To better serve their markets, companies will combine their operations and streamline their offerings. Efficiencies of scale allow businesses to reduce costs and prices and ease decisions for potential investors. Consolidation is the result: two or more companies combining into one through a merger or acquisition, for example, or the establishment of a holding company to simplify accounting and legal tasks for several subsidiaries.
Competition and Consolidation
As a business segment ages and matures, numerous companies may find themselves offering the same products, at roughly the same price and quality, to the same market. The competition drags down sales and profits, while businesses struggle to innovate and remain viable. The answer in this situation is market consolidation: the takeover of the small by the strong through outright purchase or merger. This action reduces competition and tends to boost prices. That's not so good for the consumer, perhaps, but it's a natural cyclical development in the business realm.
Building Consolidation Advantage
The "Harvard Business Review," in "The Consolidation Curve," identified "Building Scale" as a key step in the consolidation process. Scaling occurs when a few financially strong companies begin buying up the weak. Airlines, pharmaceuticals, banks and hotels are examples of industries going through this stage of consolidation. By merging or acquiring, combining operations, closing factories and reassigning workers, a firm can reduce costs and improve profit margins. In addition, cutting "redundant" administrative workers and combining sales and marketing divisions can significantly lessen labor and head-office costs.
Consolidation has important side effects for investors. When one company acquires another, the buyer typically cancels the stock of the acquisition and issues new shares of its own to pay for the purchase. This means a dilution of the buying company's stock, which is usually bad news for the stock price. Unless the company can realize significant dividends from the merger, it will be under pressure from the markets to continue cutting costs until the acquisition pays off in higher earnings. The mere prospect of a buyout or merger tends to boost the stock price for the target company, because the buyer must offer shareholders a premium over the current market price.
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Survival of the Small
A company may drop products that face too many competitors and concentrate on smaller markets to stay in business. The consolidation of global industries often has the effect of boosting entrepreneurs selling to more selective "niche" customers. While a few national mega-producers took control of the beer industry, for example, independents sprang up to offer "craft" and seasonal brews to regional markets. In this way, consolidation paradoxically can give rise to a more diverse product universe.
To Merge or Not to Merge
Business sectors evolve, as do individual businesses. The market for a particular line of products is not limitless, and consumers don't need an endless supply of companies angling for their accounts and cash. For this reason, successful businesses in fast-growing sectors, such as software or solar energy, will have plenty of suitors interested in a buyout. Timing is crucial; a company that sells itself or merges early in the consolidation phase has a good chance of realizing a greater return on its initial investments. A business that chooses to stay independent, on the other hand, will have more limited resources and will have to walk a difficult path to keep a market edge.