Why one out of every three companies on the INC. 100 is losing money.
THERE IS ANOTHER WAY, APART from growing very quickly, by which INC. 100 companies distinguish themselves from the rank and file of American business. They are . . . shhhhh . . . a great deal more likely than other companies -- those, say, on the Fortune 500 -- to be money-losing propositions.
Unprofitability is a frequent but not always uninvited companion to hypergrowth. It rarely, however, gets much publicity. The companies involved would rather talk about their strides at the top line than losses on the bottom. And you won't see losses highlighted, for example, in any of the boxes scattered throughout this section. In fact, you've got to be willing to do your own counting even to discover it.Go to the list of companies that begins on page 44, run your finger across to the "Net income" column and then down. Find the '85 net incomes, beginning with Piezo Electric Products Inc. (#2), that are embraced by parentheses. Did you count 30? That's how many there are.
Thirty percent of this year's INC. 100, with their exploding sales, showed losses. In contrast, only 6.8% of the Fortune 500 last year failed to report a profit even though total revenues of Fortune 500 companies actually slumped by 1% over the period 1981-84. Surprised at the difference? David Birch isn't. "If it were not that way," says the Massachusetts Institute of Technology researcher, "it would surprise me." Birch, who did pioneering work on the role of small companies in job generation, observes that rapid growth is always risky. "Companies that rocket up," he says, "often rocket down. Look at Apollo." Apollo Computer Inc. (#14) has grown at a 205% compound annual rate for five years, giving it an early lead in the market for engineering workstations. Its reported loss of $1.5 million in 1985 after three profitable years, if not a surprise to management, was certainly not part of the company's long-range growth strategy. Like many companies that grow fast in a market they themselves helped to create, Apollo has run up against new competition from the bigger companies that their market has attracted.
Fast-growth companies aren't immune to bad luck, errors, and plain boneheadedness. They are also vulnerable to conditions that, usually, aren't fatal to larger companies. Because they frequently rely for their sales on a single product, technology, or market, for example, what might be a pothole to a bigger company with other revenue sources and a larger capital base looks like a ditch to the small growth company. Further, explosive sales growth often requires a company to add costs -- payroll, plant, equipment -- at an equally rapid rate. If the growth rate slows abruptly, a company can be caught with excess capacity, personnel, and fixed costs. Then it is time to pare down quickly, with big write-offs, or face worse problems later. The INC. 100 landscape is dotted, if not littered, with the corpses of onetime high fliers like Air Florida System Inc. (#14 on the 1982 list), which couldn't adjust to its changing competitive landscape. It filed for Chapter 11 protection and was acquired by Midway Airlines Inc. in 1985.
For bad luck, nothing tops the falloff in world oil prices that has killed demand for High Plains Corp.'s (#61) high-priced ethanol, which it proposed to mix with gasoline to make gasohol. G.D. Ritzy's Inc. (#54) erred, however, according to analysts, by not establishing a clear marketing proposition for its fast-food restaurants. What are they? A chain of burger restaurants? Or ice cream parlors? Nobody knows. Then there is (or rather, was) Chemical Investors Inc., which closed its many doors in June 1983, just a year after it sat in the #9 spot on the 1982 INC. 100 list. CI's founder and chief executive officer, Gary Zintgraff, had a lust for acquisition but very little taste in what he acquired, and not the slightest talent for managing any of them.
Growing quickly on the tiny capital base that most young, first-spurt companies have leaves little room for even small errors and none for egregious greed.
No, what's surprising about bottom-line losses among the INC. 100 is not that they crop up so often, but how frequently they are either cultivated deliberately or calmly taken as inevitable -- part of the planned investment in growth. Companies competing in new industries or in significant markets in older industries often buy sales growth at the expense of profits. They're hoping to build market share; profits, presumably, will follow. Not every negative net income reported by a company on an INC. 100 roster qualifies as investment, but some do.
Comp-U-Card International Inc.'s, for example. CUC (#48) runs a computerized shopping service with 1985 revenues of $28.7 million and an accumulated earnings deficit at year end running to more than $10 million. The company recorded losses from its 1973 founding until 1984 while it built up its database of consumer products, prices, and vendors. It recruited members who would use their telephones or home computers to shop and buy through the database. Number of members, not dollars of profit, was the quantitative goal each year.
To have been profitable before 1984 (when it earned a scant $31,000) would have been shortsighted, CUC founder and CEO Walter Forbes argues, because it would have meant that the company wasn't spending enough to sign up new members. The formula, he says, is fairly cut and dried. Every new member costs the company about $30 in direct-mail costs to recruit and, on average, generates about $30 in revenues for the company in his or her first year. Thus, a new member represents a first-year loss because revenues don't come close to covering marketing costs and overhead. But membership renewal rates -- dependent upon keeping the customer satisfied -- run about 80%, and renewals cost relatively little. Thus, every new member means a loss in the short run but a profit in time. Taking short-term profits by holding marketing costs down, says Forbes, would have jeopardized long-term profitability. Last year, with membership reaching 4.5 million, the company -- finally -- earned $3.1 million to begin reducing its deficit.
Jacor Communications Inc.'s (#73) four consecutive years of losses may also qualify as an investment. They were part of Terry Jacobs's plan, or, at least, an anticipated consequence of it. It isn't profit that has occupied Jacor since its 1979 founding, but cash flow -- which has been consistently positive and consistently improving. The losses are, by the broadcast industry's reckoning, an accounting fluke.
Jacor acquires radio stations and, by bringing better management to bear, improves their cash flows -- essentially income before depreciation, amortization, and debt service charges. Broadcasters, says Paul Kagan, who publishes media-investment newsletters, compute the value of a station at roughly 7 to 10 times its cash flow. So, even though heavy depreciation and amortization (of intangible assets) charges kept Jacor's earnings in the red until 1985 when it made barely $100,000 on revenues of $14.4 million, the market values of its stations have grown substantially as their cash flows have improved under Jacor management.
INVESTING heavily in product development, especially when the market for that product is new and still unshaped but likely to expand geometrically when growth does begin, is a classic entrepreneurial strategy. But risky. And doubly risky, it would seem, when the product is technology-based. Quite a few of the deficit-ridden INC. 100 companies have elected to grow this way, all of them believing, of course, that their product will set the technology standard and be the one to take off when the market does. This strategy comes with several options. One is to find some other source of operating revenue -- research-and-development contracts, maybe, or an acquisition with cash flow from an existing product -- to support the development and, perhaps, to buy some additional time; another is to live entirely off capital, focusing strictly on development and letting deficits accumulate, with faith that once the product gets to market, those losses will be quickly erased.
Datacopy (#77), Amgen (#58), ORS Automation (#35), and FONAR (#82) took the latter tack, and all have shipped substantial earnings deficits while racing to convert the technology they've developed into a product they can sell. Time is as important an element as money to the success of this approach, argues Datacopy Corp. president and CEO Rolando Esteverena. Such companies as his, which developed machines for converting pages of print and other images into digital data a computer can process, have to take aim at two windows, which aren't always precisely coincident.One window, Esteverena says, is framed by feasibility -- the state of the technology will determine when the product can be made. The second window is framed by demand -- you can't sell the product until the market wants to buy.
A small young company with no alternate revenue source can't afford to hit one window and miss the second; it must pass through both on the first try. Amgen's strategy for its biotechnology products is much like Datacopy's. "Small companies like ours," says the company's director of strategic planning, Philip J. Whitcome, "will either emerge as successes, or we'll be absorbed or just fade away. [Without that initial success] we can't survive on our own." Which is why shareholders can be skittish about such strategies, especially when losses, even planned losses, stretch out quarter after quarter.
The other tack, that of finding a revenue source to offer interim support, sounds like the safer, more conservative course to follow. A miscalculation in timing or an obstinate technological problem needn't be mortal when there is something on the bottom line to cushion the shock. But experience sometimes belies theory. Look at Piezo Electric Products, with $76.4 million in sales, up from $246,000 five years earlier. Its cushion turned into a rock, and a sharp one at that.
Tiny Piezo, with just $3.5 million in sales and a $2.3-million loss in 1983, paid $11.1 million in early '84 for a maker of copper cable. The cable manufacturer's projected profits would, Piezo figured, cover the development costs of the new products the parent company was working on. But the purchase was, to say the least, ill-timed. Copper prices dropped, customer demand fell off, union labor went on strike, and the cash cow Piezo thought it was buying turned out to be a dog with a voracious appetite that accounted for most of the $22.2-million consolidated loss last year. In March, Piezo's cable-making subsidiary filed for liquidation under Chapter 7 of the bankruptcy laws.
Admittedly, hindsight encourages snideness in reports of a company's misfortune. Management consultants, security analysts, competitors, and journalists take cheap shots from time to time. (How foolish of Piezo to buy a copper-cable company just when prices were about to fall.) Likewise, you could excoriate Billy Ladin for the bad judgment that brought ComputerCraft Inc., #60 on this year's list and #8 last year, close to failure. But then you'd almost have to make the same criticism of Avner Parnes, chairman and CEO of MBI Business Centers Inc. (#70), which last year netted $2 million on sales of $50.5 million. Their growth strategies weren't so different.
ComputerCraft and MBI both opened retail computer stores. They both planned their expansions so that new stores would benefit from economies of scale in advertising and could be served from a central distribution point. They both installed experienced managers. They kept only the best-moving brands on their shelves. Both followed time-honored growth strategies. The main difference between the two is that ComputerCraft went after the consumer market and MBI sold primarily to business and government. Who could have known a half dozen years ago when their strategies were selected which of those two markets, if either, would collapse in 1985? Yet Parnes is a hero; Ladin is not.
IF PROFITABILITY IS AN EVENTUAL objective of the young, growing company, it is also a useful measuring tool for gauging management's performance. A difference between companies on the Fortune 500 and those on the INC. 100, though, is that negative profitability is nearly always an indicator of poor management performance in the former. In the latter, on the other hand, the right negative profitability, or loss, can indicate a job well done. And the right loss, as Datacopy's Esteverena puts it, is the one that was planned on. "Negative earnings are not a problem," he says, "so long as you have a kept plan." Robin Grossman, a vice-president at Salomon Bros. Inc., the New York City-based investment banking firm, says that losses among the companies in Salomon Bros.'s venture capital portfolio don't necessarily bother her. But, she adds, "We like to see them meet their business plan."
The point is that a fast-growing small company with big losses shouldn't be presumed profligate. The obverse of expanding profits is declining losses, which are equally useful signposts of progress if the rate of decline meets budgeted expectations -- or of trouble if it doesn't.
ORS Automation, which is developing products that help industrial robots to "see," lost $2.2 million on sales of $4.8 million in the first nine months of 1985. Yet ORS's vice-president of finance, Donald Shelton, gives the impression that no one runs a tighter budget than he. The company's five-year strategic plan, revised each year, is broken down into quarterly revenue-and-loss goals, and every phase of every product's development and marketing is budgeted and subject to monthly review. Without strict budget discipline, Shelton says, it is always easier to spend a little more on a project that isn't going well than to cut off its funding and reallocate the money to a more promising area. "You could throw millions of dollars into marketing [a bad product]," he says, "and most of it would go down the drain. The budget lets you exercise good business judgment in deciding how much to spend."
BUT WHEN ALL THE STRATEGIZING and budgeting is done, the INC. 100 is still about sales growth, not profitability. Maryam Wehe, a consultant with The MAC Group, in Washington, D.C., observes that Americans have a fascination with growth for its own sake, and a national assumption that growth is good. "Society endorses it. Bigger," she says, "is almost always seen as better, pushing back the Western frontier and so on. In America, you're taught this all your life. The fact that INC. publishes this list just feeds into that lust for growth." But it is also worth remembering that a lust for profitability, a common criticism of some very large public companies, can also be damaging to a business when long-term considerations are sacrificed to short-term gain.
Some growth among the INC. 100 companies is lustful and reckless, valued for itself and with regard for no other ends. But ambition of that sort predates the 100. Zintgraff of short-lived Chemical Investors sought to emulate Jimmy Ling, the Texas entrepreneur and prototypical conglomerateur, who built LTV Corp. from scratch in 1947 to the 14th spot on the Fortune 500 in just 20 years. Ling's principal objective in building a business empire was size, not coherence. The whole of LTV has never exceeded the sum of its lackluster parts.
What is surprising, given the lust that Wehe points to, is not that the occasional INC. 100 company has failed so spectacularly as to wind up in liquidation, but that so many have not. Of the 80 companies that have been listed on the 100 while showing a net loss on their income statements, only 9 have subsequently filed for bankruptcy. Four of them -- Chemical Investors, Allied Technology, Psych Systems, and Movie Systems -- are no longer in business. The others continue to operate; either they are reorganizing or they have been acquired by other companies.
Anyone who nevertheless finds disturbing the idea that 30% of the country's 100 fastest-growing companies in 1985 reported negative income should consider how jobs are created and how economies grow. MIT's Birch, in 1980, reported that those cities and regions whose economies were growing the fastest actually lost a higher proportion of their businesses to failure every year than did the declining Rustbelt. This is no paradox, Birch said. The high-growth regions had more failures, but they also had more births. The number of births, not the number of failures, makes the difference."It simply reflects the fact," says Birch, "that the healthier an economy is, the more active it is and the more its corporate population is turning over."
Losses and failure are an intrinsic part of economic growth -- the macroeconomic corollary of nothing ventured, nothing gained. Are INC. 100 companies unstable, volatile, and risky? Of course they are. Why shouldn't they be?
THE TOP 10:
Company (rank) as % of sales
Certified Collateral (31) 24.12%
Energy Oil (8) 19.74
Electronic TeleComm. (36) 19.59
Forum Group (1) 19.13
Enzo Biochem (100) 19.12
Centocor (38) 15.49
DEST (67) 14.10
Iomega (5) 12.79
V Band Systems (22) 12.78
King World Productions (64) 12.11