Sunday, October 26, 2008

Analogy #217: Hot Potato

There’s a children’s game we played when I was young called “Hot Potato.” Although there are lots of versions of the game, it goes something like this:

First children stand, facing each other, in a circle. They have a small ball, which is called the potato. The ball is tossed around as if it is a hot potato—as soon as you catch it you quickly toss it to someone else in the circle so that it won’t (theoretically) “burn” your hand.

All the while you are tossing the ball around, someone else is keeping track of the time. When the allotted time is over, the timer yells “STOP!” Whoever has the hot potato in their hand when the time stops loses and has to leave the circle.

A lot of business strategies rely on the tactic of buying or selling companies/divisions. In these transactions, assets change hands from one owner to another. It’s sort of like the game of hot potato. Property ownership gets tossed around from firm to firm, just like that ball gets tossed around with the children.

One time when asset tossing is particularly frequent is when the growth phase of an industry is long over and an industry is well into maturity or is starting to decline. The lack of growth creates a period of consolidation. At this point, a firm typically decides to either “get out” or “double-down.”

The ones who want to get out toss their assets away, as if it is a hot potato. The ones who want to double-down collect all of potatoes that the others are tossing out.

Just as in the game of hot potato, eventually the time for consolidation stops. In the game, whoever is holding the “potato” when the time ends loses the round. My observation is that more often than not, the company holding all the assets when the consolidation phase ends also tends to be a loser.

In this blog, we will see why.

The principle here is that during consolidation, the company that is doing the consolidating more often than not creates less value than the one who is exiting the business. In fact, the consolidator often ends up destroying value.

Although not directly applicable, you could see some of this principle at work in the dotcom bubble. There were a lot of young college dropouts who started up all kinds of businesses. Eventually, big companies wanted to get in on the action, so they started buying up a bunch of these dotcom startups, with the hope of creating something great out the accumulation of many dotcom assets.

After the consolidation phase ended, businesses realized those assets were purchased at bubble-sized prices. After the bubble burst, the consolidators found they were holding onto fairly worthless assets, while the ones who sold out were sitting on piles of wealth beyond belief. The ones holding the hot potato when the bubble burst lost.

Now you may argue that this was not a true consolidation phase and that bubbles are not the norm. That may be true, but the principle still holds true. It just may take a little longer to see the results.

The rationale for doubling down during the consolidation phase tends to go as follows:

1) There are economies of scale on the cost side in becoming large.
The logic is that if I buy up the assets from others and combine them with mine, I can create a ton of synergies and eliminate a boatload of duplications and waste. For example, in the recent talks to combine Chrysler and GM, there are estimates that the economies of scale could possibly cut out $10 billion in costs.

2) There are top-line sales benefits if the number of competitors are reduced.
There’s a reason why governments tend to discourage monopolies or near monopolies. They believe that if too much power is placed in the hands of too few companies, prices will go up, hurting the consumer, and putting excessive profits in the hands of the remaining firms. Although a company would not admit this is true (in order to get the deal approved by the government), there is a belief that being a large player with fewer competitors is helpful in the fight for sales and profits in a no-growth industry.

Unfortunately, reality tends to makes these two points less powerful than they at first appear. Instead, what occurs is the following:

1) The consolidator overpays for the companies it purchases.
In today’s sophisticated environment, it is highly unlikely that one can acquire a business at a lowball price (the current situation with the valuation of banks and other financial institutions notwithstanding). Everyone knows all the tricks in how to valuate companies (or can hire someone who does). Therefore, one typically has to pay a fairly high price to consolidate the market. In other words, in the purchase price, the consolidator has to pay the other company a portion of the expected synergies in order to get a deal done. So the seller gets part of the benefits of the synergies without taking any of the risk.

2) The economies of scale are less than expected.
Although people may argue about the cause, the raw fact is that business plans tend to overstate the economies of scale—both in the amount and in how soon they will occur. As a result, most of the remaining synergies are too small to cover the premium price paid. And you probably gave that amount away to the seller when you overpaid.

3) Not all of the Sales Stick
There is a reason why some customers preferred doing business with your competitor rather than with you. For some reason, a certain percentage of the market preferred not to do business with you and chose the competitor in order to avoid doing business with you. When you buy that competitor, you are buying a customer list which includes people who have been avoiding you. They may continue to want to avoid you and defect to another firm once you make the acquisition. Therefore, there are usually top-line dis-synergies in an acquisition, causing your combined sales to be less than the sum of what each firm did separately.

4) The integration of the assets is harder than one thinks.
Pride, differing cultures, different IT systems, key employee defections, and other such factors often make integration of companies slower and more costly than anticipated. All those expected synergies come up short. You save less than you think.

5) The market shrinks faster than one thinks
The reason why industries stop growing is not because people stop spending. Typically, what happens is that another industry provides a superior solution and the growth moves to the superior solution. People didn’t stop buying photographic film because they stopped taking pictures. In reality, people are taking more pictures now than ever before. They just found digital photography to be a superior solution.

The problem in declining industries is that the consolidators tend to underestimate the growth of the new industry that is providing the superior solution, in part because they do not understand the new solution. In addition, they may not see how interconnected their old solution is to the new solution and not realize how the growth of the new is at the expense of the old. Kodak terribly underestimated the digital world, because it was not their world. They could not imagine cell phones replacing cameras.

Macy’s spent a fortune to consolidate the department store industry in the US. Unfortunately, many people have found superior solutions to the department store, such as the lower priced Kohl’s chain or in high-end specialty formats, like Williams Sonoma. In addition, apparel, the core of the department store, is not as hot a category as it used to be. The greater growth has been in areas like consumer electronics, which diverts money away from apparel into stores like Best Buy.

As I’ve mentioned many times before, study after study has shown that most acquisitions end up destroying value for the acquirer. A successful consolidation strategy usually depends upon making a series of acquisitions. Just getting one right is difficult. The likelihood that all will work is slim. That’s why the seller usually does better than the buyer.

So what is the solution?

1. Consider selling out early, while you can still get top dollar for your business. For more on this, see my blog “We Can All Act Like Sports Franchise Owners.”

2. If you still want to be the consolidator, make doing good acquisitions your core competency. Cisco succeeded in consolidation because they took the time to become world class at acquisitions. That became a big part of their value-added vision.

3. Discover early what superior solution is taking the growth out of your industry and shift to that superior solution. In other words, continue to be a growth company even through your industry is may not be by moving to where the growth is. Fuji saw that photographic growth was moving to digital and they rushed into the digital void early to stake out a position and sustain growth. Dayton Hudson saw that discount stores were growing at the expense of department stores, so they sold out of many of their department store divisions early and put the money into the faster growing Target chain.

Becoming a consolidator can be an alluring strategy. You get to become the big fish in the shrinking pond. It strokes the ego to buy out those hated competitors and become the last big survivor. By contrast, selling out to the consolidator can look like defeat. However, the reality is that selling out is often the strategy which creates the greatest value, while the consolidator destroys value.

Remember the moral of the hot potato—if you hold on to it too long, you will burn your hand.

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