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My recommendation: 9/10

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Summary of notes and ideas

Absolut recommendation if you are in business or interested in it.

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What caused all those flameouts? The current emphasis in business literature suggests that everything boils down to execution.

Finding a devil’s advocate doesn’t mean asking for an analysis by your investment banker, who will put up a nice façade but has no incentive to talk you out of a deal that will generate millions of dollars in fees for his bank. It may mean turning to an independent board member. It may mean assigning a trusted senior executive. It may mean hiring an outsider.

We think about it this way: The process isn’t designed to produce the best answers; it’s designed to produce the best questions. After all, business isn’t physics. Business isn’t about finding the exact right answer, but rather is about avoiding the wrong answers and then executing as hard and as well as possible the answers that might be right…

PART ONE - Failure Patterns - ONE - Illusions of Synergy

A Bain study of 250 executives with responsibility for mergers and acquisitions found that 90 percent accepted historical data showing that two-thirds or more of takeovers reduce the value of the acquiring company.

A second McKinsey study, of more than 160 acquisitions, found that only 12 percent of the acquirers managed to significantly accelerate their growth over the next three years. Despite hopes for synergies, most poor performers remained poor performers, while most solid performers slowed down. Over all, the acquirers in the study produced organic growth rates that were four percentage points lower than peers in their industries…

While press releases proclaim a strategic fit that will change customers’ lives forever, many customers don’t notice any change —and many customers find themselves being treated worse. One study found that customers thought they got better service or prices from only 29 percent of mergers. Another found that as many as 30 percent of a company’s customers may leave during the postmerger phase. Of those who leave, two-thirds do so because of what they perceive as bad service…

It’s well documented that most acquisitions don’t pay off, mostly because the company doing the buying overpays. It makes sense that the problem would be even more acute when synergies are in play. In any sort of auction, the acquirer is going to go absolutely as high on price as it thinks it reasonably can; if it sees synergies —whether real or imagined—it’s going to be willing to pay for them. Even without a competitive situation, if the investment bankers representing the company on the block smell synergies, they’re going to push for a higher price. Why let the acquirer get all the benefit? Why not capture some of that for the shareholders of the company being bought?

Sometimes, talk of synergy leads companies to overpay in a more subtle way, through excessive opportunity costs. In other words, companies focus so much management time and attention on a synergy strategy that they lose the ability to pursue other, more fruitful opportunities…

Many people have a vested interest in seeing that cost synergies aren’t realized. After all, one person’s inefficiency is another’s job. So, salesmen protect their territory. Managers protect their turf. Everyone tries to keep doing things the way they always have, rather than switch to a unified approach. You need to make a list of who will resist and how, both so you can tackle the problems effectively and so you can discount your projected cost savings to allow for those that won’t materialize…

Once you’ve looked at the net benefits you might reap in the way of cost synergies, you need to ask yourself: How far off can I be and have the synergy strategy still work? Given that history suggests that you have a 40 percent chance of being off, and one-in-four chance of being off by at least 25 percent, you should rethink your synergy strategy if you don’t have a large margin for error.

We realize that companies sometimes say the only way to get businesses to truly cooperate is to have them operate under one roof, but we’d say that’s a danger sign. If the benefits to the businesses and to their employees are obvious, people will cooperate. If the benefits aren’t obvious, people will resist.

If you decide you truly need to buy a business to get synergies, ask yourself questions such as: How do you know that customers will flock to a new product, service, or sales channel? The only way to truly know, of course, is to test.

Because studies have shown that some 70 percent of hoped-for revenue synergies don’t appear, you need to either somehow discount the synergies you’re expecting or at least ask how far off you can be without jeopardizing your chances for success. If you don’t have a very large margin for error, you should reconsider…

If you’re still intent on proceeding, you have to deal with the fact that many acquisitions made in the name of synergy carry too high a price tag. You need to do three calculations. First, figure out what the business you’re buying would be worth on a stand- alone basis. Second, what would the business be worth if you achieved all the synergies you’ve mapped out? Third, what would the business be worth if you discounted the synergies, to account for the fact that few companies achieve all the synergies they expect?

PART ONE - Failure Patterns - TWO - Faulty Financial Engineering

Green Tree used the aggressive “gain-on-sale” accounting method to record profits. Most lenders record profits on loans as they are repaid, which means that they book actual profits after defaults, prepayments, and other transaction costs. Green Tree, instead, calculated how much money it expected to make as the loans were paid back in the future and, when it finished each round of securitization, booked that as profit. Profits, therefore, depended on its own forecast of defaults and prepayments rather than actual performance…

In a different context, Warren Buffett laid out the dangers of this sort of accounting, using his trademark homespun language. Buffett noted that accounting theory says that companies are supposed to “mark to market” their securities, such as those Green Tree issued. In other words, if something is carried on the books as being valued at $100 million, and it suddenly becomes worth $50 million, the owner needs to mark down the value of the asset and take a $50 million charge against earnings. If the value goes up by $50 million, then the company records a $50 million gain. Companies have leeway on when they have to recognize the gains and losses, but the really squishy stuff happens when it isn’t clear what the value of the securities are. With sophisticated financial instruments such as those generated by Green Tree—or, more recently, the subprime lenders—companies may “mark to model” their securities. But Buffett said we might as well call the practice “mark to myth,” because companies get to generate the models that determine the value of the securities. He said the difference between the amount of the asset carried on the books and the actual amount that could be realized in a sale, in specialized markets that can freeze almost instantly, is the “difference between what purports to be robust health and insolvency.” He added: “I’m sympathetic to the institutional reluctance to face the music. I’d give a lot to mark my weight to ‘model’ rather than to ‘market.’”12

When profits are based on loan origination rather than the long- term performance of the loan, the unfortunate consequences are

Spiegel was also aggressive about reporting those credit-card earnings. When companies extend credit, they set up a provision for potential bad debts. Visa cards, known to employ strict criteria, expected around 6.7 percent of balances to default during that period. Target maintained a provision of 6.4 percent. But, in 1999, Spiegel’s provision was just 2.4 percent; in 2000, the provision was 1.3 percent.

27 In a survey of 743 U.S., European, and Asian senior financial officers, a third responded that if their companies were going to miss analyst expectations, they would use “discretion” to buff the numbers; 46 percent of the U.S. executives said they could influence earnings by at least 3 percent…

Yet any solid strategy must be able to withstand adversity, which means that strategists must look into the abyss, assess how their designs would perform under harsh conditions, and explicitly decide whether the risk is worth the return.

PART ONE - Failure Patterns - THREE - Deflated Rollups

Research says more than two-thirds of rollups fail to create any value for investors. A Booz Allen study of rollups found that almost half had lost more than 50 percent of their market value between 1998 and early 2000, despite the stock-market boom during those years. The study found that companies tended to outperform the S&P 500 until they reached $500 million in annual revenue, at which point investors began probing more deeply and the concept fell apart.

Obscured behind the growth, though, was the fact that Loewen Group couldn’t do much to improve the operations at its funeral homes. The company as a whole might be growing earnings, but the individual homes weren’t. The growth rates could last only as long as the acquisitions kept coming.

While the clustering helped, it provided modest benefits and only on a regional basis. Outside a radius of thirty to sixty miles, Loewen Group found that clustering didn’t matter. The heavy regulation of the funeral-home industry also tends to keep economies of scale local; knowing how to comply with the rules in Biloxi doesn’t help much in Butte. There wasn’t any benefit to be had from a national brand. In fact, Loewen Group tended to hide the fact that it had bought a home, so the home could continue to represent itself as a local business and take advantage of all the ties it had cultivated over the years. While Loewen Group gained some pricing leverage with suppliers, it wasn’t much. There are some twenty-two thousand funeral homes in the United States alone, so Loewen Group was way too tiny to exert much pressure. It’s not as though it suddenly became Wal-Mart and could beat on suppliers for better prices. Loewen Group’s cost of capital was lower than it had been for the individual funeral homes, but, again, not a lot. Funeral homes are very steady, low-risk businesses— only eight out of every ten thousand fail in the United States each year—so they could already borrow at low rates…

Besides, people tend not to shop around during the emotional time that follows a death. They pick a funeral home based on some prior experience or a referral.

Rollups went for scale that wouldn’t produce economies. Sometimes, rollups wound up with diseconomies of scale. • Rollups required an unsustainably fast rate of acquisitions. • Companies didn’t allow for the tough times—and it seems that every rollup runs into tough times at some point. • Companies assumed that they could get the benefits both of decentralization and of integration. The rollups often found, however, that they could choose either decentralization or integration but not both…

These economics, by the way, can’t be dismissed as applying just to computers. They apply to some extent to all electronics products, as well as products with a significant electronic component. In addition, many other industries face versions of this when dealing with excess inventory and with the marginal costs of production. Whatever the particular situation, the point is: Claims of increased purchasing power are open to challenge.

For the first part of a rollup’s life, all that matters is growth. Growth, growth, and more growth. Investors know that the accounting for profitability is going to be hard to decipher, because of all the charges and adjustments that come from integrating lots of businesses, so they focus on the one number that’s easy to see: revenue. As long as a rollup keeps growing by leaps and bounds, it’s fine.

By their very nature, rollups are financial high-wire acts. If companies are purchased with cash, debt piles up. If companies are purchased with stock, the stock price needs to be kept high to keep the string of acquisitions going. Yet strategists often underestimate what relatively small changes in the business environment can do to rollups’ borrowing costs or stock price…

The questioning needs to be colored by the fact that so many rollups have failed; the assumption should be that the rollup won’t work, unless there is compelling evidence to the contrary.

You also need to cast a skeptical eye on all the economies of scale that you’re expecting. You may think your cost of capital will decline, but will it really? By how much? How do you know? You may decide that your pricing power will increase, but why? Be specific about how much you think you’ll be able to raise prices, by product and market. See if there isn’t some way to test your assumption before going ahead with the rollup. Do the same with purchasing power. Try to predict how much you’ll save on each supply or service you buy. If possible, test your assumptions. Be skeptical.

PART ONE - Failure Patterns - FOUR - Staying the (Misguided) Course

Another study, published in 2007, found that 60 percent of executives felt their primary source of competitive advantage was eroding. Some 65 percent said they needed to fundamentally restructure their business model. Roughly 72 percent said their main competitor five years down the road would likely be different from the main competitor at the time of the survey.

Kodak failed to avoid the digital-photography revolution even though Kodak had made a detailed (and accurate) analysis of the threat as far back as 1981, according to material provided by our friend Vince Barabba, who was an executive at Kodak at the time (and who provides considerable additional detail in his book Surviving Transformation). Kodak kept its plane on autopilot until it flew into the side of the mountain.

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…there’s are tons of more lessons to have at least heard about. These will be incredibly helpful if you run a business. Please subscribe or buy the book yourself.

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