PART I: Capturing the Value in Cost Synergies
by Ken Smith
Many industries undergo periods of consolidation, in which some companies identify opportunity to achieve competitive advantage through increased scale or scope, and others must follow in order to remain competitive. The opportunities are often triggered by changes in the market related to technology, globalization, or regulation that make larger scale or scope possible or more important.
When companies in the same industry buy others to increase scale or scope, revenues are typically additive while costs are not. Simply put, it usually takes less than twice the costs to run a company twice the size in the same business. The availability of such cost savings has been the principal motivation of many corporate combinations, including the acquisition of small players by larger ones as well as so-called mergers of equals.
Surprisingly, such acquisitions most often fail for shareholders. Over the last 20 years of study, large acquisitions of in-market, like companies have proven 40% more likely to fail than other deals. It seems the greater the opportunity for cost synergies, the greater the failure rates. However, this is not to say that these combinations have not created value. Rather, the value has been transferred overwhelmingly to the sellers.
This article explores this consolidation dilemma—a compelling economic justification to combine, but a chronic failure of the buyers to capture value for shareholders. To understand M&A strategy in this arena, it is important to first understand why and how industries consolidate—the drivers, the benefits, and the limitations. Within this context, we then explore the alternate strategies of the players and what is critical to M&A strategy in a consolidating industry.
Strategy Must Consider What is Driving Consolidation
Most industry consolidations are the result of the natural progression of an industry through its life cycle from differentiation in growth to similarity in a mature or declining market. This industry life cycle evolution has taken industry after industry from many to few players. These consolidated sectors include computer chip manufacturing, major appliances, and the automotive industry, among many others.
Capital intense industries are most subject to consolidation. For example, the economies of scale are so compelling in manufacturing that competing brands will source from the same factory in many industries (e.g., auto parts, home appliances, computer chips). Industries with expensive networks of infrastructure are natural monopolies, which is why regulators watch the consolidation of the railways and why AT&T once had to be broken up.
In some other industries, such as consumer application software development, small, entrepreneurial upstarts have advantages and easy entry. While larger players will acquire and achieve some scale advantages, they are often acquiring for other reasons and such acquisitions will not result in the consolidation because of the constant entry and growth of new players. Other examples of industries not likely to consolidate are single-product or direct service providers such as home renovation or dry cleaning. Attempts to join the consolidation trend in such industries without adequate planning can be expensive strategic errors. Such ill-conceived consolidation attempts are frequently seen when new product markets develop adjacent to an old one.
The airline industry provides an instructive example. It is a very difficult industry to enter domestically and almost impossible globally. For this reason, international carriers are few in number.
However, short-haul regional air travel has substantially lower barriers to entry. Single-engine turboprops are much less expensive to buy or lease. Operating costs are also lower, and they require fewer passengers to break even. Gates and airports inaccessible to large aircraft are available to the smaller aircraft.
Yet, in spite of the low entry barriers, the major airlines have repeatedly tried to consolidate the short-haul segment and eliminate the pesky competition. However, each time the regionals are acquired others appear to take their place, usually in the very next economic cycle.
Winners Anticipate Consolidation
Knowing what may trigger consolidation or the next round of consolidation may put a company in a position to influence or anticipate the change. Here are several of the forces that can lead to consolidation.
The economic cycle is the main trigger of consolidation in cyclical industries such as media and pulp and paper. That there will be another economic downturn is as certain as the next sunset, yet, when times are good, many players behave as if high prices will last forever, failing to invest in production efficiencies and remaining steadfastly independent. Those that plan for the next cycle and invest when they don’t have to achieve lower costs that will sustain them in the next downturn. These are the survivors and ultimately the buyers in the next cycle.
Change in the relevant market is another common trigger of consolidation and is often seen in the financial services industry. Markets can become larger as a result of market integration across product categories or across geographic borders. Banking and insurance provide a current example of market integration across products.
Changes in regulation have been another important trigger of consolidation. The US financial services market had been divided by state and product lines, but regulation changed that and triggered over two decades (so far) of bank consolidation.
Market integration across geographies also motivates consolidation as globalization is expanding the relevant market for most industries today. As the relevant market is redefined, so is the standard for competitive scale and scope, as in branded consumer goods such as automobiles and packaged goods that can leverage product development, brand development, and even advertising across borders.
See next month’s issue for Part II: Finding and Capturing Value in Consolidating Industries