The role of powerful brands in creating shareholder value

By Professor Malcolm McDonald

LSBU 14th February 2013

1

The limited value of Profit and Loss Accounts and Balance Sheets

“The information appearing in the majority of boardrooms remains predominantly financial in nature. Without (additional) information on value-creating activities management are typically flying blind – when financials tell them there is a problem management have already missed the optimal point for taking appropriate corrective action”.

PricewaterhouseCoopers – ValueReporting™ Review 2003,

Transparency in Corporate Reporting, p.25

Page 2

Inter Tech’s 5 year performance

Performance (£million) Base Year 1 2 3 4 5

Sales Revenue- Cost of goods sold

£254135

£293152

£318167

£387201

£431224

£454236

Gross Contribution- Manufacturing overhead- Marketing & Sales- Research & Development

£119481822

£141582323

£151632423

£186822625

£207902724

£218952824

Net Profit £16 £22 £26 £37 £50 £55

Return on Sales (%) 6.3% 7.5% 8.2% 9.6% 11.6% 12.1%

AssetsAssets (% of sales)

£14156%

£16255%

£16753%

£19450%

£20548%

£20645%

Return on Assets (%) 11.3% 13.5% 15.6% 19.1% 24.4% 26.7%

Page 3

Performance (£million) Base Year 1 2 3 4 5

Market Growth 18.3% 23.4% 17.6% 34.4% 24.0% 17.9%

InterTech’s 5 Year Market-Based Performance

Customer Retention (%)New Customers (%)% Dissatisfied Customers

88.2%11.7%13.6%

87.1%12.9%14.3%

85.0%14.9%16.1%

82.2%24.1%17.3%

80.9%22.5%18.9%

80.0%29.2%19.6%

InterTech Sales Growth (%)Market Share(%)

12.8%20.3%

17.4%19.1%

11.2%18.4%

27.1%17.1%

16.5%16.3%

10.9%14.9%

Relative Product QualityRelative Service QualityRelative New Product Sales

+10%+0%+8%

+8%+0%+8%

+5%-20%+7%

+3%-3%+5%

+1%-5%+1%

0%-8%-4%

Why Market Growth Rates Are Important

Page 4

%Sales RevenueCost of Goods Sold

Profit MarginAdvertisingR&DCapital Investment

Operating ExpensesOperating Profit

Investment Ratio

Key Trends

Virtuous plc (%)100

435711

57

2014

23

• Past 5 year revenue growth 10% pa• Heavy advertising investment in new/

improved products• Premium priced products, new plant, so

low cost of goods sold

Dissembler plc (%)100

6139

3-2

2014

5

• Flat revenue, declining volume• No recent product innovation, little

advertising• Discounted pricing, so high cost of

goods sold

3Note: This table is similar to a P&L with one important exception - depreciation, a standard item in any P&L has been replaced by capital expenditure, which does not appear in P&Ls. In the long-term, Capex levels determine depreciation costs. Capex as a percentage of sales in an investment ratio often ignored by marketers, and it has been included in this table to emphasize its importance.

The make-up of 14% Operating ProfitsFactorProfit on existing products over3 years oldLosses on products recentlylaunched or in developmentTotal operating profits

Virtuous plc (%)21

(7)

14

Dissembler plc (%)15

(1)

14

From Hugh Davidson’s “Even More Offensive Marketing” 1998

Quality of profits

Justifying investment in marketing assets

Whilst accountants do not measure intangible assets, the discrepancy between market and book values shows that investors do. Expenditures to develop marketing assets make sense if the sum of the discounted cash flow they generate is positive.

Balance sheet

Assets Liabilities

- Land- Buildings- Plant- Vehiclesetc.

- Shares- Loans- Overdraftsetc.

£100 million £100 million

Balance sheet

Assets Liabilities

£100 million £900 million

- Land- Buildings- Plant- Vehiclesetc.

- Shares- Loans- Overdraftsetc.

Balance sheet

Assets Liabilities

£900 million £900 million

Goodwill £800m

- Land- Buildings- Plant- Vehicles

- Shares- Loans- Overdraftsetc.

Asset Breakdown for the top 10 countries by Enterprise Value (US$ millions, 2011)

Intangibles

P and G paid £31 billion for Gillette, but bought only £4 billion of tangible assets

- Gillette brand £ 4.0 billion- Duracell brand £ 2.5 billion- Oral B £ 2.0 billion- Braun £ 1.5 billion- Retail and supplier network £10.0 billion- Gillette innovative capability £ 7.0 billion

TOTAL £27.0 billion

(David Haigh, Brand Finance, Marketing Magazine, 1st April 2005)

Brand Value

A brand may be an intangible asset for accounting purposes, but the value of brands is hard to deny. The top 100 brands increased by 2% to $2 trillion despite the global economic turmoil.

Moreover, the stocks of those 100 brands have consistently rewarded shareholders, outperforming the S & P 500 by more than 30% between April 2006 and April 2010.

Brandz Top 100 Most Valuable Global Brands. Millward Brown Optimor. 2011 study

The substitution of physical assets by intangible

In the past few decades there has been a transformation in the production function of companies– the major assets that create value and growth.

Intangibles are fast growing substitutes for physical assets.

L.Baruch. Professor of Finance Stern School of Business. NYU

(reported by Haigh D in “Marketing Accountability” Kogan Page 2010 chapter 12 page 4)

Residual goodwill

International Financial Reporting Standard 3

(IFRS 3) recommended the identification and disclosure of individual intangible assets on acquisition. The residue paid on acquisition will be referred to as “residual goodwill”. IFRS 3 also called for “impairment reviews” based on discounted cash flows (DCF) valuation techniques on each intangible asset included in Residual goodwill.

Residual Goodwill

EnterpriseValue

Tangible Assets

IntangibleAssets

Technology Intangibles

Residual Goodwill

Customer Intangibles

Marketing Intangibles

Contract Intangibles

Artistic Intangibles

Land and Buildings

Working Capital

Plant and Equipment

EnterpriseValue

Tangible Assets

IntangibleAssets

Technology Intangibles

Residual Goodwill

Customer Intangibles

Marketing Intangibles

Contract Intangibles

Artistic Intangibles

Land and Buildings

Working Capital

Plant and Equipment

What does “Brand” mean?

A logo and associated visual elements

-to add value, trademarks need to have “associated goodwill” acquired by superior product quality and service over a long period A larger bundle of associated intellectual property rights

-product design rights, trade dress, packaging, copyright in smells, sounds, advertising visuals, written copy etc. Many of these legal rights can be registered and protected.

-e.g. Mercedes product design; Guinness recipe and production process A holistic company or organisation brand

-the whole organisation: culture; people; processes etc.

-taken together, these create specific value propositions and create stronger customer relationships Hence, “brand” means one of the following:

-”trademark”; “brand”; “branded business”

Brand Equity

A financial term to denote that brands are financial assets

A propensity of specific audiences for preferences which are financially favourable to a good brand.

Brands with high equity are able to persuade people to make economic decisions based on emotional rather than rational criteria.

The Rational Consumer

20th century economics were based on the lunatic assumption that humans are ‘rational’ i.e. They calculate their maximum ‘utility’, using perfect information to reach perfect decisions, i.e. A precise point on a precise graph.

Branding

“An extreme case has to be that particularly scabrous class of drivel known as " skincare " ads. Who on earth would believe the incredulous, ludicrously pseudo-scientific, indigestible goulash of molecules and meaningless polysyllables ? "

Baker N "Cynical consumer seeks brand for meaningful relationship " Market Leader March 2009 ( pp 48-51 )

Brand Equity

Comparison of some Global Brands by the World’s Top Brand Valuation Companies

(USD) Interbrand (2010) Millward Brown (2010)

Coca Cola 70.4bn 67.9bn

Walmart - -

IBM 64.7bn 86.3bn

Microsoft 60.8bn 76.3bn

GE 42.8bn 45bn

Google 43.5bn 114.2bn

McDonald’s 33.5bn 66bn

Brands are key intangibles in most businesses

Brand

20%

OtherIntangible Assets

55%

TangibleAssets25%

Developed Markets

Brands are estimated to represent at least 20% of the intangible value of businesses on the major world stock markets. Brands combine with other tangible and intangible assets to create value

Intangible assets

Brand

Software

Patents

Distribution rights

Tangible assets

Assembled workforce

Business Goodwill

Marketing intangible

Technology intangibles

Customer intangible

Contract intangibles

Illustrative

Source: Brand Finance

Customer relationships

Government

Brands achieve this increased value by positively affecting different stakeholders

Partners

Employees

Suppliers

Bankers

Investors

• Lower borrowing costs • Better repayment conditions

• Lower prices and better terms

• Lower recruitment costs• Lower retention costs

• Greater willingness to partner• Partnership on better terms

• Higher price earnings ratio• Lower volatility

• More invitations to tender• Greater propensity to award• Higher share of fields awarded

Brand

Reputation

Brands affect business value by influencing the behaviour of a wide range of Shell’s stakeholders, some of which directly impact Shell’s P&L (and hence value)

STAKEHOLDER PERCEPTION

STAKEHOLDER BEHAVIOUR

FINANCIALIMPACT

SHAREHOLDER VALUE

Customers- individuals, businesses

Suppliers /

Partners- businesses, energy asset

ownersEmployees- current and

potential

Shareholders / Bankers

- individual and institutional

Other Stakeholder

s- government, media,

opinion formers, academics, public, environmentalists

• Pay price premium• Buy more

• Lower prices• Better terms• Willingness to partner• (more opportunities)

• Better retention• Lower salary expectations• Better qualified candidates

Revenues

CostsRevenues

CostsProductivity

CostsRisk

• Higher PE ratio• Lower volatility• Lower borrowing costs• Better repayment conditions

Influences business and brand value

Indirect influence on value

Tradem

ark

s

Brands Increasingly Drive Business Results

Successful brands

* Have a clear customer benefit

* Make a promise and keep it

* Have simplicity, clarity and honesty

* Have distinctive logos and design

* Are widely available

* Build trust

* Have a price/quality trade off – win/win

* Help consumers make good decisions

* Result? Higher margins, higher volumes, innovation, better quality

What went wrong with many brands?

Success led to smugness

Cutting corners/reducing costs

Economical with the truth (eg. ‘low fat’, but no mention of high sugar content)

Add some gold to the packaging (illusion of quality)

Became the new commodities

27

SKIN-DEEP BRANDING

If your image-only re-branding exercise isn’t accompanied by improvements in the core product or service, it is an image-wrapper branding fiasco---- a great way to waste money and get marketing a bad name.

If you improve the sizzle, don’t forget to improve the sausage

There are many products that pretend to be brands, but are not the genuine article. As the Director of Marketing at TESCO said, “Pseudo brands are not brands. They are manufacturers’ labels. They are “me-toos” and have poor positioning, poor quality and poor support. Such manufacturers no longer understand the consumer and see retailers solely as a channel for distribution”

Marketing Globe Vol 2, No. 10. 1992.

Page 31

* A brand is a name or a symbol on a product, service, person or place

* A successful brand creates super profits

* The brand is about the total experience, not the logo. Successful brands offer consistently superior value that is delivered by fair processes.

The route to Sustainable Competitive Advantage (SCA)

Differentiation HighPrice

HighVolume

Sales Revenue

Low BusinessRisk

Low FinancialRisk

PositiveNPV SCA

Economiesof Scale

LearningCurve

High CashFlows

GearingInterest CoverWorking Capital RatioOperational Leverage

Financial

OperationsLowerCosts

From Keith Ward, Cranfield School of Management

The value proposition and the brand

“The customer is simply the fulcrum of the business and everything from production to supply chain, finance, risk management, personnel management and product development all adapt to and converge on the business value proposition that is projected to the customer”.

This value proposition is represented by the brand

( The Customer Information Wars, Sean Kelly, Wiley, 2005)

( Professor McDonald February 2013 )

The Brand Iceberg

What youcan’t see

What youcan’t see

What youcan see

What youcan see

Key Assets andCompetences

SymbolBrand Name

AdvertisingPresentation

Price

HighQuality

EfficientProduction

Low Cost OperationsExcellent

Database Strong R&DHighService Levels

Strong SupplyChain Management Effective

Selling

Product

People

Brands Are Business Systems, Not Just Labels and NamesFrom “Even More Offensive Marketing” by Hugh Davidson

The overall purpose of strategic marketing is the identification and creation of sustainable competitive advantage.

AssetBase

Define markets& understandvalue

DeterminevalueProposition

Delivervalue

Monitorvalue

Map of the marketing domain

Page 36

In capital markets, success is measured in terms of shareholder value added, having taken account of the risks associated with future strategies, the time value of money and the cost of capital.

37

Shareholder value added

A branded business valuation is based on a risk-adjusted cash flow analysis of future earnings discounted at the appropriate cost of capital

Shareholder Value Added (SVA)

* What is it?– Profit after tax minus (net capital x cost of capital (%)

* There are only 3 things you can do to influence SVA1. Increase revenue (sales)

2. Decrease costs (product costs/overheads)

3. Decrease the amount of capital tied up in the business

Economic profit

Operating profit after tax £2,000Capital employed £15,000Cost of capital 10%

Economic profitOperating profit after tax 2,000less cost of capital

15,000 x 10% 1,500Economic profit 500

Risk and return

Required returns

Therefore Expected volatility in future returns

Perceived risk

41

Financial Risk and Return

High

Low

Return

HighLow

1

2

3

Risk

Adapted from Keith Ward, Cranfield School of Management

LowHigh

Financial Risk

Low

High

BusinessRisk

What is Marketing Due Diligence?

Marketing DueDiligence

Risk Assessment

Market Risk:Is the market

there?

Strategy risk:Will we get ourplanned share?

Implementation risk:Will we get ourplanned profit?

Page 44

Market Risk Profile

Product Category Existence

Segment Existence

Sales Volumes

Forecast Growth

Pricing Assumptions

The marketing strategy has a higher probability of success if the product category is well established

If the target segment is well established

If the sales volumes are well supported by evidence

If the forecast growth is in line with historical trends

If the pricing levels are conservative relative to current pricing levels

Page 45

Market Share Risk Profile

Target Market Definition

Proposition Specification

SWOT Alignment

Strategy Uniqueness

Anticipation of market change

The marketing strategy has a higher probability of success if the target is defined in terms of homogeneous segments and is characterised by utilisable data

If the proposition delivered to each segment is different from that delivered to other segments and addresses the needs which characterised the target segment

If the strengths and weaknesses of the organisation are independently assessed and the choice of target and proposition leverages strengths and minimises weaknesses

If choice of target and proposition is different from that of major competitors

If changes in the external microenvironment and macroenvironment are identified and their implications allowed for

Page 46

Shareholder Value Risk Profile

Profit Pool

Profit Sources

Competitor Impact

Internal Gross Margin Assumptions

Assumptions of Other Costs

The marketing strategy has a higher probability of success if the targeted profit pool is high and growing

If the source of new business is growth in the existing profit pool

If the profit impact on competitors is small and distributed

If the internal gross margin assumptions are conservative relative to current products

If assumptions regarding other costs, including marketing support, are higher than existing costs

Page 47

Market segment objectives: Directional Policy Matrix

High Low

High

Low

Segmentattractiveness

Relative company competitiveness

Selectively invest

Manage for cash

Strategicinvest/build

Pro-actively maintain

Cranfield University School of Management 1996

Analysis process• Attractiveness of each segment

(ranked)

• Projected net free cash flow (3/5yrs) - for each segment

• Key risk factors influencing cash flows

• Risk assessment for each segment

• Risk adjusted future cash flows per segment

• Deduct risk-adjusted cash flows from the capital x cost of capital

for each segment

• Aggregated positive net present value

Strategies to increase present value• Increase future cash flows• Cash flow happens earlier• Reducing the risk in the cash flows

Critical success factors

Nochange

Present position Forecast position in 3 yrs

A great brand is the Holy Grail, the distillation of years of creativity, sweat, ambition and investment. Not so much a logo, more a way of life, a way of being, a way of doing business: a great brand conveys everything that in your finest dreams you want your customers to understand about your business and product.

“Great stars shine brightest when the sky is darkest. In austere times, great brands bestow pleasure, maintain their premium and take a long view”

Mark Ritson, Marketing Magazine

3rd December 2008 (p.20)

APPENDIX 1

Brands as Assets

* KraftPhillip Morris bought Kraft and its portfolio of food brands for $12.9billion – four times the value of Kraft’s tangible assets

* Grand MetBought Pillsbury for $5.5billion – a 50% premium on Pillsbury’s pre-bid value and several times the value of its tangible assets

* NestlePaid $4.5billion, more than five times Rowntree’s book value

Intangible Assets: driving corporate value in the 21st century

Analysis of the world’s 35 largest stock markets (11,000 companies, total capitalisation $41 trillion) representing 99% of all quoted companies in the world by value, revealed that 63% of all enterprise value is made up of intangible assets. Only a small proportion was disclosed or explained in published accounts.

Global Intangible Tracker 2008. Brand Finance

Identification & Recognition Criteria of Intangible Assets

separable

contractual-legalControl

Future economic benefit

Identifiability

Flow of future economic benefit to entity probable

Cost reliably measurable

An intangible asset shall be recognized as an asset apart from goodwill if it arises from contractual or other legal rights or if it is capable of being separated from the acquired entity and sold, transferred, licensed, rented, or exchanged. (SFAS 141, par. 39)

Valuing trademarks and brands

Historic cost to create Costs to replace Market value “economic use”

-price premium/gross margin

-earnings split

-royalty relief

Marketing Customer Contract

• Patents (compounds, processes, technology)

• Unpatented technology• In process R&D• Product trials data and

research• Manufacturing process

controls• Computer software • Trade secrets such as

formulas and recipes• Templates and castings• Positive and negative

knowhow• Manufacturing and

operating guides

• Trade names• Trademarks• Trade dress• Service marks• Collective marks• Geographic Indicators• Certification marks• Internet domain

names• Newspaper

mastheads• Non-competition

agreements• Design rights • Packaging designs• Copyrights over

descriptors, logotypes, advertising visuals and written copy

• Customer lists• Databases• Sales or production

backlog order books• Customer contracts

and related customer relationships

• Non-contractual customer relationships

• Licensing agreements• Franchise agreements• Advertising contracts• Lease agreements• Construction permits• Operating and

broadcasting rights• Servicing contracts

(mortgage contracts)• Mineral, water, air usage

rights• Employment contracts• Assembled workforce• Distribution rights• Landing slots• Production or import

quotas • Government permits and

authorizations• Raw materials supply

contracts

Technology Artistic

• Illustrations• Artworks• Films• Pictures• Cartoons• Photography• Personality

rights

Marketing Customer Contract

• Patents (compounds, processes, technology)

• Unpatented technology• In process R&D• Product trials data and

research• Manufacturing process

controls• Computer software • Trade secrets such as

formulas and recipes• Templates and castings• Positive and negative

knowhow• Manufacturing and

operating guides

• Trade names• Trademarks• Trade dress• Service marks• Collective marks• Geographic Indicators• Certification marks• Internet domain

names• Newspaper

mastheads• Non-competition

agreements• Design rights • Packaging designs• Copyrights over

descriptors, logotypes, advertising visuals and written copy

• Customer lists• Databases• Sales or production

backlog order books• Customer contracts

and related customer relationships

• Non-contractual customer relationships

• Licensing agreements• Franchise agreements• Advertising contracts• Lease agreements• Construction permits• Operating and

broadcasting rights• Servicing contracts

(mortgage contracts)• Mineral, water, air usage

rights• Employment contracts• Assembled workforce• Distribution rights• Landing slots• Production or import

quotas • Government permits and

authorizations• Raw materials supply

contracts

Technology Artistic

• Illustrations• Artworks• Films• Pictures• Cartoons• Photography• Personality

rights

Shareholder value-adding strategies

57

Excellent Marketing Customer insights that lead

to the development of genuinely new products.

Clear positioning and branding.

Clear, honest marketing communications that make for easy access and availability.

Confusion Marketing ‘New, improved’ products

that pretend to be different. Confusing, emotional

communications to justify price premiums for parity products.

Pricing strategies designed to make comparisons impossible.

Distribution strategies that out obstacles in the way of choice.

Co. name plus grade

eg. Mercedes

DifferentSimilarDifferential Advantage

Unique brand

names eg. Tide, Bold

Co. name eg. ICI,

Standard Bank

Co. name plus product

name eg. Cadbury

Flake

Similar

Different

TargetMarket

60

They innovate around core category benefits                      They make the brand famous and distinctive (easy to recognise)  They make it easy to buy ( distribution and penetration )

In other words, they get the basics right

                       

Branding as Customer Service

 Great brands do not differentiate just for the sake of differentiation

( Professor Malcolm McDonald, January 2011 )