Merger Mania

Each Monday I post the next section of my 2001 book, which was originally called (by the publisher) Hoover’s Vision but which I have now retitled The Art of Enterprise. I have posted over half of it already; click on the “Monday” column to see all the prior sections. The entire book can be downloaded as a PDF for $10 at





Merger Mania

Industry structure is the study of questions like the following:
·                     Are there a multitude of enterprises at work in the industry, or is it an oligopoly – only a few giants – or even a single-company monopoly?
·                     Is it easy for new companies to enter the industry or has it been the same players for years?
·                     What is the rate of mergers – high, low, or non-existent?
·                     What is the rate of spinoffs and breakups?
I first studied this field – sometimes called Industrial Organization – over thirty years ago. At the time, it was a pretty esoteric field limited to a few economists (including the great George Stigler) and antitrust lawyers and scholars. But I believe this is a field that everyone should look at.
Some of my observations run against the “common wisdom.” For example, I believe that one of the most common signs of corporate (and industry) illness is the merger between two giant companies. While Wall Street and the financial press rarely pick up the signals, many mergers reflect a sad state of affairs, particularly at the acquiring corporation. Most companies react to merger news (or rumors) as though the opposite were true. When their competitors announce big mergers, they respond by desperately trying to arrange mergers of their own. However, most mergers should be seen not as threats but as opportunities for the competition. Why do I say these things, which may seem counter-intuitive? For seven reasons:
¨       Mergers are rarely done for the right reasons.
¨       Size is not all it is cracked up to be.
¨       Vertical integration is even less what it is cracked up to be.
¨       Big merger deals tend to take management’s eye off the ball.
¨       Mergers are always more difficult to carry off than expected.
¨       Great companies are usually focused on a single business.
¨       Great companies usually prefer to grow from within rather than through acquisitions.
First, let’s consider the reasons for mergers – most of which, as I’ve suggested, are misguided. Major reasons that are publicly cited for merger deals include:
¨       “Our competitors are merging, and so we must merge to stay competitive.”
¨       “The large size of our newly combined companies will allow tremendous cost-savings as we eliminate duplication.”
¨       “We will pull off tremendous synergies – one plus one equals three.”
¨       “We will get better control over our sources of supply and our distribution channels through vertical integration.”
Of course, many business leaders want to believe these things. CEOs and board members fall prey to the lure of the big deal, the “transforming transaction,” and the desire to make their company the focus of industry-wide attention. The strategic consultants and investment bankers present at the high-level meetings (who may profit from merger activity) are unlikely to say “Forget about doing this deal – send us home.” Everyone gets caught up in the sex appeal of the merger.

The Myth of Size

Probably the number one wrong reason given for a merger is sheer size. The assumption seems to be that bigger is better, so merging will make us better, stronger, more competitive. But consider these facts:
Size is the enemy of the customer. Larger firms tend to become more bureaucratic, more institutional and procedural, and more rule-bound. They often have less room for unique and entrepreneurial individuals. By contrast, smaller firms are usually more able to “turn on a dime,” to be responsive to the customer, and to involve the owners or leaders of the business in customer interaction.
Size is the enemy of vision and culture. A clear, consistent, unique vision is easier to maintain in a smaller organization than in a big one. If you study the greats like Southwest Airlines or Home Depot you will see companies that are always growing because they want to bring their greatness to more people, they want to create more jobs, and they want to enrich their shareholders. But the bigger they get, the harder these companies have to work to maintain their culture, their vision, and their unique spirit. Every new city they enter, every new store, every new division makes life harder, so they must be certain that each increment to their size is a valid expansion that continues along their visionary track. The great companies understand that growth must more than compensate for the inevitable loss that comes with increased size. And they regard the benefits of possible acquisitions with skepticism.
Size brings complexity. Especially when an organization acquires a company that is in a different business, even a slightly different one, the complexity of the leadership challenge increases enormously. Complexity is the enemy of simplicity, the enemy of clear vision.
Size alone does not win. Twenty years ago, IBM was the largest software company and the largest computer hardware company. Sears was the largest retailer. Zenith was the largest TV company. CBS was the largest television broadcaster. None of these is number one in its field today. Clearly there are other things that are more important than size.
Size brings diseconomies of scale. People talk of economies of scale but they haven’t reread their old economics textbooks. Because right after economies of scale come diseconomies of scale. That is, up to a point you get more efficient as you get bigger. A car factory that makes 100 cars a year cannot buy supplies and schedule workers as effectively as a plant that makes 20,000 cars a year. But manufacturer after manufacturer comes to realize that there is an ideal size for factories in their industry. Hewlett Packard learned years ago that the ideal plant size is not that huge. It is big enough to be efficient but small enough to maintain a sense of community and to be manageable by humans, by people who can stay in touch with the plant. Our education system is more likely to improve when educators realize that class size may be less important than school size.
So the goal should not be to build the largest plant on earth – or the largest farm or bank or retail chain. Those often fail to achieve their aims. The goal should be to build the best. If you become biggest because you are the best rather than through helter-skelter acquisitions, as Wal-Mart has done in discount stores or John Deere in tractors, that is a different story. These companies still have to fight the demon of size, but at least they can fight it with a unified culture and vision.
The benefits of vertical integration are usually a fantasy. Most mergers fall into one of two traditional categories: horizontal mergers and vertical mergers.
Horizontal mergers are mergers of peers. When the Burlington Northern Railroad took over the Santa Fe, they created an end-to-end system that was in the same exact business in different parts of the country. When a Houston dry cleaner mergers with a dry cleaning chain from Dallas, that’s a horizontal merger. But when companies acquire other companies that are “up the chain” or “down the chain,” that’s a vertical merger. For example, from time to time in their history, the movie-making companies have decided they should own the theatres so that they can control their distribution of their products. At one time, retailers owned textile factories, and most of the big newspapers bought paper companies and forests. These are vertical mergers. And one thing that history teaches us is that vertical deals often do not work.
A good example from the 90s is the acquisition of ABC by Disney. Both were great companies. The surviving parent, Disney, is still a great company. But I believe that Disney would be greater still had it not bought ABC. Go back to the 1950s, when Leonard Goldenson’s ABC and the Walt Disney Company were both struggling. As I explained earlier, the two firms cut a deal under which ABC aired a Disney show every Sunday night. ABC got a real boost to its lineup on the most important night in prime time TV, and Disney got an invaluable promotional vehicle for its new theme park, Disneyland. Two creative, driven entrepreneurs put together an arms-length deal that benefited both companies – perhaps rescuing both from failure.
Fast forward to today. If Disney has a great idea for a new TV show, can they play off ABC against NBC in search of the most advantageous deal? No. And if CBS has the perfect spot in its fall lineup for a new family-oriented show, do they call Disney? Probably not. Instead, they start talking with one of Disney’s competitors.
Apple Computer has recently announced that they are opening twenty-five retail stores in an effort to halt the decline in their share of the personal computer market (currently five percent and shrinking). I fear that this excellent company may soon learn, as Viacom, Gateway, and Warner Brothers already have, that running profitable retail stores is not a sideline. It is a tough business. Apple has hired key managers from some of the best large retailers, but running stores for a big, established retail company is not the same as starting a chain from scratch. Believe me, I know from experience. If Apple sees their stores purely as an advertising vehicle, maybe they can justify them – and the money they are likely to lose. But the odds are against a company with no retail experience achieving their published projection of “a profitable chain by the second year.” The company made this projection even before a test store was up and running, really tempting fate.
I think Apple would have greater odds of success in spreading the gospel of Apple computing if they used existing retailers more aggressively rather than striking out on their own. Who knows? Maybe Apple will be the exception and beat the odds. But I doubt it.
A vertically integrated system where suppliers are inextricably linked to specific customers is inflexible. Henry Ford’s famous River Rouge Plant was one of the most amazing industrial facilities ever built, enabling Ford to put together a complete car from raw materials in one location, even making its own steel and glass. Today the auto producers are spinning off their parts plants, and none of them want to be in the steel or glass business.
In the same vein, Wal-Mart is perfectly happy letting Sony make the television sets; Sony is happy letting Wal-Mart sell them. They both retain the flexibility to carry out their mission – with or without each other.
Mergers are always harder to pull off than people think. When Boeing bought down-on-its-luck competitor McDonnell-Douglas, it seemed like a straightforward move by a strong company taking over a weak sister. But years later, Boeing was still wrestling with how to merge the cultures of the two companies and make sense of the resulting hybrid. Boeing has never been the same since the merger.
Integrating companies is even harder when different industries are involved. Over the years, many enterprises have tried to diversify, believing that this would reduce their vulnerability to slowdowns or market reversals in specific business. Some have even sought to become conglomerates, holding companies that brought together dozens of diverse, unrelated firms under a single corporate banner. In the great conglomerate era of the 70s, Beatrice Foods, ITT, Litton Industries, Gulf & Western, and other conglomerates were formed by strong leaders like Bill Karnes, Harold Geneen, Tex Thornton, and Charlie Bluhdorn, respectively. But in each case, the conglomerate was dismantled soon after the end of the founder’s reign. One of the few diversified enterprises to stand the test of time is General Electric – and even there, I can make the case that the parts would be more valuable than the whole.
The future will bring more big mergers, but it will also bring spinoffs of unrelated businesses and dismantlings of diverse corporations, like those underway today at AT&T, GM, RJR Nabisco, and Philip Morris. There will also be a continuing rise in creative alternatives to mergers – strategic alliances, partnerships, and joint ventures. The global airline alliances like Star Alliance and One World are perhaps the most prominent examples today.
Having heard this litany of the disadvantages of mergers, you may want to ask: If mergers are so unproductive, then why do all the big companies do them? In the first place, many of our greatest companies do not “do mergers,” or do them only very rarely and with the greatest of care. They understand that most great companies are created from within, based on products and services that naturally evolve inside the company rather than on outside acquisitions. Study the history of the greatest enterprises, and you will see that the vast bulk of their growth has usually come from internal sources. I would mention Microsoft, McDonald’s, Home Depot, Wal-Mart, and Hewlett-Packard for starters. Wall Street calls such a company a pure play, because they do one thing and if you want to invest in that thing, you can do so on an undiluted basis.
When the business headlines declared that the pharmaceutical companies must merge in order to stay competitive, how many mergers took place at Johnson and Johnson or Merck? Very few.
While United Airlines was investing a great deal of time and money in trying to buy USAir before killing the deal, Southwest was zooming past them in market value and profitability, with almost none of its success (or growth) attributable to mergers.
A few years ago, computer giant Compaq became the talk of the industry when they acquired established industry player Digital Equipment. Some asked, “Whom will Dell buy to keep up?” Michael Dell took a different tack. He told the press, “This is a great day for Dell. Now we can pick up all those customers who aren’t happy with our competitors’ merger.” Most people thought he was just whistling in the dark. But in the first quarter of 2001, Dell sold 12.5% of all the PCs in the world, while Compaq sold 12.1%, the first time Compaq has lost the lead. Now Compaq has announced that it is “de-emphasizing” hardware, often a precursor of completely pulling out.
Are there any mergers that make sense? You may have good reason to consider a merger if the merger will help your enterprise:
¨       Make better products or provide superior services
¨       Improve life for your customers
¨       Save jobs that otherwise would be lost
¨       Balance strengths with weaknesses, downtimes with good times, East with West
¨       Acquire valuable assets cheap
Mergers can be a powerful way to extend the geography of an enterprise – not cheaply or easily, but perhaps quickly. Or to extend the each of the enterprise to different customer classes.
I am in the minority today in believing that the DaimlerChrysler merger may turn out to be a smart one. Today those companies are embroiled in all the agonies of integrating two companies, paying the price described above. But if they are smart (and lucky), when the dust settles they will have combined a global luxury brand with an innovative North and South American brand, a company strong in trucks and sedans with one that is strong in minivans and sport utility vehicles, an innovative styling and design team with one of the world’s greatest engineering organizations. Given how risky any merger is, I can’t be certain that things will unfold this happily for DaimlerChrysler. But I would give them pretty good odds of long-term success.
Mergers that allow one company to pick up the pieces of another can also pay off. The May Department Stores Company has posted over twenty consecutive years of record earnings per share in a mature industry. Their acquisitions are rare; they spend more energy spinning off things that don’t fit than looking for new things to take on. But in the spring of 2001, May acquired a number of vacant Montgomery Ward stores after that company’s closure. This is a pure real estate (asset) play, and one that probably makes good sense from a business standpoint.
In other cases, companies are acquired to get their talent, their management, their customer list, their technology, their faded brand name, or their product assets (an archive of great old movies or a pipeline full of promising new drugs). While acquisitions like these can be just as tough to carry off as any others, at least they sometimes make more economic sense than mergers consummated for size or ego alone.



Learning More about the Structure of Industry

The Structure of American Industry by Walter Adams and James W. Brock is the classic textbook about how industries are structured, using real industries for examples – from beer and computers to college sports. Great book.