Discipline and the Dilutive Deal

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When cereal giant Kellogg acquired Keebler Foods last year, many analysts were skeptical of the merger’s prospects. Because Keebler had a higher price-earnings ratio than Kellogg, the deal was dilutive, instantly slashing Kellogg’s estimated earnings per share by 20% (including goodwill charges). But a year after the merger announcement, Kellogg rewarded its shareholders with a 25% return. This remarkable performance flies in the face of conventional wisdom. Analysts expect dilutive deals to depress shareholder value, and accretive ones—those that instantly boost EPS—to enhance returns.

Was Kellogg’s experience an anomaly? Not at all. When we examined nearly 100 U.S. acquisitions announced between 1996 and 2000 with price tags over $1 billion, we found that the companies making dilutive deals actually outperformed those making accretive deals. (See the exhibit “How Do Dilutive Deals Do?)” In the year following the merger announcement, nearly half of companies completing dilutive deals surpassed their industry’s average stock-price returns by more than 10%. Only a third of companies that had done accretive deals achieved similar results.

What could account for this? In a word: discipline. The market’s suspicion of dilutive deals places enormous pressure on executives to be rigorous in both analyzing and executing mergers. Meanwhile, the market’s embrace of accretive acquisitions eases the pressure on executives, raising the likelihood of sloppiness in analysis and tardiness in execution.

Four Tough Tests

In previous Bain research, interviews with deal makers in a sample of 1,700 mergers showed that executives who led high-performing mergers consistently applied four disciplines, which they credit for their success:

  • Strategic Fit: They developed rational, well-articulated merger strategies that nested each transaction in existing strategy.
  • Due Diligence: They ascertained exactly how the target business operated and how it really made its money.
  • Business Synergies: They tightly quantified the value that managers planned to extract from combining operations and developed detailed plans for reaping the synergies.
  • Management Capabilities: They carefully examined their management strengths and limitations and designed the merger to exploit both companies’ capabilities.

When we examined the mergers in our current study, looking for attention to these disciplines, we found that the highest shareholder returns correlated with an aggressive focus on at least three of the four.

The Good and the Bad

Kellogg’s acquisition of Keebler demonstrates how discipline can counteract dilution. Kellogg applied all four disciplines. First, the company filled a big strategic hole in direct distribution. Kellogg was developing a line of new snack foods, including Nutri-Grain bars and Rice Krispies Treats, but it had no distribution system to get those snacks into convenience stores, gas stations, and other points of impulse buying. Keebler had strong, direct distribution but needed more volume. Second, Kellogg had a precise understanding of the business it was targeting because it had worked closely with Keebler for years before the deal. Third, the company meticulously quantified expected synergies, telling analysts to expect “$170 million in annual cost savings by 2003 through procurement savings, capacity rationalization, improved logistics and warehousing, and the reduction of duplicate expenses.” Finally, Kellogg’s executives understood and tapped Keebler’s management strengths, insisting that the Keebler team that was overseeing distribution stay on and run the new business. Indeed, Kellogg moved its snack food business under the entrepreneurial Keebler team for its next phase of innovation.

Contrast Kellogg’s high-performing dilutive deal with Hotels & Resorts’ acquisition of ITT, announced in October of 1997—a $14.6 billion merger that showcases the limitations of accretive deal making without discipline. ITT, by that time, was a hospitality and gaming company, operating brands such as Sheraton, Four Points, St. Regis, and Caesars Palace. Starwood likewise managed hotels, with a total of 30,000 rooms. Collectively, the two stood as the largest lodging operator in the world. Management expected the combined company’s earnings per share to increase by 20% to 25% in the first year. Yet Starwood’s shares lost nearly half their value in the year following the deal, and the chain continued to perform below industry standards.

Starwood Hotels & Resorts’ acquisition of ITT, announced in October of 1997, showcases the limitations of accretive deal making without discipline.

The likely culprit: sloppy discipline. Starwood’s strategic rationale was dubious. Large size doesn’t necessarily translate into superior returns, especially in a real estate business. And, in any case, the company failed to capitalize on its potential scale advantages: It continued to operate under various brands in various markets. Furthermore, lackadaisical due diligence failed to unearth costly franchisee-management problems or the poor prospects for the casino business. Better due diligence might also have alerted Starwood that its offer was too high. In countering a bid from Hilton, Starwood paid a premium for ITT that ate up any synergy benefits. Finally, Starwood’s management failed to grasp its own limitations and floundered when most of the ITT senior managers left, taking their local knowledge of the business with them. Ultimately, Starwood sold off many of the assets it acquired from ITT, most notably the gaming businesses.

The Kellogg and Starwood stories hammer home the need for merger leaders to emphasize strategic fit and integration skills, not just immediate earnings accretion. And if a little apprehension about a deal’s prospects redoubles executives’ focus on discipline, investors are bound to benefit.

A version of this article appeared in the July 2002 issue of Harvard Business Review.

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