StrategyStreet and the Board of Directors
7. Where are prices and margins heading over the next few years?
The answer to this question tells us about the future intensity of competition. The most dangerous problem is, of course, shrinkage in margins. The margins in the market are likely to shrink if market demand falls, if new competition enters the market or if one or several competitors are beginning to discount prices in a quest for market share. A declining margin environment argues for better customer retention and more vigilance on the cash balance.
Surprisingly, we have found that customers become less likely to change suppliers in low margin environments – provided they feel well treated. Often, the only way a company can grow its share in a low margin, low profit environment is by having less Negative Volatility than its competition. In a declining margin environment, measures of customer retention soar in importance for the board.
A low or falling price environment also calls for more vigilance on the cash balance. The board should see that the company's cash is astutely managed in a tough market. The company should monitor its deep discounts on excess capacity for long-term cash drains. There is a natural tendency for companies to discount prices heavily to get any contribution at all on the company's excess capacity. Usually, these discounted products go to the company's Non-core customers. What is needed is more creativity in using excess capacity to build the business with Core customers over the long-term. Acquisitions, at a good price, become more attractive for their customer relationships and cost consolidation potential. These acquisitions may not require cash. On the other hand, a low margin environment is a poor place for stock-buy back programs and aggressive capital expansion initiatives, where the returns hinge on the capture of significant new customer sales volumes.
A good understanding of future prices and margins may help the company manage its capacity more effectively. One large company looked out over its five-year future and concluded that margins would not support any new greenfield capacity addition. The industry was in overcapacity. But the company did want to grow. Over a long period, the company expected prices to rise gradually, as slow-growing demand sopped up excess capacity in the industry. The company determined that it could buy other companies in order to obtain their customers. The purchase price for these companies was roughly equivalent to the current market price for the key product in the industry. More specifically, the company found that the going prices for the acquisition of a company in the industry implied that the customers acquired would purchase products in the future at the price that current industry long-term contracts priced the industry's main product. There was no additional acquisition cost for the acquisition's excess capacity or for the cost savings from rationalization. The company could acquire these competitors, obtain their customers, rationalize their operations in order to make an attractive return on its investment, and then benefit from the slow rise in prices that the industry would enjoy in the future. The acquisition's excess capacity enabled the acquirer to grow without investing in a new major facility.
For further discussion of this question, see:
Basic Strategy Guide Step 19: Project the direction of future prices and margins.