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568 Making Key Strategic Decisions and $20 billion of annual long-distance telephone revenues, along with the NCR acquisition, would guarantee the company’s success in the PC business. They were confident enough to increase their original offer price by $1.4 bil- lion. The problem was that by this time, PCs had become a commodity and were being assembled at low-cost around the world using off-the-shelf compo- nents. Unlike the microprocessor and software innovations of Intel and Micro- soft, AT&T’s research skills held little profit potential for the PC business. AT&T hoped to use NCR’s global operations to expand their core telecom business. But NCR’s strengths were in developed countries, whereas the fastest-growing markets for communications equipment were in developing third-world regions. And in many companies, the computer and telephone sys- tems were procured and managed separately. Thus, the anticipated synergies never materialized. Finally, the two companies had very different cultures. NCR was tightly controlled from the top while AT&T was less hierarchical and more politically correct. When AT&T executive Jerre Stead took over at NCR in 1993, he billed himself as the “head coach,” passed out T-shirts, and told all of the em- ployees they were “empowered.” This did not go over well in the conservative environment at NCR, and by 1994, only 5 of 33 top NCR managers remained with the company. Disaster Deal No. 2 Throughout 1994, Quaker Oats Co. was rumored to be a takeover target. It was relatively small ($6 billion in revenue) and its diverse product lines could be easily broken up and sold piecemeal. In November, Quaker announced an agreement to buy iced-tea and fruit-drink maker Snapple Beverage Corp. for $1.7 billion, or $14 per share. CEO William Smithburg dismissed the 10% drop in Quaker’s stock price, arguing “We think the healthy, good-for-you beverage categories are going to continue to grow.” The hope was that Quaker could replicate the success of its national-brand exercise drink Gatorade, which held an extraordinary 88% market share. Snapple, which had 27% of the ready-to-drink tea segment was distrib- uted mainly through smaller retail outlets and relied on offbeat advertising and a “natural” image to drive sales. Only about 20% of sales were from super- markets where Quaker’s strength could be used to expand sales of Snapple’s drinks. Aftermath: In April 1997, Quaker announced it would sell Snapple for $300 million to Triarc Cos. Quaker takes a $1.4 billion write-off and the sale price is less than 20% of what Quaker paid for Snapple less than three years earlier. Analysts estimated the company also incurred cash losses of approxi- mately $100 million over the same period. Ending a 30-year career with the company, CEO Smithburg “retires” two weeks later at age 58. Profitable Growth by Acquisition 569 What doomed the Quaker-Snapple deal? One factor was haste. Quaker was so worried about becoming a takeover target in the rapidly consolidating food industry that it ignored evidence of slowing growth and decreasing prof- itability at Snapple. The market’s concern was reflected in Quaker’s stock price drop of 10% on the acquisition announcement. In spite of this, Quaker’s man- agers proceeded, pushing the deal through on the promise that Snapple would be the beverage industry’s next Gatorade. This claim unfortunately ignored the realities on the ground: Snapple had onerous contracts with its bottlers, fading marketing programs, and a distribution system that could not support a national brand. There was also a major difference between Snapple’s quirky, offbeat corporate culture and the more structured environment at Quaker. Most importantly, Quaker failed to account for the possible entrance of Coca Cola and Pepsi into the ready-to-drink tea segment—and there were few barriers to entry—which ultimately increased competition and killed margins. Disaster Deal No. 3 The 1998 $130 billion megamerger between German luxury carmaker Daimler- Benz and the #3 U.S. automobile company, Chrysler Corporation, was univer- sally hailed as a strategic coup for the two firms. An official at a rival firm simply said “This looks like a brilliant move on Mercedes-Benz’s part.”* The stock market agreed as the two companies’ shares rose by a combined $8.6 bil- lion at the announcement. A 6.4% increase in Daimler-Benz’s share price ac- counted for $3.7 billion of this total. The source of this value creation was simple: There was very little overlap in the two companies’ product lines or ge- ographic strengths. “The issue that excites the market is the global reach,” said Stephen Reitman, European auto analyst for Merrill Lynch in London.* Daim- ler had less than 1% market share in the U.S., and Chrysler’s market share in Europe was equally miniscule. There would also be numerous cost-saving op- portunities in design, procurement, and manufacturing. The deal was billed as a true partnership, and the new firm would keep operational headquarters in both Stuttgart and Detroit and have “co-CEOs” for three years after the merger. In addition, each firm would elect half of the directors. Aftermath: By the end of 2000, the new DaimlerChrysler’s share price had fallen more than 60% from its post merger high. Its market capitalization of $39 billion was 20% less than Daimler-Benz’s alone before the merger! All of Chrysler’s top U.S. executives had quit or been fired, and the company’s third-quarter loss was an astounding $512 million. As if all of this weren’t bad enough, DaimlerChrysler’s third-largest shareholder, Kirk Kekorian, was suing the company for $9 billion, alleging fraud when they announced the 1998 deal as a “merger of equals.” * “Auto Bond: Chrysler Approves Deal With Daimler-Benz,” The Wall Street Journal, May 7, 1998. 570 Making Key Strategic Decisions In this case, Quaker’s management was guilty of two mistakes: failure to ana- lyze Snapple’s products, markets, and competition correctly and overconfi- dence in their ability to deal with the problems. Either way, their lapses cost Quaker ’s shareholders billions. Although the jury is still out on the Daimler-Chrysler merger, analysts al- ready have assigned at least some of the blame. There were culture issues from the start, and it quickly became apparent that co-CEOs were not the way to manage a $130 billion global giant. Chrysler CEO Robert Eaton left quietly at the beginning of 2000 and there were other departures of high-level American executives. Morale suffered as employees in the U.S. realized that the “merger of equals” was taking on a distinctive German flavor and in November 2000, the last remaining Chrysler executive, U.S. president James Holden, was fired. Rather than deal with these issues head-on, Daimler CEO Jergen Schremp took a hands-off approach as Chrysler’s operations slowly spiraled downward. The company lost several top designers, delaying new product in- troductions and leaving Chrysler with an aging line of cars at a time when its competitors were firing on all cylinders. The delay in merging operations meant cost savings were smaller than anticipated as were the benefits from sharing technology. Finally, analysts suggested that Daimler paid top dollar for Chrysler at a time when the automobile industry in the U.S. was riding a wave of unprecedented economic prosperity. As car sales began to sag at the end of 2000, all three U.S. manufacturers were facing excess capacity and offering huge incentives to move vehicles. This was not the ideal environment for quickly restructuring Chrysler’s troubled operations and Daimler was facing a 35% drop in projected operating profit between 1998 and 2001. Conclusions: These three case studies highlight some of the difficulties firms face in achieving profitable growth through acquisitions. Managerial hubris and a competitive market make it easy to overestimate the merger’s benefits and therefore overpay. A deal that makes sense strategically can still be a financial failure if the price paid for the target is too high. This is espe- cially a problem when economic conditions are good and high stock prices make it easy to justify almost any valuation if the bidder’s managers and direc- tors really want to do a deal. Shrewd managers can sell deals that make little strategic sense to unsuspecting shareholders and then ignore signals from the market that the deal is not a good one. The previous examples make it clear that it is easy to overstate the bene- fits that will come after the transaction is completed. Whatever their source, these benefits are elusive, expensive to find and implement, and subject to at- tack by competitors and economic conditions. Managers considering an acquisi- tion should be conservative in their estimates of benefits and generous in the amount of time budgeted to achieve these benefits. The best way to accurately estimate the benefits of the merger is to have a thorough understanding of the target’s products, markets, and competition. This takes time and can only come from careful due diligence, which must be conducted using a disciplined Profitable Growth by Acquisition 571 ap proach that fights the tendency for managers to become emotionally at- tached to a deal. In spite of the time pressures inherent in any merger transac- tion, this is truly a situation where “haste makes waste.” A common factor in each of these transactions—and one often overlooked by managers and researchers in finance and accounting—is culture. Two types of culture can come into play in an acquisition. One is corporate or industry culture and the second is national culture, which is a factor in cross-border deals. If the target is in a different industry than the bidder, a careful analysis of the cultural differences between them is essential. Culture is especially critical in industries where the main assets being acquired are expertise or in- tellectual capital. Failure to successfully merge cultures in such industries can be particularly problematic because key employees will depart for better work- ing conditions. The attempted 1998 merger between Computer Associates (CA) and Computer Science Corporation (CSC) ultimately failed when CA re- alized that their mishandling of the negotiations and their insensitivity to the culture at CSC would cause many of CSC’s consultants to quit the merged company. We will discuss the keys to successful implementation of mergers later in the chapter. In the next section we examine the acquisition strategy of Cisco Systems Inc. We do this to make it clear that there are ways to increase your chances of success when planning and implementing an M&A strategy. ANATOMY OF A SUCCESSFUL ACQUIRER: THE CASE OF CISCO SYSTEMS INC. Cisco Systems Inc., the Silicon Valley-based networking giant, is one of the world’s most successful corporations. Revenues for the fiscal year ending July 2000 were up an incredible 55% to $18.9 billion, while net income grew to $3.9 billion, resulting in a healthy 21% net profit margin. Even more impressive was its 10th consecutive quarter of accelerating sales growth, culminating in a 61% sales increase for the last quarter. At $356 billion, Cisco’s market capitalization trailed only General Electric Company. What is behind such phenomenal results? Beginning in 1993, Cisco has acquired 51 companies, 21 of them in the 12-month period ending March of 2000. Not every one of these deals has been a winner, and certainly some elements of Cisco’s strategy are unique to the high-technology industry. However, in a recent survey of corporate M&A poli- cies Cisco was ranked number 1 in the world, and there are lessons for any po- tential acquirer in its practices. 5 We will focus on two aspects of Cisco’s acquisition strategy: the compet- itive and economic forces behind it and how new acquisitions are merged into the corporate fold. The strategic imperative behind Cisco’s acquisition spree is simple. Each year the company gets 30% to 50% of its revenue from products that it did not sell 12 months before. Technological change means that Cisco cannot internally develop all of the products its customers need. They have two choices; to limit their offerings or to buy the products and technology they 572 Making Key Strategic Decisions can’t or choose not to develop. In this case, the strategy is driven by their cus- tomer’s demands and by the realities of the industry. Once CEO John Cham- bers and Cisco’s board made rapid growth a priority, an effective M&A plan was the only way to accomplish this goal. To minimize risk, Cisco often begins with a small investment to get a better look at a potential acquisition and to as- sess it products, customers, and culture. Finally, Cisco often looks for private and pre-IPO companies to avoid lengthy negotiations and publicity. Cisco’s 1999 acquisition of fiber-optic equipment maker Cerent Corpora- tion is a good example of this strategy. Cisco purchased a 9% stake in Cerent in 1998 as a hedge against what analysts viewed as Cisco’s lack of fiber-optic ex- pertise. Through this small investment, Cisco CEO John Chambers got to know Cerent’s top executive, Carl Russo. He quickly realized that they had both come up through the high-tech ranks as equipment salesmen and had built their companies around highly motivated and aggressive sales teams. Cer- ent’s 266 employees included a 100-member sales team that had assembled a rapidly growing customer base. Cerent also favored sparse offices—a Cisco trademark—and Mr. Russo managed the company from an eight-foot square cubicle. All of these factors gave Cisco important insights into Cerent’s strengths and corporate culture. When Mr. Chambers felt comfortable that Cerent could successfully be- come part of Cisco, he personally negotiated the $7 billion purchase price for the remaining 91% stake with Mr. Russo. The discussions took a total of two and a half hours over three days. When the deal was announced on August 25, 1999, the second—and arguably the most important—phase of Cisco’s acquisi- tion strategy kicked in. Over the years, including an occasional failure, Cisco had developed a finely tuned implementation plan for new acquisitions. The plan has three main pieces: 1. Don’t forget the customer. 2. Salespeople are critical. 3. The small things garner loyalty. There is often a customer backlash to merger announcements because customers’ perception of products and brands may have changed. In the recent spate of pharmaceutical industry mergers, only those firms that avoided pair- ing up experienced substantial sales growth. As part of the external environ- ment, customers are easy to ignore in the short term when the tendency is to focus on the internal aspects of the implementation. This is a big mistake. To allay customer fears, in the weeks after Cerent was acquired, Mr. Russo and his top sales executive attended the annual Cisco sales convention meeting and Mr. Chambers joined sales calls to several of Cerent’s main customers. This lesson did not come cheaply. When Cisco acquired StrataCom in 1996, it immediately reduced the commission schedule of StrataCom’s sales force and reassigned several key accounts to Cisco salespeople. Within a few months, a third of StrataCom’s sales team had quit, sales fell drastically, and Cisco had to scramble to retain customers. In the Cerent implementation, the Profitable Growth by Acquisition 573 sales forces of the two companies remained independent and Cerent’s sales- people received pay increases of 15% to 20% to bring them in line with Cisco’s compensation practices. As a result, there was little turnover and sales grew. Cisco executives realized early on that the strategic rationale for an ac- quisition and their grand plans for the future meant little to the target’s mid- and low-level employees. They had more basic concerns like job retention and changes in their day-to-day activities. Cisco had also learned that quickly win- ning over these employees—and keeping them focused on their jobs—was crit- ical to a successful implementation. This process begins weeks before the deal is done, as the Cisco transition team works to map each employee at the target into a Cisco job. As each Cerent employee left the meeting where the acquisi- tion was announced, they were given an information packet on Cisco, tele- phone and e-mail contacts for Cisco executives, and a chart comparing the vacation, medical, and retirement benefits of the two companies. There were follow-up sessions over the next several days to answer any lingering questions. Cisco also agreed to honor several aspects of Cerent’s personnel policies that were more generous than their own, such as providing more-generous expense allowances and permitting previously promised sabbaticals to be taken. Cisco understood that these are relatively small items in the larger context of a suc- cessful and timely transition. When the merger was actually completed, Cerent employees had new IDs and business cards within days. By the following week, the e-mail and voice- mail systems had been converted to Cisco’s standards and all of Cerent’s com- puter systems were updated. By the end of September, one month after the acquisition announcement, the new employee mapping had been implemented. Most employees kept their original jobs and bosses; about 30 were reassigned because they had positions that overlapped directly with Cisco workers. Over- all, there was little turnover. This example highlights some of the factors important to developing and implementing a successful acquisition strategy. However, all companies are not like Cisco, and what works for them may not guarantee you a winning acquisi- tion plan. Cisco is fortunate to be in a rapidly growing industry in continuous need of new technologies and products. It also has the benefit of a high stock market valuation, which makes its shares valuable currency for making acquisi- tions. At the same time, the keys to successful implementation discussed previ- ously—that is, concern for the customer, taking care of salespeople, and understanding what creates employee loyalty—are universal and must be part of any acquisition strategy. In the next section we look more closely at the ques- tion of value creation in M&A decisions. CREATING VALUE IN MERGERS AND ACQUISITIONS We have already presented the dubious historical evidence on the financial performance of mergers and acquisitions. This record makes it clear that a 574 Making Key Strategic Decisions significant number destroy shareholder value, some spectacularly. In this sec- tion, we more closely examine the issue of value creation, focusing on its sources in mergers and acquisitions. We begin the discussion with an assump- tion that the objective of managers in initiating these transactions is to increase the wealth of the bidder’s shareholders. We will ignore the reality that man- agers may have personal agendas and ulterior motives for pursuing mergers and acquisitions, even those harmful to their shareholders. A discussion of these is- sues is beyond the scope of this chapter. 6 To be very clear, recall the source of all value for holders of corporate eq- uity. Stock prices are a function of two things: expected future cash flows and the risk of those flows. These cash flows may come as dividends, share price increases, or some combination of the two, but the important thing to under- stand is that changes in share prices simply reflect the market’s expectations about future cash flows or their risk—nothing more and nothing less. If in- vestors believe a company’s cash flows in the future will be smaller or riskier, ceteris paribus, the share price will decline. If the expectation is for larger or less risky cash flows, the share price goes up. Thus, when we talk about M&A decisions creating value, there can only be two sources of that value: more cash flow or less risk. Our discussion focuses primarily on the former. Consider two independent firms, A and B, with respective values V A and V B . Assume that the managers of firm A feel that the acquisition of firm B, that is, the creation of a merged firm AB, would create value. That is, they believe V AB > V A + V B . The difference between the two sides of this equation, V AB − (V A + V B ), is the incremental value created by the acquisition, sometimes called the synergy. That is, Clearly, positive synergy would be a prerequisite to going forward with the ac- quisition. In practice, things are a bit more complicated for two reasons: the costs of an acquisition and the target premium. The acquisition process carries significant direct costs for lawyers, consultants, and accountants. There is also the indirect cost caused by the distraction of the bidder’s executives from their day-to-day operation of the existing business. Finally, the data presented in the section on mergers and acquisitions shows that target shareholders in acquisi- tions typically receive a 30% to 40% premium over market price. Some trans- actions have smaller premiums, but in almost all cases, the acquirer pays a price above the pre-acquisition market value. All of these costs can be factored into the evaluation as follows: Example 3 Midland Motorcycles Inc. is considering the acquisition of Scotus Scooters. Midland’s current market capitalization is $10 million, while Scotus has a market capitalization of $2 million. The executives at Midland feel the combined firm would be worth $14 million due to synergies. Current takeover premiums average 35% and the total cost of the acquisition is estimated at $1.5 million. Should Midland proceed with the deal? (2) Net advantage of merging = V Merger costs Premium AB A B −+ () [] −−VV (1) Synergy AB A B =−+ () VVV Profitable Growth by Acquisition 575 The deal would destroy $200,000 of value. Note that this is in spite of the fact that there are $2 million of positive synergies created by the acquisition. The reality is that this synergy is more than offset by the costs of the transaction and the premium paid for the target, a typical problem in acquisitions. For ex- ample, consider Coca-Cola’s recent interest in Quaker Oats, which Coke CEO Douglas Daft felt “fit perfectly into Coke’s strategy of boosting growth by in- creasing its share of non-carbonated drinks.” 7 Even Coke’s directors felt that the strategic rationale behind the transaction was sound. But the deal was ulti mately rejected because of the price. Warren Buffett, a major Coca-Cola shareholder, said “Giving up 10% of the Coca-Cola Company was just too much for what we would get. ” 8 Note that the bracketed term in equation 2 is just the synergy as defined in equation 1. Where does this synergy or incremental value originate? From above, we know that value can only come from two places—increased cash flows or reduced risk. In this case, the synergy can be computed as follows: where ∆CF t is the incremental cash flow in period t, and r is the appropriate risk-adjusted discount rate. The total synergy is just the present value of all fu- ture incremental cash flows. Equation 3 makes it clear that changes in future cash flows or their risk are at the root of any M&A synergies. Before consider- ing how a merger might impact cash flows, recall how they are computed: With this in mind, we can look more closely at potential sources of incremental cash flows—and therefore, value—in acquisitions. We focus on the following three areas: 1. Incremental revenue. 2. Cost reductions. 3. Tax savings. Incremental Revenue More revenue for the combined firm can come from marketing gains, strategic benefits, or market power. Increased revenue through marketing gains result from improvements in advertising, distribution or product offerings. For example, when Citicorp and Travelers Inc. announced their merger in 1998, incremental revenue was a key factor: Incremental Revenues − Incremental Costs − Incremental Taxes − Incremental Investment in New Working Capital − Incremental Investment in Fixed Assets = Incremental Cash Flow (3) Synergy = + () = ∞ ∑ ∆CF r t t t 1 0 Net advantage of merging = 1 million4 10 2 1 5 35 2 0 2−+ () [] −− × () =−$ $ $. % $ $. 576 Making Key Strategic Decisions “Finally, there is the central justification of the deal: cross-selling each other’s products, mainly to retail customers. Over the next two years, Citigroup ought to be able to generate $600 million more in earnings because of cross-selling.” 9 After acquiring Miller Brewing Company in 1970, Philip Morris used its mar- keting and advertising strength to move Miller from the number 7 to the num- ber 2 U.S. beer maker by 1977. Some acquisitions provide strategic benefits that act as insurance against or options on future changes in the competitive environment. As genetic re- search has advanced, pharmaceutical firms have used acquisitions to ensure they participate in the commercial potential offered by this new technology. The 1998 acquisition of SmithKline Beecham PLC by Glaxo Wellcome PLC was motivated by Glaxo’s fear of missing out on this revolution in the industry. SmithKline had entered the genetic research field in 1993 by investing $125 million in Human Genome Sciences, a Rockville, Maryland, biotechnology company created to commercialize new gene-hunting techniques. Finally, the acquisition of a competitor may increase market share and allow the merged firm to charge higher prices. By itself, this motive is not valid justification for initiating a merger, and any deal done solely to garner monopo- listic power would be challenged by global regulators on antitrust grounds. However, market power may be a by-product of a merger done for other rea- sons. American Airline’s potential bid for USAir, while launched primarily to thwart a similar attempt by its competition, would also have implications for market power in the industry. American is particularly worried about the prospect of USAir falling into United’s hands. Nabbing the carrier for itself would give American coveted slots at Chicago’s O’Hare, New York’s LaGuardia, and Washington’s National Airport. 10 Cost Reductions Improved efficiency from cost savings is one of the most often cited reasons for mergers. This is especially true in the banking industry, as the recent merger between J.P. Morgan and Chase Manhattan makes clear. The key to executing the merger, say analysts, will be how quickly Chase can trim its expenses. It plans to save $500 million through job cuts, $500 million by consolidating the processing systems of the two institutions and $500 million by selling off excess real estate. In London, for example, the two banks have 21 buildings, and they won’t need all of them. 11 In total, there is an estimated $1.5 billion of annual savings. The link between this and value creation is easy for investors to understand and the benefits from cost reductions are relatively easy to quantify. These benefits can come from economies of scale, vertical integration, complementary resources, and the elimination of inefficient management. Economies of scale result when a certain percentage increase in output results in a smaller increase in total costs, resulting in reduced average cost. It Profitable Growth by Acquisition 577 doesn’t matter whether this increased output is generated internally or ac- quired externally. When the firm grows to its “optimal” size, average costs are minimized and no further benefits are possible. There are many potential sources of economies of scale in acquisitions, the most common being the abil- ity to spread fixed overhead, such as corporate headquarters expenses, execu- tive salaries, and the operating costs of central computing systems, over additional output. Vertical integration acquisitions can reduce costs by removing supplier volatility, by reducing inventory costs, or by gaining control of a distribution network. Such benefits can come in any industry and for firms of all sizes. Waste Systems International, a regional trash hauler in the United States, ac- quired 41 collection and disposal operations between October 1996 and July 1999 with the goal of enhancing profitability. The business model is fairly straightforward. Waste Systems aims to own the garbage trucks that pick up the trash at curbside, the transfer stations that con- solidate the trash, and the landfills where it’s ultimately buried. Such vertical integration is seen as crucial for success in the waste business. Owning landfill space gives a trash company control over its single biggest cost, disposal fees, and, equally important, produces substantial economies of scale. 12 One firm may acquire another to better utilize its existing resources. A chain of ski retailers might combine with golf or tennis equipment stores to better utilize warehouse and store space. These types of transactions are typical in industries with seasonal or very volatile revenue and earnings patterns. Personnel reductions are often used to reduce costs after an acquisition. The savings can come from two sources, one being the elimination of redundan- cies and the second the replacement of inefficient managers. When firms com- bine, there may be overlapping functions, such as payroll, accounts payable, and information systems. By moving some or all of the acquired firm’s functions to the bidder, significant cost savings may be possible. In the second case, the tar- get firm managers may actually be making decisions that limit or destroy firm value. By acquiring the firm and replacing them with managers who will take value-maximizing actions, or at least cease the ones that destroy value, the bid- der can effect positive changes. The U.S. oil industry in the late 1970s provides an excellent example of this. Excess production, structural changes in the industry, and macroeco- nomic factors resulted in declining oil prices and high interest rates. Explo- ration and development costs were higher than selling prices and companies were losing money on each barrel of oil they discovered, extracted, and re- fined. The industry needed to downsize, but most oil company executives were unwilling to take such action and as a result, continued to destroy shareholder value. T. Boone Pickens of Mesa Petroleum was one of the few industry partic- ipants who not only understood these trends, but was also willing to act. By ac- quiring several other oil companies and reducing their exploration spending, Pickens created significant wealth for his and the target’s shareholders. 13 . successfully merge cultures in such industries can be particularly problematic because key employees will depart for better work- ing conditions. The attempted. portunities in design, procurement, and manufacturing. The deal was billed as a true partnership, and the new firm would keep operational headquarters in both Stuttgart