or impractical for consumers is an ideal way to lock-in customers and keep ROIC high for a particular company. • Doctors that train on certain equipment such as stents, they usually have no compelling reason to go through the training process once more for a competitive product. Price To sell a product at a price premium, a company must find a way to differentiate its products from those of competitors. Let’s examine five sources of price premiums: Cost ROIC Capital

8. Price Premiums • Price Discipline: In commodities industries, the laws of supply and demand can drive down prices and ROIC, but some industries are able to set prices (though it is illegal in many instances), and this can create elevated ROIC levels. • OPEC (Organization of Petroleum Exporting Countries) is the world’s largest and most prominent cartel and is able to set prices on oil (though a free-rider threat exists as there is tremendous incentive to lower prices and attract more sales). Price To sell a product at a price premium, a company must find a way to differentiate its products from those of competitors. Let’s examine five sources of price premiums: Cost ROIC Capital

9. Cost and Capital Advantages • Innovative Business Method includes a combination of a company’s production, logistics, and pattern of interaction with customers. • Dell’s unique and innovative method to sell directly to customers and keeping minimal inventory by purchasing standardized parts from different suppliers and different times, allowing it to outsell its competitors until the shift to notebook computers caused a industry-wide shock • Unique Resources consists of the advantages proffered by access to something that cannot be replicated, such as a geographic location or a mine of natural commodities. • Take two nickel-mining companies, Norilsk Nickel, which produces nickel in northern Siberia, and Vale, which produces nickel in Canada and Indonesia. The content of precious metals (e.g., palladium) in Norilsk’s nickel ore is significantly higher than in Vale’s. Norilsk gets not only nickel from its ore but also some high-priced palladium. Price Cost efficiency is the ability to sell products and services at a lower cost than the competition. Capital efficiency is selling more products per dollar of invested capital than competitors. Cost ROIC Capital

10. Cost and Capital Advantages • Economies of Scale refers to the notion that with greater size, economies are born (though usually at the regional or even local level, not in the national or global market). • Profitability of health insurers is driven by their ability to negotiation prices with providers, usually doctors and hospitals (which tend to be local), and size is the key element in the ability to negotiate successfully. • For instance, anyone who wants to compete with UPS or FedEx must first pay the enormous fixed expense of installing a nationwide network, then operate at a loss for quite some time while drawing customers away from the incumbents. • Scalable Product Process represents the concept that supplying or serving additional customers is extremely low cost. Many companies use information technology (IT) to deliver such products and services in a scalable form. Because serving more customers is at negligible cost, margins rise as sales rise—a huge boost for ROIC. Price Cost efficiency is the ability to sell products and services at a lower cost than the competition. Capital efficiency is selling more products per dollar of invested capital than competitors. Cost ROIC Capital

11. Sustainability • The longer a company can sustain a high ROIC, the more value a company will create. Whether a company can sustain a given level of ROIC depends on the length of the life cycles of its businesses and products, the length of time its competitive advantages can persist, and its potential for renewing businesses and products. • Length of Product Life Cycle. The longer the life cycle of a company’s businesses and products, the better its chances of sustaining its ROIC. • While Cheerios may not seem as exciting as an innovative, new technology, the culturally entrenched, branded cereal is likely to have a market for far longer than any new gadget. Tastes change very slowly. • Ease of Imitation. If the company cannot prevent competition from duplicating its business, high ROIC will be short-lived, and the company’s value will diminish. • When the cost improvement of self-service kiosks arose in the airline industry, it translated into directly lower prices for consumers and little change in ROIC, because every airline had access to these improvements. • Potential for Product Renewal. Consumer goods companies excel at using their brands to launch new products: Think of Apple’s success with the iPod and iPhone, Bulgari moving into fragrances, and Mars entering the ice cream business.

12. An Empirical Analysis of ROIC

13. Empirical Analysis of ROIC • In this section, we present evidence on rates of ROIC for more than 5,000 U.S.-based nonfinancial companies since 1963. Our results come from McKinsey & Company’s Corporate Performance Center database. Key findings are as follows: • Median ROIC between 1963 and 2008 remained relatively constant at 10%, but it did vary dramatically across companies, with only half of the observed ROICs between 5% and 20%. • Line of Business is a major driver for ROIC, as industries with sustainable competitive advantages, such as patents and brands, have high median ROICs (15-20%), versus basic industries (paper, utilities, and airlines) with low ROICs (5-10%). • Variation within an Industry occurs, as the spread between the best and worst performers in an industry can be quite significant. • Rates of ROIC are fairly stable, as there is not much fluctuation among industry aggregate ROIC rankings, and individual company ROICs gradually tend toward their industry medians over time but are fairly persistent.

14. ROIC: 1963-2008 • The aggregate median ROIC without goodwill over these years equals about 10 percent, with annual medians oscillating in a relatively tight range between 7 and 11 percent, except during the years between 2005 and 2008. U.S.-Based Nonfinancial Companies: ROIC, 1963–2008 • A few comments: • ROIC is directly correlated with overall economy growth. Regressing median ROIC against gross domestic product (GDP) showed that a 100-basis-point increase in GDP growth translated into a 20-basis-point increase in median ROIC. • Until about 2004, median ROICs were stable. In recent years, however, a company had to earn a return on capital near 20 percent to be above the median, and a return above about 25 percent to be in the top quartile.

15. ROIC Distribution • The distribution is wide for all periods, with most companies earning between 5 and 20 percent ROIC over the past 45 years. • However, there has been a recent shift toward more companies earning very high returns on capital. • In the 1960s, only 1 percent of companies earned returns greater than 50 percent, whereas in the early 2000s, 14 percent of companies earned returns of that magnitude. Distribution of ROIC: Shifting to the Right

16. Sustaining ROIC • In this analysis, we measured the sustainability of company ROICs by forming portfolios of companies earning a particular range of ROIC in each year (e.g., above 20 percent) and then tracking the median ROIC for each portfolio over the following 15 years. • Companies earning high returns tend to see their ROIC fall gradually over the succeeding 15 years, and companies earning low returns tend to see them rise over time. Nonfinancial Companies: ROIC Decay Analysis

17. ROIC Trends: Persistence of High-Performance • The below chart shows that the best-performing companies tend not to have a full decay of their ROIC levels to aggregate median levels. High-performing companies are in general remarkably capable of sustaining a competitive advantage in their businesses and/or finding new businesses where they continue or rebuild such advantages. Nonfinancial Companies: ROIC Decay Analysis • The ROIC of both high and low performing companies tends to the median, but does not fully reach the median on either end • This points to the fact that successful businesses can sustain competitive advantages in their businesses, though it also might mean that unsuccessful business struggle to ever establish any sort of competitive advantage

18. Summary There are many lessons to learn about returns on invested capital. • These returns are driven by competitive advantages that enable companies to realize price premiums, cost and capital efficiencies, or some combination of these. • Industry structure is an important but not exclusive determinant of ROIC. Certain industries are biased toward earning either high, medium, or low returns, but there is still significant variation in the rates of return for individual companies within each industry. • If a company finds a formula or strategy that earns an attractive ROIC, there is a good chance it can sustain that attractive return over time and through changing economic, industry, and company conditions—especially in the case of industries that enjoy relatively long product life cycles.