Gap Management

A discipline for improving
operational performance and
valuation of commercial enterprises

Gap Management evolved from gap analysis methods used by management consultants to identify underperforming operations that, if brought up to best practice standards, would improve financial performance. Gap analyzes, incorporating ‘Best Practice Reviews’ and ‘Drill Downs,’ typically resulted in a Marketshare and Profit Improvement Plan. Profitability was the primary evaluation criteria.

Gap Management extends these earlier concepts and techniques to include enterprise valuation and integration as well as marketshare and profitability. Valuation is the criteria by which success is measured. Under Gap Management, a firm’s Profit Improvement Plan is subordinate to its overall Value Improvement Plan. Gap Management also differs from gap analysis in that its practitioners tend to aim ahead of today’s best practices, aiming instead at the best methods that are practical.

EZklick, an Independent Wholesale Distribution Center (“IWDC”), is used here to illustrate Gap Management methodology. An IWDC was selected for the case study because it has many attributes of an underdeveloped market. Table 1 summarizes a Value Improvement Plan (“VIP”) for increasing an IWDC’s valuation (market cap) from $2 million to $3 billion — to close a valuation gap of approximately $3 billion.

VIP preparation began with Best Practice Reviews of the IWDC’s financial performance, operations, enterprise integration, and valuation. The review unearthed numerous gaps. Revenue and profits were substandard. Most operations fell well short of best practice, including: financial accounting and reporting; inventory control; replenishment; category management; deal management; and, customer relationship management. Few processes were integrated. Valuation was minimal.

Drill Downs were conducted on operational areas, enterprise integration, and valuation to define opportunities for improvement — tasks, schedules, and investments needed to close gaps. Return On Investment (“ROI”), Cash Flow Return (“CFR”), and Value Return on Investment (VRI”) were estimated for each opportunity.

Analysis of Drill Down results showed the gaps (improvement opportunities) to be interrelated and that the IDWC’s scale of operation needed to be increased to reach best practice levels of margin and valuation.

Low volume prevented the IWDC from receiving suppliers’ best pricing and service. Marketing and overhead costs were spread over too small a base. With its single location, the IWDC could not reach the entire local market. Phase I of the Value Improvement Plan, therefore, was designed to acquire two additional distribution centers and restructure the three centers by eliminating redundant administration and operations. Quick returns from Phase I would help fund investments needed for later Phases.

During Phase I planners faced several conundrums. Operational shortcomings were highly interrelated. Category management, for example, could not be brought-up to best practice standards unless Customer Relationship Management practices improved. The IWDC’s small merchant customers bought goods from numerous suppliers with the IWDC typically capturing less than 20% of each customer’s total purchases. Getting a better handle on customer needs was difficult because clientele included ethnic merchants from diverse cultures serving fragmented markets. Cost-of-goods could be reduced 7-9% if products were purchased directly from manufacturers instead of from mass distributors. To achieve the volume needed to buy direct, however, the IWDC would need to dominate 3 or 4 markets, not just its local market — unless a special proposition could be made to manufacturers. Even if the IWDC were to buy direct, margins on physical products would not be sufficient to attract enough interest from market analysts and institutional investors to achieve premium P/E evaluations.

With the operational issues so intertwined, it was decided to tackle them simultaneously. The IWDC also elected not to adopt practice standards of the industry’s best run supermarkets and, instead, aim slightly ahead of Wal*Mart’s more advanced practices. Whereas Wal*Mart is creating consumer exchanges within brick and mortar owned by Wal*Mart, the IWDC chose to leverage preexisting infrastructure — bricks, mortar, businesses owned by others — for its consumer exchange.

Innovative use of off-the-shelf technology was selected as the means of solving much of the puzzle. An enterprise system was chosen to integrate internal operations with the IWDC’s small merchant customers and suppliers. Set-up costs and time-to-market would be cut by using an industry specific enterprise system with work rules and procedures pre-configured for the IWDC’s market.

The key was to join merchants’ operations and IWDC operations. Merchant operations would be viewed as internal to IWDC, enabling the IWDC to supply merchants with such services as: replenishment; inventory management; deal management; and, customer relationship management.

The resulting transparency of merchants’ sales, and their shoppers’ preferences, let the IWDC precisely match inventory to customer needs and instantaneously respond to competitors. IWDC becomes the default supplier because merchants’ replenishment orders are placed automatically. As a result, the IWDC’s share of its merchants’ business increases from approximately 15% to over 50% — more than doubling revenue without adding new customers. Margins move up because manual steps and mistakes involved in inventory control, replenishment, and other operations are reduced. See Phase III on the VIP in Table 1.

With a cadre of tightly integrated merchants, the IWDC is positioned to present a compelling value proposition to manufacturers. Markets served by IWDCs (and their ethnic and independent grocers) are attractive to manufacturers. The segment enjoys double digit growth versus flat supermarket sales. Though making-up less than 20% of manufacturers’ sales, it accounts for almost 80% of many manufacturers’ profits. However, the segment has been difficult for manufacturers to tackle. It is highly fragmented. Market data is incomplete. Mass market distribution methods either don’t work or are too expensive. See Nikki’s Story. EZklick’s integrated IWDC consumer exchange lets manufacturers efficiently reach the segment. It also gives manufacturers precise, realtime consumer preference data. The consumer exchange lets EZklick trade access to a desirable market, and information about the market, for direct buying privileges — which cuts its cost-of-goods by approximately 9 percent. See Phase IV in VIP.

The objective of Phase IV is to raise margins by promoting digitally deliverable products. Investment club deposits, bill paying, and emergency loans are distributed via merchants’ checkout lanes. Impact on earnings is significant. Margins on the transaction fees earned by distributing digital products approach 75% — compared to 15-20% gross margins on physical products. See Phase V.

Valuation criteria improvement is an evolving process as shown in the VIP. Market analysts respond to structural, revenue and profit improvements of Phase I through IV by adjusting valuations according to conventional yardsticks. Phase V focuses on the institutional message that the IWDC’s consumer exchange is something better. Phase V unfolds over time. Wal*Mart, for example, has been converting from a traditional retailer to a consumer exchange for several years. Competitors and institutional analysts were both slow to recognize the implications. (Wal*Mart is now projected to take an additional 20% of market share from supermarkets by 2005). Wal*Mart’s valuation has begun to not only reflect a premium based on retail results, but also recognition of the strength of its exchange.

----------------------

The preceding discussion is presented as though the Phases were discrete and occur linearly. In actuality they are more similar to the market exchange created by the IWDC. Phases overlap, are ongoing, and happen simultaneously with each action producing reactions.