Taking the Myth Out of M&As
by Louis-Jacques Darveau

Rarely a day goes by without a merger or acquisition announcement. Among all growth strategies, those involving either a merger or an acquisition seem to be favoured despite their high level of risk and uncertainty.

From an analyst's point of view, the ability to predict such asset movements is critical. In fact, an industry's landscape can be completely transformed only by one such move. The Daimler-Chrysler merger is a case in point.

In this article, we will demonstrate that M&As are far less esoteric than we sometimes believe. Obviously, the number of variables surrounding a deal makes it impossible to draw a perfectly accurate picture of an M&A in the making but, as we will see, Competitive Intelligence can make a difference between being surprised and being aware.

Learning from the past to predict the future

The M&A failure rate, ranging from 50% to 70%, clearly indicates a lack of Competitive Intelligence (CI) skills or preparation because the success of M&As is highly dependent on the quality of the CI utilized. This assertion is demonstrated by the fact that out of the four most common grounds of M&A failure, three are information-related:

  • Unpredictability
  • Agency problems
  • Misguided managers
  • Failure to grasp and articulate the strategic intent behind the deal

The question that arises therefore is if it is possible to predict the future by analyzing past experiences and strategic trends to avoid being surprised be a competitor's move?

One of the most surprising things about M&As is the apparent incapacity of companies to rationalize and learn from past experiences in order to evaluate and thus prepare for these types of transactions. Few companies except perhaps GE Capital, Cisco Systems, NationsBank and Hewlett-Packard have developed an internal evaluation system for M&A opportunities in all of the three phases of any such transaction:

  • Target selection
  • Negotiation
  • Integration

In Cisco's case, many elements (including its position as the second largest acquirer with 16 acquisitions totaling $12.29 billion in 1999 - just shy of Lucent Technologies, its highly competitive industrial landscape and need to retain talented employees) made it mandatory for the company to develop a M&A analytical process to avoid being overwhelmed by too many transactions and losing key employees at the same time.

The experience of Cisco and others is clearly proof of an organization's capacity to rationalize M&As and this capacity is strongly embedded in its understanding of a competitor's strategic thinking. The remaining question, therefore, is: how to accomplish this task effectively?

In search of the optimum path

There are two main reasons why corporations get engaged in Strategic Planning activities.

  1. Strategic Planning and one of its supporting ingredients, CI, are, or should be, part of any corporation's decision-making process. It is the "internal" aspect of strategy.
  2. Strategy helps to profile the competitors' own decision-making process and, in a superball effect, gives immediate feedback on the accuracy of the internal solutions, thus guiding the CEO into a certain path: the optimum path. This would be the "external" aspect of strategy.

Consequently, before engaging in an analysis of the M&A structure properly, it is important to assume that all corporations are acting towards the achievement of optimal performance. Although the latter may (and in most cases will) differ from one company to another, it is necessary to act as if there were a standardized comprehension of this optimum.

Take two players in the airline industry: United Airlines (United) and British Airways (BA). United, through its usual CI activities, is well aware of its industrial structure and the same goes for BA. If United comes to the conclusion, after careful analysis, that BA's best growth strategy, taking into account its cost structure, management orientation, previous moves, etc., is to start a no-frills, low-cost airline subsidiary, then United is well positioned to move a step further to adjust its own strategy.

Meanwhile, BA can either take the decision to go ahead in the project as depicted by United or embark upon another strategy (form an alliance with another airline, start a new route or else). If it chooses the first option, United is prepared to face what it considers to be the best move possible by BA or its optimum. It can take appropriate countermeasures. Conversely, if the second option is chosen, United can either do nothing (because BA did not choose the optimum path) or engage in achieving the optimum. In all cases, the winner is the one who has learned to make the proper scenarios and react accordingly.

A similar example could have been drawn from Coca-Cola and Pepsi Co.'s long time battle. Coca-Cola, during the last decade, engaged in a globalization spree, while its opponent chose diversification as its optimum, thus acquiring KFC, Pizza Hut and Taco Bell fast-food chains. Coca-Cola did not make the same mistake Pepsi Co. did because of Coke's ability to determine what the real optimum was.

First step: get to know your industry

This may sound basic but it is nonetheless fundamental. A set of well-routed bookmarks, such as those offered each month in Competia, can be an excellent source of information.

In the industries most engaged in M&A activities (those in movement following deregulation, privatization or technological convergence, for instance), the small number of players makes it rather easy to profile each of them, which in turn enables a better optimum finding and M&A tracking. The most active industries in M&A are:

  • Communications
  • Broadcasting
  • Drugs, medical supplies & equipment
  • Computer software, supplies and services
  • Electric, gas, water & sanitary services
  • Banking and finance
  • Electrical equipment
  • Oil & gas
  • Chemicals,paints & coatings
  • Aerospace and defense
  • Retailing
  • Automotive

If your company is part of any of these industries, you are likely to be affected or involved in M&As and in addition, you are able - with careful monitoring - to predict M&As. At this point, we assume that you have a thorough understanding of the market and that you have profiled each of your competitors.

Second step: learn the heavy strategic trends

Companies in all sectors are affected by strategic trends. Shareholders, financial analysts and CEOs are concerned by growth. The three interests obviously work together, one relying on the other.

Indeed, a recent study indicated that most US and European companies seek an average of 10% to 15% of growth. Therefore, the pressure is on management to engage in what is - in a given period - the latest "management fad." In fact, engaging or not in what is considered by analysts and consultants to be "the" direction to take will put tremendous pressure on the others to do the same.

Third step: identify key business drivers

The industries most subject to M&A activity are usually sharing a set of business imperatives or key business drivers. Here is a sample of some of those drivers that can be used as a check list to map a competitor's hand in terms of mergers and acquisitions:

  • Synergy needs
  • Scale economies
  • Product life cycle compression
  • Gaining access to restricted markets
  • Overcoming barriers to entry
  • Gaining market power
  • Acquiring technologies, products or skills
  • Pooling resources
  • Reducing uncertainty
  • Sharing risky research

At this point, you should be relatively certain if a company is likely to adopt a growth strategy, possibly through M&A. The tricky part remains knowing exactly which growth strategy it ought to be.

Fourth step: analyzing the growth direction

There are traditionally three generic modes of growth. Before coming to any definitive conclusion on M&A activity, one has to eliminate the possibility of a competitor taking either of the two other modes of growth.

1. Organic/Internal:
While trying to figure out a competitor's most likely moves, it is important to evaluate the possibility of it selecting this first mode of growth, which is generally less risky than an M&A. As a result, a company will normally choose such a path if the right conditions are met and if it has the correct set of resources, such as:

  • Strong technical skills
  • Effective and innovative production processes
  • Marketing systems
  • Managerial expertise

Procter and Gamble, the US consumer giant and world's biggest marketer, is less likely to choose an M&A strategy (except in the perspective of acquiring brands) precisely because of its internal strengths.

2. Alliances/Joint ventures vs acquisitions
Most mergers are the result of a careful analysis of the advantages and inconveniences of an alliance. Normally, the latter is chosen if the case against the former is too strong. There are four complementary ways in which such assessment can be made. They are called the "four I's":

Unfeasibility of an acquisition
The best indication that an alliance will be preferred to an acquisition is the unfeasibility of the latter strategy. An acquisition can be impossible to pursue because of restrictions on foreign direct investment, which has been the case for a long time in the airline industry, for example. The recent saga involving Air Canada and Canadian Airlines International saw AMR Corp. lose its edge in the Canadian market - not to mention a lot of money - and a valuable ally in One World, the airline alliance, exactly because of such restrictions.

Furthermore, an acquisition can be stopped by competition watchdogs (especially the US FTC and the European Commission) if it can potentially create a monopoly. Not too long ago, Barnes and Noble, the largest US book retailer, tried to purchase Ingram, the largest US book distributor, only to be stopped by the Federal Trade Commission. The FTC was weary of seeing the entire book distribution process controlled by a single company and clearly indicated its intention to block the deal, thus forcing Barnes and Noble to step back.

Finally, other legal and social considerations can, from time to time, set considerable barriers to an acquisition and they must not be overlooked. Such considerations can be a result of social pressures, as occurred during the Apartheid period in South Africa. Several companies - though reluctantly - had to retreat from this market if not bluntly engage in an asset sell-off.

Alliances, in contrast to acquisitions, are not definitive. A need for flexibility can therefore be a factor pointing in the direction of an alliance. If an acquisition is deemed too risky, an alliance with a call option - that is, the possibility of later acquiring a stake in the company with whom the alliance was consumed after a given period or following the fulfillment of certain conditions - can be preferred to an acquisition. UPS, the parcel company, did exactly this before entering the lucrative but risky Chinese market, whereas FDX did the opposite, with mitigated results.

In the same fashion, many automobile manufacturers are entering in joint ventures with either Japanese or troubled Korean car-makers before they move more radically in the Asian market. The recent alliances involving Nissan Corp. and Renault SA, GM and Honda Motors and Volvo with Mitsubishi exemplifying the importance of checking alliance possibilities before concluding that an acquisition is the "best way."

Indigestibility
Even if an acquisition sounds like a good thing, the digestibility of the target should be thoroughly evaluated. In fact, the acquisition could unveil many problems not originally anticipated, either as a result of rough competition or a shifting market. Integration costs, especially if the potential target is located abroad can jeopardize the success of the merger.

Information asymmetry
A lack of sufficient information can also make an alliance a more prudent choice (a dearth of information makes the viability of an acquisition impossible to evaluate). For instance, a company interested in diversifying its portfolio can find it useful to learn the new activity's constraints before fully investing in it. Whirlpool, the appliance maker, did just that before it acquired the appliance division of Philips, the Dutch electronics group. Since Whirlpool was unaware of the challenges such a move could create because it was entering the European market for the first time, the call option was far less risky. The other advantage of the call option is that it gives enough information to the acquirer to better evaluate the target's assets, which can be a difficult task from the outside, not withstanding the fact that incorrect asset evaluation is one of the main cause of M&A failure.

Again, evaluating the possibility that an alliance be preferred to an acquisition is fraught with uncertainty. Despite that, it is important to evaluate a competitor's options to measure the coherence between our analysis and theirs. If an alliance is chosen when the contrary was appropriate, it is either because we were lacking information (a sign that the CI unit has to work harder) or because the competitor is going to make a mistake and in that case it is you, ultimately, that will benefit.

Fifth step: analyzing the directions of growth

Suppose you come to the conclusion that one of your competitors would benefit from an acquisition rather than an alliance. You then need to determine in which direction such an acquisition would take place. From an M&A perspective, there are four directions of growth:

  • Unrelated diversification
  • Related diversification or horizontal acquisitions
  • Vertical integration
  • Globalization

The conglomerate strategy
Few companies are still using the conglomerate model, despite its huge popularity in the 60's and 70's. The rationale behind massive and uncalculated diversification - risk reduction - has been replaced by the assumption that investors can diversify their own portfolio. Yet several companies like GE, ITT, Eastman Kodak and Hewlett Packard still achieve growth through the conglomerate model. The last two, however, changed their strategic orientation over time and are now more focused.

With the exception of cases where a company has a very strong brand name, or has the ability to add significant value such as Virgin - whose activities range from soft drinks to rail transportation and wireless communication - it is unlikely that a competitor will engage in such diversification. On the other hand, mapping the intentions of companies like Virgin can be easier because of their necessary penchant for trend setting items. In fact, if cigarettes were still in vogue, Virgin would definitely put its name on them!

Related diversification and horizontal acquisitions
Not engaging in diversification means that corporations need to focus on their primary businesses or core competencies, thus mapping the way to horizontal acquisitions or related diversification, exemplified by the Exxon-Mobil and Daimler-Chrysler mergers or, in the latter case, the Rolls Royce takeover of Vickers. To better predict the potential players in such deals, some elements need to be analyzed such as:

  • Complementarities and overlaps
  • Corporate culture
  • Synergies possibilities
  • Possible reaction of competition watchdogs

Horizontal acquisitions are by far the most important trend in the industries identified above in this article.

Vertical integration
The M&A is most likely to be vertical in nature if the integration of the target is particularly important to the business of the acquirer. This was the reason behind many acquisitions of part-makers in the automotive industry, for instance. Despite this, one has to check and balance the possible advantages of outsourcing as a replacement. Judging from the increasing popularity of this phenomenon - even when the outsourced function remains central to a corporation's business - vertical integration is far less popular then it was decades ago. IBM Global Services, Big Blue's most active branch, has accumulated a number of contracts - with France's Galeries Lafayette for a 15 years period among many others - as an information systems administrator, a function that is nonetheless critical in the new economy.

To understand a corporation's possible interest into vertical integration, we have to look for the functions usually outsourced by competitors of the same industry. It is only with what is left that we can somehow draw an accurate picture of vertical integration grounds. In addition, one should examine the following elements:

  • Is the market working effectively?
  • Is there a competitive advantage arising from vertical integration?
  • Are rivals integrating? If yes, it could be an incentive because of less price competition and less price advantage)
  • Are the suppliers too powerful? Vertical integration can boost the bargaining power.
  • What kind of synergies could be achieved in case of a vertical integration and is this the best way to capture them?
  • Are there a lot of pricing distortions in the market? Vertically integrating can level these distortions.
  • Is the ability to dictate how assets are used an important matter?
  • Is the acquirer's brand name too important to leave in the hands of a tier company?
  • Is there a specific technology needed that lies in the hand of the target company?

Globalization
Many companies are now turning to globalization to achieve growth. Sears Roebuck, the US retailing company, understood that it was better to go global than to diversify. Its brief incursion in the financial services business proved to be unsuccessful; while at the same time, Wal-Mart was grabbing an increasing part of its market shares and later expanded globally.

Trying to predict M&As in light of globalization strategy has much to do with the compatibility of the product or service on the foreign market in what is referred to as the "liability of foreignness." Kellogg's, the cereal maker, learned the hard way that globalization was not granted for its flagship brand Cornflakes in India, when it miscalculated the eating habits of the local population in conjunction with their revenues. Coca-Cola and McDonald's, to the contrary, are famous examples of companies that went global but stayed locally responsive at the same time.

Often, it is through M&As that globalization can be achieved. Normally, such a move is explained by the acquirers' need to acquire one of the following:

  • Sales network
  • Brand names
  • Product innovation capabilities
  • Manufacturing know-how

Consequently, it is important to assess a competitor's ability to go global, in order to identify - should the first question be answered positively - the possible partners abroad.

Conclusion

The obvious conclusion is that forecasts are more often wrong than they are right. Despite the high failure level of most predictions - especially for M&As - there is no reason why one should not at least try - especially considering the extremely high level of M&A failures. While mergers are always announced with great fanfare, we rarely hear anything when the outcome is negative. This is proof that the corporate mind is not perfect.

Although no strategy can grant access to an opponent's true intentions, at least it is useful to put things into perspective by knowing not only which options are the best from an internal point of view but also from a competitor's perspective. Knowing this not only tells the CEO which path to follow, but it also enables the analyst to look for information primarily to confirm an intuition, not to gain one.


Louis-Jacques Darveau was called to the Bar of the Province of Quebec in 1997, and became a member of the Banking and Securities Litigation Group with the Law Offices of McCarthy Tétrault in Quebec City for two years. He was recently appointed by Packard Bell NEC Europe to create the Training and Development strategy for all the production sites and sales offices throughout Europe, Asia-Pacific, South Africa and the Middle East.

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This article was originally featured at www.competia.com in October 2001, and is reprinted with permission. Competia Online is a production of Competia Inc.

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