A fable of Maximus Grandeur, CEO of Gaping Maw Co[1].
Think you understand “synergies”? Think again. Most people don’t. Synergies can happen. The boost revenues and profits, but tank profit margin. In fact, math often guarantees it. Here’s an example.
In the Beginning
Consider two standalone companies. Milk Co and Ice Cream Co.
- Milk Co makes $9 million profit on revenues of $300 million. That’s 3% profit.
- Ice Cream Co makes $2.5 million on $50 million. That’s 5% profit.
- Gaping Maw Co is a large food company that makes $80 million on $1 billion in revenues. That’s 8% profit margin.
Enter Maximus Grandeur, Gaping Maw Co’s new CEO. He’s been feeling inadequate in the bedroom, so in a misplaced attempt to shore up his self-esteem and fool himself into believing that he has agency in life, he buys the two companies to feel big and powerful. Publicly, he talks about “synergy.”
Just the Math, Ma’am
The acquisitions happen. He makes no other changes.
Maximus just screwed Gaping Maw’s profit margin. The new profit margin is (all numbers in millions):
($9 milk + $2.5 ice cream + $80 legacy)/($300 milk + $50 ice cream + $1000 legacy) = 6.78%, down from 8%
Let that sink in: for purely mathematical reasons, having nothing to do with actual business operations or performance, consolidating two businesses under an umbrella business mathematically decreased the umbrella company’s profit margins.
BUT WAIT! What about synergy? That was Maximus’s publicly-stated reason for suggesting the acquisition.
The Synergy is Real
The Maximus synergy is for Ice Cream Co to buy all their milk from Milk Co instead of other suppliers. He proclaims this brilliant strategy in the annual report, to rescue the profit margin. He implements.
The new, synergy picture is this: $10 million of purchases that Ice Cream Co would have spent with other milk companies now goes to Milk Co, which will make its normal 3% profit on all those tasty new purchases. Everything else remains the same:
- Milk Co makes $9.3 million profit on revenues of $310 million. That’s 3% profit.
- Ice Cream Co still makes $2.5 million profit on $50 million. That’s still 5% profit.
- Gaping Maw Co’s legacy businesses still make $80mm on $1Bn, for 8% profit.
Considered individually, each division is doing as well or better than before the merger.
Each division is doing just peachy. In fact, Milk Co is doing better in terms of absolute sales and absolute profit. That means that Gaping Maw has $10 million more in revenues, and $300K more in profit. Each division is as healthy as ever!! Healthier, even!!
Sounds like a win, right? Wrong.
But Synergy Makes Everything Worse
Because now Gaping Maw Co’s profit margin is (all numbers in millions):
($9.3 + $2.5 + $80) / ($310 + $50 + $1000) = 6.75%
Synergies were realized, and it made the profit margin even worse.
Yes, you read that correctly. The synergies were realized, and it pushed the profit margin lower[2]! From 6.78% to 6.75%.
As a conglomerate, the profit margin has gone down, even as the absolute dollar amount of profits has gone up.
Here’s How to Think About It
Here’s why: intuitively, business units with lower profitability than the overall company drag down the overall profitability margin. The more revenues come from low-profitability businesses, the more overall profitability sinks, even though the business is doing better.
It’s also possible to acquire a high-profitability business that boosts overall profitability while absolute revenue/profit numbers may decline. It’s the math; it’s not about how efficient or well-run the business is.
But all the market cares about is profit margin of the overall company. So your stock price will tank, the CEO will get fired, and Maximus will take his golden parachute (equivalent to the last ten years’ profits of all three companies combined) and retire.
BUSINESS MORAL: Know the math before you acquire or “synergize.” Know the absolute numbers and the margin numbers. Assume investors will only pay attention to overall profit margin, which means they might push you to do dumb things to maximize that number. Don’t listen. If you’re going to do dumb things, at least do your own dumb things.
PERSONAL MORAL for Maximus: If your sex life is unsatisfying, maybe you’re spending too much time at the office. Regardless, don’t take out your frustrations on innocent companies that are doing just fine.
This article is emphatically not about CVS, even though it was inspired by reading that CVS is going to axe 2,900 jobs and possibly split up their insurance and pharmacy businesses to "improve financial performance. ↩︎
The real problem here is that we demand steady or growing profits when viewed as a percentage return. It is beyond the scope of a simple essay to give this topic the treatment it deserves. ↩︎