Risk Adjusted Return on Effort

It seems that nearly every information memo created these days has a section on international growth as a driver of future value. For some companies, it’s just a throw-in on one of the last few pages of the deck (usually right after “increased focus on R&D”). With others, it’s truly a key part of the investment hypothesis. Under either scenario, it’s worth taking a close look at the opportunities and challenges with international growth - it may be hidden upside if not addressed, or a central focus of due diligence if fundamental to future growth.

I’ve found a useful conceptual framework to use when assessing new opportunities in general is Return on Effort. I.e., what can we expect in terms of increase in shareholder value vs. what will it take to get there, and ultimately, is it worth it? When assessing international growth, however, it’s important to take this formula one step further and adjust for related risk, which can vary dramatically based on region, country and business model employed. Forming a view on the overall risk involved in pursuing international growth plans provides needed context for the return on effort, and ultimately, the impact on enterprise value. 

Let’s start with the “Return” part of the equation. Return can take many forms, but in this context the most relevant, of course, is the ultimate impact on EBITDA. And while the math behind EBITDA impact is relatively simple (Incremental Volume * Unit EBITDA Contribution), the assumptions embedded in these two variables can be difficult to assess. Specifically, it’s worth testing the following concepts during the due diligence process: 

1. Incremental Volume

Addressable Market

Naturally, the first step in making a reasonable assumption around incremental volume is understanding the size of the market in which we’re playing. The more granular we can get in understanding not just the total market, but the actual addressable market, the better we’re able to assess the feasibility of the target’s growth plans. There are many definitions of addressable (and accessible) market, but for this purpose, let’s define it as that section of the overall market that we can argue with a straight face there’s a reasonable chance of winning. A few key considerations when moving from total to addressable market:

• Organized vs. Unorganized Sectors – In many developing countries, particularly in Asia, there are official “organized” sectors of the market, as well as “unorganized” sectors that are off the radar in terms of regulations, employment law, taxes, etc. In India for example, estimates of the unorganized sector can be as high as 30-40%, depending on the industry. Why is this important? Penetrating these unorganized sectors in a real way is extremely difficult: channels, pricing, communication, fragmentation all work against material sales here. Unless the team has a clear and realistic strategy for addressing this channel, put unorganized sectors in the “unaddressable” bucket.
• Trade Barriers – Trade barriers can take many forms – from high duties and corrupt business practices to government subsidized business sectors – and can have a significant impact on a company’s ability to grow into target geographies, even if other market conditions appear favorable. Brazil, for example, which often tops lists for high-growth export markets, has notoriously high / protectionist duties across a variety of sectors with a domestic manufacturing presence.

Barriers can also take the form of “supply chain clusters” that cut across the entire value chain in support of a domestic industry vertical. In the Chinese lithium ion battery market, for example, raw materials suppliers, subcomponent producers, and cell manufacturers (with government support) have all gained scale and efficiencies to support local demand for LI battery packs, making penetrating these segments as a new player just about anywhere in the world extremely challenging.

• Level of Integration – The level of vertical integration in a sector is often overlooked when determining an industry’s true market size, but it’s a very important factor from an addressable market standpoint. Specifically, integrated businesses can be much more difficult to penetrate since they present unique advantages to the owner - cost, control, absorption, sunk costs, etc. While levels of integration can vary significantly from country to country, my suggestion here is to make an assumption on vertical integration as a portion of the entire market and put that in the “unaddressable” bucket.

In the end, the portion of international markets that a US company can actually go sell to is undoubtedly something smaller than the overall market size presented in the deck. And while putting exact figures on how to discount the overall market will likely require making some high-level assumptions, just testing management’s view on the variables discussed above can provide extremely valuable insight into how well the target’s team understands market dynamics in the countries targeted for future growth. 

Share Scenarios

Once a true view of the real, “addressable” market has been established, the next step is defining a range of market penetration scenarios. Below are some key dynamics to explore and assess when testing management’s assumptions around share growth.

• Evergreen vs. growth – Does the company already have an established presence in target (or adjacent) markets? Even if small, having some level of sales in an international market is a huge hurdle to overcome. Not only does it signify that the target’s value proposition is acceptable to at least some portion of the market, it indicates that many of the logistical challenges in serving new international markets have been addressed – terms, shipping, labeling requirements, customs, etc. – which should also facilitate entry into new geographies on the target list.
• Existing customer relationships – Does the company have current, healthy customer relationships that can be leveraged in international markets? This is often the ‘low hanging fruit’ in terms of first steps into international markets – so are likely already being exploited – but it’s still worth testing what else can be done here.

For example, can an EMEA plant also be served with just some minor products modifications, is purchasing done locally where on-the-ground sales resources can help convert regional business units, can we partner with a local supplier to serve an existing OEM? Expanding existing customer relationships will almost surely be easier than converting new customers in new geographies, so it should be fully investigated during commercial due diligence.

• Brand recognition – In both B2B and B2C businesses, “Made in USA” still carries a lot of weight in terms of competitive positioning. Several years ago, when I was heading up business development for a US energy storage company, I was constantly amazed at the reaction my team experienced from cold emails/calls to distributors on the African continent: “Oh yes, I know [Company], very famous brand.” That crack in the door led to many “wins” that are now multi-million dollar accounts. The point is, as part of the diligence process, it’s worth asking the question – are there geographies / segments where the company is not leveraging its “Made (or designed) in the USA” asset to its full advantage?
• Competitive positioning – Does the company have a clear view of how it will position its offering vs. the competition (both local and US) in target geographies? A value player in domestic markets, for example, may be seen as the premium option in developing markets, and should adjust local positioning accordingly. It’s also important to note that how market segments are actually defined can differ significantly from country to country.

For example, “quality” in the U.S. typically means that the product performs its intended task reliably and over a long period of time, whereas in Korea, quality implies a newness to the product in question, so even something that continues to perform its task, if old, will eventually lose the “quality” designation. Marketing a 1986 Mercedes, for example, as “Still runs / looks great,” while perhaps effective messaging in the US, will not get the intended response in Korea.

• Parallel imports – Parallel imports can have a significant impact on assumptions around business diversification, regional share, and margin. In this context, it’s important to understand if/how parallel imports are impacting the business in question: For example, are US customers / distributors exporting to foreign markets? Are domestic OEMs selling into the international aftermarket? Are distributors / customers in specific geographies exporting into other territories?

Each situation will be unique, but having a view on these (and similar) questions should help provide a more realistic view of actual share in various regions, signal potential channel conflict going forward, as well as give some insight into potential hidden upside (say by replacing lower margin domestic sales with higher margin, direct sales internationally where demand already exists). 

2. Contribution

Once a realistic view of the overall market is established, with equally realistic share assumptions, the next key question is what kind of return we can expect. There are a variety of ways to measure return, but for this purpose, let’s assume it’s measured in EBITDA contribution per unit – how much incremental EBITDA each unit sold overseas will contribute, and how this contribution will evolve. Without getting into detail on the calculation itself, here are a few key variables to consider as it relates to return:

• Pricing - Pricing in overseas markets can (and usually does) vary dramatically by channel, region, and country. And it’s an oversimplification to say that international markets or developing countries will be more price competitive than the US. I have worked directly with companies that were able to realize nearly 2x contribution per unit in China than they were in the US. The reason?

In this case, nearly all their competitors were based in the US and simply didn’t have the sales support, channel partners, or brand to compete effectively in China, and local suppliers couldn’t meet OE requirements. Does the management team have a clear and convincing view of how prices do / will differ by geography? If not, this needs to be systematically tested to adjust (down or up) assumptions around unit contribution. The example above notwithstanding, plan conservatively.

• Landed Cost – Understanding real landed cost at a granular level is critical to not only determining real unit contribution, but also to maximizing the overall volume / contribution equation. Who pays for freight and insurance, and how does that impact margin assumptions? What’s the actual total cost to serve? How much do taxes and duties add to unit costs and what about in-country transportation? Once these costs are understood, thoughtful decisions can be made about how to maximize overall contribution from target countries.
• Exchange Rates – Depending on how pricing is structured – in local currency or $USD – fluctuations in foreign exchange rates can have a significant impact on the business in several ways. In the most simplistic view, if priced in local currency, margins will be impacted directly by swings in exchange rates (real margin of a box sold for 100 EURO will rise as dollar weakens vs. the EURO and vice versa).

On the other side of the coin, demand for products sold in $USD will be impacted by the same fluctuations – customers buying a box for $100 will see an effective price increase as the dollar strengthens (and vice versa), potentially impacting demand and overall regional contribution. There are many other dynamics at play here, but understanding the risks, opportunities, and mitigation strategies around exchange rates is critical for forming a realistic view on overseas margin scenarios. (See our Insight Currency and Pricing for a more detailed discussion on this topic).

Once we have a view on potential upside of international growth plans, the effort involved in realizing these plans is a critical input to putting the target’s potential upside into context. Here are some general considerations when it comes to effort:

• Management Team – Understanding how much time and focus will be required by executives and other managers across the organization, while difficult to quantify, should be tested when assessing management plans for international growth. Will the effort require that key vice presidents and operations managers spend months at a time on the ground to get a new plant off the ground, or is the effort primarily one of sales and marketing that will burden certain functions that already have the bandwidth to take on the effort?
• Direct Investment – Will the proposed sales office in Germany be subleased (not requiring a large security deposit and leasehold improvements)? Will the proposed distribution center in South Africa be company run or outsourced to an experienced third party logistics provider, and at what cost? Most importantly, at this point, does the management team have a detailed view of the hard dollars associated with international growth plans and how those dollars evolve over time? If yes, you have a good starting point for a healthy discussion around these key assumptions. A “no” here likely indicates plans are very much in the conceptual stage at this point, and should likely be discounted accordingly.
• Indirect Investment – Often overlooked, how will international growth plans trickle throughout the organization from a cost standpoint? Will the website need to be translated into Korean to support sales local efforts? Will new labels need to be designed for exports to Argentina? What additional ongoing legal costs will we incur to support a rep office in Spain? Again, an important litmus test here is whether the management team has even identified and considered these costs, in addition to the actual costs themselves.
• Opportunity Costs – Any real effort to grow the international business will require some incremental time, energy, focus, and investment - scarce resources that could potentially be devoted to other strategic initiatives. Put simply, what is the trade-off in persuing the international growth effort? While perhaps hard to quantify, getting a view on the real opportunity cost, and netting that off the bookable upside, is an important part of rounding out the cost side of the equation. 

Now that we have a view on what potential upside exists, and how much effort will be required to get there, it’s critical to factor in the level of risk involved in management’s plan. Risk can take many forms - strategic, financial, compliance, etc. But whatever type of risk we’re talking about, it undoubtedly increases when growing internationally.

• Country – What risks are specific to target countries / geographies? A good general resource here is Coface's Country Risk Assessments. Country risk will naturally become more significant as the level of commitment / investment grows, but even having a small presence in a country (e.g., rep office) can carry risk beyond the obvious (e.g., establishing tax nexus if commercial bounds are overstepped).
• Compliance – This is a very broad category, and whole industries have sprouted up around managing the increasingly large range of commercial risks, but it’s a critical question as judgements for FCPA violations, for example, can be massive and sometimes result in jail time for the offender as well as key executives. At the highest level, does the target have a compliance regime, and if not, does it have plans to implement one with requisite budget identified and set aside?
• Data Security / Privacy – The big one here is General Data Protection Regulation (GDPR) data and privacy requirements, an EU law, which aims to give individuals control over their personal data and to simplify the regulatory environment for international business. According to EY, the world’s 500 biggest corporations are on track to spend a total of $7.8 billion this year to comply with GDPR. 

Larger organizations will naturally need to invest more than smaller companies in most cases, but even mid-market companies doing business with / in EU countries will need to make significant investments in additional resources, technology, and legal services to meet requirements. Costs of non-compliance can be even more significant; fines from supervisory authorities in the EU can reach up to 20 Million Euro or 4% of annual global revenues, whichever is greater.

• Financial – Financial risk can take many forms – increased bad debt, theft, underutilized capex. The hard-dollar costs to enter a market, and associated financial risk, can be fairly straightforward, but others may not appear obvious at the onset, particularly under a worse case scenario. Some countries, for example, have restrictions on liquidating investments and transferring funds out of the country if a company decides to exit. In other cases, there may be notice periods for terminating leases and contracts, as well as early termination penalties. Even if exiting a target country has a low probability of occurring, it’s important to understand what might potentially be involved, and bake those costs into the “Risk” part of the analysis. 

At the end of the day, each case of due diligence will be unique, but it usually boils down to whether the return from international growth is worth the effort, risk and opportunity cost involved to make it happen. Think of it this way: 

You’re on a ski vacation with the family and have rented a house at the base of the mountain. You wake up the first morning to 12 inches of new snow. “Yahoo!” you scream, rolling the kids out of bed to get their gear on so you can get the first run in fresh powder. Is going skiing today worth the cost, energy and effort to get gear together, kids dressed, buy lift tickets, rent skis for junior, etc.? Most certainly, that’s what you’re here for.

But then you log on to read the conditions report and there’s a huge warning about terrible road conditions on the way up the mountain. Is it worth the risk? “Sure, I have chains…but wait, do I? Shoot did I leave them at home…?” Now is it worth the risk of making the trip without chains? Possibly…12 inches of fresh powder! But some serious downside… although unlikely…hmmm? Then the kids start whining that they’d rather stay home and build snowmen, a friend calls and invites you over to watch the game over a couple drinks, and the decision becomes clear based on your risk adjusted rate of return …there’s always tomorrow….