Being Opportunistic in a Volatile World

Last week my post drew considerable attention, perhaps because of its shock value at a time when the news was truly shocking. While the tsunami was a natural disaster, the response on the part of the Tokyo Electric Company was a human calamity. Lack of preparation will invariably lead to unintended consequences, if you are managing a nuclear power plant or any other business.

The reverse is also true. The entrepreneur capable of understanding seemingly unrelated external forces, and weaving them into a thoughtful strategy, will clearly realize strategic advantage. How might the strategist consider social, technological, economic, ecological and political factors to gain insight on how to take advantage of ever changing market conditions?

Scenario planning is a methodology whereby the entrepreneur considers converging factors that (in combination) creates a tipping point. Consider some of the following predictions, based on facts already in evidence today.

In the next decade, we are likely to see:

Predicative Modeling-Cloud computing enables the migration and cross-referencing of large institutional databases.  For example, actuaries, using sophisticated algorithms are able to model ailments based on lifestyle choices monitored in real time. They are able to calculate your risk of a heart attack based on which smoothie you tend to order at Jamba Juice, your frequency of exercise, prescriptions you use, etc. Offered as a benefit of a health care plan, the member is offered incentives to opt-in and receive preferential rates. Such tools slow down rampant health care inflation.

A Cashless Society-The majority of transactions amongst big banks are managed by exchanges where no money actually changes hands. Coins of small denomination are nearing extinction. Today, you can download an iPhone app that serves as a debit card, and can be swiped within Starbucks locations.  For most transactions, cash is already irrelevant.

Smart Infrastructure- Automobiles come preinstalled with all of the features of an iPad (the 2011 Hyundai Equus will come with one) and all the benefits of the internet. Smart grids control the flow of traffic, directing drivers to particular lanes at a given speed to optimize drive time and reduce accidents. Traffic signals are regulated based on traffic volume. Sensors predict bridge and rail failures.

Of course, rapid change will occur in every industry, and the strategist must weigh various opportunities based on an organization’s ability to take advantage of them. As a general rule, organizations should seek to achieve scale and reach within its core (at least 30% market share) before expanding into new endeavors. As Jim Collins points out in his sequel to Good to Great (How the Mighty Fall), many companies fail because of an “Undisciplined Pursuit of More”.  In their zeal for diversification they often leap too far from their core competency.

Each opportunity must be assessed within the context of the organization’s resources, bandwidth, and human capital.  For every opportunity there is a cost, and an opportunity cost. To pursue any new opportunity an organization must leverage resources which dilutes focus on the core business.  Choose your opportunities carefully.

Most of our clients aspire to a similar end game; some type of liquidity event (sale). Often, such transactions lead to extraordinary material wealth, and provide a payoff for the entrepreneur’s years of sweat equity.

A recent study validates content previously published in this space. The value of businesses is not proportionate based on size. A $50 Million revenue business could be worth significantly more than 10 times that of a $5 Million business.  Within the current M&A environment, the “size premium” is magnified further by a dearth of “deal quality”.

In 2009, companies with less than $5 Million in EBITDA (earnings before interest, taxes, depreciation and amortization), yielded an average 5.1x multiple, compared to those with more than $5 Million who commanded a multiple of 5.9x.   The premium paid (16%) for profitable larger companies last year was five times the premium paid in 2006 (3%). A study conducted by GF Data Resources concluded that “average performers” (companies with less than a 10% EBITDA) earned a 4.3x multiple compared with 5.7x for above average performers. That is, a company that earns a $5 Million profit before taxes is a far more attractive asset than one with less revenue or lower margins.

As an organization moves through its lifecycle, there is a disproportionate multiplier effect to its value by virtue of which buyers are in play. Private Equity investors and lenders view the $5Million EBITDA business as better prepared to weather economic fluctuations.  We have heard the cries of smaller, poor performing businesses that have very little access to capital. Conversely, the flight to safety has created remarkable competition for businesses of the desired scale ($5 Million+) .

Thus, the entrepreneur needs to be patient and focus on the infrastructure required to support growth.  Taking the time to grow a business delivers an incredible incremental return. Assume a $40 Million business earned an 8% EBITDA ($3.2 Million) and was valued at five times ($16 Million). If the business were to leverage its infrastructure and grow to $50 Million at 10%, it would realize a $5.0 Million EBITDA. If the higher margins and scale were to produce a half turn (multiple) increase, the enterprise value would be: ($5M x5.5=$27.5M) Thus, the 25% increase in sales and 25% increase in profitability yields a whopping 72% increase in enterprise value.

The size premium should give us pause. It provides the entrepreneur with motivation, and the knowledge that his years of work and grit can provide a significant pay off.