The unexpected Switch: when customers buy from someone else

In recent articles I’ve discussed how concentration of suppliers (for all businesses) and customers (in the B2B environment) can radically increase risk to the business. Yet what about customer risk in the B2C environment? If you have many consumers as customers, where does the risk come from?

The key risk is substitution – where a consumer switches from buying your product to something else that fills their needs, typically a direct competitor. Sometimes the switch is temporary and sometimes permanent. A dominant company with a long track record against established competitors would argue that its customer base is steady and unlikely to defect, but it happens:

As an example, I’d like you to consider a time of extreme economic uncertainty, a time of potential existential threat to many, a time when politically power-struggles took place around a negotiation table yet also saw prominent leaders gunned down by extremists. Police couldn’t control the populace so the Military were called in. Ordinary citizens carried guns, some moved towns or even emigrated seeking safety elsewhere. The private security industry boomed. Those without a “Plan B” stockpiled foods, protected their homes and prepared for a long-lasting siege.

Could this time have been the USA during a Hurricane that flooded parts of a major city, destroyed homes and left many without electricity for weeks? Could it have been Greece during the height of the Euro crisis? Bosnia? The Czech Republic? Syria? Egypt? Libya? It could have been any of these, and the reality is that it could happen near you with little notice. However the example I will discuss comes from 1994 – in the months preceding South Africa’s general elections – the elections that would mark the transition to that countries’ peaceful democracy.

The consumer switch happened during the elections, but it took a while to figure out that a lasting change had happened, which meant that nearly a year after the event I got a call from a client asking for help understanding a problem. Their sales in the category had dropped around the time of the 1994 elections (i.e. ‘existential crisis), and their market share hadn’t recovered. They had gone from being dominant in a category to be the 2nd biggest player, having lost about 30% market share. Their calculations showed that they’d lost this share in just 1 quarter, on a business that had been very predictable over 30 years of its history. So what had happened?

The company that had lost market share sold powdered milk. Powdered milk competes with fresh milk and long-life milk (and of course Soy products but they are a very small part of the pie). With the crisis of the elections looming their international parent had adopted a ‘wait and see’ attitude that in turn had been adopted by the local branch. Given that many foresaw a prolonged civil war this wasn’t entirely a bad decision. So they kept production going but didn’t make any new investments into new machinery or push sales. Marketing campaigns were kept simmering along – after all, what’s the point of investing in marketing when the world is about to end?

Most consumers took a different approach: they stockpiled at least some reserves of essential items. Milk is pretty high on this list but you can’t stockpile fresh milk. So they stockpiled their old favourite alternative – the powdered milk made by my client. Then stocks ran out. Any retailer will tell you that a stock-out can be disastrous because you risk losing a sale that you’d otherwise have made. In this case the consumers couldn’t find what they wanted, so they bought the alternative – long-life milk, where a new brand had been released about 5 years previously with limited success (since most consumers hadn’t really tried it yet). The retailer didn’t lose a sale but my client did. The consumer bought something they were unsure of, under the duress of a potential existential threat.

What happened next is that the elections went peacefully. Production of all milk products carried on, but powdered milk never regained its pre-election share. The reason is that consumers who had bought the long-life brand now had it in their homes and they actually tried it. They were surprised to find that it tasted very good and they preferred this taste to powdered milk. So they permanently switched products and never went back.

Even with the election and the stockpiling consumers wouldn’t have switched if there’d been sufficient stock of their old favourite, but a lack of stock gave the consumers enough motivation to try a competing product and that permanently changed the fortunes of two companies in the market, one at the expense of the other. A big business with steady revenues and stable growth lost 30% of its market share in a single quarter to an established competitor.

So how low-risk is your business? What would it take for your consumers to switch to an alternative product or brand? Will it take an existential crisis or something far less threatening and far more common, like a new advertising campaign or better packaging? Which long-term threats will prove to be opportunities for you: climate change, rising energy costs, the rise of the hyper-connected world, or the shift in power towards China? Or will the next Marikana spark a series of events that transforms a peaceful democracy into another African civil war? What will we stockpile this time?

How locked-in are your Customers?

A while ago I was working on a deal. A large foreign company wanted to buy a stake in a local company, lets call them “MoneyCo”. I had introduced the parties and was representing MoneyCo. The discussions were warm and friendly and as more information was shared the proposed deal moved from the foreigners wanting to buy a small stake to an outright acquisition. The deal moved from discussions to a formal Heads of Agreement with preliminary approval from the M&A arm of the foreign company, to a signed term sheet and then due-diligence. The whole process to date had taken under 6 months; in other words, the deal was moving well and at typical pace for something involving people who travelled a lot and who had other things on the go.

Deals fall apart in due-diligence, and we had reason to be worried: MoneyCo had been using their clients to fund their working capital, which is something every business does but in this case they were paying their customers on 90 days when their contracts stipulated 30 days. It had got to the point where the business had negative working capital and any growth was funded by simply paying all clients a day or two later. In fact, sorting out this mess was one of the key reasons MoneyCo was considering being bought out in the first place. The end customers were big companies and they squealed loudly about the payment terms, but each month MoneyCo made sure they got paid something (even if they avoided the phone once payments were past due)!

We were worried that if we did a deal we’d first have to bring clients up to current payment, i.e. to sort out the working capital mess. This would have required several Million of the deal to go straight back into the business. More than that, we were worried that MoneyCos’ clients would switch to another provider entirely and that revenues and the deal would collapse. This worry was shared with the buyer and was a key question to be explored during the due-diligence.

The foreign companies advisors conducted a series of interviews with the major clients of MoneyCo to explore this and other issues. They asked questions designed to question the satisfaction of the client, plans for future business, and the stability of the relationship. What came out very strongly, is that the clients had no intention of moving and were comfortable with the relationship, some even talked about plans to increase the volume of business being done with MoneyCo.

Before I tell you what happened with the deal, lets look at how MoneyCo was able to get away with such late payments. Several factors were at play:

  1. MoneyCo clients were foreign companies who couldn’t operate directly in the local market (not by law, but because a major supplier chose to only allow a few local companies to distribute their product and all others had to go through those).
  2. The local market was small compared to some other markets the foreign companies were in, which meant that the parent could absorb some of the working capital issues in the local market.
  3. MoneyCo had competitors, but they charged more, were less reliable, offered less customisation, and were slow to respond on a technical level. In comparison the technical team from MoneyCo allowed clients to walk in and out of their offices and make system changes almost real time (the issues this caused are for another story).

What all of this meant is that these big companies traded off the level of service and custom product offering they received from MoneyCo for the reality of being paid very late. As the customisations gradually built up over time it became harder and harder for them to switch to a competitor, and essentially MoneyCo had sufficient power over the customer to force them to accept late payment. The clients would respond with downward pressure on the fees charged, but the reality is that they weren’t going anywhere.

So what happened to the deal? Well, the fact that the major clients were happy and stable and weren’t going to leave MoneyCo at the drop of a hat meant that the foreign acquirer was happy with the risk. However it also meant that without a potential call for immediate payment by MoneyCo to one of its biggest customers (which would effectively have put it into liquidation), the urgency to do a deal fell away for MoneyCo and on consideration they walked away. Some time has passed since then and I hear from someone that they are now paying their customers on 120 days…

Customer concentration and customer switching is a very real risk for any business. Most times, customers can easily switch to another supplier. What about your business? How many customers do you have and how easily can they take their business somewhere else? Why do they really buy from you?

Supplier Risk

Regular readers of this column will know that we’re gradually shifting away from pure theory around how to value your business and increase its potential, to more of an interactive discussion around the financial/valuation/strategic issues that entrepreneurs face. What this means is this:

If you have a question/issue you’d like to discuss with us, then send an email to finweek@valuationup.com and we’ll try to answer your questions in this column. This could be anonymous (if the numbers/industry or problem is particularly sensitive – this is entirely your call), it could also be public – in which case you’d get the added benefit of your name, company and what you do in print. As a wise man once said, there is no such thing as bad publicity.

One of the greatest things about my work is that I get to spend time with ambitious entrepreneurs, generally at a time when they are experiencing a real challenge and need to get help to make more informed choices. Like all ambitious people, they have a view of their business and their worth that is not always bedded down on reality and no-where is this more true that in their perception of the real risks they face. This is exactly what’s happened in the last month with 2 such entrepreneurs I’ve worked with:

In the first instance, I met with a BEE company that has the rights to distribute a leading international product into the public sector. Their supplier has other distributors who sell to the private sector (not so BEE) and has other BEE distributors who get exclusive rights to sell some of their smaller products. The company I met with have grown nicely for 5+ years. They have a great relationship with their supplier to the extent that the supplier even gave them a R10M working capital facility to help them when government paid slowly (of course, they ceded their debtors book as part of this deal). Things were good and they made a few million PAT a year…until last year, when the supplier changed its terms and cut the margin a bit. This year the supplier has come back to them with ambitious growth targets they have to meet or else they will terminate the contract. The problem is they can only sell to the public sector in an industry that isn’t growing nearly as fast as inflation and that is extremely price sensitive. In other words, they are up the creek without a paddle. So what are they doing? They are scrambling to open doors with other suppliers, which sounds good until you remember that the supplier owns their debtors book that will include the new suppliers. So they are faced with the only real choice – they have to do what they can in the existing business but open a new one in parallel. Whether they can eventually get a cent from 5+ years of hard work in their existing business is uncertain, but unlikely. Would you buy their business? For what?

So what happened there? Supplier power, coupled perhaps to the unintended consequences of BEE legislation and entrepreneurs who couldn’t understand the risk of having all their eggs in one basket, especially when it was going so well.

In the second instance there is another entrepreneur in another unrelated industry. He’s built a great team and great testimonials. They represent a sole supplier in the local market but have no exclusivity on any market or territory. They’ve literally sold their way into where they are now: building relationships, delivering on time, and delighting with customer care. They’ve made some money and want to start acquiring the other distributors of this suppliers’ product here. In theory this sounds good: they can buy market access from underperforming distributors and roll out their operational excellence to these new markets and thus make more money. I like their ambition, but I really don’t like how they are increasing their risk. You see, people forget that systems respond when their components change. So you have to look at what their plans might do to the market. As they buy their smaller competitors they become bigger, but still with only 1 supplier. So there is increased risk that a competing product could be launched that would rapidly take market share away from them, but the greater risk is that their supplier will wake up to the fact they are now represented by only a few distributors, one of who has over 80% of the market. The distributor then faces 3 choices: they can continue as is with a lot of risk in one basket, they can push more business to other existing or new distributors, or they can buy their largest distributor and bring this all in house. A lot of this is going to depend on the suppliers’ strategy, not the entrepreneurial distributor. So how much control do they really have? If you were to buy this business would you be happy that 100% of your revenues depended entirely on 1 supplier? If you were to lend them money so that they could buy their smaller competitors would you consider this high risk or low risk? Would you not want them to have other suppliers whose product they could offer to their market?

In both these examples, there are businesses that look great on the outside. They’ve grown consistently (at least until last year); they’ve increased market share and profits. However in both cases they’re entirely dependent on 1 single supplier who effectively controls how much profit they make. There are no guarantees in business, but there’s a high probability that serving a single supplier puts your business at huge risk.

How many suppliers do you have? How will you mitigate that risk?

The impact of recession on small business

Having spent a lot of time in this column looking at how to value and increase the valuation of your business, it’s time to look at how things can and do go wrong. In our current turbulent and uncertain times a global recession is only one creditor nation default or central-banker decision away, and the impact of increasing energy costs will also strip most economies of part of their real growth for the next 2 decades too. So this stuff is very real and very important. Let’s get stuck in:

The official definition of a recession is “two consecutive quarters of negative growth in GDP”. What is really means is a slump in consumer demand leading to slowdown of the manufacturing sector and a loss of jobs in manufacturing and distribution industries. Since consumer demand typically powers about 60% of the economy, the effects are widespread. If the recession is global, then a drop in consumer demand and real income around the globe will ultimately affect the demand for base minerals sourced from our country and with it mines are closed and more jobs lost.

So how does it affect the typical entrepreneur? To answer that question I’ll start with exploring how a recession impacts large businesses:

Take a large manufacturing company in the early stages of a recession. Demand falls and as it does so, revenues and profits decline. Stock may pile up until production is cut back to meet actual demand, which means that working capital sits idle in the stockpile and the firm has less cash to run on. In order to keep expenses down the manufacturer will respond with a hiring freeze, or even laying-off part of its workforce. They will also cut back on R&D, and cancel orders for new equipment. They’ll most likely reduce expenditure on marketing and advertising too. Each of these cuts has roll-on effects to the people and companies that would normally supply them to the firm. As the recession continues investors will be disappointed with performance and may force management changes and/or sell the share. The firm may seek to change suppliers at this point – for example they may fire their advertising agency or shift other production to lower-cost suppliers. Tensions with labour will increase as the firm struggles to increase productivity by doing more with fewer people. Wages for those who still have jobs might be reduced. Expensive ‘managerial’ staff will face certain cuts. On the capital market side, the firm will find it harder to raise money on the public markets and the cost of debt would also have risen as banks scramble to protect themselves against increased lending risk. It’s valuation will go down, possibly even to the point that debt may be restructured or else the firm will be placed into business rescue or even liquidation.

Quality of production will almost certainly suffer; for example an airline might put in more rows of seats yet drop the number of flights on a route. It may also cut back on maintenance costs – with an increase in mechanically related delays and even catastrophic failure. A recent example of this is the airline 1Time, which had several maintenance related issues before their liquidation. (Having seen this pattern before, I’d regard maintenance-related issues as a clear sell-signal for anyone holding the shares in that airline).  Other companies may reduce the quality of ingredients, changing the flavour of their product and potentially driving away consumers who don’t like the change.

The drop in advertising means that not only is the agency under threat, but that media spend is reduced and suddenly there are newspapers, magazines and web-sites that can no longer stay in business. Consumer confidence drops and the recession spreads further.

How does this affect the smaller business?

Almost all of what happens to the bigger firms also happens to the smaller ones. However with smaller reserves and possible dependence on fewer customers and suppliers for their business, the smaller firm is more at risk. Without substantial capital assets to be used for collateral, the smaller firm will struggle to raise the money it may need to survive. Bankruptcy rates are higher for smaller firms than large ones during hard times – one of the reasons why smaller firms carry more risk and thus have higher costs of capital than large ones.

The trick is in being prepared: having multiple sources of supply and multiple customers, so that the loss of one doesn’t kill the business. Most SMBs fail here with a huge concentration of risk. A well run SMB will be managing working capital tightly and will quickly respond when hard times loom. When buying a business think carefully through what the impact of a recession on it would be: most of the factors that come into play would be outside of your control for the first year, and as such you should think carefully about how to structure a deal so that the seller carries this risk.

The silver lining:

Lastly, recessions don’t last forever and although the entrepreneurial spirit can take a beating the growth opportunities for those who survive the recession can be immense. If your competitor is struggling there is a good chance you can win theirs customers over to you and win through market consolidation. There is also ample research to suggest that businesses founded during a recession do better than those founded during boom times. If you can sail your ship in rough waters, you can certainly sail in smooth.

How Operational Effectiveness boosts your business

There are 3 levers can you pull to influence the financial potential and valuation of your firm: (a) you can improve your strategy to achieve greater market share and higher revenues through price x volume effects, (b) you can improve your operational effectiveness – making sure that you don’t overspend on any supplier or expense and that you manage your cash conversion cycle tightly, and (c) you can improve your capital structure so that you reduce the overall cost of capital and thus improve your valuation. Of these, most SMBs tend to worry mostly about sales and strategy. Some worry about the cost of capital but generally only through trying to reduce the interest they pay on debt (v. employing the optimal amount of debt). The area that many entrepreneurs ignore when they set strategy or question what they can do to improve is operations. Yet it’s the place I almost always advise people to start; here is why:

Running a tight ship by managing your Accounts receivable, Accounts payable and Inventory levels frees up cash. When we use a Discounted free cash flow model for valuation, this extra cash immediately increases the value of the firm. Thus a well run firm is worth more than a poorly run firm. Secondly, when your operations are good you can do more with less cash and you are less of a risk to your funders, so you can negotiate a lower interest rate with them. In other words, your return on capital employed goes up, which means that your cost of capital can come down and your valuation goes up. Of course the growth rate your firm can achieve without changes to dividend policy, capital structure or profitability also increases. This means that your increased operational effectiveness increases the potential growth rate of the firm, in other words it enables you to pursue a more aggressive strategy without the need for external funding. Yet in so many companies the operational stuff is seen as secondary to the more prestigious tasks of strategy and sales.

There’s another great reason to focus on operations first: the changes you’ll need to make are not complex and the results will show quickly. You can make radical improvements to your working cash cycle within 3 to 6 months by managing it carefully. Similarly with your profitability: you can work through your income statement, looking for ways to reduce costs of sales, making sure you don’t have surplus or unproductive staff, removing expenses that aren’t business related or shifting spend to items where returns are more certain. The improvements you can make here don’t take long to do and their impact is felt almost immediately. The trick is to ‘peel back the onion’ and to explore each item in enough detail to find the savings. As a former strategy consultant I’ve seen this exact approach work with astounding effect in large Banks, Airlines and manufacturing companies – the same can work for any SMB and achieve similar percentage returns, just the numbers are proportionately smaller.

To sum up these changes, lets recap the last 3 articles that looked at operational improvements possible by changing Accounts Receivable, Accounts Payable and Inventory. I’ll use the demo business on ValuationUP.com as an example; here are the combined effects:

  Accounts receivable

(days).

Accounts Payable (days). Inventory turnover (x) Free Cash flow Y1 DCF Valuation
Old Sloppy 75 58 7.14 4,910 30,707
Tight Ship 30 88 25 13,512 41,852
Change 45 days

 

30 days

 

17.86x 8,602 11,145

 

Using the combined effects of improving Accounts Receivable, Accounts Payable, and Inventory Turnover, the business generates an extra 8,602 Free cash in Year 1 (a 2.75 times improvement in Free Cash Flow) and increases ist Valuation from 30,700 to 41,145 (a 36% improvement in Valuation).

I’ve discussed the basics of how to achieve these changes in the previous articles, however the point to consider is how much easier it is to achieve these changes than the increase in sales required to generate the same change in valuation. This will depend on the business, but for most SMBs who find themselves in an industry that’s ‘perfectly competitive’ (i.e. one where making abnormal returns is almost impossible) the answer will be that it’s easier to improve your valuation through operational effectiveness than through strategic measures. Since the art of strategy is really about allocating resources most effectively to achieve the growth of the value of the firm, for many businesses the correct strategy will be to chase down operational targets rather than sales ones; especially as getting operational efficiencies up increases the strategic and capital structuring potential of the business. Food for thought…