Profit, not external growth, should be the sensible strategy?

I’m focusing this week on writing about evidence and examples which help students focus their studies on business strategy. Some specific blog posts to follow, but I thought this piece on external growth strategy in the FT was a very useful summary of some of the key evaluative points which students can use to good effect in their essays. I know not everyone has access to FT.com so I thought I might precis the key points, which we’ll develop over the next few days.

The fundamental problem for many CEOs of larger businesses is that their firms operate in mature markets which offer little prospect of growth. By definition, mature markets have low or static growth rates, with market shares pretty stable and little room for strategies which enable one firm to significantly increase their share of an existing segment. We often see such CEOs opt for an acquisition-based growth strategy. But the savvy student will recognise the high risks involved.

I like this quote in the article from Colin Mayer (Oxford University) which sums up the problem nicely:

“However, the relentless pursuit of [revenue]growth is the single most important source of corporate failure. It is the cause of value-destroying acquisitions, overinvestment, excessive retentions and overstaffing. Growth should be the consequence, not the source, of success.”

A good discussion question for students would be to ask them what Professor Mayer means by some of those key words.

What, for example, is meant by “value-destroying acquisitions”? A simple, but strong answer would be something like this.

A value-destroying acquisition is one in which the returns earned from the acquisition are less than the returns that shareholders require from their investment.

For example, Kraft Foods bought Cadbury for £11.6bn in January 2010. Let’s assume that Kraft shareholders expect their firm to make a return of (say) 20% per year on the capital invested. That would mean that Cadbury would need to generate extra profits of at least £2.3bn each year (assuming that the value of Cadbury itself - the residual value - stays at £11.6n). If Cadbury fails to earn this additional return, then value is being destroyed for Kraft’s shareholders.

The numbers above are deliberately simplistic. But they help make a point which is that a business which invests in a takeover has to ensure that it generates a good return from the investment. Shareholders expect it. Firms often fail to achieve this, and acquisitions have a history of going horribly wrong. We’ll provide some examples of this in blog entries this week.

The main reason why an acquisition “destroys value” is simply that the price paid for the takeover was much too high. Students who recall the ROI formula (hopefully they all do!) will appreciate that it is difficult to make the % return high if the investment (the bottom line of the calculation) is too high.

However, acquisitions are also incredibly tough to manage well. They involve substantial resources by the acquiring firm - time, people and cash. The integration of a firm and its new investment is also tough to manage successfully. Yet despite the widespread evidence that acquisitions are high risk and prone to failure, CEOs of firms still seem to love them. Why? We’ll examine that too over the coming days.