Investors be warned. Companies can grow themselves to Bankruptcy! Here’s how

Growing too fast for their own good! A bit puzzling ain’t it? 

TL;DR version

Rapid business expansion can destroy shareholder value. For the following reasons:

  1. Unprofitable acquisitions.
  2. Leadership lost vision and touch with core customer
  3. The business model was flawed in the first place
  4. The supply chain is ill-equipped for expansion.
  5. No understanding of local consumer preferences.
  6. Small Addressable market. 

I also highlight some Quick methods to gauge the profitability of an acquisition.

#1 Unprofitable Acquisitions

Company acquisition is quite a common practice. There are many reasons why companies do acquisitions. For instance:

  • Product Acquisition, Increase the Portfolio of Brands to reach new markets.
    For example, Adidas acquired reebok back in 2006 to diversify their portfolio of brands and to break into an American market with reebok’s NFL & NBA association. Reebok was one of the worst company acquisitions for Adidas.
  • Strategic Acquisition, to maintain market dominance by an acquisition of assets that is complementary to the company’s core services. An example Shopify’s acquisition of Deliverr, to protect and enhance its small business enterprise service, to counter amazon’s continuous encroachment. An increase in revenue from strategic acquisition can be hard to pinpoint. Investors really have no way of knowing if it is a profitable acquisition. 
  • horizontal acquisition, for manufacturers, agriculture, Utilities, and pharmaceutical companies. New facilities are often acquired in order to increase the diversity of product portfolios and increase operating capacity. A great example is Hyflux, once touted as SGX darling stock, due to poor overseas facilities acquisition. The company end up declaring bankruptcy in 2019.

#2 Leadership lost vision and touch with core customer

Company pivot or expansion into a new market can be exciting for shareholders as it could mean double-digit growth numbers and a rapid increase in shareholder value. However, venturing too far out of their area of competency can prove to be very distributive. 

For example, General Electric used to be America’s biggest company but due to poor company management and an undisciplined expansion into new markets out of their core competency. GE Capital’s financial segment nearly sank the company during the 2008 Recession. It was very evident in a bad economical climate the company was overstretched and bloated.

#3 The business model was flawed in the first place.

Very rarely do you get to see a fundamentally flawed company going public. These companies are known as “Zombie companies”.

One famous example in modern history is WeWork. Although the company’s failure was attributed to the “alleged” toxic culture and incompetency of management. Management was also blamed to have misled investors. The business model was fundamentally flawed. From my understanding, WeWork’s business model was simply to buy or sign a master lease agreement with an office building and sub-lease the space out to multiple tenants and earn the difference. The problem was WeWork has a long-term debt obligation that it has to meet periodically. However, WeWork’s sub-lease tenants usually have a short renting period. Hence if WeWork’s occupancy rate falls below a threshold, the company will not be able to meet its debt obligations.

#4 Supply chain ill-equipped for expansion.

There are a few mistakes a company can make that are as damaging as mismanagement of the supply chain. Supply chain issue is extremely costly to a company and leaves a lasting bad impression on its customers. An example FoxMeyer’s 1996 Delta III project logistic disaster. However, due to a series of poor decision-making, execution, and ignorance. The company lost $34 million worth of inventory because of system failures and employee lash back. Almost resulted in the firm bankruptcy. 

#5 No understanding of local consumer preferences.

It is said that Business models that deal directly with consumers can’t be replicated everywhere. This is because consumer preference changes by region/country. As a culture, economic standing, and taste change. For example, Walmart failed in Germany, Starbucks in Australia, and Ford failure in India. Numerous other similar case studies could be found readily online.

#6 Small Addressable market.

Sometimes the company simply overestimated its customer base. For example Peloton. During the 2020 lockdown Peloton’s record-breaking sales number drove the prices sky high. However, this success was short lifted, as countries began to ease restrictions, Peloton sales fell. The increase in manufacturing capacity for the 2020 boom just became a double edge sword. The company soon halted its production capacity in 2022. Plus in 2021, there was a recall of its treadmill products presumably to due a manufacturing error. However, this company and market are still young who knows what might happen given the consumer shift in preference for home workout equipment.

A quick method to gauge the profitability of an acquisition.

To know if an acquisition is profitable to the company, read the:

  • Cash flow statement financial notes
  • Revenue and COGS attribution
  • Interest coverage ratio
  • Shareholder letter.
  • ROIC vs WACC. If ROIC is higher it means shareholder value was created.

Usually, the reasons decline in revenue or profit margin would be made known to investors when investors read the annual report or the AGM.