chap - 10 methods of developments

© The Institute of Chartered Accountants in England and Wales, March 2009 443

Contents

chapter 10

Methods of development

Introduction

Examination context

Topic List

1 Methods of growth

2 Organic growth

3 International expansion

4 Mergers and acquisitions

5 Joint ventures, alliances and franchising

6 Obtaining capital to finance growth

Summary and Self-test

Answers to Self-test

Answer to Interactive question

Business strategy

444 © The Institute of Chartered Accountants in England and Wales, March 2009

Introduction

Learning objectives Tick off

Identify methods of further developing a specific business which take account of positionalanalysis and risk

Recommend methods most likely to achieve the business's strategic objectives, and justify themethods selected

Specific syllabus references for this chapter are: 2b, 3f.

Practical significance

The management of firms are under pressure to grow their businesses. Share prices depend on the abilityto deliver better earnings next year than last year – so do management careers.

Growth has implications for jobs at all levels of the organisation. Mergers and acquisitions are one form ofgrowth and support a huge corporate finance, legal and financial advice industry.

Growth is also risky. It weakens internal controls and involves huge sums of money which are often spentwith only flimsy 'strategic advantage' arguments to support it.

Stop and think

The CEO of Tesco takes pride in quoting the statistic that 10 years ago Tesco was the third largestsupermarket group in the UK, whereas today it is the largest in the UK and third largest in the entireworld.

How has this growth been achieved? What risks has it exposed the company and its shareholders to? Has it actually benefited Tesco shareholders?

Working context

Chartered Accountants are involved with the growth strategies of businesses in many ways:

Assisting small clients in drawing up financial proposals to get funding from banks Conducting the financial elements of due diligence audits Assessing the effect of growth, say by acquisition, on internal controls Provision of corporate finance advice for listing or during acquisition negotiations Corporate recovery and reconstruction work if the plan goes wrong

Syllabus links

This chapter considers issues of raising business finance which will be familiar to you from yourBusiness and Finance studies.

The discussion of acquisition and mergers here complements the studies you will be taking inFinancial Management concerning business valuations.

METHODS OF DEVELOPMENT


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Examination content

Exam requirements

Having decided on a strategy for growth, an organisation must consider how that growth is to be achieved.This chapter considers the options available to a business that wishes to expand. In the exam you are likelyto be expected to apply the knowledge covered in this chapter to the scenario, in order to advise anorganisation on the most appropriate method of expansion.

Business strategy


1 Methods of growth

Section overview

Many organisations pursue growth, which can be defined in many ways such as increases in profits ormarket share, for example. Growth may be achieved organically, or through a link to another firm.Once a firm has made its choice as to which strategies to pursue it needs to choose an appropriatemechanism:

– Develop the business from scratch

– Acquire or merge with an already existing businesses

– Co-operate in some way with another firm

1.1 What is growth?

An organisation's growth may be expressed in a number of ways, for example:

Sales revenue (a growth in the number of markets served) Profitability (in absolute terms, and as a return on capital) Number of goods/services sold Number of outlets/sites Number of employees Number of countries

Chapter 6 looked at Ansoff''s four directions (or vectors) of growth available to the business. Growth maybe achieved by a number of mechanisms:

Develop the business from scratch Acquire or merge with an already existing business Co-operate in some way with another firm

The main issues involved in choosing a method of growth are these.

A firm may not be able to go it alone, or it may have plenty of resources to invest

Two different businesses might have complementary skills

Does a firm need to move fast?

A firm might wish to retain control of a product or process

Is there a potential acquisition target or joint venture partner with compatible people andorganisation culture?

Risk: A firm may either increase or reduce the level of risk to which it is subject.



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1.2 Expansion method

Lynch summarised possible expansion methods in the matrix below.

CompanyNew

location

Internaldevelopment

Externaldevelopment

Homecountry

Abroad

Internaldomestic

development

Joint ventureMerger

AcquisitionAlliance

Franchise/licence

ExportingOverseas office

Overseas manufactureMultinational operation

Global operation

Joint ventureMerger

AcquisitionAlliance

Franchise/licence

2 Organic growth

Section overview

Organic growth is expansion by use of internal resources.

Its advantages are the maintenance of overall control, and the fact that managers can concentrate onproduct-market issues, rather than concerns of organisation structure.

Its drawbacks are that it can be slow and there may be barriers to entry preventing organic growth.

Definition

Organic growth: Expansion of a firm's size, profits, activities achieved without taking over other firms.

2.1 Benefits of organic growth

Firms pursue organic growth for a number of reasons.

The process of developing a new product gives the firm the best understanding of the market andthe product

It might be the only sensible way to pursue genuine technological innovations

There is no suitable target for acquisition

It can be planned and financed easily from the company's current resources and the costs are spreadover time

The same style of management and corporate culture can be maintained so there is less disruption

Hidden or unforeseen losses, common in acquisitions, are less likely with organic growth

It provides career development opportunities for managers otherwise stuck in their present roles

It could be cheaper because assets are being acquired without additional payments for goodwill (e.g.future earnings foregone by the persons selling their business or shares)

Business strategy


It is less risky. In acquisitions the purchaser may also take on liability for the effects of decisions madeby the previous owners (e.g. underpaid tax, liability to employees for health and safety breaches and soon).

2.2 Drawbacks of organic growth

It may intensify competition in a given market compared to buying an existing player

It is too slow if the market is developing very quickly

The firm does not gain access to the knowledge and systems of an established operator so it canbe more risky

It will initially lack economies of scale/experience effects

There may be prohibitive barriers to entry in new markets

3 International expansion

Section overview

International expansion is a big undertaking and firms must understand their reasons for it, and besure that they have the resources to manage it, both strategically and operationally. The decisionabout which overseas markets to enter should be based upon assessment of market attractiveness,competitive advantage and risk.

3.1 Reasons for overseas expansion

Some of the reasons management cites for expanding overseas are the following:

Chance: A company executive may recognise an opportunity while on a foreign trip or the firm mayreceive chance orders or requests for information from potential foreign customers.

Life cycle: Home sales may be in the mature or declining stages of the product life cycle. Internationalexpansion may allow sales growth since products are often in different stages of the product life cyclein different countries.

Competition: Intense competition in an overcrowded domestic market sometimes induces firms toseek markets overseas, where rivalry is less keen.

Reduce dependence: Many companies wish to diversify away from an over-dependence on a singledomestic market. Increased geographic diversification can help to spread risk.

Economies of scale: Technological factors may be such that a large volume is needed either to coverthe high costs of plant, equipment, R&D and personnel or to exploit a large potential for economies ofscale and experience. For these reasons firms in the aviation, ethical drugs, computer and automobileindustries are often obliged to enter multiple countries.

Variable quality: International expansion can facilitate the disposal of discontinued products andseconds since these can be sold abroad without spoiling the home market.

Finance: Many firms are attracted by favourable opportunities such as the following:

– The development of lucrative emerging markets (such as China and India)– Depreciation in their domestic currency values– Corporate tax benefits offered by particular countries– Lowering of import barriers abroad

Familial: Many countries and companies trade because of family or cultural connections overseas.

Aid agencies: Countries that benefit from bilateral or unilateral aid often purchase goods whichnormally they would not have the money for.



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Involvement overseas

Reasons supporting involvement overseas

– Profit margins may be higher abroad.

– Increase in sales volume from foreign sales may allow large reductions in unit costs.

– The product life cycle may be extended if the product is at an earlier stage in the life cycle inother countries.

– Seasonal fluctuations may be levelled out (peak periods in some countries coinciding withtroughs in others).

– It offers an opportunity of disposing of excess production in times of low domestic demand.

– International activities spread the risk which exists in any single market (e.g. political andeconomic changes).

– Obsolescent products can be sold off overseas without damage to the domestic market.

– The firm's prestige may be enhanced by portraying a global image.

Reasons for avoiding involvement

– Profits may be unduly affected by factors outside the firm's control (e.g. due to fluctuation ofexchange rates and foreign government actions).

– The adaptations to the product (or other marketing mix elements) needed for successoverseas will diminish the effects of economies of scale.

– Extending the product life cycle is not always cost effective. It may be better to develop newproducts for the domestic market.

– The opportunity costs of investing abroad – funds and resources may be better utilised athome.

– In the case of marginal cost pricing, anti-dumping duties are more quickly imposed now thanin the past.

Chapter 9 gave a more detailed discussion of the risks of international operations.

3.2 Issues for management to consider

3.2.1 Strategic issues

Is the venture likely to yield an acceptable financial return?

Does it fit with the company's overall mission and objectives?

Does the organisation have (or can it raise) the resources necessary to exploit effectively theopportunities overseas?

What is the impact on the firm's risk profile?

What method of entry is most suitable?

3.2.2 Tactical issues

How can the company get to understand customers' needs and preferences in foreign markets?

Does the company know how to conduct business abroad, and deal effectively with potentialpartners there?

Are there foreign regulations and associated hidden costs?

Does the company have the necessary management skills and experience?

Such tactical issues may mean overseas expansion is more easily achieved through some form of acquisitionor shared arrangement, rather than by organic growth.

Business strategy


4 Mergers and acquisitions

Section overview

A merger is the integration of two or more businesses. An acquisition is where one businesspurchases another. This offers speedy access to new technologies and markets, but there are risks:only about half of acquisitions succeed.

The mechanics of financing and undertaking a merger are essential to its success.

4.1 The motives for acquiring companies

Definitions

A merger is the joining of two separate companies to form a single company.

An acquisition is the purchase of a controlling interest in another company.

Some acquisitions are dressed up to look like mergers (i.e. a combination of equals) because it suggestsagreement and may ease the integration of cultures.

In financial reporting, BFRSs do not permit the concept of a merger. Nevertheless, strategically and in termsof financial arrangements, a merger may best describe a business combination, rather than being forced toidentify an acquirer.

The classic reasons for mergers/acquisitions as a part of strategy are as follows.

Reason Effect on operations

Marketing advantages New product range

Market presence

Rationalise distribution and advertising

Eliminate competition

Production advantages Economies of scale

Technology and skills

Greater production capacity

Safeguard future supplies

Bulk purchase opportunities

Finance and management Management team

Cash resources

Gain assets

Tax advantages (e.g. losses bought)

Risk-spreading Diversification

Retain independence Avoid being taken over by acquiring predatorby becoming too big to buy

Overcome barriers to entry Acquired firm may have licences or patents

Outplay rivals Stop rival getting the target



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4.2 Porter's attractiveness tests

An acquisition at a bargain price is unlikely to make up for a long-run lack of profits due to a flawed industrystructure. For reasons of cost, the ideal acquisition is in an industry not yet attractive but capable of beingmade attractive.

Porter proposes two tests:

1. The 'cost of entry' test

Unfortunately attractive industries tend to have high costs of entry. Premiums likely to be paid for theacquisition of companies are an important consideration.

2. The 'better off' test

The acquisition must do something for shareholders that they cannot do for themselves.Diversification for its own sake will not increase shareholder wealth. Asset stripping brings only one-off benefits and is not a sound basis for long-run investment.

Worked example: Morrisons buy Safeway

Family controlled supermarket operator Morrisons became the UK's fourth largest supermarket retailer in2004 as a result of the acquisition of larger rival Safeway for £3bn. Originally an offshoot of the US group ofthe same name, Safeway was established as an independent company in 1987. Its fortunes were bumpy tosay the least over the next ten years, but the group finally found its feet in 2001 with the appointment of anew CEO and an emphasis on fresh food and aggressive pricing. In a bold move to become a nationaloperator, regional group Morrisons agreed a deal to acquire Safeway in 2004, despite fierce competitionfrom a number of other, more powerful supermarkets that also bid for Safeway once Morrisons' offer wasmade. These later bidders were precluded by the Competition Commission from buying the company, buttheir interventions had the effect of making Safeway more expensive.

Integration of the two businesses proved far more difficult than Morrisons had anticipated, forcing thegroup to issue an almost unprecedented total of five profit warnings in just the first six months of 2005.

The integration problems included:

Rationalisation of competing stores: This was required by the UK Competition Commission as acondition of allowing the acquisition to proceed and led to the sell-off of 113 stores.

Rationalisation of depots and distribution systems: This led to a threatened strike by the logistics teamand in Morrisons having to pay more to achieve the rationalisation.

Cultural issues: Morrisons was headquartered in Bradford, Yorkshire (Northern England) and had areputation for bluff dealing. Safeway was managed from Hayes, Middlesex (Southern England) andcarried over many of the cultural styles from the US. Morrisons' Chairman Sir Ken Morrison made hisdistain for 'soft southern ways' abundantly clear and the job losses of the early months were principallyborn by Safeway management. This had the effect of removing a cadre of management with theknowledge of how Safeway and its systems operated.

Integration of IT systems: Safeway operated an industry standard People-Soft system and had justintroduced new accounting systems. Morrisons had a bespoke system which relied on manualinventory recording and reconciliations. They struggled for a year to integrate the systems, admittingin April 2005 that they had lost control over the table of accounts and could not assess storeprofitability in the acquired business, before switching off the superior Safeway system and reverting tothe original, and inferior, Morrisons system.

Changes to stores: Morrisons stores featured narrower aisles and higher shelving than Safeway to givebetter yields, they had a different name, they had different product ranges. The stores were graduallyconverted from the more up-market Safeway to the value-positioned Morrisons.

Joint ventures between Safeway and petrol retailers to set up convenience stores on forecourts wereabandoned.

Business strategy


The autocratic and hands-on style of the Chairman of the group and grandson of the founder irkedinvestors who forced the appointment of NEDs against his wishes. Following the 5th profit warning in 6months he resigned his Chair of the operating board in May 2005 but retained the overall Chair of thecompany. The share price did not fall on this announcement.

Morrisons appeared to be back on track by the end of 2006.

4.3 Acquisitions and risk

Acquisitions provide a means of entering a market, or building up a market share, more quickly and/or at alower cost than would be incurred if the company tried to develop its own resources.

Corporate planners must however consider the level of risk involved. Acquiring companies in overseasmarkets is more risky, for a number of reasons.

The acquirer should attempt an evaluation of the following.

The prospects of technological change in the industry The size and strength of competitors The reaction of competitors to an acquisition The likelihood of government intervention and legislation The state of the industry and its long-term prospects The amount of synergy obtainable from the merger or acquisition

4.4 Synergy as a motive for acquisitions

Definition

Synergy: The benefits gained from two or more businesses combining that would not have been availableto each independently. Sometimes expressed as the 2 + 2 = 5 effect. Synergy arises because ofcomplementary resources which are compatible with the products or markets being developed and is oftenrealised by transferring skills or sharing activities.

Worked example: Marriott group

The US-based Marriott group provides a good example of skill transfers. The group initially began in therestaurant business. One of its major skills was the use of standardised menus and hospitality routines.Much of its initial business was in the sale of takeaways to customers on the way to the airport. Accordinglyit diversified in turn into airline catering, in-house catering, family restaurants, gourmet restaurants, hotels,cruise ships, travel agents and theme parks. Interestingly some areas, such as gourmet restaurants and travelagents, where skills were not easily transferred, were subsequently divested.

Synergies arise from four sources:

1. Marketing and sales synergies

Benefits of conferring one firm's brands on products of another Use of common sales team and advertising Ability to offer wider product range to the client



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2. Operating synergies

Economies of scale – in purchasing of inputs, capital equipment etc. Economies of scope – including use of distribution channels and warehousing. Rationalisation of common capacity (e.g. logistics, stores, factories) Capacity smoothing (e.g. one firm's peak demand coincides with the other's slack time)

3. Financial synergies

Risk spreading allows cheaper capital to be obtained Reduction in market competition if firms in similar industry Shared benefits from same R&D Possibly more stable cash flows Sale of surplus assets

4. Management synergies

Highly paid managers used to fix ailing firm rather than administer successful one Transfer of learning across businesses Increased opportunity for managerial specialisation in a larger firm

Worked example: Rolls-Royce and Vickers

Rolls-Royce has a strong business in defence aerospace, and has won an average of 30% of the UK civilaerospace market over the past three years.

With aerospace a maturing market, Rolls-Royce has looked for new expansion opportunities. Since itsacquisition of Vickers in 1999, it has built a strong presence in marine markets, which now accounts forabout 15% of the Rolls-Royce group's revenue. More than 20,000 commercial and naval vehicles use Rolls-Royce equipment, and Rolls-Royce engines power 400 ships in 30 navies. Its global presence makes thispossible: Rolls-Royce Naval Marine Inc deals with the US Navy as a US-registered company. The reasons forits expansion are:

The marine industry is looking to increase engine power for both passenger and freight ships The marine industry is under pressure to meet demanding emissions regulations.

The products acquired as a result of the Vickers takeover were market leading marine brands thatexpanded Rolls-Royce's route to market and made it a world leader in marine systems, from vessel designand control, to winch manufacture and steering gear.

4.5 The mechanics of acquiring companies

Management will wish to assess the value of an acquisition. A number of methods are available which youwill know as share valuation techniques from your other studies.

Price/earnings ratio: The EPS of the target multiplied by the PE of the predator (if a comparablebusiness) or of a well-run firm in the same industry as the target. This gives a guide to maximumvalue of the target.

Present share price of target: This would be the minimum price that shareholders could beexpected to accept. Shareholders expect a bid premium on top of this.

Accounting rate of return whereby the company will be valued by estimated future profits overreturn on capital.

Value of net assets (including brands): This is another minimum value but may be relevant if the firmhas significant assets (e.g. mineral extraction firms) or if break-up of an underperforming group iscontemplated.

Dividend yield: Gives a guide to the investment value of the share.

Business strategy


Discounted cash flows, if cash flows are generated by the acquisition. A suitable discount rate(e.g. the acquirer's cost of capital) should be applied.

Acquisitions may be paid for by:

Issuing new shares in the acquiring company, which are then used to buy the shares of the companyto be taken over in a 'share exchange' arrangement

Borrowing debt to buy the shares in the target company (sometimes called a leveraged buyout)

Using the cash reserves of the predator company (its war chest)

Some combination of the above

Broadly speaking there are two types of acquisition approaches:

1. Agreed bids: Here there have been discussions beforehand between the boards of the twocompanies and their significant investors and a price and management structure agreed. The bid isannounced and the board of the target recommends acceptance to the shareholders.

2. Hostile (contested) bids: The predator has either been turned down by the board in discussions ordid not approach them to begin with, preferring to build a shareholding over the months beforehandat lower prices before announcing a bid to the market through the financial media.

Worked example: Tata Steel – consolidation in the steel industry

The following examples contrast agreed with contested bids.

Announcement by Tata Steel April 2007

TATA Steel completes £6.2bn acquisition of Corus.

Tata Steel has completed its £6.2 billion (US$12 billion) acquisition of Corus Group Ltd at a price of 608pence per ordinary share in cash. The enlarged company will have a pro forma crude steel production of 27million tonnes in 2007 and will be the world's fifth largest steel producer with 84,000 employees across fourcontinents.

Ratan Tata, Chairman of Tata Steel and Corus, said:

'The completion of this acquisition of Corus by Tata Steel is a major step forward in the Company'sglobal strategy and represents an exciting future for both businesses. I firmly believe that both TataSteel and Corus, two companies with long, proud histories, share a common business culture and aglobal vision for the business.

'Corus' top management will remain with the enlarged Group and the bringing together of bothmanagement teams is an expression of the strong confidence and trust that exists between the twoorganisations, which will ensure the successful integration of the combined business. Together we area well balanced company, strategically well placed to compete at the leading edge of a rapidly changingglobal steel industry.'

Jim Leng, the retiring Chairman of Corus, said:

'Corus had twin objectives from the outset. One was to secure the best value for our shareholdersand the other was to ensure the best strategic future for the business. With Tata Steel, we havedelivered both and the directors, senior management and other employees of Corus will see today asthe beginning of an exciting new era. The Corus and Tata Steel combination will enable us to build oncomplementary skills in global markets. I am very much looking forward to working with Mr RatanTata and the Boards and directors in both companies.'

Summary of news articles June 2006

Arcelor board finally agrees to EUR27bn offer from Mittal Steel

Mittal Steel sealed a EUR27bn merger with Arcelor yesterday, finally winning the unanimous backing of itsLuxembourg-based rival's board after an acrimonious six-month battle for a deal that will create a steelbehemoth with sales of $70bn a year.



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The Rotterdam-based Mittal Steel first tabled an offer for Arcelor in January, which was rejected as '150 percent hostile' by Arcelor's board. The prime minister of Luxembourg – which along with Belgium's Walloonregion owns an 8 per cent stake in the steel group, also rejected the deal in terms, while the French financeminister Thierry Breton told parliament he had never seen such a 'badly prepared' approach.

The Board of Arcelor proposed a buy back of 25 per cent of its stock at EUR44 a share that would havehanded the Russian oligarch Mr Mordashov, owner of Russian steel giant Severstal, a 38 per cent stake inArcelor, while bypassing the usual requirement in Luxembourg for an investor to table a full bid when theirholding in a company passes 33 per cent. If passed this would have been a 'poison pill' for the Mittalapproach as the competition authorities would not have permitted a group combing Arcelor with Severstalto be acquired by Mittal.

Shareholder unrest forced Arcelor to cancel the buy-back vote, with one of the company's largestshareholders, the Spanish steel magnate Jose Maria Arsitrain, calling for the resignation of Messrs Doll andKinsch [CEO and Chair respectively of Arcelor] accusing them of ignoring investors' wishes.

The new company will be called Arcelor Mittal, and Arcelor's current chairman Joseph Kinsch will retainthe same role at the business for the next three years. Lakshmi Mittal will be president, while Arcelor'scurrent chief executive, Guy Doll remains part of the management team.

This distinction is blurred by indicative offers which are prices offered by the predator but conditional onfurther discussions and also on opportunities to gain confidential access to the target's financial records andsenior management and clients. They are effectively invitations to negotiate.

Hostile bids mean that the predator is buying the target with only an arm's length knowledge of its affairs. Itis also surrounded by derogatory statements by each Board about each other which makes any resolutioninevitably one of the victor marching into the offices of the vanquished with bad consequences for moraleand public image.

Agreed bids allow the predator to gain access to the data room, i.e. to take office space in the target for5-10 days and to call for such financial information as needed and to interview staff. Due diligence auditsmay be carried out by the predator's advisors in which they will seek to establish:

Quality of the financial records

Existence and quality of the assets

Existence of any contingent liabilities which may crystallise on the predator (e.g. tax and pensionliabilities)

Quality of client and supplier relations

This will involve the expertise of accountants and other professionals.

4.6 Acquisitions and earnings per share

Growth in EPS will only occur after an acquisition in certain circumstances:

When the company that is acquired is bought on a lower P/E ratio or

When the company that is acquired is bought on a higher P/E ratio, but there is profit growth to offsetthis.

There may also be a 'bootstrapping' effect from the acquisition which would increase the EPS of thenew group relative to the previous EPS of the acquirer even without efficiency gains.

4.6.1 Buying companies on a lower P/E ratio

For example, suppose that Giant Ltd takes over Tiddler Ltd by offering two shares in Giant for one share inTiddler. Details about each company are as follows.

Business strategy


Giant Ltd Tiddler LtdNumber of shares 2,800,000 100,000Market value per share CU4 –Annual earnings CU560,000 CU50,000EPS 20p 50pP/E ratio 20 –

By offering two shares in Giant worth CU4 each for one share in Tiddler, the valuation placed on eachTiddler share is CU8, and with Tiddler's EPS of 50p, this implies that Tiddler would be acquired on a P/Eratio of 16, which is lower than the P/E ratio of Giant, which is 20.

Now, suppose that the acquisition produces no synergy, and there is no growth in the earnings of eitherGiant or its new subsidiary Tiddler, the EPS of Giant would still be higher than before, because Tiddler wasbought on a lower P/E ratio. The combined group's results would be as follows.

Giant groupNumber of shares (2,800,000 + 200,000) 3,000,000Annual earnings (560,000 + 50,000) CU610,00

0EPS 20.33pIf P/E ratio is still 20, the market value per share would be: CU4.07

The opposite is true as well, so that if a subsidiary is acquired on a higher P/E ratio, and there is no profitgrowth, then the enlarged group would suffer a fall in EPS and probably also a fall in share price.

4.6.2 Buying companies on a higher P/E ratio, but with profit growth

Buying companies on a higher P/E ratio will result in a fall in EPS unless there is profit growth to offset thisfall. For example, suppose that Starving Ltd acquires Bigmeal Ltd, by offering two shares in Starving forthree shares in Bigmeal. Details of each company are as follows.

Starving Ltd Bigmeal LtdNumber of shares 5,000,000 3,000,000Value per share CU6 CU4Annual earnings:

Current CU2,000,000

CU600,000

Next year CU2,200,000

CU950,000

EPS (current) 40p 20pP/E ratio 15 20

Starving Ltd is acquiring Bigmeal on a higher P/E ratio, and it is only the profit growth in the acquiredsubsidiary that gives the enlarged Starving group its growth in EPS.

Starving group

Number of shares (5,000,000 + 2,000,000) 7,000,000

Earnings

If no profit growth (2,000,000 + 600,000) CU2,600,000 – EPS would have been 37.14p

With profit growth (2,200,000 + 950,000) CU3,150,000 – EPS will be 45p

4.7 Reasons for failure of acquisitions

Takeovers benefit the shareholders of the acquired company often more than the acquirer. According tothe Economist Intelligence Unit, there is a consensus that fewer than half of all acquisitions are successful, ifseen from the point of view of the buyer's shareholders.



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Worked example: Ford and Kwik Fit

Monday, 12 April, 1999 (BBC Website)

Ford's Kwik-Fit fix

The Ford Motor company is buying the leading car repair firm Kwik-Fit.

Ford is paying just over a billion pounds for what is Europe's largest independent fast-fit repair chain with1,900 outlets.

Entrepreneur Sir Tom Farmer, who founded Kwik-Fit in 1971, will stay on and is to assume a key rolewithin the Ford Motor company once the deal is finalised.

'This (deal) is like a wedding and Kwik-Fit is being married to a fantastic husband in the organisation of theFord Motor Company which is known and respected throughout the world,' he said.

Sir Tom is set to pocket £75m from the sale of his 8% stake (sic: 8% of £1bn is £80m) in the company,adding to his already-considerable wealth. The Sunday Times Rich List on Sunday ranked him as Britain's 315thrichest man.

Successful customer formula

Ford President and Chief Executive Officer Jacques Nasser said the acquisition of the fast-fit repair chain 'isan important step towards Ford's goal to become the world's leading consumer company that providesautomotive products and services through world class brands'.

He said that Kwik-Fit was an outstanding company, that had created a successful customer formula.

Ford said the operation will allow its motor dealers to build closer relations with customers in after salesservice.

It will also enable Kwik-Fit to accelerate its European expansion plans. Kwik-Fit already has outlets in sevenEuropean countries. In the UK and Ireland it has 644 specialist tyre, exhaust and brake fitting centres, whileit also runs a motor insurance operation.

Professor Garel Rhys, director of the Centre for Automotive Industry Research at Cardiff UniversityBusiness School, said the move was in line with Ford's aim to broaden its activities beyond merely makingand selling cars.

Other benefits will be that Ford can give Kwik-Fit greater buying power for suppliers. It will also bring backto Ford the repair business which its own dealerships have lost to Kwik-Fit in recent years, he said.

Monday, 12 August, 2002, (BBC Website)

Ford sells Kwik-Fit for huge loss

Ford has sold the car maintenance and repair business Kwik-Fit to private equity group CVC CapitalPartners for £330m.

The move is part of Ford's current policy of selling off its non-core operations in order to raise cash.

But the sale represents a big loss for the car maker, which bought Kwik-Fit for £1bn in 1999.

'Positive outcome'

Ford will retain a 19% stake in the new company so it can benefit from any future growth in the business.

'The sale of Kwik-Fit is a positive outcome for Ford and CVC,' a Ford spokesman said.

'As we have said since the beginning of the year, we want to divest non-core assets and this gets us veryclose towards our goal for the year.'

Source: BBC website

Business strategy


Worked example: poor value from acquisitions

Acquisitions are a financial disaster for shareholders, new research suggests.

A study of the performance of large takeovers completed between 1977 and 1994 has found that in the fiveyears after a deal, the total return on investment underperformed by an average of 26 per cent, comparedwith shares in companies of similar size.

The research, by Alan Gregory and John Matako, of the University of Exeter's new Centre for Finance andInvestment, showed that the effect of acquisitions on share price and dividends varied according to whetherthe bids were hostile or non-hostile and whether they were equity–financed or cash backed.

The underperformance on share-based deals is 36 per cent over five years, relative to non-acquisitive companies.

Agreed bids also generated negative returns, with shareholders doing 27 per cent less well. Agreed share-based deals led to underperformance of 37 per cent.

Cash financing or bidder hostility were not enough on their own to make a profit likely, the report found.However, bids that are cash-backed and hostile have a better chance of creating, rather than destroying,shareholder value.

On a small sample, the academics found that successful hostile cash bids generated an average 50 per centincrease in the profitability of shares in the five years after the bid. Share-based bids perform poorlybecause shares in the acquiring companies are overvalued in the first place, Dr Gregory suggested.

He added that the process of gaining co-operation from the target board might also increase the cost, asexecutives might have to be persuaded to agree only if the acquirer offers over-generous terms.Unnecessary cost may be incurred if executives in an acquired company retain their jobs after completionof deals, he said.

Gabriel Rozenberg, The Times, 18 October 2004

The reasons for the poor performance of acquisitions include:

Acquirers conduct financial audits, but, according to research by London Business School, only 37%conducted anything approaching a management audit.

Some major problems of implementation relate to human resources and personnel issues such asmorale, performance assessment and culture. If key managers or personnel leave, the business willsuffer.

A further explanation may be that excessive prices are paid for acquisitions, resulting in shareholdersin the target company being rewarded for expected synergy gains.

Lack of actual strategic fit between the businesses.

Failure of new management to retain key staff and clients.

Failures by management to exert corporate governance and control over larger business.

4.8 Reasons acquisitions still occur

Many acquisitions and mergers are successful.

Evidence of a loss of value resulting from a merger doesn't consider what worse might have happenedif the firms had not combined.

Vested interests of corporate financial advisors in pressing for the acquisition, i.e. commissions andfees.

Weak corporate governance allows domineering CEOs or boards to pursue personal agendas withshareholder funds (e.g. 'empire building').

Short-term need for boards to give impression of strategic action to convince investors that businessis growing.



10

As the following example illustrates however some mergers and acquisitions are reasonably successful.

Worked example: Hewlett Packard and Compaq merger

Five years on: HP Compaq merger declared a success

IDC believes the deal has achieved its main objectives.

Five years after the mega-merger that saw Compaq climb into bed with Hewlett Packard, IDC [anindependent IT industry research organisation] has declared the deal a success.

The analyst firm said at the time of the merger, which was first mooted in September 2001, that the twocompanies would be 'better off together'.

IDC has now claimed that the firms have successfully completed a 'massive integration effort' and movedthe combined company forward to new revenue and profit levels.

'What makes the merger interesting from a technology perspective is the extent to which HP has improvedits position in a number of core markets that were rapidly commoditising,' said Crawford Del Prete, seniorvice president of communications, hardware, services and software research at IDC.

'The merger came at a time when both companies were becoming irrelevant in a number of key productcategories.

'By completing the deal when it did, HP managed to position itself for the next wave of enterprisecomputing by leaping ahead of the trends that were working against the two companies as independententities.'

According to IDC, an important linchpin to the merger's success was the commitment to infrastructuresoftware, which helped move the combined company away from commodity hardware and into themanagement layer.

OpenView [HP's Enterprise Management software product] gave HP a foundation from which to build inthe software business, putting the company in a stronger position to compete with the largest system andservices providers worldwide, the analyst firm noted.

However, it was not just technological change that facilitated the merger. IDC maintained that thecommitment to cultural change was equally important, where it was hoped that the infusion of Compaq'sfast-paced corporate culture would help increase HP's 'business velocity'.

But IDC warned that organisational changes have remained a 'critical issue' as HP had reduced the size of itsworkforce, seen the departure of two chief executives, and reorganised its management structure.

'The merger accomplished what HP and Compaq set out to do in the first place, providing the critical massand reach needed to ensure a long-term role in an industry undergoing a fundamental transition,' said JeanS. Bozman, research vice president in IDC's Worldwide Server group and co-author of the report.

'This deal enabled the merged company to grow revenue and profits in an increasingly competitivemarketplace.'

Source: Robert Jaques, vnunet.com 08 November 2006

http://www.hp.com/

http://www.idc.com/

http://www.vnunet.com/

Business strategy


5 Joint ventures, alliances and franchising

Section overview

These are other types of arrangement whereby businesses pool resources.

5.1 Choosing business partners

The following factors should be considered in choosing business partners for joint ventures, alliances andfranchising.

Drivers What benefits are offered by collaboration?

Partners Which partners should be chosen?

Facilitators Does the external environment favour a partnership?

Components Activities and processes in the network.

Effectiveness Does the previous history of alliances generate good results? Is the alliance justa temporary blip? For example, in the airline industry, there are many strategicalliances, but these arise in part because there are legal barriers to cross-border ownership.

Market-orientation Alliance partners are harder to control and may not have the samecommitment to the end-user.

5.2 Joint ventures

Definitions

Consortia: Organisations that co-operate on specific business prospects. Airbus is an example, aconsortium including British Aerospace, Dasa, Aerospatiale and Casa.

Joint ventures: Two or more organisations set up a third organisation or co-operate in some otherstructured manner to share control. This is very common in entering normally closed markets. Forexample, Jardine Matheson (historically based in Hong Kong, from where it derives much of its profits, butnow registered in Bermuda with shares traded in Singapore) has a joint venture with Robert Fleming theUK merchant bank, in the firm Jardine Fleming, which amongst other things, is involved in securities trading.

A joint venture: is a contractual arrangement whereby two or more parties undertake an economicactivity which is subject to joint control.

Joint ventures are especially attractive to smaller or risk-averse firms, or where very expensive newtechnologies are being researched and developed. Other advantages of joint ventures are:

They permit coverage of a larger number of countries since each one requires less investment.

They can reduce the risk of government intervention.

They can provide close control over operations.

A joint venture with an indigenous firm provides local knowledge.

They can also be a learning exercise.

They provide funds for expensive technology and research projects.

They are often an alternative to seeking to buy or build a wholly owned manufacturing operationabroad.

Core competences, which are not available in one entity can be accessed from another venturer.



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The major disadvantages of joint ventures are:

Major conflicts of interest over profit shares, amounts invested, the management of the jointventure, and the marketing strategy.

Problems in each party protecting intellectual property such as proprietary product designs,process methods.

Danger that a partner may seek to leave joint venture if its priorities change (e.g. shortage offunds) or it is acquired by another firm.

Lack of management interest: The JV will be seen as a secondment outside of the main careerhierarchy of the parent firms.

Exit routes may be unclear, including sharing of the assets generated in the venture.

Contractual rights may be difficult to enforce across geographical borders or regulatory boundaries.

Worked example: Sony & Ericsson to form joint venture

In April 2001 Sony and Ericsson announced that they would form a joint venture to develop telephoneproducts. Sony would provide the marketing and design input, while Ericsson would contribute thetelecoms skills. In March 2002 they launched their first joint brand mobile phone with the ability to sendpictures and multimedia messages. This most recent incarnation involves a phone which acts as an MP3player. Acquisitions by the JV have occurred since as the company seeks to take a prime position in thenext generation Mobile Services Architecture where there will be seamless links between mobile phonehandsets and the internet.

5.3 Alliances

Some firms enter long-term strategic alliances with others for a variety of reasons. Such alliances tend tobe a looser contractual arrangement than a joint venture and no separate company is formed.

They share development costs of a particular technology.

The regulatory environment prohibits take-overs (e.g. most major airlines are in strategic alliancesbecause in most countries there are limits to the level of control an 'outsider' can have over anairline).

Complementary markets or technology.

Strategic alliances only go so far, as there may be disputes over control of strategic assets.

Worked example: Siemens and GE

In January 2006 Siemens and General Electric announced that they would co-operate in the launch of a newGE-developed security device for shipping containers. The two companies are the largest conglomerates inEurope and the USA respectively.

The product, called Commerce Guard, will have 'first-mover' advantage, but GE believes Siemens' strength inEurope makes co-operation necessary if the product is to achieve a high level of penetration globally.

Alliances have some limitations:

Core competence: Each organisation should be able to focus on its core competence. Alliances maynot enable it to create new competences.

Strategic priorities: If a key aspect of strategic delivery is handed over to a partner, the firm losesflexibility. A core competence may not be enough to provide a comprehensive customer benefit.

Business strategy


5.3.1 Information systems based alliances

The cost of major Information system (IS) based methods of working, combined with their inherentcommunications capability have made alliances based on IS a natural development. There are four commontypes:

Single industry partnerships: For example, UK insurance brokers can use a common system calledIVANS to research the products offered by all of the major insurance companies.

Multi-industry joint marketing partnerships: Some industries are so closely linked with othersthat it makes sense to establish IS linking their offerings. A well-known example is holiday bookings,where a flight reservation over the Internet is likely to lead to a seamless offer of hotel reservationsand car hire.

Supply chain partnerships: Greater and closer co-operation along the supply chain has led to theneed for better and faster information flows. Electronic data interchange between customers andsuppliers is one aspect of this improvement, perhaps seen most clearly in the car industry, where thebig-name manufacturers effectively control the flow of inputs from their suppliers.

IT supplier partnerships: A slightly different kind of partnership is not uncommon in the IT industryitself, where physical products have their own major software content. The development of theseproducts requires close co-operation between the hardware and software companies concerned.

5.4 Franchising and licensing

Franchising is a method of expanding the business on less capital than would otherwise be possible.Franchisers include IKEA, McDonald's, Starbucks and Pizza Hut.

Franchising can be a method of financing rapid growth without having to raise as much capital asconventional business structures. The British Franchising Association was set up in 1977, and well-established retail franchises include Prontaprint, Sketchley Cleaners and Kentucky Fried Chicken.

The mechanism

The franchiser grants a licence to the franchisee allowing the franchisee to use the franchiser's name,goodwill, systems.

The franchisee pays the franchiser for these rights and also for subsequent support services which thefranchiser may supply.

The franchisee is responsible for the day-to-day running of the franchise. The franchiser may imposequality control measures on the franchisee to ensure that the goodwill of the franchiser is notdamaged.

Capital for setting up the franchise is normally supplied by both parties. The franchiser may help thefranchisee in presenting proposals to suppliers of capital; presenting a business plan based on asuccessful trading formula will make it easier to obtain finance. Thus far, the franchiser needs lessequity capital than other business structures.

The franchiser will typically provide support services, including national advertising, market research,research and development, technical expertise, and management support.163

Advantages for the franchiser

Rapid expansion and increasing market share with relatively little equity capital, since franchisees willput in some capital. Strategically, the franchiser will be able to pursue an aggressive expansion policy tocover all geographical areas and establish brand dominance which otherwise could not be afforded.

The franchisee provides local knowledge and unit supervision. The franchiser specialises in providing acentral marketing and control function, limiting the range of management skills needed.

The franchiser has limited capital in any one unit and therefore has low financial risk.

Economies of scale are quickly available to the franchiser as the network increases. Hence supply ofbranded goods, extensive advertising spend are justifiable.



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Franchisee has strong incentives.

The advantages for the franchisee are mainly in the set-up stages, where many new businesses often fail.The franchisee will adopt a brand name, trading format and product specification that have been tested andpractised. The learning curve and attendant risks are minimised. The franchisee usually undertakes training,organised by the franchiser, which should provide a running start, thus further reducing risk.

Disadvantages

A franchisee is largely independent and makes personal decisions about how to run his operation. Inaddition, the quality of product, customer satisfaction and goodwill is under his control. The franchiserwill seek to maintain some control or influence over quality and service from the centre, but this willbe difficult if the local unit sees opportunities to increase profit by deviating from the standards whichthe franchiser has established.

There can be a clash between local needs or opportunities and the strategy of the franchiser. Forexample, in the late 1980s McDonald's pursued a strategy of widening the usage of outlets, inparticular by encouraging breakfast trade and family groups in the evenings. As part of this it wasdetermined that ideal locations would be in pedestrian areas, near to schools, hospitals, office centres.A franchisee in an industrial town may disagree with this strategy and want to locate on a busyapproach road to an industrial estate.

The franchiser may seek to update/amend the products/services on offer, while some franchisees maybe slow to accept change or may find it necessary to write off existing inventory holdings.

The most successful franchisees may break away and set up as independents, thereby becomingcompetitors.

5.5 Licensing agreements

A license grants a third-party organisation the rights to exploit an asset belonging to the licensor.

Licenses can be granted over:

The use of brands and recipes (e.g. Coca Cola manufactured 'under license' in Bangladesh)

A patent or technology (e.g. an IT firm may be licensed to install and maintain some given softwareapplication)

A particular asset (e.g. a drinks firm may buy a license to exploit a mineral water source or a mediafirm will license the rights to produce and sell a particular film, book or recording in its country)

Licensees will pay an agreed proportion of the sales revenue to the licensor for the right to exploit thelicense in a given geographical area or for a given range of products.

License agreements will vary considerably in the constraints the place on the licensee. Some will dictatebranding, pricing and marketing issues. Others will leave there decisions to the licensee.

5.6 Agency arrangements

These can be used as the distribution channel where local knowledge and contacts are important, e.g.exporting. The agreements may be restricted to marketing and product support. Other situations whereagents are used include:

Sales of cosmetics (Avon) Holidays Financial services, e.g. insurance

The main problem for the company is that it is cut off from direct contact with the customer.

Business strategy


6 Obtaining capital to finance growth

Section overview

The finance available to support growth of the business varies according to its size and stage ofdevelopment.

This section builds on the knowledge you have gained in other papers of sources or finance, assets,and costs of finance.

The purpose is to demonstrate the different financing approaches available at each stage and, inparticular, the issues surrounding firms floating on a public equity market.

6.1 Financing needs for stages of business growth

A simple model of growth for a profit-seeking business is presented below.

Stage Financing need Possible financesources

Start up Securing initial capital items e.g. tools, vehicles, premises

One-off payments e.g. franchise cost, purchase of licensesor leases

Personal savings

Personal borrowings

Credit cards

Supplier credit

Hire purchase

Leases

Venture capital

Small business Additional assets to support volume growth

Reduce exposure of owners

Obtain better income for owners

Retained profits

Business loans

Leases

Supplier credit

Development capital

Growth tocorporation

Primary capital to buy capital items and premises tosupport bigger and potentially more diverse business

Increased working capital needs

Investment in development initiatives e.g. new products,exploration of new markets, R&D

Financing of acquisitions of other firms

Possible exit of original founders as firm become too bigfor them to manage and they wish to 'cash in'

Retained earnings

Development capital

Public equity markets

Commercial paper andcorporate bonds

Maturecorporation

Support of existing operations

Need to finance dividends to shareholders

Retained earnings

New issues of equity

Commercial bills andbonds



10

Different sources of funds

Over the longer term, a company might raise new funds from the following sources.

Cash built up from retained earnings – the most important form of finance in practice for bothsmaller and larger businesses.

The capital markets

– Initial Public Offers (IPO): sale of shares to public for first time (for example by companiesacquiring a stock market listing for the first time)

– Rights issues (new shares to existing shareholders)

– Issues of loan capital – debt instruments sold to investors

Other sources include:

Bank borrowings – a source which businesses of all sizes are likely to consider

Government sources – for example grants

Venture capital – equity sold by new ventures to specialist venture capital firms (sometimes calledprivate equity firms) which carry a high level of risk for the investor

The international money and capital markets (commercial paper, bonds and currencyborrowing), which only larger companies will make use of in practice

6.2 Seeking a stock market listing

Seeking a listing means making the equity available to any outsiders prepared to pay the initial price, butthereafter who are free to sell to anyone they choose.

The following are reasons why a company may seek a stock market listing.

Access to a wider pool of finance

A company that is growing fast may need to raise larger sums than is possible as a private unlistedcompany. A stock market listing widens the number of potential investors. It may also improve thecompany's credit rating, making debt finance easier and cheaper to obtain.

Improved marketability of shares

Shares that are traded on the stock market can be bought and sold in relatively small quantities at anytime. This means that it is easier for exiting investors to realise a part of their holding.

Transfer of capital to other uses

Founder owners may wish to liquidate the major part of their holding, either for personal reasons orfor investment in other new business opportunities.

Enhancement of the company image

Quoted companies are commonly believed to be more financially stable, and listing may improve theimage of the company with its customers and suppliers, allowing it to gain additional business and toimprove its buying power.

Facilitation of growth by acquisition

A listed company is in a better position to make a paper offer for a target company than an unlistedone.

The drawbacks of seeking a listing are:

High initial costs of gaining admission to the market

Listing on the Stock Exchange has very onerous conditions and requires large resources and effort toachieve.

Business strategy


Loss of managerial autonomy

The board will need to take the wishes of external shareholders into account in decisions and keepthem informed on the prospects for the business. Often they pay for the services of corporate financeand investor relations experts to manage this.

Costs of compliance with exchange regulations

Companies must comply with the exchange rules. This has implications for decision taking andcorporate governance.

Media interest

The public company will be newsworthy and so effort must be put into creating the right impressionwith the journalists and ensuring good PR.

Potential loss of control

Depending on the market and the constitution of the firm it is possible for third parties to seizecontrol of the firm by obtaining more than 50% of the voting shares. Holdings over 20% will oftennecessitate a board position for the holder because if they sell the share price would fall considerably.

Subject to stock market sentiment

Although the individual prices of shares reflect sentiment about the firm's earning outlook the overalloutlook of the market will affect all share prices. Anticipation of recessions and interest rate rises, orscandals and business failures will sharply reduce the share prices. This means IPOs may fetch poorprices or that the company can be acquired cheap in a hostile bid.

Interactive question 1: Stock market sentiment [Difficulty level: Intermediate]

The Financial Times published the following market report. Read it and then answer the questions thatfollow.

'Share prices in London moved up again to all-time highs yesterday, measured by the stock market's mainindices, the FT-SE Actuaries All-Share and the FT-SE 100.

There were, however, signs that the market's move to record levels could be running out of steam. WallStreet, one of the prime motivating forces behind the London market's recent rise, briefly penetrated the5,000 level on the Dow Jones Industrial Average, shortly after the US market opened for trading. But itquickly dropped back to the mid-4980s, and around two hours after London closed for business the Dowwas still jousting with the 5,000 mark.

The failure of the US index to move decisively through 5,000 was one of a number of worrying signalsaffecting London. Others included the emergence of yet more profits warnings, notably from Rexam, thepaper group, and a decline in international bond markets.

Dealers said London had run into some determined selling pressure when it passed 3,630. 'Above that level,we ran into some real selling' said one market maker. The FT-SE 100 index finished the day a net 19.6firmer at an all-time closing high of 3,628.8, after reaching a record intra-day peak of 3,639.5. The FT-SE-AAll-Share index ended at a best ever 1,776.87, up 7.47.'

(a) What is a 'profits warning'?

(b) What was the sentiment or mood of the UK stock market on this day?

See Answer at the end of this chapter.



10

Summary and Self-test

Summary

Business strategy


Self-test

Answer the following questions.

1 What is the primary method of growth for most organisations?

A AcquisitionsB Organic growthC MergerD Franchising

2 Distinguish a merger from an acquisition.

3 Fill in the blanks in the statement below, using the words in the box.

(1) ……………… provide a means of entering a (2) …………….. or building up a (3) ……………… ,more quickly and at a lower (4) ……………… than would be incurred if the company tried todevelop its own (5) ………… . Corporate planners must however consider the level of (6)………………. involved.

risk cost market market share resources acquisitions

4 What is a leveraged buy-out?

5 Define a joint venture. What are the chief disadvantages of a joint venture for a company?

6 Fill in the blanks.

Particularly important questions in a buyout decision are:

Can the buyout team ……………. to pay for the buyout? Can the bought out operation generate enough ……………….?

7 Identify four reasons why a company may seek a stock market listing.

8 Ponda Ltd

Ponda Ltd is the second largest vehicle manufacturing firm in Europe. The board was recentlyconcerned about the lack of 'infant' products in the firm's portfolio, and so decided to launch anelectric car – the Greencar. Early research has shown that the demand is expected to be much higherin the US market than in the European market. This is at least partially due to the well publicisedfailure of a similar vehicle in Europe launched in the 1970s, having a top speed of only 30 mph andrequiring recharges at the rate of at least three per hour.

For the initial trial launch Ponda has decided to distribute the car using the American dealerEnvirofriend Inc. The firm was keen to participate in the venture to bolster its environmentalcredentials in the market. If the launch proves to be successful, the arrangement will be reviewed. Ifthe new product proves to be as popular as the board of Ponda hopes, it may be necessary to enlistadditional distribution networks. However, the managing director has assured Envirofriend that thenetworks will include Envirofriend (so long as the Greencar continues to be sold in Americanmarkets).

Ponda had originally wanted to invoice Envirofriend in sterling, but reluctantly agreed to do so indollars, on the understanding that all the cars would be paid for, whether sold or not. Envirofriendaccepted this risk, as the car's remarkable technical properties were expected to result in near certainsales (according to research).

If the car is popular in the initial market, Ponda has decided to penetrate the mass market as quicklyand efficiently as possible by setting up a manufacturing subsidiary in the US. It has never been theintention of the firm to distribute its own products; Ponda will continue to do so via third parties.Franchising is currently being considered as part of the distribution mix.

Ponda's strategic planning department has investigated the possible effect of US Government policy onthe Greencar venture. You have been given a rough draft of the research.



10

(1) It is likely that indigenous firms will be awarded preferential taxation treatment, such as 100% taxdepreciation, on research-related expenditure.

(2) Government grants for the purchase of the robotic machinery required for the manufacture ofthe electric cars are to be awarded to firms buying from US companies.

(3) Legislation is currently being planned to increase redundancy payments required in the hi-techmanufacturing industries. It is felt that this may lead to firms investigating ways in which to utilisetheir spare capacity.

(4) Unfortunately for Ponda the potential competitors are all government suppliers.

(5) The regulatory bodies in the US are likely to bring severe pressure to bear on Ponda –particularly with regard to price and environmental performance indicators.

(6) The Government has already decided to buy a large number of electric motorbikes for the stateeducation sector, to provide free transport to children from low income families (as analternative to public transport). The scheme has proved extremely popular in rural areas. The USsupplier has profited considerably from the deal, and is considering diversification into relatedareas.

(7) Import tariffs are to be levied on all 'environmental' goods manufactured by firms which are notresident in the US.

(8) A network of 'recharging points' is to be set up by the US Government, designed for use by alltypes of 'electric vehicle'. The government is keen to set up the system as quickly as possible, andis therefore planning to develop a system ensuring compatibility with the first firm offeringmarketable vehicles.

(9) Output tax is to be levied on petrol, but not on electricity obtained from the 'rechargingnetwork'.

Apart from political research Ponda has also commissioned research into the environmentalmovement in the US. There is a board consensus in favour of electrically-powered vehicles,particularly in urban areas. The main lobby against such products argues that the switch from petrolengines to electrical engines merely transfers the pollution problem from the car to the power station.Ponda is finding it difficult to judge which lobby will win the greater support in the long term.

The technology associated with the Greencar is far superior to that developed by other manufacturersto date: the electric car is no longer the poor relation of the petrol car. In fact, the Greencar hasconsistently outperformed its 'petrol using' rivals in respect of

Miles per $ of 'fuel'

Top speeds

Quietness inside the car

Reliability of the engine

Servicing frequency required

Environmental pollution

Ponda is concerned about the expected speed of competitive reaction if the car causes the revolutionin the industry which its performance specification would merit. Unfortunately, a patent could not beobtained for the design, so Ponda is expecting its rivals to introduce 'copycat' versions a year or soafter the initial launch. One strategy, currently under serious consideration, would be to sell themanufacturing technology to allow production of the Greencar under licence. In any case the directorsare sure of the need to establish a strong brand image as quickly as possible, so that the genericproduct – the electric car – becomes strongly identified in the mind of the consumer with the brandname Greencar, rather as the generic product 'vacuum cleaner' is strongly associated with the brand'Hoover'.

Business strategy


Requirement

Write a memorandum to the managing director of Ponda concerning the strategic aspects of theGreencar project.

Your memorandum should include the following.

US Government policy

A discussion on whether the manufacturing plant should be constructed by Ponda or acquired orwhether manufacturing should be licensed.

Consideration of the appropriateness of franchising as a distribution strategy for the Greencar.

(20 marks)

9 Greg Lee Hair Ltd

Introduction

Greg Lee Hair Ltd is a company which runs hairdressing salons in London. The company was foundedand is run by the eponymous Greg Lee, a man to whom modesty is an unknown quality. To be fair,Greg has had recognition for his skills as a coiffeur. Two years ago he won an international hair-stylingcompetition in Paris, and last year he received a gold medal (now adorning his chest on a chunkychain) at the Los Angeles Hair Artists' Conference. His most recent triumph was to be photographedwhile attending to the hair of a lady who is widely expected to become the next Princess of Wales.

The company began with a single salon, but Greg showed great flair promoting and managing thebusiness. There are now four salons in central London all making good profits because of the premiumrates that the 'Greg Lee' name currently commands. Some financial data for these salons is shown inthe Appendix. It is not unusual for the salons to be booked up for weeks in advance, though room canalways be found at short notice for film stars and minor royalty. Greg runs one salon himself part ofthe time and has installed managers in the others.

Greg is ambitious, and wants his business to move forward.

Greg Lee's plans

Greg is aware that hairdressers have ephemeral reputations. One year he can be the darling of theglossy magazines, the next year he can have descended back into obscurity. Presently he is on thecrest of a wave and feels that he must strike whilst the curling tongs are hot. He has already appointeda PR agent who is adept at getting work and credit for him in the top magazines and fashion shows.

Greg has thought about several ways in which his relatively small business could be developed into amuch more substantial one that would have lasting value. His ideas are as follows.

Plan 1 To open a national chain of hairdressing salons

Plan 2 To launch a range of hair care products

Plan 3 To run a chain of hair transplant/trichological clinics.

The markets for each of these activities have the following characteristics.

1 Hairdressing salons

These are already widely distributed, with at least one in most small villages. They are nearly allsmall businesses, with the owner working in the salon and employing one or two people. Thestandard of service and skill offered varies widely. Prices tend to be governed more by thelocation of the salon and the standard of shop-fittings than by the skill of the cutters and stylists.Many of the owners make only modest livings, and the businesses have very seasonal trade andare susceptible to economic recessions. The larger towns sometimes have franchises of the VidalSassoon group.

2 Hair care products

There is a huge range of these on the market. Boots (a large high-street chemists chain), forexample, stocks 240 lines of shampoo, as well as conditioners, dyes, mousses and so on. Many of



10

the big stores, such as Marks and Spencer, market their own brands. Other internationalcompanies have very strong brand names such as 'All Clear' (Elida Gibbs), 'Head and Shoulders'and 'Wash and Go' (Procter & Gamble), supported by complex and expensive marketingcampaigns.

The chemistry of hair care products is not difficult to master and it is easy to find suitableformulae. The raw materials are easy to obtain, and the production process is little more thanmixing the materials in a large vat.

3 Hair transplant clinics

Historically this has always been a low growth market. Recently the market has begun to declineslightly, because it has become fashionable to be bald. Curiously, the decline in interest in hairtransplants and associated techniques has occurred when medical advances have at last allowedthe techniques to achieve reliable results. Not long ago these techniques were liable to produce acuriously grouped hair distribution pattern, looking like the bristles on a toilet brush.

There is a major chain of 25 clinics presently up for sale by the liquidators of a fashion company.This chain has 70% of the market and the remaining 30% is shared amongst many smalltrichologists. No detailed investigation has been performed on the clinics that are up for sale, butthe liquidator has given assurances that this part of the fashion group trades profitably and wasnot the cause of the group's failure.

Personnel

Greg has constant difficulties with personnel management. He finds it difficult to recruit trained stylistsand cutters of the right quality. Many have to be almost entirely retrained once recruited. Those thatare recruited often have poor attendance records, are often moody, and are obviously working atGreg Lee's to gain experience before attempting to open a salon of their own. Partly the personnelproblem is because of the notoriously low wages in the industry; this is in common with many serviceindustries.

Once a staff member becomes established, clients will often ask to be attended to by that personspecifically. If a hairdresser moves to a rival establishment, the client often moves too. A lot of staffpoaching goes on, with staff being attracted to other jobs with lucrative sign-on deals. If all else fails,staff can set up on their own offering home hairdressing services. Their prices can easily undercutthose of salons.

Requirement

Greg Lee feels that he needs some professional guidance about his three plans and he has approachedyou, an independent consultant, for advice. He realises that relatively few financial details are availableyet, but would appreciate a memorandum setting out

(a) The main strategic considerations associated with each of his plans, including an analysis of thetype of market and market forces involved

(b) The resource requirements implied by each plan

(c) The options recommended for realising each plan.

(27 marks)

Business strategy


Greg Lee Ltd – Appendix

Average salon financial information

CUSales 300,000Consumables – shampoos, conditioners, etc 25,000Rent 50,000Electricity and gas 3,000Telephone 1,000Laundry 7,000Wages

Full-time staff 60,000Part-time staff 30,000

Depreciation 12,000Decoration 2,000Repairs and maintenance 2,000Insurance 2,000Advertising 3,000Refreshments 3,000

(200,000)Profit 100,000Tax @ 25% (25,000)Profit after tax 75,000

10 Kultivator Ltd

Kultivator Ltd was founded ten years ago by Jamie Dimmock and Charlie Oliver, when they openedtheir first garden centre in Hampshire. Since then the business has grown, both organically andthrough the acquisition of other privately-owned businesses. The largest acquisition took place in theyear ended 31 July 20Y0, following an injection of capital by a small number of institutional investors,who now own 15 per cent of the company's share capital. As a result, Kultivator Ltd currentlyoperates a chain of 25 garden centres across the south of England, employing 1,250 staff. In order toexpand further, it is now considering raising more capital, either through borrowing or by floating onthe London Stock Exchange to obtain a full listing.

The industry background

Over the past fifteen years a growing proportion of consumer spending in the UK has been devoted togardening. This has been matched by a rapid growth in the number of garden centres and an increasingnumber of TV programmes and 'lifestyle' magazines dedicated to the pastime. Today, two out of threepeople in Britain admit to gardening as a hobby, which makes it the country's most popular pastime,and the industry now employs 60,000 people.

Most garden centres are privately-owned businesses, usually operating from one site. Frequently theybuy in bedding plants and specialist services, sometimes franchising retailers to offer particular services(e.g. mower repairs and garden equipment sales; garden furniture; fencing; greenhouses and huts;fountains and water garden facilities; etc). Others have developed expertise in growing certain types ofplants and trees, which has enabled them in part to capture a niche in the market and partiallyintegrate their production activities into one or more retailing outlets.

Despite the rapid growth in this part of the consumer market, amongst large companies only a fewDIY chains have ventured into the field. A major inhibiting factor appears to have been the general lackof horticultural skills amongst potential employees. Such skills, however, are often possessed by theowners of smaller, locally-based businesses. Some of these – such as Kultivator Ltd – have been ableto expand successfully, either growing organically by opening up new outlets, or – more usually – byacquiring other ready-made family businesses. This has enabled them to take advantage of economiesof scale in retailing (e.g. in providing deliveries), and their buying power when dealing with largerspecialist suppliers (e.g. of plants and trees and of garden equipment).



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The flotation option

A merchant bank consulted by Kultivator Ltd has estimated the most likely flotation value of thebusiness would be CU94,200,000. This is based on the estimated 20Y0/20Y1 pre-tax profit growing at4 per cent per annum over the next three years and thereafter at 2 per cent per annum.

The bank has proposed that the company should be floated on The London Stock Exchange. Thismeans that Jamie Dimmock and Charlie Oliver will together receive over CU20 million for part oftheir holding in the business, but still leave them with a controlling interest of 63%.

The views of the owners of Kultivator Ltd

Jamie Dimmock is disappointed with the merchant bank's advice. He believes that it is undulypessimistic to assume that the growth rate in pre-tax profits will be as low as 4 per cent per annumover the next three years, falling thereafter to a mere 2 per cent. After all, in recent years profits havegrown faster than the increase in revenue, reflecting the company's ability to reap the rewards ofeconomies of scale, while at the same time being able to exercise greater bargaining power whennegotiating with suppliers. He believes that the merchant bank's rather pessimistic forecasts are basedon an unrealistic assumption that the large DIY groups will take a growing share of the market at theexpense of independents such as Kultivator Ltd. Already they face an effective barrier to entryinasmuch as they are having difficulty in employing skilled horticulturalists. Customers are increasinglyanxious to have appropriate advice, and the existing well-rewarded staff at Kultivator Ltd have theappropriate expertise. In the circumstances, he would prefer either to rely on further bank borrowingor to seek advice from another merchant bank.

Charlie Oliver does not entirely agree. She is not so sure that the barriers to entry facing the largeDIY groups are that high, and anyway she cannot quite see what competitive edge companies such asKultivator Ltd have over these groups when it comes to recruiting skilled personnel. Equally, shewould favour growth by pursuing an alternative production strategy rather than only by expandingretail sales. This could be achieved if Kultivator Ltd were to grow its own plants and shrubs or soughta tie-up with a nursery or seed merchant. Capital could also be used to increase holdings ofinventories and reduce short-term borrowings, thus strengthening the company's working capitalposition.

Requirement

As an assistant to a partner in the firm of accountants which advises Jamie Dimmock and CharlieOliver, draft a memorandum for them which deals briefly with the following issues:

An assessment of how floating the company might affect the objectives of the company, eventhough Jamie Dimmock and Charlie Oliver would still control the business.

The validity of the assumptions which appear to underlie the growth projections implicit in themerchant bank's calculation of the company's flotation value, dealing in particular with:

– Barriers to entry and the threat of competition from large DIY groups

– Whether growth should be via vertical integration or horizontal expansion

Whether organic growth should be preferred to expansion via acquisition.

Note: Ignore taxation.

(15 marks)

Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved theseobjectives, please tick them off.

Business strategy


Answers to Self-test

1 B

2 A merger is the joining of two separate companies to form a single company.An acquisition is the purchase of a controlling interest in another company.

3 (1) Acquisitions (2) market (3) market share (4) cost (5) resources (6) risk

4 A leveraged buyout (LBO) is an acquisition which has been financed largely by debt, often debt securedon the assets of the firm to be acquired.

5 A joint venture is an arrangement where two firms (or more) join forces for manufacturing, financialand marketing purposes and each has a share in both the equity and the management of the business.The major disadvantage of joint ventures is that there can be conflicts of interest.

6 Particularly important questions in a buyout decision are:

Can the buyout team afford to pay for the buyout? Can the bought out operation generate enough earnings to pay the interest on the borrowings?

7 Four of the following five: access to a wider pool of finance; improved marketability of shares; transferof capital to other uses (e.g. founder members liquidating holdings); enhancement of company image;making growth by acquisition possible.

8 Ponda Ltd

Memorandum

To The Managing Director, Ponda Ltd

From F Smith

Date Today

Subject The strategic aspects of the Greencar project

Government policy

According to research present policy favours the US firms over foreign competition. Import tariffs fornon-resident companies in the sector, preferential taxation treatment relating to R&D expenditure,grants to aid the purchase of equipment from US firms, and heavy government expenditure on Ponda'scompetitors all mean that Ponda has an inherent disadvantage compared to the US competition. Theextent of the government support is well illustrated by the government contract to buy electricmotorbikes for the state sector. This has resulted in the supplier making large profits, and thus beingable to finance new developments internally, which may include the production of a Greencar-likeproduct.

The planned legislation concerning increasing the redundancy payments in the high-technology sectoreffectively acts as an exit barrier, as firms will incur high costs if they attempt to close downmanufacturing plant. Therefore, excess capacity in the industry is to be expected. Some firms may usethis spare capacity to produce rival products to the Greencar. Alternatively, Ponda can use thisresource to 'contract out' its productions.

The output tax treatment of electricity from the recharging network (at 0%) gives the electric carproduct an advantage over its petrol-engine rivals. This is an advantage for the entire industry, but ismost significant for Ponda, which, as the pioneering manufacturer, will be the first to realise thebenefits. Similarly, the government-funded recharging network will prove advantageous to Ponda,particularly as the technical capability (with Ponda) will inevitably force Ponda's rivals to alter theirdesigns.



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The manufacturing plant

The manufacturing facility, whether acquired or constructed, will only be required if the initial sales gowell. This is expected because of the extraordinary technical specification of the Greencar. Therefore,given a successful result in the test market, the company should proceed with a 'fast growth' strategyin order to capture the mass market before the competition has a chance to enter the market. Pondacould achieve this by

(i) Buying an existing manufacturing firm (bearing in mind that the process of adoption may beonerous and lengthy)

(ii) Allowing other firms to manufacture the Greencar under licence (essentially a joint venture)

(iii) Setting up its own plant.

The case in favour of Ponda setting up its own plant is weak: to build up the necessary capacity quicklyby internal means could be difficult. However, the overwhelming case against Ponda setting up its ownplant is found in the US Government policy of favouring US firms. Because of increased redundancypayment legislation, many suitable firms will have spare capacity that they are anxious to use. It shouldbe possible to enter into a very favourable joint venture with a US firm. (It is assumed that if a US firmwere taken over by Ponda, it would lose its favoured position as a US firm.)

Franchising as a possible distribution a strategy

Assuming that the test market is a success, the firm should attempt to reach the mass market as soonas possible. Assuming that Ponda has arranged sufficient production capacity to achieve this,distribution networks must be set up quickly. The main choice appears to be between establisheddealers and franchisees (since Ponda has expressed an intention not to set up its own networks).There is an additional constraint: under either scenario Envirofriend must be included in thedistribution mix.

Franchising is an arrangement whereby a company distributes products – usually of a 'famous' brandtype (as Greencar is expected to become). For the privilege the franchisee pays a capital sum (at thestart of the arrangement) plus a stream of royalty payments, dependent on the success of thefranchise.

Franchising would be a suitable component of distribution for Ponda for the following reasons.

The arrangement typically involves tight control over the marketing elements of the businesssuch as brand name, unique selling points to employ, in-store promotions, etc. A unifiedmarketing effort across the outlets is essential for the firm to penetrate the market, and this isarguably easiest to achieve by franchising.

The franchisees are strongly motivated to sell a high volume of cars (since their success dependson it).

Ponda does not have to invest in any capital (this is provided by the franchisee), thus the strategyis low risk (for Ponda) if the project fails no capital has been wasted, whereas if the projectsucceeds the franchisees suffer (and Ponda is not affected).

Franchise systems have been associated with a high rate of growth (e.g. McDonald's in the 1980s)– ideal for Ponda.

The disadvantages include the following.

Selection of the franchisees may be difficult (given the new type of products).

Since the Greencar has no track record, setting the balance between the initial fixed capital andthe variable royalty payments could be difficult.

The time spent in training the franchisees could result in a drain on resources.

Nevertheless, these disadvantages are not insurmountable, and therefore the franchising strategy is tobe recommended.

Business strategy


9 Greg Lee Hair Ltd

Memorandum

To Greg Lee

From Consultant

Date Today

Subject Your options for expansion

Types of market

Chain of hairdressing salons

This is a fragmented market. This means that there are many small independent businesses and that, ingeneral, large national and international businesses have made little impact.

The market remains fragmented because there are no great advantages to consolidation. For example,there are relatively few economies of scale available, customers often want convenience so want alocal salon, they want a personal service from a hairdresser they know, and they often want anindividual (not a standardised) service and look.

In addition, it is easy for newcomers to enter the market (such as home services) and this will alwaysadd risk to ventures which seek to consolidate the business.

If this plan is to be successful, the chain of salons will have to offer something unique to the customerwhich cannot be emulated by smaller operators; it will also have to overcome the advantages thatsmaller operators can have in this market.

Other than kudos arising from use of your name, it is difficult to see what this chain will offer.

A range of hair care products

This is a mature market dominated by large international organisations. They will enjoy greateconomies of scale in manufacturing, distributing and marketing.

Therefore, it will be difficult for you to enter this market and the product range is not wide enough tosupport the opening of your own outlets.

Hair transplant/trichological clinics

Currently this is a declining market and, at first glance, appears unattractive as it does not promise anylong-term future.

However, this can give opportunities. A major chain is up for sale and you can use the declining trendto argue down the price and gain a 70% presence in the market quite cheaply.

Of course, if the market continues to decline, this may be a bad deal, but you must decide:

(i) How quick the decline will be

(ii) Whether there will be long-term decline.

For example, although presently bald is beautiful, this may be only a passing whim of the fashionindustry, and demand for the clinic's services may soon increase again.

If you were to achieve a 70% share of the market, you would dominate the smaller operators and yourname might give respectability to what may be a business sector full of charlatans.

However, you should also consider whether association with the clinics would adversely affect yourhairdressing business.

Resources

Each plan will require money to be invested, but thereafter each will have different resourcerequirements.



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Chain of hairdressing salons

This implies the recruitment, retention and management of a large number of personnel, widelydispersed throughout the country. The information that you have supplied to me indicates thatpersonnel management in this business in not easy.

A major effort will be required in this area and, if possible, ways will have to be devised to encouragegood staff to stay.

This will reduce the recruitment burden and will mean that fewer staff leave to compete with yoursalons.

You will also need to lease and fit out a large number of salons. Some professional advice should besought in lease negotiation.

To reduce the burden of personnel and property administration you are recommended to considerfranchise arrangements; this is developed further below.

A range of hair care products

To launch this on your own would require enormous manufacturing, distributing and marketingresources.

To commit such resources to a new venture would imply that considerable risks are being taken asthe venture could well fail.

It would be much safer to lend your name to other manufacturers' products; this is developed furtherbelow.

A chain of transplant/trichological clinics

Here, you can acquire a ready-made organisation complete with premises and staff. Although thesewill need careful management it is unlikely to present as immediate a problem as starting up a chain ofsalons.

Remember that you may have to wait some time before business picks up again, and during this timeyou may wish to consider carefully the image presented by the clinics.

Marketing may well be the resource which most needs to be supplied.

Options recommended for realising each plan

A national chain of hairdressing salons

It is recommended that you pursue this option by setting up franchises. The advantages of this methodare:

(i) Franchisees will subscribe capital

(ii) Franchisees manage locally – especially important given the personnel difficulties that would beintractable if managed centrally

(iii) Franchisees can provide a well-motivated, local service

(iv) Franchisees should be asked to sign the leases, so removing risk from Greg Lee Hair Ltd.

In exchange, franchisees will be able to use the 'Greg Lee' name and to enjoy national marketingcampaigns.

A chain of hair care products

The entrance barriers and risks associated with this option are so great that you are recommendednot to attempt this on your own. Instead, you are advised to enter into a marketing agreement with alarge producer.

The producer will already have the manufacturing and distributing system in place and a new brandname can easily be added to the product portfolio.

Greg Lee Hair Ltd would receive a royalty and publicity.

Business strategy


The publicity would help you to also set up the chain of franchised salons.

A chain of hair transplant/trichological clinics

If you decide to acquire this chain, then there appears to be little option initially but to buy theundertaking from the liquidator.

As there may well be significant unidentified liability claims from former patients, you are stronglyadvised not to buy the company.

Instead, you are advised to buy the business assets and goodwill and to place these in a new companythat will be free from old liability claims.

As there are presently only 25 clinics, these could be centrally managed. If many more were to beadded, the franchise system might be more satisfactory; this would have the same advantages asmentioned above.

10 Kultivator Ltd

Memorandum

To AN Other & Co

From Assistant to A Partner, AN Other & Co, Chartered Accountants

Date Today

Subject Objectives, assumptions and growth

An assessment of how floating the company might affect the objectives of the entity,even though the existing majority shareholders would still control the business

Clearly at the present time Jamie Dimmock and Charlie Oliver, as controlling shareholders ofKultivator Ltd, can run the business in a way which suits their own private objectives.

These might include maximising revenue, expanding the business, and/or maximising their directors'salaries.

However, as soon as outside shareholders take a stake in the company the interests of JamieDimmock and Charlie Oliver will be constrained to some degree, even if they retain a controllingstake in the business.

In fact, Jamie Dimmock and Charlie Oliver will almost certainly already be constrained to some extent,given that institutions have taken a 15% stake in the business.

It is unlikely that they will have done this without having some say in the way in which the company ismanaged e.g. by appointing a director to the board.

It is also probable that the bank will also have placed restrictions on the way in which the directorsmay operate if it has lent money to the business.

However, in the absence of any contractual constraints, in company law the fact that Jamie Dimmockand Charlie Oliver would still own more than 50% of the share capital of Kultivator Ltd wouldeffectively mean that they could do very much as they pleased.

This follows from the 'majority rule' principle established in Foss v Harbottle in 1843.

The main constraint imposed by company law is that Dimmock and Oliver will no longer have a 75%majority of votes, which would enable them to pass a special resolution.

But once a company becomes a Ltd there is an implied assumption that the directors must run abusiness in the best interests of all the shareholders, presumably meaning that the overriding goal is tomaximise the value of the company.

This is now formally recognised with respect to quoted companies in the Combined Code onCorporate Governance that is included in The Stock Exchange's Listing Agreement.

Nevertheless, despite the introduction of the Code on corporate governance of listed companies, themajority owners of a business exercise considerable power.



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Consequently one could regard the overriding goal of shareholders' wealth maximisation as beingseverely constrained in the case of Kultivator Ltd by the fact that Jamie Dimmock and Charlie Oliverwould still in large part be able to pursue their own private objectives, even if this might lower thevalue of the business to the detriment of the minority of shareholders.

However, Dimmock and Oliver will no longer be able to determine their directors' salaries immunefrom criticism.

The validity of the assumptions which appear to underlie the growth projections implicitin the merchant bank's calculation of the company's flotation value

(a) Barriers to entry and the threat of competition from large DIY groups

With respect to the growth rates assumed, these depend on a number of factors.

These include the growth in demand in the industry and the level of competition (which willaffect both the volume of sales and the prices and profit margins that can be charged).

Estimates of the former will depend in part on the forecasts for the economy as a whole and onconsumer tastes and habits.

The level of competition, however, will depend on a number of factors (e.g. the rate oftechnological change and how easy it is for rivals to enter the industry if it appears to beprofitable).

It is the latter issue that is to be addressed here, i.e. are there significant barriers to entry?

Jamie Dimmock apparently takes the view that the merchant bank's assumption that the growthrate in pre-tax profits over the next three years will only be 4% per annum and thereafter 2% perannum is far too pessimistic.

He bases this assessment on the fact that in recent years profits of Kultivator Ltd have grownfaster than the increase in revenue reflecting the company's ability to reap the rewards ofeconomies of scale as it has expanded, while at the same time using its greater bargaining powerwhen negotiating with suppliers.

Nevertheless, he believes that there is still potential for further profitable growth.

This is because he does not believe that the large DIY groups will take a growing share of the(expanding) market at the expense of independents because they face an effective 'barrier toentry'.

In particular, they do not possess one of the key 'core competences' possessed by Kultivator,namely horticultural expertise. Moreover, these groups are finding it difficult to employ personnelwith the necessary skills, which is a severe disadvantage when customers are anxious to haveappropriate advice.

Further, he believes independents (such as Kultivator) have an in-built advantage here becausethey pay well qualified staff appropriately.

However, as Charlie Oliver seems to be suggesting, there is nothing to stop the large DIY groupsmatching these pay scales, so that alone is unlikely to be an effective 'barrier'.

Only if there is some other factor that enables independents to hold on to the scarce supply ofskilled labour will such a 'barrier' be effective.

(And then presumably only in the short term as the labour market adjusts, more individuals trainas horticulturalists or where appropriately trained personnel are recruited from abroad.)

In fact, there are several other possible barriers to entry that may thus far have prevented DIYfirms entering the industry, quite apart from the fact that they may not anticipate growthprospects to be sufficiently attractive.

These include:

The fact that existing garden centres have strong bargaining power with suppliers and/or arevertically integrated, giving them a competitive edge

Business strategy


Garden centres enjoy the maximum economies of scale, so DIY firms could not beat themon efficiency grounds

DIY stores are typically located at relatively expensive city centre or edge-of-town sites,whereas garden centres are usually to be found out in the country.

Another difference is that DIY stores typically use the 'shed' format, as this facilitates rapidthroughput and the use of JIT inventory replenishment systems. By contrast, garden centres tendto carry large ranges of plants, shrubs and trees, many of which will be slow moving.

Garden centres also often emphasise their ambience, tending to focus on a positive 'shoppingexperience' (e.g. by offering refreshment facilities). In other words, DIY stores and traditionalgarden centres appear to be catering for different niche markets.

On the other hand, DIY firms enjoy certain advantages, suggesting that there would be synergiesif they decided to expand their garden centre activities (e.g. they already stock garden furniture,decking, huts, tools and garden equipment).

(b) Whether growth should be via vertical integration or horizontal expansion

Charlie Oliver appears to think that independents such as Kultivator may enjoy anothercompetitive advantage, namely through vertical integration by growing their own plants andshrubs or seeking a tie-up with a nursery or seed merchant.

If this is so, it would provide an alternative means of expanding to horizontal integration, wheremore and more garden centres are set up or are acquired.

(However, it should be recognised, of course, that the two means of growth are not mutuallyexclusive.)

The main disadvantage of vertical integration is that it reduces flexibility and tends to increaseoperational gearing.

On the other hand, there should be opportunities to cut costs (e.g. by reducing the levels ofinventories of plants, shrubs and trees held at individual garden centres, although such savings arelikely to be minimal).

Another potential advantage, which may be important for Kultivator, is that it should be easier toexercise quality control (potentially important where customers are likely to want plants whichgrow vigorously and flower profusely).

The main benefits of horizontal integration are that it should provide opportunities to exploiteconomies of scale, while at the same time slightly reducing risk exposure as a result ofdiversification.

More generally, if Jamie Dimmock and Charlie Oliver really feel that the merchant bank hasundervalued their business, they could raise finance to expand the business in other ways.

Whether organic growth should be preferred to expansion via acquisition

In a perfect market there should be little to choose between expansion via organic growth rather thanvia acquisition, regardless of whether the proposal involves horizontal or vertical integration.

The additional costs that will be incurred setting up a business from scratch, including the greater risksbeing taken, should be matched by the higher price one might expect to pay to acquire a 'goingconcern' where someone has already taken those risks.

In practice, however, other strategic considerations are likely to determine which option will bepreferred.

Thus, for instance, if speed is of the essence to secure a competitive advantage in a market, expansionvia acquisition is likely to be preferred.

Indeed, sometimes two independent entities will see it as being in their mutual interest to engage in adefensive merger, in which case both sides should benefit by sharing the potential synergistic gains.



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However, at other times, where speed is not of the essence, it may be preferable for a business togrow organically, particularly where it has an in-built competitive advantage (e.g. because it has atechnological superiority, backed up by patents).

In the circumstances relating to Kultivator, the main justification for opting for expansion viaacquisition, rather than via organic growth, would be to establish a strong position in the market.

Given the fact that the DIY groups are an ever-present threat, there may be a strong case for trying toexpand as quickly as possible via acquisition, even though this may mean that a large part of thepotential synergistic gains may have to be paid for 'up front'.

Business strategy


Answer to Interactive question

Answer to Interactive question 1

(a) This is an announcement by a company that its profits will be lower than had previously beenexpected. A profits warning usually results in a drop in a company's share price, because it meansthat the company is less valuable than was previously thought.

(b) The market reached an all-time high, reflecting a mood of optimism about the future of theeconomy and business performance. There are some indicators, however, that prices have gone ashigh as they will for the moment (or that they may begin to fall).

chap - 10 methods of developments

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