Monday, September 27, 2004

Is Market Demand the Lifeblood of Capitalism?

Is Market Demand the Lifeblood of Capitalism?

When British economist Alfred Marshall first wrote about the concept of demand and supply in his 1890 book Principles of Economics, he made a profound observation about the life of a business and that of a human being. Each followed a strikingly similar path starting with birth, moving through growth, to maturity, and finally into decline, and ultimately death. In his words:

A business firm grows and attains great strength, and afterwards perhaps stagnates and decays; and at the turning point there is a balancing or equilibrium of the forces of life and decay. And as we reach to the higher stages of our work, we shall need ever more and more to think of economic forces as resembling those which make a young man grow in strength until he reaches his prime; after which he gradually becomes stiff and inactive, till at last he sinks to make room for other and more vigorous life.

Lost, however, over the last century of extraordinary growth, is Marshall's observation that nothing lasts forever. Implied in his statement is that demand is also not immortal, regardless of endless price decreases. More than 100 years ago when Marshall first captured the essence of the law of demand and supply, there wasn't a whole lot to demand beyond the basic categories of food, clothing, and shelter. However, as the 20th century dawned, the arrival of the automobile, first in Europe and then in North America, signaled the start of a long and remarkable run for demand. At one time easily controlled by simple price adjustments, demand shows almost no sign of vitality today, and there is no evidence to suggest that it will change anytime soon.

As the 21st century dawned, there were more consumers in more countries consuming more products in more categories than at any other time in history. The events of the early part of the 20th century, including the introduction of mass production, helped make all products affordable not just for the rich, but for the growing number of people who were rapidly populating an entirely new group in the social strata between the rich and the working class: the middle class. The significant and concurrent conditions that allowed for such a unique growth dynamic were:

  • Population growth.

  • The development of thousands of new categories of products and services.

  • The ability to rapidly communicate with an increasing number of consumers everywhere.

By the end of the 20th century, there was hardly a category that was not populated by all three major classes. Even the poor had cell phones, cars, houses, televisions, Play Stations, computers, and e-mail.

The lack of worldwide demand today is neither an indictment of corporations such as Kraft Foods nor the mature consumer packaged goods industry in which it competes. In fact, quite the opposite might be true. The folks at Kraft Foods might have done their jobs too well over the last 50 years, effectively hastening the onset of saturation by influencing as many people on the planet who can afford to do so to consume as much cream cheese, cookies, and cereal as they possibly can. With the universe of bagel noshers largely fixed, even some of the most successful marketers in the world can't convince them to increase their consumption of schmeers. Now, satiated consumers worldwide are increasingly saying, "No mas! Nicht mehr! No, I do not want fries with that!"

Countless corporations in dozens of industries across all sectors are flirting with flat or even shrinking year-over-year revenue growth. Even a decade of aggressive mergers and acquisitions has largely resulted in simply creating bigger corporations with little or no organic growth.

Obscured by the events of September 11, 2001 and the 2003 war in Iraq, is an underlying trend that has gone largely unnoticed over the last quarter-century: demand, and the rate of unit and revenue growth for corporations around the world, has gradually slowed to a trickle.

However, as the rate of revenue growth has dwindled, the global investment community's expectations for consistent earnings growth have intensified. A rigid and unrelenting demand for increased profit growth, in the absence of an accompanying boost in natural revenue, has created a mathematical dilemma that is sending some corporations on acquisition shopping sprees, many on the cost-cutting warpath, and others beyond the boundaries of ethical business behavior. The rash of financial fabrications involving high-profile public corporations certainly raised the specter of impropriety in the early years of this century. It also increased our awareness of the lengths to which corporations will go to deliver the level of earnings that Wall Street expects.

On the surface, this revenue problem seems imminently fixable. A stimulus package here, zero percent financing there, and we are magically back on the growth track. However, there are new fundamental symptoms that suggest otherwise. Although productivity gains have greatly helped in the delivery of earnings growth over the last decade, our ability to continue to increase output per worker is fading. Sometimes forgotten is the fact that revenue is the single most important element in generating earnings. Without revenue, there can be no earnings at all, and without a constant inflow of new revenue, the long-term prospect for delivering earnings growth in perpetuity for some of the most established and historically successful businesses in the world could be at risk.

Over the course of the last 25 years, some have confused stock market performance with the actual operational performance and health of the corporations that are traded on Wall Street. More often than not, when graduates from the Class of 1990 and later are asked, "How's the company doing?" they respond with information about the corporation's stock performance: "It's up 2 percent this quarter." Without operational performance, it's difficult to see an appreciation in stock performance over the long term. Have we already forgotten about the dot-com debacle? Some have become so blinded by the prospect of building personal wealth that they forget that the operational performance of a corporation really comes down to three basic elements:

  1. Costs

  2. Revenue

  3. Earnings

However, we don't always remember that these elements follow a natural progression: investment (costs), income (revenue), and profit (earnings). There are no earnings at all without revenue. When asked if the pace at which earnings are outgrowing revenues troubled her, one high-profile Wall Street analyst simply brushed off the question remarking, "Earnings have always grown faster than revenues." Obviously, she never launched a business.

The most frightening aspect of this statement was that she believed she was right. This dangerous perspective illustrates that we have effectively created two separate, often disconnected worlds: the world of Wall Street and the world of business. The connection between the two worlds has been reduced to a single number every three months—earnings—with little regard for the means taken to deliver those earnings. The lack of demand and, therefore, lack of revenue growth is causing corporations to take actions that they never had to before.

Dow component corporation Eastman Kodak is a good example. Caught in a rapidly changing industry, Kodak is essentially the same size it was a decade ago (about $13 billion in sales), but with about 40,000 fewer employees. It's been a tough decade for Kodak, as well as for the greater Rochester, New York area where the company is headquartered.
con·cept: Is Market Demand the Lifeblood of Capitalism?