Apply systems thinking to avoid missteps.
December 2017 Vol. 6 No. 12

Most companies do a fine job of analysis. The danger, however, is failing to step back and see the big picture by understanding the relevant pieces and how they interact. 

In today's newsletter we look at the interconnection of competitive systems and I share suggestions for applying this to your own business.
Happy holidays,

Charlie Goodrich
Founder and Principal
Goodrich & Associates
In this issue...
Analysis Without Understanding the Big Picture Can Be Dangerous

Years ago, when I worked for Kraft Foods, there was a wave of merger activity going on - big prices were being offered for branded food and consumer product companies.

Esmark (the old Swift meat company) bought Norton-Simon, home of brands such as Hunt-Wesson and Avis. That, in turn, was bought by Beatrice. Soon after, the buyout firm Kohlberg Kravis Roberts (KKR) bought Nabisco for what was, at the time, the largest corporate buyout in U.S. history.

We looked in detail at the companies purchased and the prices paid and were bewildered. What were others seeing that we were not? Our CEO and Board had to have good reasons to tell Wall Street why we were deliberate bystanders.

So we probed all sorts of things and hired lots of consultants. We examined our cost of capital down to the navel lint level. (Some good did come of that: Kraft adopted the Stern Stewart EVA concepts before they were trademarked as EVA.) But try as we might, it didn't add up.

Before long we learned the real answer - not from our analysis but from our Wall Street "sources." All consumer brands (branded food among them) had been going through a period of raising prices. With those price increases came increased profit margins and, therefore, rising cash flow. There were a variety of reasons why the industry was able to raise prices, but that doesn't matter. Our "sources" told us that KKR and the rest of Wall Street had done their analysis: margins were increasing, the trend was up, and it would continue forever!

We were relieved. It wasn't us, it was them... KKR was indeed nuts. After all, when we looked at the food industry as a competitive system rather than as just a collection of isolated company financials, we didn't think margins could increase forever. At some point, as the opportunity becomes too tempting, competitors enter the market, either as private label or as new brands altogether. Consumers do eventually balk and substitute other products. Sure enough, the Nabisco buyout tanked sooner rather than later.

At Kraft, we kept our point of view private. Indeed, we sold Duracell to KKR at a huge premium to market expectations. Our pitch? Duracell had been increasing prices and profit margins and that would go on forever. Why? Well "everyone" knows prices can go up forever and Duracell's largest competitor, Eveready, had just been sold to Ralston Purina in a debt-funded deal, forcing Ralston to raise battery prices to pay down the debt. (KKR did learn by this time and sold Eveready for a bundle to Gillette, just as the drugstore battery market peaked, thanks to the embedding of rechargeable batteries in new devices.)

So why did Kraft get things right and why did KKR blow it? In short, because Kraft was grounded in reality, one based on a broader understanding of how systems interrelate. KKR, on the other hand, was off in financial dreamland. They were full of brilliant financial guys (and back then, it was all guys) and they analyzed everything. Wherever they looked they found increasing profit margins. So they forecasted the trend and, voila!, they paid a big price, financed by junk bond holders that didn't know any better.

At Kraft we used a broader perspective. We regarded our world as an interconnected system of customers - customers who have an infinite array of choices to spend their money, and competitors who knew how to eye the size and profit potential of a market. The prior year, in fact, I had completed a study of Kraft's most profitable product line to guestimate how much higher we could raise prices before competitors would decide to spend big bucks and jump in.

It's critical to understand the big picture

Detailed analysis is important, of course, but understanding how the parts interact and fit together, as well as gauging which of today's trends are unlikely to be sustainable, is equally significant.

To do that, you will need to look broadly at the relevant business ecosystem and understand its workings. Some tips...
  • When looking for the big picture from an industry perspective, use the Porter model as a starting point. Evaluate your competitors; the threat of new competitors; the power of your suppliers; the power of your customers; and the threat of substitutes for your product or service.
  • When looking at your company's financials, consider the big picture as well. Yes, projecting the income statement, balance sheet and cash flow are important to "see" ahead. But make sure as well to consider the financial outsiders your company depends upon. Will customer concentration increase or decrease, thereby increasing or decreasing your credit risk? Will your ability to cover fixed charges such as debt payments increase or decrease to the point that better, cheaper funding sources might be available? On the flip side, might your current funding sources pull the plug?
  • Understand that internal controls use a systems approach. Done properly, there is a system of checks and balances to make sure transactions happen correctly, financial statements are accurate, and so forth. This should take into account the big picture of how the business operates in order to control the risk that things are wrong. So, for those financial types that struggle to think systematically, think about control systems.
  • Dig in and analyze to ensure that your big picture view is grounded in reality. Does the "system" work the way you think it does? After all, internal control systems are audited to ensure they are working. Your "big picture" requires similar scrutiny.
The consumer product buyout frenzy of the mid-eighties is a cautionary tale for all of us. Most companies do a fine job of analysis - KKR certainly did. The danger, however, is failing to step back and see the big picture by understanding the relevant pieces and how they interact. Above all, make sure that whatever picture you rely on is for real.
Please share with your colleagues
Heard on the Street

John Cochrane, Senior Fellow of the Hoover Institution at Stanford and former professor of the University of Chicago Booth School of Business, has an interesting blog post on the history of the FCC and how its creation and subsequent regulations have always been designed to protect certain politically powerful businesses (usually the incumbents).

As an example, cell phone technology was announced in 1945 but wasn't introduced into the United States for another thirty-eight years, thanks to the Bell monopoly's decision to sit on it until the late sixties. Read here for more.

About Us

Goodrich & Associates is a management consulting firm. We specialize in helping our business clients solve urgent liquidity problems. Our Founder and Principal, Charlie Goodrich, holds an MBA in Finance from the University of Chicago and a Bachelor's Degree in Economics from the University of Virginia, and has over 30 years experience in this area.

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