MAKING ACQUISITIONS WORK IN HOSTILE MARKETS
by Donald V. Potter
When the words “hostile” and “acquisition” appear together in the same sentence, the subject is usually hostile takeovers. A great deal has been written in recent years about unfriendly acquisitions. We, however, uses the words differently, suggesting a different relationship. Our concern is not with hostile takeovers per se but with hostile markets-markets in which the competition is so intense for so long that few players will survive. Under those conditions, acquisition can be a valuable strategic move if a company can act at the right time to take over the right competitor.
A hostile market or industry is one in which too many competitors are pursuing too little customer volume. Hostility can begin when demand declines. But in about three-quarters of markets, the cause is an expansion of competition. The problem, then, is usually too many players.
The symptom of a hostile market is low returns. Average return on equity in a hostile industry is below 8% or 9%, and earnings before interest and taxes (EBIT) as a percentage of total capital employed is below 13% or 14%.
Hostility is common. Nearly every industry experiences hostile conditions at some time, and often at recurring intervals. Industries that have been hostile at some time in the last few years include air express, airlines, beer, cement, computers, copiers, lodging, machine tools, steel, tires, table wine, and trucking.
Hostility is also a long-term problem. When the industry becomes hostile, it usually stays that way for 15 years or more. The airline industry, for example, was deregulated 16 years ago, and the end of its hostility is nowhere in sight. Hostility truly ends only when an industry has passed through all five of its inevitable stages.
Before a market becomes hostile, it is usually dominated by a few confident market leaders who have been raising prices faster than costs and inflation have climbed. Real price increases over five years or more generally encourage the entrance of new competitors who somehow can unbundle the product or offer an acceptable alternative at a lower price. The new entrant begins taking share, but market leaders resist dropping their prices to compete. These leaders reason that their established position and strong brand franchise will keep customers loyal, and that only weaker players will lose share to the upstarts. Eventually, though, enough share shifts so that even the market leaders find their position eroding, and they must drop their prices to compete.
When Compaq Computer Corp. finally dropped its prices, for example, the computer industry became hostile. Once the market price collapses, hostility has begun.
Stage One: Margin Squeeze
Customers, the largest customers in particular, realize that they can demand and get price discounts of 15%, 20%, and even 25% off standard industry pricing. No supplier can resist these demands for discounts because customers can and will leave. As a result, discounts are matched across the industry and everyone’s margin suffers.
Stage Two: Product Proliferation
At this point customers are volatile, meaning that they are willing to switch suppliers if a better option is available. Since prices are already low, however, there is little chance left to gain share by cutting price. Suppliers scramble to find other ways to compete, and that is by offering product variations-either unbundling the product to offer a lower price on one part of the product offering or adding benefits to the product to make it more attractive at the current price. Product proliferation rarely moves much share, though, because competitors’ initiatives usually can be copied quickly across the industry.
Stage Three: Self-Defeating Cost Reduction
Desperate to keep viable margins, companies chop fat and, eventually, flesh. Many cost reduction efforts are ultimately self-defeating because they result in lower standards of customer service. Once customers can see the cuts-once they realize, for example, that quality has slipped, response time is slower, or there are fewer people to help them-they have yet another reason to leave. As a practical matter, costs almost never come down as fast as share falls when costs are reduced at the expense of the customer.
Stage Four: Consolidation and Shake-Out
Some competitors simply leave the market; others are acquired by stronger companies. And typically these companies reduce the cost of their overhead, by combining their staffs and operations (which may mean layoffs) and by spreading the remaining overhead over a larger base of sales. The result of consolidation and shake-out is a smaller number of competitors but even tougher competition, because the survivors at this point are larger, leaner, and meaner.
The Final Stage: Rescue
Hostility does eventually end, although not always when competitors believe it has. A hostile market sometimes will achieve a temporary respite lasting perhaps 18 months to three years. There may be an unexpected surge in demand. Or political or economic changes may alter global competition. For example, in 1987 a devaluation of the dollar made domestic steel more competitive versus European or Asian steel, and immediately American steel production went from 65 million to 78 million tons a year.
Long-term, permanent relief-that is, rescue-occurs when just three or four competitors, in control of about 85% of the industry, are satisfied with their market share and decide not to discount prices in order to gain more business.
Acquisition as a Strategic Move
When and how can acquisitions be a part of a company’s strategy for surviving market hostility? The answer is that the right acquisition can help meet two objectives:
- Gaining share; and,
- Reducing unit costs.
Gaining Share and Customers
One of the ironies of market hostility is that, while hostility makes customers more demanding and more ready and willing to change suppliers, share shift actually decreases once hostility begins. In fact, the greatest period of share shift takes place just at the onset of hostility when new entrants are luring customers with different offerings and lower prices while market leaders refuse to play the game.
Once market leaders begin responding, and matching others’ competitive moves, customers can get what they want from their current suppliers. Despite threats, few customers actually move unless their current supplier somehow “fails” them by not keeping pace with competitors.
Once hostility begins, then, share is extraordinarily difficult to gain. It may have to be bought.
What, though, is important to acquire? Not cash flow, or assets, which are largely irrelevant in the hostile market environment. The purpose of acquisition is to gain new customers, to add share. Market share does count, especially in times of hostility.
Conventional wisdom holds that greater sales volume helps a company move down the learning curve and reduce its costs. This is true. But market share counts for another reason. All things being equal, customers tend to stay in existing relationships. Luring away competitors’ customers can be expensive under the best of conditions and almost impossible once market hostility sets in. For the same reasons, though, keeping one’s own customers should be quite feasible. The challenge is in getting additional customers. In a hostile market, acquisition is often the least expensive-indeed, maybe the only-way to gain share.
For an acquisition to be beneficial, though, the right customers need to be acquired. The acquired company’s customer base must meet two criteria:
- Loyalty; and,
- Substantial net addition.
The Target’s Customers Must Be Loyal
The acquisition will be pointless if customers slip away like sand between your fingers. Customers have to be sufficiently committed to the supplier that is acquired so that they will stay after the acquisition.
Some companies, by the nature of their business, have disloyal customers. These companies are often price-shavers who have habitually offered prices 2% to 3% off industry standard, and they gain or lose share with a certain fickle buying segment depending on their prices at the moment. Other companies have weakened customer loyalty by eroding their brand franchises.
In the appliance industry, Admiral Corp. offers an example of an unwise acquisition. As this industry consolidated over the last 20 years, Admiral, noted mainly for refrigerators, was bought by Magic Chef Inc., whose primary offerings are stoves and ranges. By the time Admiral was acquired, however, its name had been run down and it no longer brought Magic Chef a loyal base of customers in what for the buyer was a new segment of the appliance market. Eventually, Magic Chef itself was bought up by Maytag Corp. in 1986 in a further consolidation of the market.
A more successful example can be found in the glass container industry. Owens-Illinois Inc.’s long-time role as industry leader had been in jeopardy until, in 1986, it acquired a smaller competitor, Brockway Glasse Co. As a result of this acquisition, Owens Illinois’ market share jumped from 27% to 41%.
A Substantial Net Addition
In acquisitions, one plus one doesn’t necessarily make two. Stated differently, it isn’t always possible for the acquiring company to hold all of the volume that it formerly got from a customer plus all the volume that the acquired supplier formerly enjoyed.
Why not? Because customers do not want to place too much of their volume with a single supplier. Most customers, in fact, have three categories of suppliers, each filling a different role.
The primary supplier usually accounts for most of the customer’s purchases. But the customer also will have a relationship with a secondary supplier, giving that supplier enough volume to maintain the relationship so that the customer can maintain leverage with the primary supplier and take out insurance against any supply problems. A tertiary supplier also may get business from time to time to meet peak demands, to provide additional insurance and leverage, or to supply a special product need.
The key to knowing how much net new volume an acquisition can add is to look for overlaps in client relationships or roles. If the acquiring company and the target serve the same customers in the same or even in different roles-for example, one is the primary supplier and the other the secondary supplier – combining these competitors may result in some share loss for the merged company. Most likely the customer will give some of that business to another supplier, perhaps even a new supplier, for its own protection.
Owens-Illinois’ acquisition of Brockway shows the dynamics of overlap. After the acquisition, Owens-Illinois’ share went up to 41%, but in the next four years it dropped slightly to 40%. The two companies had served some of the same customers. Where there was overlap, the very large companies that had several suppliers were willing to consolidate the OI-Brockway volume. But smaller companies for whom either Owens-Illinois or Brockway had been the primary supplier then added another supplier that took some of the volume.
Reducing Unit Costs
Market hostility also increases the importance of reducing costs, which becomes especially important in the latter stages of hostility. The challenge, as we have seen, is to reduce costs without eroding quality or service, which are visible to customers.
Acquisitions can be the key to reducing costs because the combined companies usually can reduce their overhead and then, assuming that the customers of the acquired company are loyal, spread their costs over a large customer base, resulting in lower unit costs.
Two examples illustrate the cost-reduction potential of acquisitions in a hostile market.
Anchor Glass Container Corp. is now the No. 2 competitor in the glass container industry. But it wasn’t always so. Anchor took shape in 1983 by acquiring the glass container division of the former Anchor Hocking Corp. and added Midland Glass Co. in 1984 and Diamond-Bathurst Inc. in 1987. While adding customers, Anchor rigorously cut overhead costs. Midland’s overhead was cut by a whopping 80%. Overall, Anchor reduced its sales, general, and administrative expenses as a percent of revenues from 11% in 1982 to only 3% in 1988.
Delta Air Lines Inc.’s rise to become the No. 3 domestic airline got a big boost when it acquired Western Air Lines Inc. in 1986. The acquisition gave Delta additional ties to the West Coast, including a hub in Salt Lake City and service to 44 additional cities, and allowed it to consolidate its one western hub, in Los Angeles, with Western’s. As part of the deal, Delta brought Western’s salaries up to its own higher levels, raising its total cost for salaries and related expenses by 14%. But this cost was offset by a 20% increase in sales. As a result, Delta’s unit cost structure fell notably through the acquisition.
When a market becomes hostile, bigger is nearly always better. Larger companies usually are better positioned to survive the long period of intense competition because they have a larger customer base across which to spread costs, and therefore a lower cost position. As hostility approaches, and especially once it begins, however, the only way for a company to become bigger quickly is likely to be by acquiring competitors and securing their market shares. A well-planned acquisition can be the strategic move that ensures eventual prosperity.
(Note: This Perspective was written in the context of the economy in 1995. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)
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