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Acquisition and Restructuring Strategies
1. Explain the popularity of acquisition strategies in firms competing in the global economy. 2. Discuss reasons why firms use an acquisition strategy to achieve strategic competitiveness. 3. Describe seven problems that work against developing a competitive advantage using an acquisition strategy. 4. Name and describe attributes of effective acquisitions. 5. Define the restructuring strategy and distinguish among its common forms. 6. Explain the short- and long-term outcomes of the different types of restructuring strategies.
Opening Case The Increased Trend Toward Cross-Border Acquisitions THE POPULARITY OF MERGER AND ACQUISITION STRATEGIES
Mergers, Acquisitions, and Takeovers: What Are the Differences?
REASONS FOR ACQUISITIONS Increased Market Power
Strategic Focus Oracle Makes a Series of Horizontal Acquisitions While CVS Makes a Vertical Acquisition
Overcoming Entry Barriers Cost of New Product Development and Increased Speed to Market Lower Risk Compared to Developing New Products Increased Diversification Reshaping the Firm’s Competitive Scope Learning and Developing New Capabilities
PROBLEMS IN ACHIEVING ACQUISITION SUCCESS Integration Difficulties Inadequate Evaluation of Target Large or Extraordinary Debt Inability to Achieve Synergy Too Much Diversification Managers Overly Focused on Acquisitions Too Large
EFFECTIVE ACQUISITIONS RESTRUCTURING Strategic Focus DaimlerChrysler Is Now Daimler AG: The Failed Merger with Chrysler Corporation Downsizing
Downscoping Leveraged Buyouts Restructuring Outcomes
SUMMARY REVIEW QUESTIONS
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EXPERIENTIAL EXERCISES NOTES
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Chapter Introduction: With continued merger and acquisition activity, this chapter is very important. The chapter’s material is summarized in Figure 7.1, which can be used to help students mentally organize what they learn in the chapter about mergers and acquisitions.
OPENING CASE The Increased Trend toward Cross-Border Acquisitions
Cross-border business is becoming more prevalent each year. The number of cross-border acquisitions is one indicator of the intensity of global markets. Foreign direct investments increased 76.7 percent from 2005 to 2006. Both the United States and the United Kingdom have become beneficiaries from having open borders and markets that allow foreign capital to purchase domestic assets and from the importation of foreign managerial talent associated with managing acquired assets. However, concerns have surfaced about whether or not foreign acquisitions will make it much harder for domestic employees to become top- level managers. Examples of foreign takeovers include renowned professional soccer team, Manchester United, which was purchased by a U.S. sports tycoon.
Students should note that the U.S. and UK are not the only targets of foreign investors. Other European firms, such as those from Spain, have been purchasing a significant number of foreign firms. Spanish firms gained experience through an international push in Latin America decades ago. Particularly Telefonica, a large telecommunication firm, purchased a number of telecommunication companies that had been privatized in Latin American. This experience has now been transferred across Europe not only in the merging of telecommunication firms and banks, but also in merging train and airport management services, and infrastructure management services. Recently Abertis sought to takeover Autostrade SpA, providing the Spanish firm control over the train routes in Italy and other countries in Europe. Japanese firms have also become active in large overseas takeovers after being somewhat inactive for a number of years.
Many firms, not only from developed countries, but also from emerging economies, are increasingly becoming involved in merger and acquisition activities. In the latter half of the twentieth century, acquisition became a prominent strategy used by major corporations to achieve growth and meet competitive challenges. Even smaller and more focused firms began employing acquisition strategies to grow and to enter new markets. However, acquisition strategies are not without problems, as some acquisitions fail.
Interestingly, much of the acquisition activity by European and Japanese firms have been driven by currency valuations, especially relative to the United States, as the dollar is much lower in value than either the euro or the Japanese yen currencies compared to the 1990s. Emerging economies, such as India, have become quite aggressive in overseas transactions as well. India’s Tata Group won the bid for British steel maker Corus Group PLC for $13.2 billion.
In summary, the number of cross-border deals continues to increase, leading many emerging-country firms to pursue acquisitions in developed countries, especially in the United States, the United Kingdom, and elsewhere in Europe. These developed economies have more open policies that allow emerging-country economies to make inroads, especially in mature globalizing businesses such as steel and aluminum, or basic services including managing airports and railroads.
American firms have been the most active acquirers of companies outside their domestic market, but in the global economy, companies from all over the world are choosing this strategic option with increasing frequency (despite the fact that such acquisitions can be difficult to negotiate and later to operate because of the differences in foreign cultures). Still other firms diversify primarily via acquisition. For example, Telefonica of Spain has acquired a number of recently privatized Latin American telecommunication companies to compete against cable firms entering the local phone service business. Similarly, Autotrade of Italy has become a targeted acquisition of Abertis of Spain. Autotrade oversees Italy’s toll road system. But despite sound logic for acquisition, integration and
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synergy formation can prove very elusive. Make a short list of the most likely challenges to acquisition. What steps can firms take to avoid these?
1 Explain the popularity of acquisition strategies in firms competing in the global economy.
In the latter half of the 20th century, acquisition became a prominent strategy used by major corporations to achieve growth and meet competitive challenges. Even smaller and more focused firms began employing acquisition strategies to grow and to enter new markets. However, acquisition strategies are not without problems; a number of acquisitions fail. Thus, the chapter focuses on how acquisitions can be used to produce value for the firm’s stakeholders.
THE POPULARITY OF MERGER AND ACQUISITION STRATEGIES
Acquisitions have been a popular strategy among U.S. firms for many years. Some believe that this strategy played a central role in the restructuring of U.S. businesses during the 1980s, 1990s, and into the twenty-first century.
Increasingly, acquisition strategies are becoming more popular with firms in other nations (e.g., those of Europe). In fact, about 40 to 45 percent of the acquisitions in recent years have been made across country borders (i.e., where a firm headquartered in one country acquires a firm headquartered in another country).
Merger and acquisition trends: • There were five waves of mergers and acquisitions in the 20th century, the last two in the 1980s and 1990s. • There were 55,000 acquisitions valued at $1.3 trillion in the 1980s. • Acquisitions in the 1990s exceeded $11 trillion in value. • World economies (especially the U.S. economy) slowed in the new millennium, reducing M&As completed. • Mergers and acquisitions peaked in 2000 at about $3.4 billion and fell to about $1.75 billion in 2001. • The global volume of announced acquisition agreements was up 41 percent from 2003 to $1.95 trillion for
2004, the highest level since 2000, and the pace in 2005 was significantly above the level of 2004. • Although the frequency of acquisitions has slowed, their number remains high. • In the latest acquisition boom between 1998 and 2000, acquiring firm shareholders experienced significant
losses relative to the losses in all of the 1980s.
A firm may make an acquisition to do the following: • increase its market power because of a competitive threat • enter a new market because of an available opportunity • spread the risk due to the uncertain environment • shift its core business into more favorable markets (e.g., because of industry or regulatory changes)
Evidence suggests that at least for acquiring firms, acquisition strategies may not result in desirable outcomes. Studies have found that shareholders of acquired firms often earn above-average returns from an acquisition, while shareholders of acquiring firms are less likely to do so. In approximately two-thirds of all acquisitions, the acquiring firm’s stock price falls immediately after the intended transaction is announced, indicating investors’ skepticism about the likelihood that the acquirer will be able to achieve the synergies required to justify the premium.
Mergers, Acquisitions, and Takeovers: What Are the Differences?
Before starting the discussion of the reasons for acquisitions, problems related to acquisitions, and long-term performance, three terms should be defined because they will be used throughout this chapter and Chapter 10.
A merger is a transaction where two firms agree to integrate their operations on a relatively co-equal basis because they have resources and capabilities that together may create a stronger competitive advantage.
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An acquisition is a transaction where one firm buys a controlling or 100 percent interest in another firm with the intent of making the acquired firm a subsidiary business within its portfolio.
While most mergers represent friendly agreements between the two firms, acquisitions sometimes can be classified as unfriendly takeovers. A takeover is an acquisition—and normally not a merger—where the target firm did not solicit the bid of the acquiring firm and often resists the acquisition (a hostile takeover).
2 Discuss reasons why firms use an acquisition strategy to achieve strategic competitiveness.
REASONS FOR ACQUISITIONS
Teaching Note: You may find it helpful to refer students to Figure 7.1, which lists the reasons for acquisitions (discussed more fully in the sections that follow).
STRATEGIC FOCUS Oracle Makes a Series of Horizontal Acquisitions While CVS Makes a Vertical Acquisition
Oracle, SAP, and Microsoft compete in the database management software arena. SAP holds approximately 22 percent of the market share while Oracle and Microsoft each hold 10 and 5 percent respectively. Competitive intensity between these three players is becoming more intense as they target customer firms that have not integrated their firms’ business units using databases. Once a software provider is selected by a targeted firm, it becomes relatively costly for that firm to switch to another platform. Because of these significant switching costs, Oracle is utilizing a horizontal acquisition strategy in order to pursue growth. The logic applied is that each acquisition has an established customer-base that will likely be retained because of the high switching costs incurred to switch platforms. In addition, the products offered by the acquired firm’s sales force will be expanded to include Oracle’s catalog, and Oracle’s sales staff will have an expanded catalog to offer current Oracle customers.
Oracle’s acquisition strategy began when Oracle’s CEO, Larry Ellison, decided that the corporate-software industry had matured and needed consolidation. A series of acquisitions led to Oracle’s 50 percent revenue increase to $17.7 billion in the fiscal year ending May 2007. The acquisitions also enabled Oracle to develop a refined set of industry focuses with applications in retail, financial services, utilities, communications, and government service.
In addition, Oracle acquired three organizations specializing in retail software. These acquisitions allowed Oracle to win thirty new retail customers in 2006 and 2007, including Wal-Mart, Nordstrom, and Perry Ellis International. Perry Ellis International expects to save more than $20 million a year in improved just- in-time inventory controls, improved merchandising efficiency, and software that helps to adapts its pricing by store and region efficiently through the application of the newly integrated Oracle software applications.
Comparatively, SAP is ahead in specific industry applications. It has applications in twenty-six industries compared to Oracle’s five. Also, beyond large corporations in specific industries, both companies are pursuing growth in small- to medium-sized enterprises.
In a vertical merger, CVS Corporation, a drugstore chain, purchased pharmacy-benefits manager (PBM) Caremark RX, Inc., for $21 billion in 2007. The combined company will have $75 billion in annual sales, far higher than any other competitor, including Walgreens and comparable PBMs such as Medco Health. In this vertical acquisition CVS is purchasing a powerful customer that negotiates on behalf of large companies and their health insurance providers. One of the incentives for this vertical merger is that PBMs have put pressure on drugstores by negotiating prices on behalf of their clients and forcing firms into mail- order plans for prescription drugs. The merger will help CVS obtain large deals with big companies by offering significant discounts to employees for CVS private-label products. When Wal-Mart began
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charging much lower prices for generic drugs in many of their stores, drugstores and PBM firms felt additional pressure for mergers. Walgreens, a large competitor of CVS, also plans to increase its PMB business, but it has not signaled whether it will use an acquisition process.
Students should be able to differentiate between horizontal and vertical acquisitions and the reasons for each. The above examples of both vertical and horizontal acquisitions are well explained. You may want to defer discussion of this article until you visit the later one on DaimlerChrysler. The above acquisitions have achieved operational and financial goals. The DaimlerChrysler merger did not achieve intended goals and can be considered a failure. Perceived synergies never came to fruition, and differences in markets were too great to overcome. How did Oracle, SAP, and CVS overcome these common snags?
Increased Market Power
As discussed in Chapter 6, a primary reason for acquisitions is that they enable firms to gain greater market power. Acquisitions to meet a market power objective generally involve buying a supplier, a competitor, a distributor, or a business in a highly related industry.
While a number of firms may feel that they have an internal core competence, they may be unable to exploit their resources and capabilities because of a lack of size.
When a competitor in the same industry is acquired, a firm has engaged in a horizontal acquisition. Horizontal acquisitions increase a firm’s market power by exploiting cost-based and revenue-based synergies.
Research suggests that horizontal acquisitions of firms with similar characteristics result in higher performance than when firms with dissimilar characteristics combine their operations. Examples of important similar characteristics include strategy, managerial styles, and resource allocation patterns.
Horizontal acquisitions are often most effective when the acquiring firm integrates the acquired firm’s assets with its assets, but only after evaluating and divesting excess capacity and assets that do not complement the newly combined firm’s core competencies.
A vertical acquisition has occurred when a firm acquires a supplier or distributor, which is positioned either backward or forward in the firm’s cost/activity/value chain.
When a target firm in a highly related industry is acquired, the firm has made a related acquisition.
Teaching Note: Remind students that, as discussed in Chapter 6, during the 1960s and 1970s, both horizontal and related acquisitions were discouraged as they were regularly challenged by agencies of the federal government. The ability of firms to make horizontal acquisitions increased in the 1980s because of changes in the interpretation and enforcement of anti-trust laws and regulations by the courts and the Justice Department.
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It is important to note that acquisitions intended to increase market power are subject to regulatory review, as well as to analysis by financial markets.
Overcoming Entry Barriers
As discussed in Chapter 2, barriers to entry represent factors associated with the market and/or firms operating in the market that make it more expensive and difficult for new firms to enter the market.
It may be difficult to enter a market dominated by large, established competitors. As noted in Chapter 2, such markets may require: • investments in large-scale manufacturing facilities that enable the firm to achieve economies of scale so that
it can offer competitive prices • significant expenditures in advertising and promotion to overcome brand loyalty toward existing products • establishing or breaking into existing distribution channels so that goods are convenient to customers
When barriers to entry are present, the firm’s best choice may be to acquire a firm already having a presence in the industry or market. In fact, the higher the barriers to entry into an attractive market or industry, the more likely it is that firms interested in entering will follow acquisition strategies.
Entry barriers firms face when trying to enter international markets are often great. Commonly, acquisitions are used to overcome entry barriers in international markets. It is important to compete successfully in these markets since global markets are growing faster than domestic markets. Also, five of the emerging markets (China, India, Brazil, Mexico, and Indonesia) are among the fastest growing economies in the world.
Acquisitions between companies with headquarters in different countries are called cross-border acquisitions.
Teaching Note: Chapter 9 examines cross-border alliances and the justification for their use. Cross-border acquisitions and cross-border alliances are alternatives firms consider while pursuing strategic competitiveness. Compared to a cross-border alliance, a firm has more control over its international operations through a cross-border acquisition.
Historically, U.S. firms have been the most active acquirers of companies outside their domestic market. However, in the global economy, companies throughout the world are choosing this strategic option with increasing frequency. In recent years, cross-border acquisitions have represented as much as 40 percent of the total number of acquisitions made annually.
Some trends in cross-border acquisitions: • Because of relaxed regulations, the amount of cross-border activity among nations within the European
community also continues to increase. • Many large European corporations have approached the limits of growth within their domestic markets and
thus seek growth in other markets. • Many European and U.S. firms participated in cross-border acquisitions across Asian countries that
experienced a financial crisis due to significant currency devaluations in 1997, and this facilitated the survival and restructuring of many large Asian companies such that these economies recovered more quickly than they would have otherwise.
Acquisitions represent a viable strategy for firms that wish to enter international markets because these: • may be the fastest way to enter new markets • provide more control over foreign operations than do strategic alliances with a foreign partner
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Cost of New Product Development and Increased Speed to Market
Acquisitions also may represent an attractive alternative to developing new products internally because of the cost and time required to start a new venture and achieve a positive return.
Also of concern to firms’ managers is achieving adequate returns from the capital invested to develop and commercialize new products—an estimated 88 percent of innovations fail to achieve adequate returns. Perhaps contributing to these less-than-desirable rates of return is the successful imitation of approximately 60 percent of innovations within four years after the patents are obtained. Because of outcomes such as these, managers often perceive internal product development as a high-risk activity.
Internal development of new products is often perceived by managers to be costly and to represent high risk investments of firm resources. While sometimes costly, it may be in the firm’s best interest to acquire an existing business because of the following: • The acquired firm has established sales volume and customer base, thus yielding predictable returns. • The acquiring firm gains immediate market access.
In addition to representing attractive prices, large pharmaceutical firms have used acquisitions to supplement products in the pipeline with projects from undervalued biotechnology companies; thus, this is one way to appropriate new products.
Lower Risk Compared to Developing New Products
As discussed earlier, internal product development processes can be risky, in that entering a market and earning an acceptable return on investment requires significant resources and time. All the same, acquisition outcomes can be estimated easily and accurately (as compared to the outcomes of an internal product development process), causing managers to view acquisitions as carrying lowering risk.
Teaching Note: Not long ago, P&G acquired premium dog and cat food manufacturer Iams Co. to support the launch of its pet products into supermarket chains and mass merchandisers such as Wal-Mart. Having assessed the potential of Iams in the marketplace, P&G managers were confident they would achieve positive results through their strategy; thus, they may have considered entry into the premium pet-food market through acquisition to be less risky than entering the market via internal product development.
Because acquisitions recently have become such a common means of avoiding risky internal ventures, they could become a substitute for innovation, which has a serious downside (e.g., the decline of Cisco systems).
Teaching Note: Although they often enable firms to offset the risk of internal ventures and of developing new products, acquisitions are not without risks of their own. Acquisition-related risks will be discussed later in this chapter.
It should be easier for firms to develop new products and/or new ventures within their current markets because of market-related knowledge, but firms that desire to enter new markets may find that current product-market knowledge and skills are not transferable to the new target market.
Acquisitions also may have gained in popularity as a related or horizontal diversification strategy (enabling rapid moves into related markets, or to expand market power) and as an unrelated diversification strategy because of the changes in regulatory interpretation and enforcement of anti-trust laws discussed in Chapter 6.
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United Technologies: A Mini-Case
Both related diversification and unrelated diversification can be implemented through acquisitions. For example, United Technologies has used acquisitions to build a conglomerate firm by assembling a portfolio of stable and noncyclical businesses (including Otis Elevator Co. and Carrier air conditioning) since the mid-1970s in order to reduce its dependence on the volatile aerospace industry. It main businesses have been Pratt & Whitney jet engines, Sikorsky helicopters, and aerospace-parts maker Hamilton Sundstrand. It has also acquired a hydrogen-fuel-cell business. However, perceiving an opportunity in security due to problems at airports and because security has become a top concern for both governments and corporations, United Technologies acquired Chubb PLC, a British electronic- security company, for $1 billion. With its acquisition of Kidde PLC, in the same general business, in 2004 for $2.84 billion, UTC will have obtained 10 percent of the world’s market share in electronic security. All businesses UTC purchases are involved in manufacturing industrial and commercial products. However, many involve relatively low technology (e.g., elevators, air conditioners and security systems).
Using acquisitions to diversify a firm is the quickest and often the easiest way to change its portfolio of businesses—e.g., Goodrich evolved from a tire maker to a top-tier aerospace supplier through 40+ acquisitions.
Firms must be careful when making acquisitions to diversify their product lines because horizontal and related acquisitions tend to contribute more to strategic competitiveness, and thus they are more successful than diversifying acquisitions.
Teaching Note: Remember, related diversification seeks lower costs through economies of scope, synergy, and resource sharing, while unrelated diversification hopes to realize financial economies and better internal resource allocation among diverse businesses.
Reshaping the Firm’s Competitive Scope
To reduce intense rivalry’s negative effect on financial performance, a firm may use acquisitions as a way to restrict its dependence on a single or a few products or markets.
Teaching Note: The following are examples of auto manufacturers that have gone through acquisitions to reduce dependence of too few businesses: • General Motors acquired Electronic Data Systems and Hughes Aerospace to lessen its
dependence on the domestic automobile market (where its market share had declined from approximately 50 percent in 1980 to less than 30 percent 10 years later) and escape intense competition with Japanese automakers. However, GM later sold these businesses to focus its efforts on its core automobile business.
• DaimlerChrysler considered expanding into financial and computer services, aftermarket sales, and electronics and satellite systems to pursue more desirable operating margins in areas that are more attractive than are alliances or acquisitions in car manufacturing.
• Ford management considered making the company the world’s leading consumer services business that specializes in the automotive sector by tapping all sectors in after-sales markets, including repairs, replacement parts, and product servicing. To evaluate its success in reshaping the firm’s competitive scope through diversification, Ford would measure its performance against world-class consumer firms, regardless of industry (i.e., rather than using the traditional yardsticks of rival automakers).
Learning and Developing New Capabilities
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Some acquisitions are made to gain capabilities that the firm does not possess —e.g., acquisitions used to acquire a special technological capability. Acquiring other firms with skills and capabilities that differ from its own helps the acquiring firm to learn new knowledge and remain agile, but firms are better able to learn these capabilities if they share some similar properties with the firm’s current capabilities.
One of Cisco System’s primary goals in its early acquisitions was to gain access to capabilities that it did not currently possess through its commitment to learning. The firm developed an intricate process to quickly integrate the acquired firms and their capabilities (knowledge) after an acquisition is completed.
Figure Note:Figure 7.1 presents the reasons for making acquisitions and the problems encountered. A comment that problems will be discussed in ensuing sections is appropriate.
Reasons for Acquisitions and Problems in Achieving Success
Seven reasons for acquisitions are presented in the left-hand bubble-column while seven problems in achieving acquisition success are presented in the right hand bubble-column of Figure 7.1.
To summarize, the seven reasons that firms (and managers) implement acquisition strategies are to: • increase market power • overcome entry barriers • reduce the cost of new product development and increase speed to market • lower risk compared to developing new products • increase diversification • avoid excessive competition • learn and develop new capabilities
The seven reasons for poor performance of acquisitions or problems faced in attempts to achieve success are: • integration difficulties • inadequate evaluation of target • large or extraordinary debt • inability to achieve synergy • too much diversification • managers overly focused on acquisitions • too large
Note: Problems encountered as firms try to successfully achieve their objectives and create value from acquisitions will be discussed in detail in the next sections of this chapter.
3 Describe seven problems that work against developing a competitive advantage using an acquisition strategy.
PROBLEMS IN ACHIEVING ACQUISITION SUCCESS
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Research suggests that perhaps 20 percent of all mergers and acquisitions are successful, approximately 60 percent produce disappointing results, and the last 20 percent are clear failures. Successful acquisitions generally involve a well-conceived strategy in selecting the target, the avoidance of paying too high a premium, and employing an effective integration process.
A number of problems accompany an acquisition strategy. Acquisition-related problems shown in Figure 7.1 and that will be discussed in this section are: • difficulties in integrating the two firms after the acquisition is completed • paying too much for the target (acquired) firm or inappropriately or inadequately evaluating the target • the cost of financing the acquisition, related to large or extraordinary debt • overestimating the potential for gains from capabilities and/or synergy • excessive or too much diversification • management being preoccupied or overly focused on acquisitions • the combined firm becoming too large
Integration problems or difficulties that firms often encounter can take many forms. Among them are: • melding disparate corporate cultures • linking different financial and control systems • building effective working relationships (especially when management styles differ) • problems related to differing status of acquired and acquiring firms’ executives
The importance of integration success should not be underestimated. Without successful integration, a firm achieves financial diversification, but little else. Consider these points. • The post-acquisition integration phase may be the single most important determinant of shareholder value
creation (or value destruction) in mergers and acquisitions. • Managers should understand the large number of activities associated with integration processes.
Teaching Note: Several years ago, Intel acquired Digital Equipment’s semiconductors division. On the day Intel began to integrate the acquired division into its operations, six thousand deliverables were to be completed by hundreds of employees working in dozens of countries.
It is important to maintain the human capital of the target firm after the acquisition to preserve the organization’s knowledge. Turnover of key personnel from the acquired firm can have a negative effect on the performance of the merged firm.
Teaching Note: Following are some example of firms and the steps they took to preserve human capital through the acquisition process. • When AllliedSignal acquired Honeywell, the firm set an aggressive timetable to merge
their operations into a $24 billion industrial powerhouse in six months, despite the great diversification involved. This required a team to develop and implement the integration.
• Rapid integration is one of the guidelines that DaimlerChrysler uses for successful firm integration in a global merger or acquisition. Managers are encouraged to deal with unpopular issues immediately and honestly so employees will be able to anticipate the effects the integration is likely to have on them.
• Cisco Systems is quick to integrate acquisitions with its existing operations. Focusing on small companies with products and services related closely to its own, some believe that the day after Cisco acquires a firm, employees in that company feel as though they have been working for Cisco for decades.
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Inadequate Evaluation of Target
Due diligence is a process through which a firm evaluates a target firm for acquisition. In an effective due-diligence process hundreds of items are examined in areas as diverse as the financing for the intended transaction, differences in cultures between the acquiring and target firm, tax consequences of the transaction, and actions that would be necessary to successfully meld the two workforces.
Due diligence is commonly performed by investment bankers, accountants, lawyers, and management consultants specializing in that activity, although firms actively pursuing acquisitions may form their own internal due-diligence team.
Teaching Note: For the reasons below, firms often pay too much for acquired businesses: • Acquiring firms may not thoroughly analyze the target firm, failing to develop adequate
knowledge of its true market value. • Managers’ overconfidence may cloud the judgment of acquiring firm managers. • Shareholders (owners) of the target must be enticed to sell their stock, and this usually
requires that acquiring firms pay a premium over the current stock price. • In some instances, two or more firms may be interested in acquiring the same target firm.
When this happens, a bidding war often ensues and extraordinarily high premiums may be required to purchase the target firm.
Teaching Note: Some acquirers over-paying for target firms include the following:
• British retailer Marks & Spencer paid $750 million for Brooks Brothers of the United States, but the acquisition was still unsuccessful after more than ten years of integration.
• Sony paid a 28 percent premium for CBS Records and a 60 percent premium for Columbia Pictures.
• Bridgestone paid a 60 percent premium for Firestone, and its winning bid was 38 percent higher than a competing bid from Pirelli.
• National City Corporation agreed to acquire First of America for a price that was 3.8 times book value and 22.9 times First’s estimated 1998 earnings—National City’s stock fell 5.9 percent.
• First Union Corp. paid 5.3 times book value when it acquired CoreStates Financial Corp. • Federated paid $10 per share for Broadway Department Stores when Broadway’s stock
was selling for $2 per share, a 400 percent premium in a transaction valued at $1.6 billion to acquire Broadway’s prime West Coast real estate locations.
Teaching Note: An example of effective due diligence was DaimlerChrysler’s 1999 decision not to acquire Nissan Motor Company. DaimlerChrysler wanted Nissan to expand its access to global auto markets, especially those in Southeast Asia. But the target had $22 billion in debt, which caused concern among DaimlerChrysler executives and derailed the acquisition.
Large or Extraordinary Debt
In addition to overpaying for targets, many acquirers must finance acquisitions with relatively high-cost debt.
In the 1980s, investment bankers developed a new financing instrument for acquisitions, the junk bond. Junk bonds represented a new financing option in which risky investments were financed with money (debt) that provided a high return to lenders (bond holders). Junk bonds offer relatively high rates, some as high as 18 to 20 percent during the 1980s.
Teaching Note: Junk bonds are considered by many to be a new financing option, not because they are new, but because they represented the first instances in which non-
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investment grade (below a B rating) securities were used to raise funds by companies whose securities were normally rated as investment grade.
Teaching Note: A number of well-known and well-respected finance scholars argue in favor of firms utilizing significantly high levels of leverage because debt discourages managers from misusing funds (for example, by making bad investments) because debt (and interest) repayment eliminates the firm’s “free cash flow.”
Inability to Achieve Synergy
Acquiring firms also face the challenge of correctly identifying and valuing any synergies that are expected to be realized from the acquisition. This is a significant problem because, to justify the premium price paid for target firms, managers may overestimate both the benefits and value of synergy.
To achieve a sustained competitive advantage through an acquisition, acquirers must realize private synergies and core competencies that cannot easily be imitated by competitors. Private synergy refers to the benefit from merging the acquiring and target firms that is due to the unique assets that are complementary between the two firms and not available to other potential bidders for that target firm.
Teaching Note: As pointed out earlier, the average return to acquiring firm shareholders is near zero, and many of these lead to negative returns for acquiring firm shareholders.
Anheuser-Busch: A Case Example
Anheuser-Busch acquired Eagle Snacks and Campbell Taggart with the stated purpose of achieving synergies. Anheuser-Busch believed that this distribution-related synergy between snack foods, bakery products, and beer that could be leveraged while its expertise in the use of yeast in the brewing process could be applied to Campbell Taggart’s bread-making process.
However, distribution synergies were not available as beer, bread, and snack foods were ordered by different store product managers. Frito-Lay responded with new products and improved distribution to offset the threat of Eagle Snacks. In fact, distribution became more complex and more expensive.
In addition, competition in the beer industry increased and Anheuser-Busch management felt that Eagle and Campbell Taggart diverted their attention away from their core business, resulting in delays in new product introduction and a loss of momentum.
As a result, Anheuser-Busch sold Eagle Snacks and spun off the Campbell Taggart unit so that it could focus its efforts on expanding its presence in international beer markets where synergies are more likely to be available with its domestic beer market.
These general problems may be encountered in many acquisitions. However, there are many other causes of the poor long-term performance of acquisitions. In fact, some of the reasons for poor long-term performance also may lead to the problems already discussed.
Firms experience transaction costs when using acquisition strategies to create synergy. Direct costs include legal fees and charges from investment bankers. Managerial time to evaluate target firms and then to complete negotiations and the loss of key managers and employees post-acquisition are indirect costs.
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Too Much Diversification
In general, firms using related diversification strategies outperform those using unrelated diversification strategies. However, conglomerates (i.e., those pursuing unrelated diversification) can also be successful.
In the drive to diversify the firm’s product line, many firms overdiversified during the 60s, 70s, and 80s.
As detailed in Chapter 6, information processing requirements are greater for a related diversified firm (compared to its unrelated counterparts) due to its need to effectively and efficiently coordinate the linkages and interdependencies upon which value-creation through activity sharing depends.
In addition to increased information processing requirements and managerial expertise, overdiversification may result in poor performance when top-level managers emphasize financial controls over strategic controls.
TeachingNote: Controls will be discussed in more detail in Chapters 11 and 12.
Financial controls may be emphasized when managers feel that they do not have sufficient expertise or knowledge of the firm’s various businesses. When this happens, top-level managers are not able to adequately evaluate the strategies and strategic actions that are taken by division or business unit managers. As a result, • When they lack a rich understanding of business units’ strategies and objectives, top-level managers tend to
emphasize the financial outcomes of strategic actions rather than the appropriateness of the strategy itself. • This forces division or business unit managers to become short-term performance-oriented. • The problem is more serious when manager compensation is tied to short-term financial outcomes. • Long-term, risky investments (such as R&D) may be reduced to boost short-term returns. • In the final analysis, long-term performance deteriorates.
Teaching Note: The experiences of many firms indicate that overdiversification may lead to ineffective management, primarily because of the increased size and complexity of the firm. As a result of ineffective management, the firm and some of its businesses may be unable to maintain their strategic competitiveness. This results in poor performance.
As noted earlier in this chapter, acquisitions can have a number of negative effects. They may result in greater levels of diversification (in products, markets, and/or industries), absorb extensive managerial time and energy, require large amounts of debt, and create larger organizations. As a result, acquisitions can have a negative impact on investments in research and development and thus on innovation.
Reducing the emphasis on R&D and on innovation may result in the firm losing its strategic competitiveness unless the firm operates in mature industries in which innovation is not required to maintain competitiveness.
Managers Overly Focused on Acquisitions
If firms follow active acquisition strategies, the acquisition process generally requires significant amounts of managerial time and energy.
For the acquiring firm this takes the form of: • searching for viable candidates • completing effective due diligence • preparing for negotiations with the target firm • managing the integration process post-acquisition
The desire to merge is like an addiction in many companies: Doing deals is much more fun and interesting than fixing fundamental business problems.
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Due diligence and negotiating with the target often include numerous meetings between representatives of the acquirer and target, as well as meetings with investment bankers, analysts, attorneys, and in some cases, regulatory agencies. As a result, top-level managers of acquiring firms often pay little attention to long-term, strategic matters because of time (and energy) constraints.
Firms can reach economies of scale by growing. But, after a certain size is achieved, size can become a disadvantage as firms reach a point where they suffer from what is called “diseconomies of scale.” This implies that problems related to excess growth may be similar to those that accompany overdiversification.
Other actions taken to enable more effective management of increased firm size include increasing or establishing bureaucratic controls, represented by formalized supervisory and behavioral controls such as rules and policies that are designed to ensure consistency across different units’ decisions and actions.
On the surface (or in theory), bureaucratic controls may be beneficial to large organizations. However, they may produce overly-rigid and standardized behavior among managers. The reduced managerial (and firm) flexibility can result in reduced levels of innovation and less creative (and less timely) decision making.
4 Name and describe attributes of effective acquisitions.
Research has identified attributes that appear to be associated consistently with successful acquisitions: • when a firm’s assets are complementary (highly related) with the acquired firm’s assets and create synergy
and, in turn, unique capabilities, core competencies, and strategic competitiveness • when targets were selected and “groomed” through earlier working relationships (e.g., strategic alliances) • when the acquisition is friendly, thereby reducing animosity and turnover of key employees • when the acquiring firm has conducted due diligence • when management is focused on research and development • when acquiring and target firms are flexible/adaptable (e.g., from executive experience with acquisitions) • when integration quickly produces the desired synergy in the newly created firm, allowing the acquiring
firm to keep valuable human resources in the acquired firm from leaving
Table Note: The attributes or characteristics of successful acquisitions and their results are summarized in Table 7.1.
Attributes of Successful Acquisitions
Successful acquisitions generally are characterized by the following attributes and results: • target and acquirer having complimentary assets and/or resources which results in a high probability of
achieving synergy and gaining competitive advantage • making friendly acquisitions to facilitate integration speed and effectiveness and reducing any acquisition
premium • target selection and negotiation processes which result in the selection of targets having resources and assets
that are complimentary to the acquiring firm’s core business, thus avoiding overpayment • maintaining financial slack to make acquisition financing less costly and easier to obtain
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• maintaining a low to moderate debt position which lowers costs and avoids the trade-offs of high debt and lowers the risk of failure
• possessing flexibility and skills to adapt to change to facilitate integration speed and achievement of synergy • continuing to invest in R&D and emphasizing innovation to maintain competitive advantage
Note: The table also lists seven “results” of successful acquisitions.
Teaching Note: One way to teach the finer points of the M&A process is to see its parallels with marriage and courtship. Though the source is rather dated now, Jemison & Sitkin (1986, Academy of Management Review) offered an interesting analysis based on this framework. Their points are too extensive to comment on here, but reference to their writings is helpful.
5 Define the restructuring strategy and distinguish among its common forms.
Restructuring refers to changes in the composition of a firm’s set of businesses and/or financial structure.
From the 1970s into the 2000s, divesting businesses from company portfolios and downsizing accounted for a large percentage of firms’ restructuring strategies. Restructuring is a global phenomenon.
During this period, restructuring can take several forms: • downsizing, primarily to reduce costs by laying off employees or eliminating operating units • downscoping to reduce the level of firm unrelatedness • leveraged buyouts to restructure the firm’s assets by taking it private
Sometimes firms use a restructuring strategy because of changes in their external and internal environments. For example, opportunities sometimes surface in the external environment that are particularly attractive to the diversified firm in light of its core competencies. In such cases, restructuring may be appropriate.
STRATEGIC FOCUS DaimlerChrysler Is Now Daimler AG: The Failed Merger with Chrysler Corporation
In 1998, Daimler-Benz acquired Chrysler for $36 billion. Eight years later (2007), DaimlerChrysler sold Chrysler to a consortium of private investors for $7.4 billion. Daimler retained 20 percent of Chrysler. Ultimately, Daimler will not get much out of its original $32 billion investment other than to unload $18 billion in pension and health care liabilities. Many of the problems with the merger are derived from the labor and health care legacy cost differences, which have be estimated to be as high at $1,500 per vehicle on average, compared to an estimated $250 per vehicle for foreign firms such as Toyota. The Chrysler acquisition by Daimler was not its first troublesome buy-out. Daimler also made acquisitions in Asia by acquiring controlling interest in Japan’s Mitsubishi Motors Corp. and with Korea’s Hyundai Motors Corp. These investments also had problems, and Daimler divested the Mitsubishi assets in 2004 and likewise in the same year sold its 10 percent stake in Hyundai because of significant losses after the recession of 2000.
Daimler has not been the only auto manufacturer to stumble with horizontal acquisitions. The above failure is reminiscent of the failed acquisition of Rover by BMW. BMW ultimately sold the Rover assets for little in return except that BMW was able to unload debt off its books like the Daimler restructuring to divest the Chrysler assets. The Rover assets were similarly acquired by private equity firms with additional investment from a Chinese firm, Nanjing Automobile, which wished to gain entry into more developed markets such as those in Europe and the United States.
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Private equity firms have been active in recent years, buying up an array of businesses across a wide variety of industries in automobiles, steel, natural resources, and even electronics. (Phillips Electronics recently sold pieces of its firm to private equity operations.) The finance industry is able to facilitate the restructuring of these industrial assets due to the availability of debt, which is substituted for equity in publicly traded firms. The hope in Detroit among the other auto firms is that the financial experts associated with private equity firms will help the Big Three auto firms (GM, Ford, and Chrysler) in the United States deal with their excessive cost structure associated with union pensions and health care costs, which make up the bulk of the cost differences between U.S. and foreign firms. If they are not able to restructure the cost situation, the next step will be bankruptcy, the method used by many other firms in the airline and steel industries to restructure these costs. Private equity firms were also involved with these deals, especially after they came out of bankruptcy. One potential opportunity for Chrysler is financing auto and other purchases. Previous to the Chrysler deal, Cerberus purchased 51 percent ownership in the GMAC assets from General Motors Corporation. GMAC is the financing line of General Motors. Likewise in the Chrysler deal, Cerberus gains control of the Chrysler finance operation. In combination with the GMAC assets, once the financial unit activities are extracted from the operations of Chrysler, Cerberus hopes to develop a strong financing business, not only in financing automobiles but also potentially in financing opportunities such as mortgages. Compared to the automobile operations, the financing arms are already profitable even with the problems that GMAC is having with its sub-prime home lending unit, Residential Capital Corp. The Chrysler example illustrates the riskiness of acquisitions, the difficulty of integration, as well as what happens with failed acquisitions leading to divestiture and how private equity firms are involved in the process. Chrysler illustrates the potential for success as well as the risk of failure, and how firms deal with exit when an acquisition strategy fails.
Students can do a post-mortem examination of the DaimlerChrysler failure. Is there a trend that has developed in automotive mergers? Misguided notions of synergistic capabilities? Capabilities to be successful in new markets? And then there are the private equity groups. Why have private equity investors been able to succeed where manufacturers have failed? Do your students feel that automobile manufacturers would be more successful with vertical acquisitions?
Once thought to be an indicator of organizational decline, downsizing is now recognized as a legitimate restructuring strategy and has been one of the most common restructuring strategies adopted by U.S. firms.
Downsizing represents a reduction in the number of employees, and sometimes in the number of operating units, but may or may not represent a change in the composition of the businesses in the firm’s portfolio.
In the late 1980s, early 1990s, and early 2000s, thousands of jobs were lost in private and public organizations in the United States. One study estimates that 85 percent of Fortune 1000 firms have used downsizing as a restructuring strategy. Moreover, Fortune 500 firms terminated more than one million employees, or 4 percent of their collective workforce, in 2001 and into the first few weeks of 2002. This trend continued in many industries. For instance, in 2007, Citigroup signaled that it cut 15,000 jobs and up to five percent of its workforce over time, in the process taking a $1 billion charge.
Firms use downsizing as a restructuring strategy for different reasons. The most frequently cited reason is that the firm expects improved profitability from cost reductions and more efficient operations.
Compared to downsizing, downscoping has a more positive effect on firm performance.
Downscoping refers to the divestiture, spin-off, or other means of eliminating businesses that are unrelated to the firm’s core business. In other words, downscoping refocuses the firm on its core businesses.
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While downscoping often includes downsizing, the former is targeted so that the firm does not lose key employees from core businesses (because such losses can lead to the loss of core competencies).
As indicated by the discussion of overdiversification earlier in the chapter, reducing the diversity of businesses in the portfolio enables top-level managers to manage the firm more effectively because • the firm is less diversified as a result of downscoping • top-level managers can better understand the core and related businesses
Note: Indicate to students that the requirements and characteristics of strategic leadership by a firm’s top management team are discussed more fully in Chapter 12.
Teaching Note: There are many examples of downscoping strategies. Two of these with which the students are likely to be familiar are the following: • General Motors’ successful spin-off of EDS • PepsiCo’s spin-off of its fast-food businesses (e.g., Taco Bell, Pizza Hut, & KFC)
U.S. firms use downscoping as a restructuring strategy more frequently than do European companies. However, there has also been an increase in downscoping by Asian and Latin American firms as they adopt Western business practices.
Teaching Note: Research has shown that refocusing is not usually successful unless the firm has adequate resources to have the flexibility to formulate the necessary strategies to compete effectively.
A leveraged buyout (LBO) refers to a restructuring action, whereby the management of the firm and/or an external party buys all of the assets of the business, largely financed with debt, and thus takes the firm private.
Often, LBOs are used as a restructuring strategy to correct for managerial mistakes or because managers are making decisions that primarily serve their personal interests rather than those of shareholders.
In other words, a firm is purchased by a few (new) owners using a significant amount of debt (in a highly leveraged transaction) and the firm’s stock is no longer traded publicly.
In general, the new owners restructure the private firm by selling a significant number of assets (businesses) both to downscope the firm and to reduce the level of debt (and significant debt costs) used to finance the acquisition.
A primary intent of the new owners is to improve the firm’s efficiency. This enables them to sell the firm (outright to another owner or by a public stock underwriting), thus capturing the value created through the restructuring. It is not uncommon for those buying a firm through an LBO to restructure the firm to the point that it can be sold at a profit within a five- to eight-year period.
There are three types of leveraged buyouts: management buyouts (MBO), employee buyouts (EBO), and whole-firm buyouts where another firm takes the firm private (LBO). Research has shown that management buyouts can also lead to greater entrepreneurial activity and growth.
6 Explain the short- and long-term outcomes of the different types of restructuring strategies.
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Downsizing often does not lead to higher firm performance; in fact, research has shown that downsizing contributed to lower returns for both U.S. and Japanese firms. The stock markets in the firms’ respective nations evaluated downsizing negatively. Investors concluded that downsizing would have a negative effect on companies’ ability to achieve strategic competitiveness in the long term. Investors also seem to assume that downsizing occurs as a consequence of other problems in a company.
Teaching Note: In free-market based societies, downsizing has generated a host of entrepreneurial opportunities for individuals to operate their own businesses. In fact, as discussed in Chapter 13, start-up ventures in the United States are growing at three times the rate of the national economy.
Downsizing tends to result in a loss of human capital in the long term. Losing employees with many years of experience with the firm represents a major loss of knowledge. As noted in Chapter 3, knowledge is vital to competitive success in the global economy. Thus, in general, research evidence and corporate experience suggest that downsizing may be of more tactical (or short-term) value than strategic (or long-term) value.
Downscoping generally leads to more positive outcomes in both the short and the long term than does downsizing or engaging in a leveraged buyout (see Figure 7.2). Downscoping’s desirable long-term outcome of higher performance is a product of reduced debt costs and the emphasis on strategic controls derived from concentrating on the firm’s core businesses. In so doing, the refocused firm should be able to increase its ability to compete.
While whole-firm LBOs have been hailed as a significant innovation in the financial restructuring of firms, there can be negative trade-offs. • the resulting large debt increases the financial risk of the firm • the intent of the owners to increase the efficiency of the bought-out firm and then sell it within five to eight
years can create a short-term and risk-averse managerial focus • these firms may fail to invest adequately in R&D or take other major actions designed to maintain or
improve the company’s core competence.
Figure Note: Restructuring alternatives—downscoping, downsizing, and leveraged buyouts —and short- and long-term outcomes are summarized in Figure 7.2.
Restructuring and Outcomes
As illustrated in Figure 7.2, • Downsizing reduces labor costs, but the long-term results are a loss of human capital and lower
performance. • Downscoping reduces debt costs and emphasizes strategic controls, which result in higher performance. • Leveraged Buyouts provide an emphasis on strategic controls but increases debt costs; the long-term
outcome is an increase in performance, but also greater firm risk.
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— ANSWERS TO REVIEW QUESTIONS
1. Why are acquisition strategies popular in many firms competing in the global economy? (pp. 183-184)
Acquisition strategies are increasingly popular around the world. Because of globalization, deregulation of multiple industries in many different economies, favorable legislation, etc., the number of domestic and cross- border acquisitions is high (though the frequency has slowed recently). As is the case for all strategies, acquisitions indicate a choice a firm has made regarding how it intends to compete. Because each strategic choice affects a firm’s performance, the possibility of diversification merits careful analysis. A firm may make an acquisition to increase its market power because of a competitive threat, to enter a new market because of the opportunity available in that market, or to spread the risk due to the uncertain environment. In addition, a firm may acquire other companies as options that allow the firm to shift its core business into different markets as volatility brings undesirable changes to its primary markets.
2. What reasons account for firms’ decisions to use acquisition strategies as one means of achieving strategic competitiveness? (pp. 184-191)
Firms often choose to follow acquisition strategies (1) to increase market power (by becoming larger); (2) to overcome entry barriers (by acquiring a firm with a position in the target industry); (3) to reduce cost of new- product development and increase the speed to market entry; (4) to reduce the risk associated with developing new products internally; (5) to diversify both firm and managerial risk by increasing the level of diversification; (6) to reshape the firm’s competitive scope; and (7) to boost learning and the development of new capabilities.
3. What are the seven primary problems that affect a firm’s effort to successfully use an acquisition strategy? (pp. 191-196)
Firms following acquisition strategies face seven major problems. (1) They may face difficulty in successfully integrating the two firms. This is especially true when integration involves melding disparate corporate cultures, linking disparate financial and control systems, building effective working relationships when management styles differ, and when the status of acquired firm executives is uncertain. (2) Owing to inadequate evaluation of the target firm (a process known as due diligence), acquirers may pay more for the target firm than it is worth. (3) If the acquisition is financed with debt, as many were in the 1980s, the costs related to a significant increase in debt—interest payments and debt repayment—may squeeze the firm’s cash flow and limit managerial flexibility resulting in the firm passing up attractive long-term investment opportunities. It is also important to note that debt also has positive effects since leverage can assist a firm in its development, allowing it to take advantage of attractive expansion opportunities. (4) Acquiring firms also may overestimate the existence and value of synergies from combining the two firms. In many cases, the value to be gained from synergy is overestimated because of a failure to consider the integration and coordination costs that may be incurred. (5) Too much diversification may mean that the portfolio of businesses that the firm owns is beyond the expertise of managers, that management depends too much on financial controls (rather than more effective strategic controls), and that acquisitions may become a substitute for innovation. (6) Managers may be overly focused on acquisitions and neglect the firm’s core businesses. (7) The combined firm may become too large to manage efficiently and effectively, as the firm experiences diseconomies of scale or bureaucratic controls stifle decision making.
4. What are the attributes associated with a successful acquisition strategy? (pp. 196-198)
As identified in Table 7.1, the following attributes tend to lead to successful acquisitions: • Acquired firm has assets or resources that are complementary to the acquiring firm’s core business • Acquisition if friendly • Acquiring firm selects target firms and conducts negotiations carefully and deliberately • Acquiring firm has financial slack (cash or a favorable debt position) • Merged firm maintains low to moderate debt position • Has experience with change and is flexible and adaptable • Sustained and consistent emphasis on R&D and innovation
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5. What is the restructuring strategy and what are its common forms? (pp. 198-202)
Defined formally, restructuring is a strategy through which a firm changes its set of businesses and/or financial structure. There are three common forms of restructuring strategies.
Downsizing is a reduction in the number of a firm’s employees, and sometimes in the number of its operating units, but it may or may not change the composition of businesses in the company’s portfolio. Thus, downsizing is an intentional proactive management strategy, whereas decline is an environmental or organizational phenomenon that the firm cannot avoid and that leads to erosion of the organization’s resource base.
As compared to downsizing, the downscoping restructuring strategy has a more positive effect on firm performance. Downscoping refers to divestiture, spin-offs, or some other means of eliminating businesses that are unrelated to a firm’s core businesses.
Commonly, downscoping is referred to as a set of actions that results in a firm strategically refocusing on its core businesses. A firm that downscopes often also downsizes simultaneously. However, it does not eliminate key employees from its primary businesses while doing so because such action could lead to the loss of one or more core competencies. Instead, a firm simultaneously downscoping and downsizing becomes smaller by reducing the diversity of businesses in its portfolio.
A leveraged buyout (LBO) is a restructuring strategy whereby a party buys all of a firm’s assets in order to take it private. Once the transaction is completed, the company’s stock is no longer traded publicly. It is common for the firm to incur significant amounts of debt to finance a leveraged buyout. The three types of leveraged buyouts include management buyouts (MBO), employee buyouts (EBO), and a whole firm buyout (the last occurring when another company or partnership purchases an entire company instead of a part of it).
6. What are the short- and long-term outcomes associated with the different restructuring strategies? (pp. 202-203)
As identified in Figure 7.2, the short-term outcome from downsizing is a reduction in labor costs, but this yields two negative long-term outcomes—loss of human capital and lower performance. Downscoping leads to reduced debt costs and an emphasis on strategic controls, which in turn produces higher firm performance as a long-term outcome. Finally, leveraged buyouts can lead to higher performance (long-term) through an emphasis on strategic controls, but it also yields high debt costs (short-term) that produce higher risk for the firm (long-term).
— EXPERIENTIAL EXERCISES
Exercise 1: Comparison of Diversification Strategies
The use of diversification varies both across and within industries. In some industries, most firms may follow a single- or dominant-product approach. Other industries are characterized by a mix of both single- product and heavily diversified firms. The purpose of this exercise is to learn how the use of diversification varies across firms in an industry, and the implications of such use.
Working in small teams of four to seven persons, choose an industry to research. You will then select two firms in that industry for further analysis. Many resources can aid in identifying specific firms in an industry for analysis. One option is to visit the Web site of the New York Stock Exchange (http:// www.nyse.com), which has an option to screen firms by industry group. A second option is http:// www.hoovers.com, which offers similar listings. Identify two public firms based in the United States. (Note that Hoovers includes some private firms, and the NYSE includes some foreign firms. Data for the exercise are often unavailable for foreign or private companies.)
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Once a target firm is identified, you will need to collect business segment data for each company. Segment data break down the company’s revenues and net income by major lines of business. These data are reported in the firm’s SEC 10-K filing, and may also be reported in the annual report. Both the annual report and 10-K are usually found on the company’s Web site; both the Hoovers and NYSE listings include company homepage information. For the most recent three-year period available, calculate the following: Percentage growth in segment sales
Net profit margin by segment
Bonus item: compare profitability to industry averages (Industry Norms and Key Business Ratios publishes profit norms by major industry segment.)
Next, based on your reading of the company filings and these statistics, determine whether the firm is best classified as: Single product
Prepare a brief PowerPoint presentation for use in class discussion. Address the following in the presentation: Describe the extent and nature of diversification used at each firm.
Can you provide a motive for the firm's diversification strategy, given the rationales for diversification put forth in the chapter?
Which firm’s diversification strategy appears to be more effective? Try to justify your answer by explaining why you think one firm’s strategy is more effective than the other.
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Exercise 2: Corporate Juggling
What are the implications for managers when their firm shifts from competing in a single product segment to multiple segments? Additionally, how is the manager’s role affected by the similarity or dissimilarity of these segments?
This exercise will be completed in class. The instructor will assign students randomly to two different types of teams: part of the class will be assigned to teams of five to seven persons, and the remainder of the class will be assigned to teams of ten to fourteen persons. Each team will assign one person to serve as a facilitator.
The instructor will give each facilitator a bag of objects. The goal is for each team to juggle as many objects as possible. The team will start with one object, which should be tossed from person to person. When the group is ready, ask the facilitator for a second object. Continue to add objects up to your group’s ability.
— INSTRUCTOR'S NOTES FOR EXPERIENTIAL EXERCISES
Exercise 1: The Gap
The purpose of this exercise is to illustrate how firms balance acquisition versus internal development in the process of diversification. Students are asked to answer the following questions:
1. Describe Gap’s emphasis on acquisition versus internal development.
2. What restructuring has the company undertaken? Would you recommend additional restructuring?
3. Between 2002 and 2006, how well have the different divisions of The Gap performed?
Horizontal Expansion Activities
Much of the Gap’s expansion has come in the form of internal development. The company has launched new store chains which have focused on specific market segments – e.g., babyGap, GapKids, and the Gap Outlet. All of these can be considered as brand extensions versus entirely new segments, however. In 1994, Gap launched the Old Navy brand. Forth & Towne, focusing on women’s fashion, was launched in 2005, and Piperlime was launched in 2006. The latter was a Web-only shoe shop.
Gap made two substantial acquisitions in the mid-1980s: Banana Republic was purchased in 1983 and Pottery Barn in the following year. Prior to its acquisition, Pottery Barn was a closely held company that had been in operation since 1949.
Restructuring and Performance
Pottery Barn was sold to Williams-Sonoma in 1986, only two years after the acquisition. Additionally, the Forth & Towne division was closed in 2007, also after just two years in operation.
Regarding further restructuring, students will likely offer varying suggestions on this topic. The Gap’s 2006 Annual Report provides the following segment sales data (in millions):
Segment 2002 2003 2004 2005 2006 Gap 5,436 5,777 5,746 5,409 5,134
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Banana 1,928 2,090 2,269 2,287 2,487 Old Navy 5,804 6,436 6,747 6,856 6,829 Forth & Towne 8 27
Additionally, the following data is useful for comparison as well:
2002 2003 2004 2005 2006 Overall sales* 14,455 15,854 16,267 16,023 15,943 Net income* 478 1,031 1,150 1,113 778 Gross margin 34.0% 37.6 39.2 36.6 35.4 Comparable store sales increase
-3% 7% 0% -5% -7%
* in millions
Overall, The Gap’s sales have been relatively stagnant during the last five years. Net income has been volatile, and gross margins have seen some variation as well. Comparable store sales have been flat or shrinking the last few years. Banana Republic has reported the largest growth in sales during this window, with Old Navy growing at a substantially slower pace. Ironically, the core Gap brand has reported declining sales for the last three years.
In summary, Gap’s problem appears to be difficulty in getting people into their stores. In recent years, the company has focused on cost-cutting. As a result, their styles appear out of touch with current demand. In 2007, the company replaced their CEO, and had also engaged Goldman Sachs for advice on modifying their strategy. Consequently, any recommendations to divest any of the core brands would be premature.
If the instructor plans to do a detailed discussion of this exercise in class, the following Fortune article provides excellent background on Gap, including a brief history of the firm, and the transition from its founders to a professional manager: GAP: DECLINE OF A DENIM DYNASTY, Jennifer Reingold. Fortune. New York: Apr 30, 2007. Vol. 155, Iss. 8; pg. 96.
Exercise 2: Cadbury Schweppes: Too Much of a Sugar Rush?
The purpose of this exercise is to help students understand the challenges associated with a merger strategy predicated on synergies. While both Cadbury and Schweppes had strong brand recognition in their respective markets, there was little in the way of overlap by combining both firms. This example is also useful for illustrating the role of shareholder activism, as well as different mechanisms for divestiture. Students are asked to prepare a PowerPoint presentation that addresses the following questions:
1. What precipitated Stitzer’s announcement to separate the beverage and candy operations?
2. What were the main factors hindering the success of the Cadbury/Schweppes merger?
3. What are the pros and cons of divesting the beverage segment?
4. What are the different options that Stitzer can pursue in divesting Schweppes?
For a class debrief, it is useful to ask two or three teams to make a brief presentation of their findings. The instructions in the textbook indicate that there should be one slide per question. The brevity of these presentations means that you should be able to have two or three teams present in ten or fifteen minutes, leaving additional time for discussion.
The following Wall Street Journal articles can be helpful for leading a debrief on the assignment:
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• In breakup, CEO of Cadbury faces his biggest deal; parting of the firm’s candy and drinks businesses may put both in play. WSJ, March 16, 2007, page A1.
• Cadbury’s delayed sale of unit poses risks. WSJ July 28, 2007, page A3.
• Cadbury Schweppes PLC: U.S. Beverages division may be spun off, not sold. WSJ, August 2, 2007.
In the March 16 announcement, CEO Stitzer noted that the company had been considering separating the candy and beverage units for some time. Shareholders had often made such a recommendation previously, based on an expectation that the two companies were undervalued following the merger. However, the timing suggests a different reason for the announcement: only days before, investor Nelson Peltz of Trian Fund Management had purchased a 2.98% stake in Cadbury Schweppes. Peltz had made previous acquisitions of companies such as H.J. Heinz and Tiffany’s, and was an advocate of breaking up the candy and beverage units.
One of the factors hindering the success of the merger was the inability of the firms to realize synergies. While both segments may appear very similar on the surface, the WSJ articles indicate that each had very different production and distribution systems. Another possible factor is that the CEO was very focused on acquisitions: Stitzer was a merger and acquisition lawyer to joining Cadbury Schweppes, and was a major advocate of the firm’s decision to acquire Dr. Pepper, 7 Up, Dentyne, Bubaloo, and Trident.
The lack of substantial synergies is one reason in favor of divesting Schweppes. Revenues from a sale could help Cadbury either reduce its debt, or to acquire a more closely related firm. One downside of a divestiture is that Schweppes provides the majority of the firm’s net income, despite representing a smaller proportion of sales. Finally, the separation of the two companies increases the likelihood that Cadbury might subsequently become the target of a takeover.
In the March 16 WSJ article, Stitzer laid out three approaches for separating Schweppes:
• Direct sale, probably to private equity.
• Breaking Cadbury and Schweppes into two independent public companies
• Selling part of Schweppes initially, with a goal of eventually selling off Cadbury’s remaining ownership stake.
In the six months following the announcement, Cadbury Schweppes reported a substantial drop in profit and narrower margins, which could make the beverage unit less attractive to private equity firms. According to the August 2 WSJ article, a spin-off versus private equity sale could mean substantially less money for Cadbury: An estimate 6.5 billion British pounds for a spin-off, versus 7-8 billions pounds for a sale.
— ADDITIONAL QUESTIONS AND EXERCISES
The following questions and exercises can be presented for in-class discussion or assigned as homework.
Application Discussion Questions
1. Evidence indicates that the shareholders of many acquiring firms gain little or nothing in value from the acquisitions. Why, then, do so many firms continue to use an acquisition strategy?
2. Of the problems that affect the success of an acquisition, ask the students which one they believe is the most critical in the global economy. Why? What should firms do to make certain that they do not experience such a problem when they use an acquisition strategy?
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