Building Deals on Bedrock



Reprint: R0409J

The headlines are filled with the sorry tales of companies like Vivendi and AOL Time Warner that tried to use mergers and acquisitions to grow big fast or transform fundamentally weak business models. But, drawing on extensive data and experience, the authors conclude that major deals make sense in only two circumstances: when they reinforce a company’s existing basis of competition or when they help a company make the shift, as the industry’s competitive base changes.

In most stable industries, the authors contend, only one basis—superior cost position, brand power, consumer loyalty, real-asset advantage, or government protection—leads to industry leadership, and companies should do only those deals that bolster a strategy to capitalize on that competitive base. That’s what Kellogg did when it acquired Keebler. Rather than bow to price pressures from lesser players, Kellogg sought to strengthen its existing basis of competition—its brand—through Keebler’s innovative distribution system.

A company coping with a changing industry should embark on a series of acquisitions (most likely coupled with divestitures) aimed at moving the firm to the new competitive basis. That’s what Comcast did when changes in government regulations fundamentally altered the broadcast industry. In such cases, speed is essential, the investments required are huge, and half-measures can be worse than nothing at all. Still, the research shows, successful acquirers are not those that try to swallow a single, large, supposedly transformative deal but those that go to the M&A table often and take small bites.

Deals can fuel growth—as long as they’re anchored in the fundamental way money is made in your industry. Fail to understand that and no amount of integration planning will keep you and your shareholders from bearing the high cost of your mistakes.

Whether they like it or not, most CEOs recognize that their companies can’t succeed without making acquisitions. It has become virtually impossible, in fact, to create a world-class company through organic growth alone. Most industries grow at a relatively slow pace, but investors expect companies to grow quickly. Not everyone can steal market share, particularly in mature industries. Sooner or later, companies must turn to acquisitions to help fill the gap.

Yet acquisitions can be a treacherous way to grow. In their bids for new opportunities, many companies lose sight of the fundamental rules for making money in their industries. Look at what happened to manufacturing giant Newell.

In their bids for new growth, many companies lose sight of the fundamental rules for making money in their industries.

When Newell’s top managers approached their counterparts at Rubbermaid in 1999 about the possibility of a merger, it looked like a deal from heaven. Newell had a 30-year track record of building shareholder value through successful acquisitions of companies like Levolor, Calphalon, and Sanford, maker of Sharpie pens. Rubbermaid had recently topped Fortune’s list of the most admired U.S. companies and was a true blue-chip firm. With its long record of innovation, it was very profitable and growing quickly.

Because Newell and Rubbermaid both sold household products through essentially the same sales channels, the cost synergies from the combination loomed large. Newell expected to reap the benefits of Rubbermaid’s high-margin branded products—a range of low-tech plastic items, from laundry baskets to Little Tikes toys—while fixing a number of weak links in its supply chain.

Rubbermaid’s executives were encouraging: As long as the deal could be done quickly, they said, they’d give Newell an exclusive right to acquire their company. Eager to seize the opportunity, Newell rushed to close the $5.8 billion megamerger—a deal ten times larger than any it had done before.

But the deal from heaven turned out, to use BusinessWeek’s phrase, to be the “merger from hell.” Instead of lifting Newell to a new level of growth, the acquisition dragged the company down. In 2002, Newell wrote off $500 million in goodwill, leading its former CEO and chairman, Daniel Ferguson, to admit, “We paid too much.” By that time, Newell shareholders had lost 50% of the value of their investment; Rubbermaid shareholders had lost 35%.

What went wrong? It’s tempting to brush off the failure as a lack of due diligence or an error in execution. Admittedly, when Newell looked beneath Rubbermaid’s well-polished exterior after the deal closed, it discovered a raft of problems, from extensive price discounting for wholesalers to poor customer service to weak management. And Newell’s management team, accustomed to integrating small “tuck in” deals, greatly underestimated the challenge of choreographing a merger of equals.

Yet even without those problems, Newell would have run into difficulties. That’s because the deal was flawed from the start. Although Rubbermaid and Newell both sold household basics to the same pool of customers, the two companies had fundamentally different bases of competition. Levolor blinds and Calphalon pots notwithstanding, Newell competed primarily by efficiently churning out prosaic goods that could be sold at cut-rate prices. Rubbermaid was a classic brand company. Even though its products were low-tech, they sold at premium prices because they were distinctive and innovative. Rubbermaid could afford to pay less attention to operating efficiency. The two companies had different production processes and cost structures; they used different value propositions to appeal to customers. If Newell’s executives had remained focused on the company’s own basis of competition—being a low-cost producer—they would have seen from the outset that Rubbermaid was incompatible.

How can acquirers avoid the Rubbermaid trap? We’ve been studying the question for years. In fact, we’ve analyzed 15 years’ worth of data (from 1986 through 2001) from more than 1,700 companies in the United States, Europe, and Japan; interviewed 250 CEOs in depth; and worked with dozens of big companies in planning and implementing mergers and acquisitions. Our research has confirmed our experience, leading us to conclude that major deals make sense in only two circumstances: when they buttress a company’s current basis of competition or when they enable a company to lead or keep up with its industry as it shifts to a different basis of competition. In other words, the primary purpose of mergers and acquisitions is not to grow big fast, although that may be the result, but for companies to do what they do better.

The primary purpose of mergers and acquisitions is not to grow big fast, although that may be the result, but for companies to do what they do better.

That means some companies should never do major deals. Firms that have a truly unique competitive edge—the Nikes, Southwests, Enterprise Rent-A-Cars, and Dells of the world—should avoid big deals altogether. For such companies, large-scale acquisitions are usually counterproductive, diluting their unique advantages and hampering future growth.

It also follows that the odds are overwhelmingly against the success of a single headline-grabbing megadeal. If you already do what you do better than anyone else, a big merger or acquisition can only siphon money, resources, time, and management attention away from the core business. And even if you don’t, rarely will a single deal be the solution to all your company’s problems and bring no issues of its own.

Perhaps this sounds self-evident. But few companies are so strategic in their approach to mergers and acquisitions. When we surveyed 250 senior executives who had done major deals, more than 40% said they had no investment thesis—meaning they had no theory of how the deal would boost profits and stock price. And half of those who did have an investment thesis discovered within three years of closing the deal that their approach was wrong. That means fewer than one in three executives went into deals with a sound reason that actually stood the test of time for buying a company. All too many of them made the same mistake Newell did with Rubbermaid: pursuing an acquisition that conflicted fundamentally with their company’s existing or desired basis of competition.

In this article, we’ll examine how successful acquirers in both stable and changing industries use the basis of competition to guide their deal-making decisions. We’ll also explore how a company’s rigorous understanding of its basis of competition can change the way it approaches the deal-making process. But first, let’s take a closer look at what we mean by basis of competition.

The Basis of Competition

Much of the allure in the notion that acquisitions enable companies to get big fast must lie in its connection with a related idea: that industry leadership equals market share leadership. That is, the leading companies in an industry are those with the most customers and the highest sales. But if this were true, American Airlines would be far more successful than Southwest, IBM would still be the industry leader in computer hardware, and Hertz would be more profitable than Enterprise.

If size is no necessary virtue in a particular industry, then virtue must lie elsewhere. In our experience, what determines industry leadership varies significantly from field to field. We propose that, broadly speaking, companies can achieve industry leadership in five ways: through superior cost position, brand power, consumer loyalty, real-asset advantage, and government protection. (See the exhibit “The Finer Points of Competitive Advantage.”) Getting bigger may bolster one or more of these bases of competition, but it doesn’t guarantee leadership. And recognizing which basis matters the most in a given industry can be tricky.

The Finer Points of Competitive Advantage

For instance, what’s the basis of competition for the venerable British department store Harrods? While the company’s name is certainly well known, its brand is not the main reason the trendy shop can sustain its high margins. And even though its upscale British service is important, customer loyalty is not the primary basis of competition either. Rather, it’s the shop’s premier address in London’s tony Knightsbridge neighborhood—an asset advantage—that allows Harrods to charge the high prices it does.

On what basis does independent credit card issuer MBNA compete? It’s not just that its size confers economies of scale. In the financial services industry, cost-to-income ratios determine the winners. The cost of acquiring new customers is so substantial that the highest returns go to the companies that capture the largest share of wallet from their best customers. In short, MBNA and companies like it compete on customer loyalty. Accordingly, MBNA’s strategy focuses on bolstering customer retention by getting the right customers, not just getting the most customers. That approach guided its acquisition in 2004 of Sky Financial Solutions, a company that provides financing for dental professionals. With nearly three-quarters of all dentists in the United States already carrying an MBNA credit card, the Sky deal offered a way for MBNA to cement loyalty and expand its share of wallet.

And what about Comcast? It excels at managing blue-collar contractors and negotiating with content providers, but it does not compete primarily through asset advantage. Its monthly billing system is highly efficient, but it does not compete primarily on cost either. Competing in a regulated industry, its primary advantage lies in being a master of red tape: obtaining rights of way and negotiating with local municipalities to assure rates. So it competes primarily on the basis of government protection.

One of the things that makes recognizing a company’s basis of competition less than straightforward is that few organizations are pure play. Low-cost producer Newell, you may recall, also had some strong brands. Yet as a manufacturer, its cost position is what tends to seal its fate. Conversely, while Rubbermaid was a manufacturer, as with most consumer products companies, its earnings capacity was primarily tied to its brand power.

When firms do deals that strengthen their basis of competition, as MBNA did, they increase their earning power; when they don’t, they weaken their earning power. Clearly, then, every merger or acquisition your company proposes to do—whether big or small, strategic or tactical—should start with a clear statement of how money is made in your business (what the company’s basis of competition is) and how adding this particular acquisition to your portfolio will further your strategy for capitalizing on that basis and thereby make the firm more valuable. If this were easy, far more acquisitions would succeed. Let’s take a look at how one company used those principles to guide its acquisitions and grow profitability in an industry whose basis of competition was stable—although at first glance it may not have seemed that way.

Building on Success

Every multinational food company with sales greater than $5 billion grew through extensive acquisitions. It’s not hard to see why. New products are essential for growth, and it’s cheaper to buy a new sandwich spread or snack food than to develop one. Merger and acquisition activity in this industry has been especially intense during the past ten years, which have seen a host of acquisitions by the large food companies: Philip Morris’s Kraft buying Nabisco, General Mills purchasing Pillsbury, Sara Lee gobbling up Earthgrains, to name only a few. One of the most successful acquisitions was Kellogg’s takeover of Keebler, a good example of a company that knew what it was buying and why and that reaped the returns to prove it.

Kellogg’s basis of competition is unquestionably its brand strength. For decades, a shelf full of household-name products like Corn Flakes, Rice Krispies, and Special K steadily delivered top-tier operating margins of 17.5% and a leading share of the ready-to-eat cereal market. The company’s strong brand meant it could raise prices just enough each year to generate the upside profit surprises that shareholders love.

But by the mid-1990s, Kellogg’s once-crisp universe was growing soggy. Post, the number three competitor, had initiated a fierce price war. General Mills, the traditional number two, began vying for market share lead. Retailers stepped up offerings of store brands, with companies like Ralston Foods happily supplying these goods at lower prices. Worse still, to more and more consumers, that bowl of Corn Flakes, once considered the obligatory way to start the day, was becoming a hassle in a time-constrained world. Between 1996 and 2000, Kellogg’s share price dropped nearly 20% in a booming stock market.

This was the situation Carlos Gutierrez inherited when he became the company’s CEO in 1999. Despite the cost pressures from Post, Gutierrez and his team recognized that Kellogg’s brand strength, not its cost position, remained its strongest competitive weapon. Even if people were skipping breakfast, they still liked to snack on cereal-based products during the day. Between 1996 and 2001, the market for handheld breakfast bars grew 8% annually even as demand for ready-to-eat cereals declined 5% year after year. Kellogg had strong brands that lent themselves well to snacking, notably its Nutri-Grain bars and Rice Krispies Treats.

Firmly committed to what the company did—compete on brand—Gutierrez and his team focused on how they could do it better, paying particular attention to the capabilities Kellogg would need to sustain its brand strength in a rapidly consolidating marketplace. They concluded that the company had to excel in three areas: new-product development, broader distribution, and the creation of a culture skilled at executing business plans more quickly.

Revamping Kellogg’s culture and creating new products could be addressed internally by training people differently and by redirecting spending on capital and R&D projects. Distribution, however, was another matter. The best way to deliver snacks was through a direct distribution channel. But building one from scratch would be inordinately expensive. Kellogg needed to buy one.

Gutierrez and his team set their sights on Illinois-based Keebler. Keebler was the number two cookie and cracker maker in the United States, behind Nabisco. But it wasn’t Keebler’s cookie-making prowess that excited Kellogg; it was where Keebler sold its cookies and how it got them there. Keebler had an outstanding direct store-delivery system. Rather than ship products to a retailer’s warehouse and expect the retailer to put them on the shelves, Keebler sent out a fleet of panel trucks every day to deliver fresh snacks directly from its bakeries to store aisles, greatly speeding inventory turns.

Kellogg calculated that acquiring Keebler would add one to two points to the top line by moving Kellogg into a high-growth distribution channel and by filling that channel with an expanded line of snacks. The Keebler acquisition became pivotal in Kellogg’s turnaround, as revenue rose 43% between 1999 and 2003 and operating income nearly doubled. The key to the deal’s success was that it allowed the company to extend its existing brand strength into new products and additional channels.

Kellogg’s decision to build its brand even as the very concept of breakfast was changing might appear risky. In our experience, however, company leaders consistently underestimate the potential left in their core businesses. High-performing companies drive their businesses to achieve full market share and profit potential before taking on something new.

That’s a lesson IMC Global learned—eventually. For many years, IMC was the leading North American producer of phosphates and the number two producer of potash, two key ingredients in crop fertilizer. During the late 1990s, IMC tried to extend its traditional basis of competition—asset advantage—by bolstering its phosphate and potash mines and processing plants with a move into specialty chemicals. But what looked like a push into a related business was not. The specialty chemicals business had different supply chains and customers from those of the phosphate- and potash-mining business. What’s more, the phosphate industry was still highly fragmented, and IMC overlooked the opportunity to roll up companies in its core business. The businesses IMC bought did not enhance its asset advantage, either by growing its share of potash and phosphate assets, or by adding new technology to lower its costs, or by bringing in new points of distribution. Instead, the acquisitions added leverage to the balance sheet and diverted management time and cash from maintaining IMC’s leadership position in its core fertilizer business.

A new management team brought in to turn around the business recognized that future growth and profitability hinged on restoring the focus on phosphates and widening distribution in what had become a global market. The new team divested all the businesses unrelated to fertilizers that had been added during the late 1990s. In early 2004, IMC agreed to merge with $2 billion Cargill Crop Nutrition, a move that increased its phosphate mining and processing capacity. And in a market where all the growth is coming from less-developed countries, Cargill Crop Nutrition’s global distribution system provides a source of competitive advantage for Mosaic, the new company. Though the deal is still in its early stages, preliminary results are good, and we expect it to be successful in the long run because the deal is squarely in line with the way IMC makes its money.

Using Deals to Power Change

At the other end of the spectrum from the IMC and Cargill scenario are the glamorous, high-profile deals aimed at transforming companies or entire industries. The idea of using acquisitions as strategic masterstrokes gained momentum throughout the 1990s, and a host of high-flying companies, including Vivendi Universal, AOL Time Warner (which changed its name back to Time Warner in October 2003), Enron, and natural gas provider Williams employed the technique.

That list alone may be enough to turn readers off to the concept. But the approach shouldn’t be discarded entirely, because when the basis of competition in an industry changes, transformational deals can make sense. Advances in technology, shifts in regulations, and the emergence of new competitors can change an industry’s competitive base so abruptly that even the fastest organizations can’t alter their core businesses rapidly enough to adapt organically to the new market, leaving acquisitions as the best way to recast the business. Much, however, hangs in the balance. Speed is critical, the investments required are enormous, and taking half measures can be worse than doing nothing at all.

Getting it right requires companies to have a clear understanding of the new basis of competition, and one big deal seldom offers the best way to get there. Clear Channel Communications is one company that successfully used a series of deals to segue to stronger growth, after the foundation for competition in its industry shifted dramatically in the 1990s. Let’s see how.

Lowry Mays was an accidental radio entrepreneur. The former investment banker found himself in the radio business when a friend backed out of a radio station deal in 1972, and Mays was left holding the property. During the next 23 years, Mays and his two sons became accomplished deal makers in broadcasting, acquiring two dozen radio stations one by one, most for less than $40 million. Government regulation formed the basis of competition in radio broadcasting during the 1970s and 1980s, and success lay in securing exclusive licenses granted by the Federal Communications Commission in particular local markets.

Knowing what their business was about, the Mayses were clever in how they built it. They were savvy financiers, bolstering cash flow from radio operations with debt financing to fund expansion. They became expert at anticipating when local radio stations were about to come up for sale. When those stations hit the market, the Mayses were prepared with strong bids.

Using this approach, the Mayses’ company, Clear Channel, vaulted to number six in radio broadcast revenues, close behind Infinity Broadcasting, Evergreen Media, Disney, Chancellor Broadcasting, and Cox Broadcasting. By 1995, however, the Mayses had hit a ceiling. Federal law limited broadcasters to two stations per market and 40 nationwide, and Clear Channel was bumping up against those barriers. Then the game changed. In 1996, Congress deregulated the industry, allowing companies to own as many as eight stations in a large market and eliminating nationwide limits entirely. Overnight, the basis of competition in radio shifted. Cost leadership would determine the industry’s winners rather than skill in trading up to the most lucrative local licenses. The Mayses understood that this new basis of competition favored operating on a national and possibly a global scale, which would enable broadcasters to spread their costs.

Players in the radio broadcasting industry divided into two camps: the buyers and the bought. The Mayses intended to be buyers. As the industry redefined itself, Clear Channel applied a savvy strategy to this new basis of competition. It combined aggressive acquisitions to gain scale with innovative new operating practices—such as providing packaged playlists, centrally distributing formats to stations around the country, and using the same “local” weatherman to report on cities as distant from each other as Tampa and San Diego—to capitalize on its size.

Clear Channel’s coherent strategy quickly moved it to the top of the industry. At the beginning of 2004, the company owned about 1,200 radio stations in the United States and had equity interests in more than 240 stations internationally. Its next nearest competitor, Viacom, owned about one-fifth as many stations.

Clear Channel’s steady focus on cost led the company to look beyond broadcasting as well. In 1997, it spotted cross selling and bundling opportunities for local advertising and diversified into the billboard business by acquiring a succession of small companies. Then, in 2000, it became the leading live-concert promoter through the acquisition of SFX Entertainment.

The financial results of Clear Channel’s acquisition-driven growth strategy have been exceptional, as each deal has reinforced the company’s shift to cost-based competition. From 1995 through 2003, company revenues and income grew at an astounding rate of 55% annually. Clear Channel generated a 28% average annual shareholder return during the same period.

While Clear Channel was able to adjust to the realities of a changing industry through a series of acquisitions, most firms moving to a new basis of competition will almost certainly need to consider divestitures as well. Otherwise, they will find themselves trying to compete in two different ways—a sure recipe for failure. An example of an effective acquirer-divestor is the Thomson Corporation. From 1997 to 2002, Thomson transformed itself from a traditional conglomerate that included newspapers, travel services, and professional publications into a focused provider of integrated electronic information to specialty markets. This made sense, as the growth of the Internet had changed the basis of competition in its industry from customer loyalty (newspaper subscriptions and renewals) into real-asset advantage (ownership of proprietary databases).

Starting in 1997, Thomson zeroed in on a small number of businesses in its portfolio that were especially well positioned to capitalize on the industry’s shift. As Thomson’s executives saw it, the new basis of competition centered on achieving scale by developing proprietary technologies that transformed the way information was delivered and integrated into the workplace. Exploiting this technological potential became the core of the Thomson investment thesis. Thomson realized that continuing to use its newspapers as a way to distribute information that originated with wire services owned by others would become an indefensible position, as the Internet made alternate modes of publication much cheaper and easier. Instead, it needed to own the information, so it divested newspapers and bought databases. Thomson sold more than 60 companies and 130 newspapers, raising $6 billion. With the proceeds, it invested heavily in its core markets by acquiring more than 200 businesses in educational, legal, tax, accounting, scientific, health care, and financial information publishing. Over the course of this transformation, the company improved its operating margin by 6%. Today, Thomson is a leader in electronic information databases; owning the information allows the company to earn superior returns.

Disciplining the Deal

Adopting such a strategic approach to M&A argues for an equally deliberate approach to managing the M&A process within your company. Yet the most common approach could hardly be called deliberate, much less strategic. Here’s what usually happens.

An investment banker calls up the CEO with a target for sale and a deal book that provides background material. “This is your chance to be the industry leader,” he declares. Or maybe he says, “Your core business is stagnant; you need to look elsewhere for growth.”

In response, the corporate development staffers run off and do a quick screen, based on a cursory review of the book and a superficial industry overview. If they discover that the banker is bending the truth or that the company in question is in a lot of trouble, they balk. But if the deal still looks “interesting”—however that may be defined—they construct a valuation model and conduct financial and legal due diligence.

In a few weeks, the team builds a case for the deal. Then they dive into hundreds of hours of negotiations, presentations, and board discussions—all aimed more or less consciously at naming a price that will fly and getting a green light from the board.

We hope none of this sounds familiar to you, because the odds are stacked high against picking a deal successfully this way. If the acquisition team is reacting rather than acting, it’s likely to pursue plain vanilla deals with prices below the valuation model, deals with limited upside and almost unlimited downside. Meanwhile, the team will turn down deals that appear to be too expensive but actually aren’t in terms of their long-term strategic benefits. And it will fail to uncover opportunities it might turn up on its own if it followed a strategic road map.

The best acquirers follow a process we call “planning for opportunity.” Long before any opportunity arises, these people have their basis of competition firmly in mind, and the strategy they need to capitalize on it is carefully considered. They think long and hard about what kinds of deals they should be pursuing. Then a corporate M&A team works with individuals who are closer to the ground in the line organizations to create a pipeline of priority targets, each with a customized investment thesis, and together, they look for opportunities to win over interesting prospects. They systematically cultivate a relationship with each target so that they are positioned to get to the table as soon as (or, even better, before) the target goes on sale. By this stage, canny acquirers are likely to have months or even years invested in the prospective deal. As a result, they’re often willing to pay a premium or act more quickly than rivals because they know precisely what they can expect to achieve through the acquisition.

Thus, seasoned acquirer Cintas, a leading manufacturer of uniforms in the United States and Canada, assigns someone to keep in touch with each potential target, often for years. This individual, who comes from the line organization, reports to the corporate M&A team, which ensures that she stays in touch with the target and watches for favorable conditions to pull the trigger on talks. Indeed, the deal team sometimes even “puts a bullet in the gun” by giving senior executives a compelling reason to contact the target if changes in that company, or in the marketplace, warrant it. Through this sophisticated system, the $2.7 billion Cincinnati-based company has sustained its sales growth for 34 years at a compound annual rate of 23%. Profits have grown at an even more impressive 30% annually.

By now it should be clear that strategic deal making generally argues against the big-bang approach of transforming a business through a massive acquisition. Our analysis of the deals made by 1,700 acquirers between 1986 and 2001 underscores the fact that the most successful acquirers do a lot of deals, that they do deals more or less continually, and that the average deal size is small. In our database, U.S. companies that did 20 deals or more during the 15-year period generated shareholder returns almost twice as high as the returns from companies that did no deals at all. Frequent acquirers outperformed those that did fewer than five deals by a factor of 1.7. And companies that acquired firms for 15% or less of the value of their own market capitalization on average earned returns six times higher than those that bought companies 35% of their size or larger. (See the exhibit “Slow and Steady.”) The conclusion is clear: Go to the table frequently, and take small bites.

Slow and Steady

Strategic deal making generally argues against the big-bang approach of transforming a business through a massive acquisition.

• • •

Can deal making solve your growth problem? In many cases, yes, as long as those deals are built on a sound competitive foundation and anchored in the fundamental way your company makes money. Understand that, and you’ve taken the first step toward M&A success. Fail to take that step, and no amount of integration planning will keep you and your shareholders from bearing the high cost of your mistakes.

A version of this article appeared in the September 2004 issue of Harvard Business Review.


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