Deciding To Acquire: Strategy Fundamentals

Introduction

Admittedly, I struggled when creating the schedule of blog posts for 2018.  The conflict centered on what to include in this first substantive post.  Should I begin with what I believe is the beginning of the M&A process, or lead off with a flashier, more deal-centric topic?  After some hemming and hawing I have decided to begin at the beginning, and thus our first few posts will address how to decide whether to engage in M&A.

To assess whether acquisitions are appropriate, you must first address the basic strategy building blocks.  Since many of us haven’t been to B-school in a while (or perhaps at all) we’ll begin with a review of 5 common strategy evaluation tools.  This will provide a framework for future posts on how to address strategy challenges using M&A.  It isn’t flashy, but as Stephen R. Covey suggests, let’s begin with the end in mind.

Tool #1: Porter’s 5 Forces
Michael Porter of Harvard Business School created this classic strategy evaluation tool.  The “5 Forces” are as follows:

1. Competitive rivalry
2. Bargaining power of suppliers
3. Bargaining power of customers
4. Barriers to entry
5. Availability of substitutes

The relevance of each of these varies tremendously from company to company.  I had the privilege of working with PepsiCo on their acquisition of Quaker Oats, and I can attest that PepsiCo’s culture has ben highly influenced by being in an industry dominated by 2 large players- a duopoly.  The 5 forces also work in concert with one another.  Notice that if there are 2 significant industry participants, the barriers to entry are often high, and thus the availability of substitutes low.  Bargaining power for suppliers is likely to be low as well, since both will be significant customers.  Interestingly, the bargaining power of customers will hinge on the competitive posturing of the companies in the duopoly.  If they are more focused on one another than on the bottom line, customers may have more power.  If each adopts a “you are only as smart as your dumbest competitor” mindset, customer bargaining power will be lower.

Tool #2: SWOT Analysis
Albert Humphrey of the Stanford Research Institute developed the SWOT- or strengths, weaknesses, opportunities, and threats- model.  This is also sometimes called the “mirrors and windows” model, since the first two items require an internal examination, while the following two address external factors. 
Interestingly, while most executives seem to be able to execute a Porter’s 5 Forces exercise fairly easily, it has been my experience that many need external help to get thru a useful SWOT analysis.  The more internally focused the company, the more this holds true, although most seem to struggle with an honest assessment of both weaknesses and competitive threats.  Regardless, having this knowledge is a critical input to understanding whether acquisitions are a good investment, so I recommend either engaging consultants or volunteering for a business school case study to get a thorough, objective analysis.

Tool #3: PESTLE Analysis
Harvard Business School created the PEST framework, which was later modified to include the remaining 2 factors.  This model is used to assess the following macro-level risks:

1. Political
2. Economic
3. Socio-cultural
4. Technological
5. Legal
6. Environmental

As with Porter’s 5 Forces, the significance of each of these will vary.  For example, healthcare is an industry that currently experiences an almost extreme level of political risk at the macro level.  Commodities business are particularly sensitive to economic risks, and extractive and chemical companies deal with environmental risks as a matter of course. 
A good PESTLE analysis will provide the macro-level backdrop for your SWOT analysis, so it is key to ensure that the teams working on each are coordinating. You want to get complementary outputs, reflecting a consistent perspective.  Bear in mind that the goal isn’t to eliminate these risks, that is usually not possible, but rather to understand the impact they have on the variability of investment outcomes.  Higher risk companies may want to include more “stress testing” on the valuations of deals, for instance.

Tool #4: Elasticity and Tool #5 TAM/Share Capture
Our final 2 tools are not so much strategy frameworks as just basic business principles; however, both are often neglected when evaluating M&A.  Elasticity measures the sensitivity of demand to price.  TAM, or Total Addressable Market, is a mathematical calculation of what total volume is likely for a given product. 
The actual formula for elasticity is as follows:
Elasticity= % change in quantity demanded/% change in price
You can go uber-geek, and hire an economist to perform the calculations if you wish; however, most companies have enough pricing and competitive data to develop at least a working assumption of how sensitive their demand curve is to pricing changes.  Of course, this will be highly correlated with the findings from the Porter’s analysis in regards to industry competitiveness and bargaining power of customers.
TAM is a bit of a “burr under the saddle” for me, as I routinely see M&A models that make wildly unrealistic assumptions using growth rates.  For example, a while back I was presented with a model where the revenue assumption would have required every American man, woman, and youth from age 15-45 to purchase 3 identical camping items from the company every year, using the provided pricing assumptions.  Obviously not realistic, but very easy to do if all one does is to project a growth rate assumption over future periods!
To calculate TAM you must first decide what your target market is (i.e. Americans between 15-45 in the previous example) identify the population of that group overall, then the population likely to be in the market for your product or service.  The next step is to calculate what percentage of those in the market will buy each year, which is usually accomplished by assuming a useful life for the product.  The resulting calculation is the total annual volume of product that we expect to be sold to our target demographic in our target region.
Share capture assumptions go hand-in-hand with TAM, and should reflect the competitive environment indicated in the Porter’s and SWOT models.  How much of the total market can you realistically expect to capture, given what you have learned from both the competitive analysis, and the effects of elasticity on price?

Conclusion
Hopefully the usefulness of these tools in providing insight into a company’s readiness for M&A is apparent, and I haven’t lost too many readers with my “unflashy” initial post.  The best investments for any company are the ones that realistically address strategic challenges, and thus optimize the overall value and return.  And to understand what strategic challenges to address, there really is no substitute for a little strategy analysis legwork.

I look forward to hearing your thoughts,
K