CHAPTER 7

Expansions, Mergers, and Other Opportunities

The boom phase of the business cycle is fueled by “cheap money”—that is, the Federal Reserve injecting new money into the banking system. This increase in liquidity causes short-term interest rates to fall to levels below what the free market would have determined by the interplay of supply and demand of savers and borrowers. The Fed’s actions set into motion an unsustainable period of economic activity throughout the structure of production and “irrational exuberance” in the financial markets, especially the stock market. The inevitable bust arrives when the Federal Reserve raises interest rates by withdrawing liquidity from the financial system to dampen the overheated economy. In short, the Federal Reserve causes the systematic ups and downs of the economy in its attempt to “smooth out” the business cycle (which it causes), keep employment robust, and maintain a target annual price inflation rate of 2 percent.

As we have shown in previous chapters, the Federal Reserve’s track record leaves much to be desired. Both the dot-com and the housing bubbles confirm the consequences of the Federal Reserve’s easy money policies. And the current boom that began in 2009 which was interrupted by the coronavirus pandemic in 2020 will eventually end when the Federal Reserve “tightens” credit conditions to deal with the overheated economy.

Other consequences of the Federal Reserve’s easy money policies can also be identified during a business cycle. During the boom phase, corporate managers and small business owners tend to be reasonably—and at times wildly—optimistic about future business conditions. Corporate CEOs in virtually all sectors of the economy view the economic expansion as an opportunity to grow their businesses beyond what the free market would have signaled them to do and/or “hunt” for takeover candidates. Small business owners, on the other hand, see the upswing in economic activity as an opportunity to enlarge their current location, or expand their businesses by opening up new locations or creating a franchise business model. The challenge, therefore, for all business decision makers is to determine what actions to take during the boom phase of the cycle that are sustainable and not based on the euphoria caused by the Fed’s easy money policies. In this chapter, we will examine three actions business decision makers can undertake as the business cycle unfolds—developing economies of scale, expansion opportunities, and mergers.

Economists, management consultants, and other experts have been analyzing the benefits of economies of scale for generations. One insight that has been gleaned from the study of this phenomenon is the concept of agglomeration. The creation of “clusters” such as Silicon Valley, which emerged from the intellectual expertise at Stanford University, allowed economies of scale to develop by bringing together skilled workers, complementary firms, and venture capitalists to a unique location that has been “difficult to duplicate.”¹ The automobile industry was and is a classic example of agglomeration in Detroit for decades, as General Motors, Ford, and Chrysler made the Motor City one of the successful urban centers during the heyday of American dominance in the motor vehicle sector. The clustering of an industry also is an example of how companies that are geographically close could share knowledge through licensing and other arrangements.

Nevertheless, as the United States has been evolving for the past 60 years to more of a service-oriented, high-tech, and digital-age economy, economies of scale have become less important as a strategy and tactic. Instead, entrepreneurs would be better served if they kept their eye on the ball and focused on the economics of value.²

The economics of value highlights the alternative approaches to economies of scale. The traditional economies of scale can be summed up as “bigger is better” to the extent that entrepreneurs can increase production, lower costs, and increase profitability. The focus of economies of scale is “product centric,” while the economics of value concentrates on consumer satisfaction “so that they can experience the maximum (subjective) value.”

Small businesses with a well-defined niche in the marketplace can implement the economics of value strategy seamlessly by focusing their energies on customer service, product exclusivity, and brand differentiation. With e-commerce exploding in the number and amount of transactions in the past 10 years, the retailers that have thrived met consumers’ needs—an easy online purchase experience, free shipping, and free returns and exchanges. The economics of value can thus be implemented by businesses of all sizes.

According to the economics of value, because “scale can be rented”—by using Amazon Marketplace or cloud computing—entrepreneurs do not need to “scale up” and incur more uncertainty.³ However, if (sustainable) business conditions warrant scaling up, then the decision to maintain the economics of value should be paramount to reap the rewards of satisfying customers’ needs. In other words, by maintaining a high-value consumer experience, repeat business is the entrepreneur’s best outcome, which is in many ways no different than an annuity, a steady cash flow to the small business owner, or the corporation.

Even if entrepreneurs are “doing everything right’ as far as consumer satisfaction and providing value are concerned, what happens to sales and profitability when the inevitable downturn unfolds and consumers retrench? This begs the question: what sector is the business in? The most economic-sensitive, like housing, autos, discretionary goods and services such as jewelry, travel, and so forth? Or, is the business in the nondiscretionary sector that performs relatively well during a recession—businesses that deal in consumer staples, utilities, health care, and the like? The answer to these questions would result in taking actions during the early stages of the boom to take advantage of the robust economy and then preparing for the downturn. The skill of business decision makers to navigate the ebbs and flows of changing conditions would be reflected in the company’s bottom line. As the COVID-19 pandemic caught virtually all businesses totally off guard (who could have planned for such a phenomenon and the subsequent lockdowns and business contraction?), the unfortunate reality is that thousands of businesses have permanently closed for no fault of their own and their owners and employees must either start all over or go to work for someone else.

Expansion Opportunities

Once a business experiences success, the natural tendency is to expand at the current location or build a new plant closer to consumers or open another retail store in the same city, county, or state. Seldom, however, would a retail store open a second location in another state.

The primary goal of expanding a business would be to attract new customers. One example would be a comic book storeowner expanding the square footage of the premises and invite local artists to display their original works.⁴ The increase in foot traffic could potentially bring in new comic book customers and provide an income stream for the storeowner, whether it is renting the space out or taking a percentage of the artists’ sales.

Another expansion opportunity would be to develop an additional revenue stream in the same location. For example, a bakery could expand its operations by creating a small restaurant to serve breakfast and lunch.⁵ With the 2020 pandemic in the backdrop, takeout meals or a small sitting area for customers would not require a major investment to generate revenue and increase the bakery’s bottom line. Even with more people working remotely, local bakeries with a dining component would provide individuals an opportunity to take a break and visit their local businesses for a snack or take out meal.

The food business is the least sensitive sector during the business cycle and undoubtedly provides “comfort and joy” to remote worker while also giving them the opportunity to stretch their legs during the day. So small food businesses, depending upon the zoning codes and other local regulations, could partner with a baker or chef. A local boutique, jewelry store, or high tech business could benefit by having an additional income stream from a food or any other well-suited business. The risk for the small business owner would be relatively minimal, especially if the partner picks up the expansion costs, and the return on investment could be relatively high.

Other methods to expand sales include creating a customer loyalty program, building an e-mail list, forming strategic partnerships, making licensing deals, franchising the business, expanding internationally, diversifying the product line, or offering new services. Those are among some of the strategies that could be utilized to grow a business by making relatively minor capital expenditures.⁶

Before any of these strategies are undertaken, a committee could be formed at the corporate level to investigate each one of these approaches to find out which ones will provide the greatest bang for the buck. For small business, a consultant could be hired or the owner and partners (if there are any) could begin to do the research if they are so inclined. No matter what the size of a business is, having the most reliable information is imperative to make an informed decision regarding expansion opportunities. For small business, a misstep could be fatal and costly when trying to expand business. For incorporated businesses expansions are not a dunk shot. Even mega corporations can stumble—like Coca-Cola’s misstep with the introduction of Coke light in 2013; the company had to drop it from its product portfolio a few years later.⁷

One of the tempting expansion opportunities is to go international by opening up an overseas manufacturing operation and/or retail locations. The standard benefits are increased sales and profitability as well as numerous other advantages—such as new market penetration, accessing local talent, beating your competition, and establishing regional centers to provide established international customers with numerous services.⁸ Before going it alone in Europe, South America, Africa, or Asia, a business should investigate establishing an alliance—partnership with a successful overseas corporation, a U.S. multinational or a local business.

Although the desire to expand internationally may be a strategic goal, it comes with various amounts of risk, especially if the company wants to go it alone. The cost of establishing an overseas presence and the costs of possibly having to terminate operations could be very costly especially for small and medium-size businesses. The risks and costs of complying with local and national regulations may be daunting. Understanding the cultural and business practices overseas to have a successful presence maybe a hurdle too high to overcome. Thus, before stepping into the international pond, so to speak, managers and small business owners would need to obtain substantial data and information about how to have a successful outcome. Tapping the expertise of an international business consultant would probably be one of the first steps a business owner would do before deciding to expand overseas. In other words, it would be better to know not to enter an overseas market than to enter a market and incur expenses and show no return on investment.

Nevertheless, an expansion strategy allows a company to diversify its “portfolio” that could have different sensitivities to business cycles. Thus, a firm with four or five subsidiaries could have a company or companies that are highly profitable during the boom but whose profits decline or may turn into losses during the bust. It is during the downturn in the economy that the firm could be in financial distress and not recover. Therefore, adding a relatively noncyclical company or company to a firm’s portfolio would “smooth out” its profitability over the course of the business cycle.

Mergers and Other Opportunities

The so-called urge to merge has not been dampened despite the fact that up to 90 percent of mergers do not work out well.⁹ Call it empire building, ego gratification, or just plain old speculation with shareholders’ money, corporate managers are prone to paying exorbitant prices for so-called trophy businesses. Doug French summarizes the risks associated with corporate mergers.¹⁰ French distills the works of several accountants, business consultants, and economists who highlight the traps involved in corporate mergers.

One of the key variables in the evaluation process of an acquired company is the discount rate, which is applied to future earnings to determine its present value and the future terminal value of the enterprise. A low interest rate will therefore increase the net present value of the potential acquired firm and justify a relatively high price. However, if the interest rate is “depressed” because the Federal Reserve has injected liquidity into the financial system, corporate managers in essence will be fooled by the mispriced cost of capital and thus overbid for the acquired company. Thus, during the boom phase of the cycle, especially when the Federal Reserve is keeping interest rates down to stimulate employment and production, mergers and acquisitions (M&A) tend to accelerate because the cost of capital makes it attractive for corporate managers to go on an acquisition spree.¹¹

Kison Patel has compiled a list of the eight biggest M&A failures of all-time, and concluded,¹²

Virtually all these mergers took place during the boom phase of the business cycle. America Online’s (AOL) acquisition of Time Warner occurred when the economy was in recession and AOL management undoubtedly thought there would be enormous synergies between it and entertainment giant Time Warner. And Bank of America acquired Countrywide during the Great Recession of 2008, when the Federal Reserve and U.S. Treasury induced the largest banks in the country to acquire financial institutions that were in terrible shape when the housing bubble burst.

Fast forward to 2016 when AT&T announced it would merge with Time Warner. After a trial in which the Justice Department objected to the merger, the U.S. District Court in Washington, DC, decided the merger could go ahead and AT&T’s $85 billion takeover was finalized. Time will tell if this time Time Warner has found a long-term home in the telecommunications giant’s portfolio.

Some mergers that have so far proved sustainable include Unilever’s purchase of Ben & Jerry’s in 2000. Under the terms of the agreement, the Vermont-based ice cream maker retains its own board of directors and continues its social mission.¹³ Before Facebook went public in 2012, Mark Zuckerberg decided to make a strategic investment and purchased Instagram for $1 billion, even though the photo sharing service had no revenue.¹⁴ Several years later (2017), Amazon purchased Whole Foods for $13.7 billion, giving the giant e-commerce retailer huge presence in the brick-and-mortar retail sector.¹⁵ A year later, privately held Belkin was purchased for $866 million by unit of Foxconn Technology Group, the Taiwanese-based assembler of Apple’s iPhones.¹⁶ Chet Pipkin founded Belkin nearly four decades ago in his parents’ house and “cashed out” to a major overseas company, but still runs the company and thrives in solving problems, especially during the Covid epidemic.

One entrepreneur, Brynn Putnam, whose company, Mirror, thrived during the pandemic sold the at-home fitness product to Lululemon Athletica Inc., for $500 million.¹⁷ Although she sold the company, she still runs the business and reports to the CEO, Calvin McDonald, of Lululemon. With sales rising robustly as the pandemic forced more individuals to work at home and exercise there as well, Putnam felt it would be wise to let Mirror be purchased by a successful clothing retailer, which would allow her “baby,” her creation, to thrive in the future.¹⁸

In the aforementioned examples, the founders of these companies decided to reap the benefits of their entrepreneurial efforts and be taken over by deep pocket companies who could take their businesses to the next level of success. Creating a company, finding a niche in the marketplace, and applying proven management, marketing, and financial expertise are the ingredients to provide value for consumers. The only merger that was based on speculation and strategic vision was the Facebook takeover of Instagram. Nevertheless, starting from scratch, these entrepreneurs became fabulously wealthy confirming that small businesses can survive and thrive over the course of several cycles (Belkin, Whole Foods, and Ben & Jerry’s), while others (Instagram and Mirror) was scooped up by companies that saw the potential strategic benefits of the takeovers.

From a tactical perspective, both small business owners and corporate managers can, more often than not, take advantage of depressed asset prices during an economic downturn to purchase a rival or a business that would fit in a corporation’s portfolio. Purchasing assets at well below replacement or book value could be one of the most optimal methods to grow a business with lower risk. As Warren Buffett once famously said during the 1973–1974 bear market, he felt like he was a kid in a candy store when the stock prices of great companies were selling for 40 percent, 50 percent, or more below their previous highs. Buffett outlined his approach to buying stocks in a New York Times op-ed (October 16, 2008) when he reiterated his tactic for buying stocks: “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.”¹⁹ Although the stock market didn’t hit bottom until March 2009, Buffett’s insights about the ebbs and flows of the financial markets have served Berkshire Hathaway’s shareholders well for the more than 55 years he has been the CEO. Buffett’s approach can also be applied to purchasing privately held companies at favorable prices when economic conditions are depressed. In a downturn, small business owners may decide the depressed economic conditions are too much to deal with and decide to sell to get out from under the burden of falling sales and declining profitability or losses.

The bottom line is that corporate managers and small business owners need to have the wherewithal—cash reserves and/or access to capital—during a downturn to make strategic purchases. Inasmuch as market fluctuations are marked by fear and greed of investors and business owners, there will always be opportunities to purchase quality companies at attractive prices when the opportunities arise.