1. The role of powerful brands in creating shareholder value By Professor Malcolm McDonald LSBU 14 th February 2013 1

2. 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

3. Inter Tech’s 5 year performance Performance (£million)Base Year12345 Sales Revenue - Cost of goods sold £254 135 £293 152 £318 167 £387 201 £431 224 £454 236 Gross Contribution - Manufacturing overhead - Marketing & Sales - Research & Development £119 48 18 22 £141 58 23 £151 63 24 23 £186 82 26 25 £207 90 27 24 £218 95 28 24 Net Profit£16£22£26£37£50£55 Return on Sales (%)6.3%7.5%8.2%9.6%11.6%12.1% Assets Assets (% of sales) £141 56% £162 55% £167 53% £194 50% £205 48% £206 45% Return on Assets (%)11.3%13.5%15.6%19.1%24.4%26.7% Page 3

4. Performance (£million)Base Year12345 Market Growth18.3%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 Quality Relative Service Quality Relative New Product Sales +10% +0% +8% +0% +8% +5% -20% +7% +3% -3% +5% +1% -5% +1% 0% -8% -4% Why Market Growth Rates Are Important Page 4

5. % Sales Revenue Cost of Goods Sold Profit Margin Advertising R&D Capital Investment Operating Expenses Operating Profit Investment Ratio Key Trends Virtuous plc (%) 100 43 57 11 5 7 20 14 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 61 39 3-23-2 20 14 5 Flat revenue, declining volume No recent product innovation, little advertising Discounted pricing, so high cost of goods sold 3 Note: This table is similar to a P&L with one important exception - depreciation, a standard item in any P&L has been replaced by capital expenditure, which does not appear in P&Ls.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 Profits Factor Profit on existing products over 3 years old Losses on products recently launched or in development Total operating profits Virtuous plc (%) 21 (7) 14 Dissembler plc (%) 15 (1) 14 From Hugh Davidson’s “Even More Offensive Marketing” 1998 Quality of profits

6. 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.

7. Balance sheet AssetsLiabilities - Land - Buildings - Plant - Vehicles etc. - Shares - Loans - Overdrafts etc. £100 million

8. Balance sheet AssetsLiabilities £100 million £900 million - Land - Buildings - Plant - Vehicles etc. - Shares - Loans - Overdrafts etc.

9. Balance sheet AssetsLiabilities £900 million Goodwill £800m - Land - Buildings - Plant - Vehicles - Shares - Loans - Overdrafts etc.

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

12. 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, 1 st April 2005)

13. 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

14. 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 )

15. 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.

16. Residual Goodwill

17. What does “Brand” mean? l 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 l 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 l 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 l Hence, “brand” means one of the following: -”trademark”; “brand”; “branded business”

18. Brand Equity l A financial term to denote that brands are financial assets l A propensity of specific audiences for preferences which are financially favourable to a good brand. l Brands with high equity are able to persuade people to make economic decisions based on emotional rather than rational criteria.

19. The Rational Consumer 20 th 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.

20. 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 )

21. Brand Equity

22. Comparison of some Global Brands by the World’s Top Brand Valuation Companies (USD)Interbrand (2010)Millward Brown (2010) Coca Cola70.4bn67.9bn Walmart-- IBM64.7bn86.3bn Microsoft60.8bn76.3bn GE42.8bn45bn Google43.5bn114.2bn McDonald’s33.5bn66bn

23. Brands are key intangibles in most businesses Brand 20% Other Intangible Assets 55% Tangible Assets 25% 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

24. 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

25. 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 FINANCIAL IMPACT SHAREHOLDER VALUE Customers - individuals, businesses Suppliers / Partners - businesses, energy asset owners Employees - current and potential Shareholders / Bankers - individual and institutional Other Stakeholders - 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 Costs Revenues Costs Productivity Costs Risk Higher PE ratio Lower volatility Lower borrowing costs Better repayment conditions Influences business and brand value Indirect influence on value Trademarks Brands Increasingly Drive Business Results

26. 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

27. 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

28. 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

30. 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.

31. 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.

32. The route to Sustainable Competitive Advantage (SCA) Differentiation High Price High Volume Sales Revenue Low Business Risk Low Financial Risk Positive NPV SCA Economies of Scale Learning Curve High Cash Flows Gearing Interest Cover Working Capital Ratio Operational Leverage Financial Operations Lower Costs From Keith Ward, Cranfield School of Management

33. 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 )

34. The Brand Iceberg What you can’t see What you can’t see What you can see What you can see Key Assets and Competences Symbol Brand Name Advertising Presentation Price High Quality Efficient Production Low Cost Operations Excellent Database Strong R&D High Service Levels Strong Supply Chain Management Effective Selling Product People Brands Are Business Systems, Not Just Labels and Names From “Even More Offensive Marketing” by Hugh Davidson

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

36. Asset Base Define markets & understand value Determine value Proposition Deliver value Monitor value Map of the marketing domain Page 36

37. 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

38. 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

39. 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 SVA 1.Increase revenue (sales) 2.Decrease costs (product costs/overheads) 3.Decrease the amount of capital tied up in the business

40. Economic profit Operating profit after tax £2,000 Capital employed £15,000 Cost of capital10% Economic profit Operating profit after tax 2,000 less cost of capital 15,000 x 10% 1,500 Economic profit 500

41. Risk and return 41

42. Financial Risk and Return High Low Return HighLow 123 Risk Adapted from Keith Ward, Cranfield School of Management

43.  Low High Financial Risk  Low High Business Risk

44. What is Marketing Due Diligence? Page 44

45. Market Risk Profile l Product Category Existence l Segment Existence l Sales Volumes l Forecast Growth l 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

46. Market Share Risk Profile l Target Market Definition l Proposition Specification l SWOT Alignment l Strategy Uniqueness l 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

47. Shareholder Value Risk Profile l Profit Pool l Profit Sources l Competitor Impact l Internal Gross Margin Assumptions l 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

48. Market segment objectives: Directional Policy Matrix High Low High Low Segment attractiveness Relative company competitiveness Selectively invest Manage for cash Strategic invest/ 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 No change Present positionForecast position in 3 yrs

49. 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.

50. “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 3 rd December 2008 (p.20)

51. APPENDIX 1

52. Brands as Assets * Kraft Phillip Morris bought Kraft and its portfolio of food brands for $12.9billion – four times the value of Kraft’s tangible assets * Grand Met Bought Pillsbury for $5.5billion – a 50% premium on Pillsbury’s pre-bid value and several times the value of its tangible assets * Nestle Paid $4.5billion, more than five times Rowntree’s book value

53. Intangible Assets: driving corporate value in the 21 st 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

54. Identification & Recognition Criteria of Intangible Assets separable contractual-legal Control 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)

55. Valuing trademarks and brands l Historic cost to create l Costs to replace l Market value l “economic use” -price premium/gross margin -earnings split -royalty relief

57. Shareholder value-adding strategies 57

58. l Excellent Marketing l Customer insights that lead to the development of genuinely new products. l Clear positioning and branding. l Clear, honest marketing communications that make for easy access and availability. l Confusion Marketing l ‘New, improved’ products that pretend to be different. l Confusing, emotional communications to justify price premiums for parity products. l Pricing strategies designed to make comparisons impossible. l Distribution strategies that out obstacles in the way of choice.

59. Co. name plus grade eg. Mercedes Different Similar Differential Advantage Unique brand names eg. Tide, Bold Co. name eg. ICI, Standard Bank Co. name plus product name eg. Cadbury Flake Similar Different Target Market

60. 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 )