THE STORY
Let’s assume for a moment that you are invited to a lavish dinner party. Not only that, the invitation says you are the guest of honor.
You show up for the dinner and find it to be more lavish than your wildest dreams. The crowd is huge. The entertainment is extravagant, with numerous famous performers. There is more food than you have ever seen before, and it is of the highest gourmet quality.
Everyone at the dinner keeps telling you how great you are. In fact, they are so generous in their praise that they say they are willing to surrender to your greatness.
Things are going fantastically; you cannot be happier. Then suddenly—in a flash—everyone disappears. You are quickly left alone, the last person standing…at least for a moment. Then the owner of the establishment appears.
The owner of the establishment says, “Here is the bill for dinner party, payable immediately.”
You look at the bill in shock. It is more money than you could ever afford to pay in your lifetime, let alone pay immediately. You turn to the owner and say, “But I was the guest of honor. I shouldn’t have to pay this.”
But the owner replies, “I heard everyone surrender their obligations to you. Besides, you are the only one left. Who else is there to give the bill to?”
Not long after that, you get another invitation—an invitation to stay in debtor’s prison until you can pay off the bill for the dinner party. And attendance is mandatory.
THE ANALOGY
Sometimes being the last person standing is less of a victory than it at first seems. You may have outlasted everyone else, but it may just mean that you are the only one left to pay all of the bills.
Most industries go through life cycles, starting with incubation, followed by rapid growth, maturity and then decline. Usually during the maturity phase, the industry starts to consolidate. First, the bigger players begin to acquire all of the smaller players. Then the bigger players start acquiring each other. Eventually there are only one or two major players left.
At first, the survivors of consolidation feel like the guest of honor in the story above. If you are one of the survivors, then you must be better and smarter than the rest, right? Every time you acquired someone else, the acquired companies had to surrender their power to you, which felt grand. Everything seemed to be going your way and it felt like a great party.
Unfortunately, the party eventually ends. The maturity phase of the industry lifecycle moves to the decline phase. You paid a high price to acquire all of those firms (probably with a lot of debt), and now the declining market cannot support your infrastructure. Industry profit margins are shrinking and sales are in decline. There is nobody left to sell your business to, since you are the only one left in the business (and outsiders won’t invest in a declining industry unless you are willing to sell out at a great loss). And now the bill arrives to pay back all of that debt used to finance the consolidation…and the bill is more than you can afford.
By contrast, the firms who sold out early received a premium price for their business. They may have lost out in the industry survival game, but they came out ahead in their return on investment. They were able to leave the party flush with cash and escape before the bills came due.
THE PRINCIPLE
The principle here is that retreat can often be a better strategic option than victory. There is a price to be paid for victory, and sometimes the price is too high. Selling out early in the consolidation phase is often a better option than trying to hang on.
Study after study has shown that most acquisitions fail to provide an adequate return on investment. In other words, companies pay more for acquisitions than they end up being worth. There tend to be a handful of reasons for this:
1) Overestimation of External Potential.
Acquirers often assume that the market potential is greater than what eventually develops. In reality, the growth phase ends sooner than expected or the decline phase is larger than expected. As mentioned in a previous blog, if businesses feel threatened by a new growth vehicle, they will retaliate, and blunt the growth rate of the threat (see the blog “Bombs Start Wars”).
Whenever I have seen early projections of the potential of a new industry, the estimates are almost always way too large. Remember the early days of internet retailing, when the “experts” were projecting the doom of the traditional retailer and how the dotcom retail specialists were going to rule the world? Well now, many years later, the volume of retail done on the internet is well short of those projections and it is the sites owned by traditional retailers which tend to be succeeding better than the dotcom specialists. Amazon has never lived up to the potential inherent in its early high stock price.
Overestimating external market potential will create a tendency to pay too much for companies during the consolidation phase.
2) Overestimation of Internal Consolidation Potential
Just as overestimation of external factors can make a company pay too much, so can overestimation of internal factors. Usually somewhere in the calculation of the value of an acquisition is an estimation of the synergies in combining the companies. The synergistic benefits include factors like:
a) Elimination of redundancies in costs between the two firms.
b) Economies of scale in combining sales volume
c) Added leverage in the supply chain, which is assumed to provide greater control over one’s ability to influence levels of profitability.
When synergies such as these are overestimated, then one is likely to pay too much for the acquisition. And guess what…studies have shown that synergies are often overestimated. Savings and influence are rarely as great as estimated. Integration is usually messier and costlier than projected.
3) Egos and Bidding Wars
In the fight to win the battle to survive consolidation, emotion can sometimes get the better of us. The passion to win can create a buying frenzy, where competing firms bid up the price of acquisition targets. As stated in a previous blog, even great acquisition targets can become lousy acquisitions if the bidding frenzy pushes the price too high (see the blog “It Depends”).
Given these three factors (over estimation of external factors, over estimation of internal factors, and bidding wars), it should not be surprising to find that the company who sells during the consolidation often creates greater value for its shareholders than the one who purchases the company.
For example, let’s look at the traditional department store industry in the United States and how the Target Corporation (formerly called the Dayton Hudson Company) played the consolidation game.
During the growth phase of the industry, the Dayton’s department store company bought up a number of department store properties across the United States. At the same time, they were experimenting with a new concept, called Target discount stores. Eventually, the company figured out that discount stores had a strong path ahead of them and that department stores were starting to reach maturity. As a result, in 1984, when department stores were still going strong, the company sold its department store divisions in non-core markets---John Brown in Oklahoma and Diamond’s in Arizona. Because the industry was still seen to be strong and growing by others at the time, Dayton Hudson received a premium price when they sold the properties.
By the 1990s, consolidation was in full force and Federated Department Stores (now called Macy’s) and the May Company were in a battle to become a surviving consolidator. Dayton Hudson took advantage of the frenzy to get a fairly good price for selling its remaining department store divisions to May Company in 2004.
Unfortunately, by now, traditional department stores were well into the decline phase. They were being successfully attacked from below by Kohl’s and discount stores. They were being successfully attacked from above by high-end department stores like Neiman Marcus and Nordstrom’s. Sales per store for the May Company were in a long-term decline. They had paid too much for their acquisitions. The “bills were coming due” and they could not afford them.
The May Company became desperate and in 2005 sold out to Federated, who changed all the store names to Macy’s. Because May had stayed in the game too long, Federated was able to purchase the May Company relatively inexpensively (and got all of those Dayton Hudson stores for far less than what the May Company had paid for them a year earlier).
And there are many doubts in the industry as to whether the Macy’s Company will be able to ultimately get a favorable return on its department store investment. Yet, Dayton Hudson took its profits from getting out early and put it into Target stores and is appearing to do quite well.
SUMMARY
Often times, the factors involved in consolidation create a situation where the ultimate survivor overpays for the right to be the “last one standing.” Selling out early can often be a better strategic choice.
FINAL THOUGHTS
If your strategy is to ride out a consolidation to the end, here are some suggestions. First, develop a core competency in integrating businesses. This is not an easy task. It takes special skills. Second, be realistic in your expectations for the industry. Don’t overestimate the benefits. Third, be willing to walk away from a deal if the bidding gets too high. You may have a chance to come back later and get it at a lower price.
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