Category: Strategy

The composition of a company’s corporate officers or board can tell you a lot about a company’s operations and culture. “If a corporation has two executives who think alike,” Ray Kroc, the man who transformed McDonald into an international juggernaut, told a bunch of college students. “One of them is unnecessary.” In the case of McDonald’s corporate officers, during Kroc’s time, the group’s diverse background was viewed as a key strategic asset.

In Kroc’s mind, McDonald’s wasn’t building a typical company. At that time, franchise businesses made most of their money off up-front franchising fees. Kroc wanted to invert that model. Instead of charging $50,000 for a franchise fee, McDonald’s would charge just $950 upfront and 1.5% of future revenue. To ensure that 1.5% generated sustainable income, Kroc had to perfect the firm’s business operations—a first for a food service company.

He didn’t want to hire a bunch of MBAs to manage his business because they were all trained in a specific management approach–one that prioritized upfront fees over a long term partnership. In McDonald’s: Behind the Arches author John F. Love summarized Kroc’s situation, “Even the best hotel and restaurant schools had no notion of the type of business Kroc was building.”

McDonald’s corporate officers: Kroc’s ideal

This ethos resulted in a preference for hiring action-orientated people over academics. College and advanced degrees weren’t needed. What McDonald’s needed was people who had common sense and were willing to work the long hours necessary to build an innovative new model.

Love highlights the McDonald’s commitment to this ideal.

When he joined McDonald’s personnel department in 1962, Jim Kuhn was greatly relieved to learn that McDonald’s did not require (and still does not) a college degree for managerial slots. ‘ ‘The thing that I loved at McDonald’s,” Kuhn says, “was that they just told me to go out and get the best damn people I could get and to look at them, not their credentials. We hired people that would not have gotten through the door at other companies, not because they were losers but because they were not traditional.”

That philosophy is intact today and is reflected in the surprising lack of college degrees inside McDonald’s executive suite. Of the twenty-six executives at the senior management level of McDonald’s Corporation, fully twelve are without college degrees, including Chairman Turner. Among the company’s eighty corporate officers—from assistant vice president on up—forty-three (or 54 percent) do not have baccalaureates. For its size, McDonald’s also has relatively few MBAs (twenty-eight), and it is likely the only company in America with more than $1 1 billion in sales that does not boast a single Harvard MBA. “Our people all have real-world degrees,” Kuhn says.

This ideal turned hiring into a core strategic asset. While its competitors focused on perfecting the now, they were building towards the future.

Modern composition..still an asset?

Does McDonald’s carry on this same preference for action and results over academic achievement? Well, the short answer seems to be no. Obviously, times have changed. America’s view towards college attainment has shifted tremendously. In 1960, when Kroc was laying the foundation of the McDonald’s empire, just 7.7% of Americans were college graduates. In 1986, when Behind the Arches was published, the number was around 20%. Today, that number is 35%. But still, I was surprised by the results.

According to their website, there are 14 corporate officers. Of these McDonald’s corporate officers, all 14 have college degrees. 8 of the 14 (57%) have advanced degrees. 5 have MBAs.

As McDonald’s heads into new and unproven areas of business, namely e-commerce, it’s easy to wonder if Kroc’s vision may be better suited.

But on the bright side, there is now at least one Harvard MBA within the company: CEO Chris Kempczinski.

Photo by Erik Mclean on Unsplash

General Electric announced it would sell its lighting business to Savant Systems in a deal valued at $250 million. The agreement itself was long rumored but still comes as a surprise. In a way, the transaction signifies the death of an era–almost as if Coca-Cola sold of its sugary beverage line. General Electric didn’t invent the light bulb, but it did invent consumer light bulbs—the first affordable and mass-produced version. This spring boarded General Electric into the pantheon of history’s great companies. In the mid-2000s, G.E. was in everything from consumer goods to entertainment, and it boasted annual revenues on par with a middle-income country. Then, mismanagement forced the company to rethink the conglomerate strategy. “It has shifted its focus to making heavy equipment,” the WSJ wrote in its coverage, “like power turbines, aircraft engines, and hospital machines.” In 2019 G.E.’s revenue dropped to around $30 billion. 

Sometimes significant shifts beg simple questions. If G.E. was one of history’s best companies and it was a conglomerate, what is a conglomerate? Is there a standard conglomerate definition? What was the rationale for becoming one? Did the conglomerate strategy lead to General Electrics’ decline?

Definition of a conglomerate

The best conglomerate definition I’ve found is courtesy of Matt Stoller. In his book Goliath, he describes the structure as follows:

A conglomerate is simply a holding company or corporation that operates in multiple industries, usually owning individual divisions that could stand apart as separate businesses on their own. Early conglomerates were initially focused on a suite of related activities, like G.E. and electrical system in the 1900s or branded food conglomerates of the 1920s.

Like all aspects of business, the conglomerate structure evolved as American politics evolved. Founded in 1892 by five titans, including J.P. Morgan and Thomas Edison, General Electric combined a variety of small electrical component companies under one umbrella.

From the company’s official history:

As both businesses expanded, it had become increasingly difficult for either company to produce complete electrical installations relying solely on their own patents and technologies. In 1892, the two companies combined. They called the new organization the General Electric Company.

Several of Edison’s early business offerings are still part of G.E. today, including lighting, transportation, industrial products, power transmission, and medical equipment. The first G.E. Appliances electric fans were produced at the Ft. Wayne electric works as early as the 1890s, while a full line of heating and cooking devices were developed in 1907. G.E. Aircraft Engines, the division’s name only since 1987, actually began its story in 1917 when the U.S. government began its search for a company to develop the first airplane engine “booster” for the fledgling U.S. aviation industry. Thomas Edison’s experiments with plastic filaments for light bulbs in 1893 led to the first G.E. Plastics department, created in 1930.

Basically, through a variety of mergers and acquisitions, General Electric was able to monopolize all aspects of the early American electrical system—from the technical standards and power generation by industry—to the light bulbs screwed into sockets by consumers. 

Throughout the Great Depression, America’s attitudes toward corporate concentration changed. The consensus view was that monopoly power, like General Electric held, was bad for society. The result was a variety of New Deal regulations designed to stop conglomerates from rolling up entire industries.

Stoller explains what happened next:

But in the early 1960s a new type of conglomerate emerged, although this time these corporations were shaped by strict antitrust laws. In this instance, cash-rich corporations like RCA and LTV invested in entirely unrelated lines of business—Hertz or Wilson Sporting Goods,say—the argument being that an excellent executive team could manage any line of business well. One of the highest-flying conglomerates at the time, LTV, bought business lines in missiles, electronics, electrical cable, sporting goods, meat and food processing, and pharmaceuticals. 

Essentially, General Electric was generating enormous amounts of cash and could no longer use that money to acquire businesses within its core industry.

General Electric, like many monopoly-based conglomerates, decided to expand outward.

The benefits of a conglomerate

The following image lists every industry General Electric operated in 2000. That year it had revenues of about $130 billion. Adjusted for inflation, that’s about $190 billion of revenue in modern times.  To put things in perspective, in 2019 the IMF estimated the New Zealand had a total GDP of about $204 billion.

General Electric was incredibly diverse. It had its hands in everything from entertainment production (NBC) to Lighting and Medical systems.

Here’s the revenue break down by business unit:

The smallest business unit had revenues of over $5 billion; larger than many best-of-breed companies. It was the definition of a conglomerate.

So we know what conglomerates are and why they became diversified across a variety of industries. Any definition of a conglomerate needs to explain the benefits of the structure. There are three major pieces.

Rise of Management

G.E. viewed businesses as interchangeable. In the eyes of leadership, a great manager could manage a microwave division just as successfully as they could manage a production company. If there was an opportunity, even if it was completely unrelated to their core competency, the company would jump headfirst. General Electric was proved right during expansionary economic conditions and was dead wrong the minute things went south. 

Reduced Short Term Risk

Appliances and Industrial Products don’t have high margins like entertainment or finance, but they involve less risk and generate large amounts of cash flow—that the company can use to fund other deals and reduce risky ones.

Writing in The Master Switch, Tim Wu describes how this enabled G.E. to purchase Universal, a film production company.

Universal would enjoy as much of a hedge as any entertainment firm could hope for. By 2008, G.E. had annual revenues of over $183 billion, while Universal had income of $5 billion, less than 3 percent of the total. With a holding company of that size, the prospect of losing millions on a single film, while not pleasant, is no existential threat. Here was the ultimate defense against even the biggest movie bomb: a corporate structure so titanic that the fate of a $200 million film can be a relatively minor concern.

Synergy!

Being a conglomerate in a variety of disparate industries allows the company to augment itself across a variety of transactions. Synergy is a terrible word, but it’s the best one I can think of.

Fortune Magazine explains how it worked:

The relationship is symbiotic. G.E. Capital helps G.E. by financing the customers that buy G.E. power turbines, jet engines, windmills, locomotives, and other products, offering low interest rates that competitors can’t match. In the other direction, G.E. helps G.E. Capital by furnishing the reliable earnings and tangible assets that enable the whole company to maintain that triple-A credit rating, which is overwhelmingly important to G.E.’s success. Company managers call it “sacred” and the “gold standard.” Immelt says it’s “incredibly important.”

That rating lets G.E. Capital borrow funds in world markets at lower cost than any pure financial company. For example, Morgan Stanley’s cost of capital is about 10.6% (as calculated by the EVA Advisers consulting firm). Citigroup’s is about 8.4%. Even Buffett’s Berkshire Hathaway has a capital cost of about 8%. But G.E.’s cost is only 7.3%, and in businesses where hundredths of a percentage point make a big difference, that’s an enormously valuable advantage. And thanks to the earnings strength of G.E.’s industrial side, G.E. Capital can maintain its rating without holding much capital on its balance sheet.

Combined with a rising stock market, in the mid-2000s, G.E.’s conglomerate strategy looked like a great deal.

Until it wasn’t.

The Weakness of a Conglomerate

No definition of a conglomerate would be complete without the structures weaknesses. If you look at G.E.’s 2000 income statement, something should stick out. It was ostensibly an industrial conglomerate that made everything from MRI machines, power turbines, and microwaves. However, around 50 percent of its revenues came from financial services—most of them intertwined with the industrial business. Again, management looked great during boom times, but it became clear how incompetent management was in bad times.  

Over at The Week, Jeff Spross detailed the disaster:

As entangled as it was in the mortgage bubble and the shadow banking sector, G.E. Capital toppled over. At the height of the 2008 crisis, literally no one would lend to it in the overnight markets. G.E. Capital was only saved by an emergency injection of $12 billion from Warren Buffet and other investors. It turned out that the good reputation and credit rating of G.E.’s traditional businesses had essentially been used to gamble wildly in the financial markets.

The end result was staggering.

From the New York Times:

General Electric said Wednesday that the federal government had agreed to insure as much as $139 billion in debt for its lending subsidiary, G.E. Capital. This is the second time in a month that G.E. has turned to a federal program aimed at helping companies during the global credit crisis.

G.E. Capital is not a bank, but granting it access to a new program from the Federal Deposit Insurance Corporation may reassure investors and help the lender compete with banks that already have government-protected debt, a G.E. spokesman, Russell Wilkerson, told Bloomberg News.

“Inclusion in this program will allow us to source our debt competitively with other participating financial institutions,” Mr. Wilkerson said.

Essentially, all three of the benefits of a conglomerate were so grossly mismanaged that laws had to be shifted to classify G.E. as a bank. If it wasn’t reclassified, it could of brought down large portions of the world’s economy. 

Compounding matters, G.E. followed up the financial crisis with a series of bad acquisitions across its’ entire portfolio—including, the largest industrial purchase in the company’s history. 

Turns out it’s only easy to manage a large corporation when the stock market is rising. 

Conclusion

Rephrasing Matt Stoller’s definition of a conglomerate:

General Electric was simply a corporation that operated in eight different industries, including medical devices, light bulbs, and power generation. At its’ peak, each division generated over $5 billion a year. In boom years, the structure reduced short-term risk, created synergies, and allowed managers to shine. In bad years, the inefficiencies and mismanagement, often masked by its size, brought the firm down.

Image via Flickr

Consumer packaged goods (CPG) companies are everywhere. However, most consumers know the brands not the companies. Sprite, Tide, and Moleskine notebooks are all packaged goods brands purchased and used by millions every day. Coca-Cola, P&G, and Moleskine are the CPG companies that produce them. From an operational perspective, a CPG company manufactures products, sells them to retailers, who then sell them to consumers.

The table below gives a few more examples:

CPG Brands have been around for hundreds of years, although in modern times, CPG categories are mostly considered to be fast moving goods like food, drinks, and cleaning products. Put it this way, if you buy it regularly, it’s probably a CPG. Today, CPG brands are marketed around a variety of traits. Some like Clif Bar and Gatorade are performance-based. Others, like Dove soap, are centered around equality and self-love. Originally, CPG brands were built around one thing: safety.

Why is this? In the early 1900s, most goods were effectively brandless, sold out of general stores from bulk supplies. This led to manufacturers and retailers taking advantage of an unwitting public. 

In his book on the rise of the Atlantic and Pacific tea company, Marc Levinson, explains:

Lemon extract often contained no lemon. Bottled soft drinks used coal tar, a carcinogen, as a colorant. Some ketchups used saccharine, even then suspected as a hazardous adulterant, as a preservative. The “tin” in tin cans contained as much as 12 percent lead, which leached into the fruits and vegetables. Zinc chloride, used to prepare the tops for soldering, often ran into the cans during the soldering process, poisoning the food inside.

As a result, CPG companies began to brand themselves in terms of quality and safety. If a consumer saw Dove soap on the shelf, they knew it was a quality bar that floated, and they’d purchase it with confidence. Manufacturers were now incentivized to differentiate their products. If you’re looking to learn about the business processes and operations that enabled this differentiation, check out this article, which details the rise of Kraft-Heinz. If you’re looking to learn about private label business strategies read this article on TreeHouse Foods. The rest of this post focuses on the high level business strategy of a CPG company. The goal of each is to try and sell as many products as they can, to as many customers as they can reach.

Today, most CPG companies adopt a business model that pushes towards horizontal or vertical integration to accomplish the goal.

CPG, P&G, and Horizontal Integration

Up until about twenty years ago, the definition of a CPG company was straight forward. P&G was a CPG company that manufactured a variety of household products that customers purchased at retail stores.

As I wrote earlier, six major business processes drive consumer product companies.

Research and development: Creating a product that consumers want.

Production: Figuring out how to manufacture the improved product at scale.

Supply Chain: Ensuring that you have enough raw commodities to manufacture the product.

Transportation: Getting the product to the customer (retailer).

Sales: Ensuring the product gets prime placement for a customer through negotiations and pricing.

Marketing: Generating consumer awareness and demand through advertising.

These processes are incredibly scalable and repeatable across multiple categories of goods. Once a company builds up a production system or a sales department, it can sometimes seamlessly plug new items and offerings into the established business process.

Horizontal integration is simply when a company in one category, expands into another category. In the case of P&G, it started in bath soap, moved to laundry soap, then paper products, coffee, potato chips, and even dog food. Each category may seem different, but the core business processes are the same. The general process of producing, selling, and distributing aspirin and cough medicine to retailers is identical. The more products that a CPG company can sell into a retailer, the more leverage it generates. Fifty years ago, a lot of vertical integration was done organically, through research and development. Today, it’s primarily done through acquisitions. The logic is simple. Lax anti-trust enforcement means that retailers are becoming more and more powerful, which means that a CPG company needs more brands to bargain with.

CPG Companies and Retailer Segmentation

Just because the goal of a CPG company is “to sell as as many products as they can, to as many customers as they can reach,” it doesn’t, however, mean that a CPG company will sell its products to all retailers. The retailers it chooses to sell to should fit within the brand’s perceived segment.

Initially, a branded CPG company like P&G was hesitant to sell products through discount stores—as it believed the stores tarnished their middle-class identity. But money talks. Many opted to sell smaller pack sizes and value options when dollar stores became a consistent revenue driver for manufacturers.

On the other hand, Nike is a premium brand. It’s mostly an apparel company, but they certainty produce some CPG-like products. You will probably never see Nike products at Dollar General. Instead, it opted to target high-end retailers and athletic stores, but even that is changing.

From the WSJ:

Nike plans to continue working closely with 40 partners, ranging from brick-and-mortar standbys like Foot Locker Inc. and Nordstrom Inc. to newer partners like Amazon and online luxury boutique Farfetch, on new apps and in-store experiences. It said it wouldn’t eliminate the thousands of other retail accounts that it currently manages, but Nike Brand president Trevor Edwards said “undifferentiated, mediocre retail won’t survive.”

After a few years, NIKE announced it would no longer sell through Amazon, instead, looking to build up its own direct-to-consumer capabilities.

A CPG Company and Vertical Integration

Nike’s decision to abandon Amazon had many drivers. The first is probably Amazon’s refusal to combat counterfeiting. The second is perhaps Nike’s desire to integrate vertically. Vertical integration is when a company internalizes every business process—from 1-6. Instead of buying another brand to create more leverage against retailers, it buys a commodity supplier or builds its own storefront to create efficiencies within production and distribution.

A vertically integrated CPG company would sell products to retailers and directly to customers via company owned stores or feature a robust direct-to-consumer/catalog model. In the case of Nike, it now has over 1,150 retail locations—each with an average revenue of $34 million.

This strategy obviously can’t be executed by all CPG companies—especially fast-moving consumer goods (FMCG). It would be completely unrealistic for Coca-Cola or Campbell Soup Company to open stores that only sold their products. It’s also entirely impractical for a FMCG to develop a profitable direct-to-consumer business. Customer acquisition costs are too high for the products given that Facebook and Google own an effective duopoly on online advertisement. Most CPG vertical integration comes from retail stores themselves–who do so through private label.

Private Label CPG and Retailer Vertical Integration

So far we’ve focused primarily on branded CPG. That is, the name brand products that every knows and loves. But brands do not operate in a vacuum. Coke is not just competing against Pepsi, but against Walmart’s Sam’s Cola. For as long as chain retailers have existed they’ve sold some level of unbranded or private label products.

For the bulk of the 20th-century private label, brands were considered inferior to branded products. That changed, however, when many products became standardized through better production and supply chain practices. Today, private labels aren’t just low-priced offerings, but brand builders for the retail chains themselves.

According to the book, Private Label Strategy:

The three best-selling private label categories in food and nonfood may still be predictable—milk, eggs, and bread in food; food-storage and trash bags, cups and plates, and toilet tissue in nonfood. However, today’s large and sophisticated retailers are able to develop credible private label offerings for categories where traditionally customers were more wary of straying from their favorite manufacturer brand names. Nowadays, store brands are present in over 95 percent of consumer packaged goods categories. Among the fastest-growing categories for private label sales are lipstick, facial moisturizers, and baby food.

Once you see a Retailer’s operating model, you’ll understand why there is such a push from retailers.

Retailer’s Operating Model

The image below is a typical retail operating model.

The shelf price is the price consumers pay a retailer. The margin is the difference between what the retailer paid the CPG company, minus the retailer’s labor and fixed costs. As you can see, there isn’t much in the retailer’s margin. This graph doesn’t include all retailer considerations (consumer preferences, product demand via mass advertising, differences in revenue per square foot of shelf-space, etc.). Still, you can certainly see why retailers want to get to vertically integrate through private label.

If a retailer owns the production of private label good, they mostly capture all the margin between the production cost and the shelf price. The high fixed cost associated with production gave manufacturers power in a negotiation, but as retailers have become larger and larger, the cost became a non-issue.

The end result of this is that established CPG brands aren’t just facing competition from other manufacturers, but they’re facing intense competition from retailers–who used to be their partners.

In Conclusion, What is a CPG Company?

It’s tough to give a complete and exhaustive definition of a CPG company. That’s because they are so varied in what they produce and how they sell. But definitions help, and hopefully, this helps better understand what a consumer packaged goods company is and the business model it uses to makes money.  

At a high level, a CPG company is a firm that manufacturers products that consumers regularly buy. It then sells those products to retailers, who sell them to the end consumer. The goal is to sell as many products, to as many consumers as possible. Today, CPG companies succeed by generating leverage over retailers by offering a variety of goods through horizontal integration. Conversely, retailers are vertically integrating, and offering their own private label goods to compete with CPG companies.

Photo by Bernard Hermant on Unsplash