Benchmarking your Board

At this time of year, many boards are preparing for their annual review of board effectiveness.  For Canadian public companies, the review may include external benchmarking using the metrics of the annual Board Games ranking in the Globe & Mail.  The Clarkson Centre for Business Ethics and Board Effectiveness, the source of the Board Games analyses, is no doubt busy now collecting the 2018 annual reports, refining the criteria and preparing the analysis to rank the governance of Canada’s largest public companies.

Since its inception 17 years ago, Board Games has served to bring a lot of attention to governance, especially from the over 200 companies and trusts that are the subject of the metrics and rankings.  Each year the Globe & Mail and the Clarkson Centre get complaints from companies that feel the metrics and/or rankings are faulty.  I’m told that most of the conversations begin with something like: “These metrics are wrong and/or unfair and/or misapplied and/or meaningless…..”  but then end with: “Please tell me how we can get a better ranking next year.”  So the rankings draw attention and changes are often made as a result.  In fact, the Globe & Mail reports that in the last 5 years alone, the average score has improved from 69 to 75 and the number of companies scoring 80 or above has increased from 29 to 42.

However, there is an important omission in the metrics that I think is fundamental to good governance – shareholder value.

I teach the course “Oversight of Strategy”, a one-day course run by the Institute of Corporate Directors (ICD).  One of the cases we use is the 2014 Ivey case about Canadian Pacific Railway (CP) in the period 2011 to 2012.  You’ll recall that this is when hedge fund Pershing Square invested in CP and ultimately shook up the board, replaced the CEO and implemented a new strategy that drove the stock price from $60 to $230 per share.  The classroom challenge is to consider how the board could have fallen so short in its oversight of CP’s strategy prior to Pershing Square taking an interest.  Course participants (mostly corporate directors) are always astounded to read that CP ranked 4^thout of 253 companies in the 2011 Board Games, while performing so poorly for shareholders in the years leading up to Pershing Square’s intervention.  They ask: “What’s wrong with these metrics?”

The CP case is not isolated. The last Board Games (Globe & Mail, November 26, 2018) featured a comparison of highest and lowest governance scores for 11 industry sectors.  If you look up the long-term total shareholder return performance versus industry for the companies featured[1], you’ll find the following surprising facts:

• In 6 of these sectors the so-called “worst” outperformed the “best”. Specifically, Rogers, Alimentation, NexGen, Aurora, Tricon and Atco are each identified as governance “worsts” and yet each delivered superior long-term returns to shareholders than its sector’s governance “best”, respectively Telus, Metro, Suncor, Chartwell, Boardwalk and Emera.
• In 2 others sectors the “worst”, namely Shopify and Canada Goose, have not been in the public markets long enough to show long-term returns, but so far are significantly outperforming their comparators, Descartes and Gildan, respectively.
• In 2 other sectors, financials and materials, the data is inconclusive.
• In only one case, Canadian National Railways, is the governance “best” also clearly the best long-term performer for shareholders against comparator Westshore.

As a practicing director and a proponent of good governance, I would have expected the opposite.  That is, good governance should usually result in better outcomes for shareholders, not worse.

Some argue that “good governance” is good for its own sake.  “If we do the right things, then the shareholders will be rewarded in the long run.”  But how do we know these are “the right things”?  The above examples stand in contrast.

A measure of long-term returns to shareholders needs to be incorporated into the benchmarking metrics of good governance.  It is not be hard to do, it enhances the value of the exercise and it provides a better basis for continuous improvement.

The easiest and most impactful way to incorporate long-term shareholder value is to make it a modifier of current Board Game scores.  This can be done by multiplying the current governance score by a shareholder performance index, for example, a ratio of 5-year total returns of the company to the total returns of the industry[2].  If a company performed the same as its industry, this does not affect the governance score.  If a company outperformed for shareholders, its governance score is enhanced proportionately. If a company underperformed for shareholders, its governance score is diminished.

Factoring in long-term shareholder value in such a way brings the shareholder perspective into the scoring. For example, it would have put the score for CP (prior to Pershing Square) where it belonged – at the bottom of its industry – good governance cosmetics should not give any comfort to a board that is overseeing such poor performance.)  It would also correct many of the anomalies in the “best-worst” comparisons in the last report – several of the governance “worst” would move up based on good returns and some that scored “best” would move down.

Incorporating long-term shareholder returns as a good governance metric also partially corrects for Board Games’ harsh governance ranking of companies with dual-class share structures.  Many of these are family-controlled companies that are significantly outperforming their peers in long-term value creation.

Finally, the presence of shareholder value among the metrics serves as a guide to ongoing improvement of the metrics.  That is, when the metrics of good governance get out of alignment with long-term shareholder returns (as they seem to be now in Board Games) it should be cause to ponder: Are the current metrics all correct?  Do we have the weightings right?  Are we missing metrics that could make a difference to good governance?

For example, dual-class structures can be used to protect companies from the short-term interests of the market, (takeovers, in particular), and allow these companies a longer time horizon. Many of them are top performers but are penalized in Board Games.  The major banks are similarly protected from hedge fund influence and takeovers by the widely-held rule, but they are assigned no such penalty.

When you benchmark your board, measure what really matters for good governance.  Governance benchmarking should be more than a game.

 

Ken Smith

Corporate Director

[1]Anyone can do this using public sources; I used trailing total returns to November 2018 month end as provided by Morningstar.ca

[2]Technically, the formula is (1 + company total return %)/(1 + industry total return %), where % is versus base investment 5 years prior.  This is a standard metric for relative total returns.

Revenue Synergies in M&A – Part II: Revenue-based M&A strategies that work

(Excerpts from Chapter 3 of “The Art of M&A Strategy”, Smith & Lajoux, McGraw-Hill, New York, 2012.)

In Part I, we looked at why M&A based on revenue synergies creates superior value to cost synergies. We also noted the difficulty in achieving revenue synergies and the risks associated with aggressive M&A growth strategies.

In Part II, we look at four generic revenue-based strategies and the role of M&A in each, including successful examples:

1. Growth within a current market with current product offerings
2. Growth within a current market with new products
3. Growth into a new market with current products
4. Growth into a new market with new products

In each case, there could be a make versus buy decision. That is, if there is growth potential available, is it best achieved organically or by acquisition? While most acquisitions cover more than one of these four vectors, this categorization provides a convenient framework for examining the unique issues associated with each.

Current markets and current products

If a company has growth potential within current markets and product categories, it is either because there is potential to expand the market (additional customers or increased consumption) with the products “as is”, there is potential to expand the market with product improvements, or the potential new customers or consumption is currently being served by competitors.

In the first case, M&A likely has no role. For example, many people who could afford life insurance choose not to buy it, even though there are numerous product variations in the market. This is primarily a marketing and sales challenge to interest new customers in life insurance or to improve the coverage of existing customers.

In the second case, there is capacity for market expansion with product improvements. For example, you might use your favorite search engine more often if it were more effective for your purposes. In this case, there could be a make versus buy decision for the needed product improvements. For example, Google is constantly acquiring innovations to improve its core product, such as Deja.com in 2001 for search capabilities, Applied Semantics in 2003 for text processing for online advertising, and Picas in 2004 for photo recognition.[1] (Google uses acquisitions in all four generic growth strategies—discussed later.)

In the third case, the make versus buy decision is between competing for the competitor’s customers versus acquiring the competitor. In effect, this is in-market consolidation in which customer acquisition may be a primary motivator.

However, absent significant cost synergies or issues with market structure, an in-market acquisition for customers is unlikely to pay off. There are two problems with such an acquisition. First, the target’s acquisition price will already factor in the net present value of the contribution of all of these customers (less fixed overhead, of course). Second, in this scenario the buyer may not retain all the customers—these customers all bought from a competitor before, and nothing prevents them from doing so again. If there are other choices in the market, it is highly likely that at least some customers will go to them. (If there were no other choices in the market, there would be an antitrust problem.)

So the revenue synergies are negative, and the deal economics can’t work on customer acquisition alone. The only way for such an acquisition to pay off, therefore, is if other synergies such as R&D, manufacturing, marketing, or corporate overhead are significant.

This theory was demonstrated in the in-market mergers during US bank industry consolidation. As deal pricing ran up to and above the value of cost synergies, banks began identifying a range of revenue synergies in their deal proposals, including product growth and pricing synergies. However, when products unique to one bank were offered to the customers of the other, there was little uptake. For common products, when the teams sat down to decide pricing, product by product they chose the lowest price between the two banks for fear of losing customers to other banks in the market. As a result, the revenue synergies were negative. Throughout US bank industry consolidation, the in-market deals performed worse than cross-market deals in which cost synergy was lower, but revenue synergy was positive. (More to come on this scenario.)

Moreover, M&A has a meaningful role in growth within current product markets only in the context of a make versus buy decision to advance product improvements or as part of a consolidation play. In the latter case, there must be compelling cost synergies to outweigh the inevitable negative revenue synergies.

New products in current markets

This type of business combination is sometimes called related diversification. Related diversification transactions are in general more likely to create value than unrelated diversification or consolidation.[2] If such a merger can introduce a product to new markets, then substantial revenue growth can occur with little impact on total costs.

This type of transaction is well illustrated in the acquisition of Lotus Development Corporation by IBM in 1995, which was IBM’s first large step from computer hardware into computer software. IBM acquired Lotus for $3.5 billion or $64 per share, double the trading value before the bid. In addition to the strategic imperative for IBM to diversify, the deal logic was to grow Lotus revenues by offering its products through the vast markets served by IBM.

Analysts were skeptical of the deal for three reasons—it was a diversification, the premium was high, and, at the time of the transaction, IBM had a history of crushing the entrepreneurial culture of the growth companies it acquired.

However, IBM carefully managed the integration issues and focused on achieving the product–market synergies. Protocols were established to keep the companies and cultures separate except for one thing—the IBM sales force was to sell the Lotus products. The number of Lotus “seats” (or desktops) was the measure of success, and “Get Lotus seats” became a rallying cry postdeal. The deal more than paid for itself and, in spite of the high premium paid, it created shareholder value and launched IBM successfully into software.

Such deals can be highly successful because they create new value, almost from nothing. Unlike consolidation synergies, these are not one-time revenue synergies but continue into the future. Such synergies are also less transparent and less transferable to other potential buyers, and hence less likely to get negotiated into the price of the deal.

Another domain of similar product–market combinations is the bancassurance market in Europe. Deals such as Credit Suisse–Winterthur, Lloyds TSB–Abbey Life, Banco Santander–Banco Hispano (BSBH), and Den Danske–Danika created value by offering the comprehensive channels of the banks for the marketing of insurance products. For example, 65% of BSBH’s mortgage customers were acquiring life insurance from them when offered. While the famous acquisition of Travelers Insurance by Citibank in 1998 is often used as proof that such deals don’t work, life insurance premiums were multiplied through Citibank channels, in spite of what many say was only a partially executed deal logic. The success rate of these so-called cross-pillar deals was over 70% versus the dismal 40% success rate of in-market bank mergers.[3] Over the past decade, banks remained one of the fastest-growing channels for insurance products in Europe, and in the years following the passage of the Gramm-Leach-Bliley Act in 1999, allowing bank-insurance integration in the United States, US banks bought more insurance brokers than banks.[4]

In markets in which customers want end-to-end service, the acquisition of an additional piece of the offer can add value even beyond the growth of the new product by making the entire customer offering more complete and compelling.

For example, United Parcel Service has acquired various customs brokerage services. One such acquisition was Livingston Customs Brokerage in Canada in 2000.[5] Canada and the United States are each other’s largest trading partners so the North–South lanes between Canada and the United States are strategically important to any freight transportation company. The services of Livingston were, of course, marketed across UPS’s vast US customer base achieving growth for the Livingston products through UPS channels, similar to the foregoing examples.

However, the benefit to UPS far exceeded the direct impact of brokerage sales growth. First, UPS could then offer to its US shippers and Canadian consignees a simple, complete, and speedier service than if they used the Livingston brokerage directly. This was a competitive advantage over companies that did not offer a complete service of transportation and customs clearance. In addition, the economics of the Canadian lanes downstream from Livingston then benefited from greater route density—a key driver of courier economics.

Google acquires to offer new products to existing markets as well. The acquisition of Neotonic in 2003 led to the launch of a an e-mail platform with superior spam filters (gmail), and Google’s acquisition of YouTube in 2006 undoubtedly fueled growth of both the search engine and video sharing.[6]

However, while product–market combinations are strategically compelling, there are also many failures. Most of the failures are the result of trying to sell products through unsuitable channels. For example, many technology firms combined with strategy consulting firms in the 1990s and early 2000s believing that the strategy firms would offer channels to the senior executives that would help sell all of their products. In fact, the sales context and skills for strategy versus IT sales are very different, and the acquired channels did not work well. For example, McKinsey & Company acquired Information Consulting Group (ICG) in 1989, a 250-person information technology firm based in Washington, D.C. By 1993 half of the partners and more than half of the staff left.[7] Electronic Data Systems’ acquisition of A.T. Kearney was eventually undone—long before EDS itself got acquired and renamed by HP. The US Web–Mitchell Madison Group combination later went bankrupt.[8] Accenture organically grew a large, top-tier strategy practice that disbanded within a few years (although Accenture has more recently reentered general management consulting).

The lesson of these failures is the lesson of all revenue-based M&A strategies: revenue synergies are earned when customers like the idea. So a product–market combination will have compelling deal logic if and only if it also presents a compelling value proposition to customers. Few clients would clamor for IT and strategy help in one basket, but many do want other kinds of combinations. For example computer hardware with software that works is an attractive proposition.. So is being able to insure your home where you get your mortgage (and have to provide proof of insurance), or being able to ship items using a complete, door-to-door, cross-border freight transportation service. In revenue synergies, the customer is always right.

Taking existing products into new markets

This is another type of M&A strategy with compelling logic for some of the same reasons. Successfully entering a new market segment or geography creates new value, whether done organically or by acquisition. It also carries substantial risk in either case.

There are many examples of geographic expansion through acquisition. For example, while Wal-Mart developed across America organically, it chose to acquire in order to enter some international markets. While it initially opened new stores in Mexico and Hong Kong, it acquired 122 Woolco stores to enter Canada and 21 Wertkauf units in Germany, and it entered China and Korea through joint ventures.[9]

The advantages of using M&A in international expansion are speed and market knowledge. Wal-Mart acquired complete chains in Canada and Germany that it then rebranded as Wal-Mart. It brought instant value to these acquisitions by reducing the cost of goods, leveraging its buying power and vast supply network. In some cases, its selection, layout, operations, and brand added value through growth in same-store sales.

Opening stores in these markets one at a time clearly would have taken longer. An organic approach in this case also opens up additional costs and risks. First, there were loyalties to the incumbent discount operations that would have taken time and money to overcome. Second, as a new entrant, Wal-Mart would have been more likely to miss the mark on selection and marketing. Third, the acquisition approach provided a local executive team and resources across each market, saving recruiting and training costs.

However, the acquisition approach also multiplies the consequences of getting it wrong. For example, in 1982 Canadian Tire Corporation, Canada’s largest and most successful hard goods retailer, entered the US market through the acquisition of White Stores, a chain of more than four hundred automotive retail stores. Canadian Tire attempted to convert the stores into a format similar to that used by its Canadian stores. Unfortunately, this failed, and Canadian Tire took losses of over $300 million and faced a lawsuit of $400 million launched by dealers who had come south to start stores. In 1985 Canadian Tire exited.[10]

The successes outnumber the failures. Cross-border deals in Europe substantially outperform domestic deals. Only US overseas transactions have a success rate below 50%, and this is due mainly to poor postdeal management failing to deliver on attractive potential.[11]

Among the many companies that have grown internationally by acquisition are Manulife in financial services (e.g., John Hancock in the United States, Daihyaku Mutual in Japan, and Pramercia Life in the Philippines), UPS in transportation (e.g., Alimondo in Italy and Germany and a number of freight airline services), and General Foods, now part of Kraft, in consumer goods (e.g., La India Company in Venezuela, Hostess in Canada, Kibon ice cream company in Brazil, and Krema Hollywood Chewing Gum in France), and Google (e.g., Chinese search engine Baidu in 2004), to name a few.

It should be noted that among the successful transactions during the US bank consolidation were the cross-region deals.[12] It may seem counterintuitive that the less the overlap the more likely is success. However, the cost synergies were often negotiated into the acquisition price of the US banks, and the revenue synergies in in-market deals were negative, as noted earlier in this chapter. The cross-region deals averted the negative revenue synergies and in the best cases brought a better national brand, filled in product gaps, and introduced a superior operating approach to the acquired bank.

However, the magnitude of some of the failures is sobering. For example, the 1998 merger of Chrysler with Daimler-Benz, a $37 billion stock-swap deal, was the largest trans-Atlantic merger to that day. The new company, with market capitalization approaching $100 billion, saw synergy potential in retail sales, purchasing, distribution, product design, and research and development. Three years later DaimlerChrysler’s market capitalization was $44 billion and its stock was dropped from the S&P 500, largely due to clashes of culture and mismanagement.[13]

Geographic expansion (even domestically) almost always crosses cultural borders, so in addition to the usual challenges of the integration of corporate cultures, these deals must manage across national or regional cultures and must do this across vast distances.

To enter new markets with new products

On the face of it, this sounds like unrelated diversification. However, we refer here to situations in which there are product synergies and/or market synergies.

The growth strategy of Zwilling J.A. Henckels of Germany illustrates how M&A can facilitate growth across products and markets simultaneously. Zwilling is best known as the manufacturer of fine cooking knives under the brands Henkel and Zwilling. Over the past 10 years they have expanded into new segments of cooking knives as well as into cookware and beauty, each time through acquisitions in a new market.

The 2004 acquisition of US Tweezerman in the beauty segment significantly enhanced Zwilling’s footprint in US department stores while providing a new product line to market around the world. In 2008, Zwilling acquired Staub of France, a manufacturer of fine cast iron cookware. Staub is now marketed throughout Zwilling’s international markets, and Zwilling cooking knives have enjoyed increased sales in France. Similarly, that same year the acquisition of Demeyere Cookware of Belgium, manufacturer of fine stainless steel cookware, added a product to market internationally while gaining better access in the Benelux countries.[14]

Moreover, with each of these acquisitions Zwilling was able to simultaneously take new products to its existing channels and take its current product lines to new markets, thus gaining the benefits of both the second and third types of growth strategies.

Like the foregoing strategies to use current markets for new products and to bring current products to new markets, this type of acquisition creates new revenue with little added cost, and hence can add significant value. (Zwilling is a private company and the actual value created in these deals is not available.)

Google’s 2011 acquisition of Motorola Mobility Holdings for $12.5 billion was, among other things, a new product—new market acquisition. The Motorola deal may have been in some measure a defensive move in light of mounting patent infringement cases against Google’s Android operating system used in 150 million mobile devices. However, the move simultaneously advanced Google in the telephony market with a leading smart-phone hardware product.[15]

Another company that executed multiple acquisitions of this type is Cisco Systems. Cisco grew to be a leader in digital network technologies through over 125 acquisitions from 1993 to 2010. Each acquisition added products to Cisco’s offering, bringing Cisco closer to a “one stop shop” for network technologies. Simultaneously, these acquisitions created a spider web of market channels, ideal for addressing its fragmented and entrepreneurial customer markets. Indeed, Cisco executed minimal integration, preferring to keep the market relationships of each acquired company. Yet it created substantial value for shareholders rising from its initial public offering (IPO) value in 1990 of $224 million to $84 billion in 2011. (At the height of the dot.com bubble, Cisco was the largest company in the world by market capitalization.)[16]

This type of growth is very difficult to achieve organically. Entering new products and markets simultaneously requires new resources and skills. Even if such investments can be made well, a new entrant must then win customers from existing competitors. So, at best, an organic approach to this type of growth strategy would take a much longer time to execute, and the probability of failure would be high.

However, it is also risky to execute such growth strategies through acquisition because diversification acquisitions have, in general, low success rates, and this type of revenue synergy can be a stretch—the deal logic is sometimes stretching reality, and, even when the deal logic is sound, the implementation can be a stretch of skills.

Keys to the success of the foregoing Zwilling and Cisco examples were excellent fit of new product lines, new channels highly suitable for a full range of products, and an implementation approach that preserved the strengths of the acquired companies.

In Part III, we extract the lessons from the successes and the failures, and outline the common risks and key success factors for revenue-based M&A strategies.

Notes

[1]. “Top 10 History of Google Acquisitions and Where They Are Today,” Lilo Magazine–Benny, March 22, 2011, accessed October 9, 2011, from http://lilomag.com/2011/03/22/top-10-history-of-google-acquisitions-and-where-they-are-today/

[2]. Kenneth Smith and S. E. Hershman, “How M&A Fits Into a Real Growth Strategy,” Mergers & Acquisitions, 32, no. 2 (1997).

[3]. SECOR Consulting, “Shareholder Value Created and Destroyed in Financial Services Mergers—Implications for Public Policy,”, report submitted to the Federal Consultation on Large Mergers in Financial Services, December 22, 2003, accessed October 9, 2011 from http://www.fin.gc.ca/consultresp/mergersRespns_9-eng.asp.

[4].“Banks in Insurance: A Five-Year Retrospective since the Passage of GLB,” Bank Director Magazine 2nd qtr. (2004).

[5]. “UPS Logistics Group to Acquire Livingston,” Business Wire, August 30. 2000, accessed October 9, 2011 from

http://findarticles.com/p/articles/mi_m0EIN/is_2000_August_30/ai_64997242/.

[6]. “Top 10 History of Google Acquisitions.” and Where They Are Today.”, ibid

[7]. International Directory of Company Histories, vol. 9. (St. James Press, Greenhaven, CT, 1994).

[8]. US Web acquired Mitchell Madison Group in 1999 and was subsequently acquired by Whitman Hartt in 2000 and renamed MarchFirst; MarchFirst filed for bancruptcy protection in 2001, see E-Commerce Times April 13, 2001.

[9]. See the Wal-Mart website at walmartstores.com at About Us – http://walmartstores.com/AboutUs/7603.aspx.

[10]. “Canadian Tire’s Mistaken Leap in the US Market”, Canadian Broadcasting Corporation, broadcast December 8, 1985, accessed October 9, 2011 from http://archives.cbc.ca/economy_business/consumer_goods/clips/16903/.

[11]. Ken Smith, “Losing (Ownership) Control,” speech to the Canadian Consulate in New York, February 24, 2010.

[12]. See Kenneth W. Smith and Eliza O’Neil, “Bank-to-Bank Deals Seldom Add Value”, ABA Banking Journal, December 2003, pp 7-10.

[13]. Sydney Finkelstein, “The Daimler-Chrysler Merger,” a case history developed at Dartmouth College http://mba.tuck.dartmouth.edu/pdf/2002-1-0071.pdf.

[14]. See the Zwilling website at http://www.zwilling.com/en-DK/Company-profile–company_profile/Chapter–kapitel/The-international-brand-policy-of-ZWILLING-J.A.-HENCKELS–1096.html, accessed October 9, 2011

[15]. Omar El Akkad,”Google’s Motorola Deal ‘by and large’ a Defensive Play in Patent Wars”, Globe and Mail, August 15, 2011, accessed October 9, 2011, from http://www.theglobeandmail.com/globe-investor/googles-motorola-deal-by-and-large-a-defensive-play-in-patent-wars/article2129737/

[16]. George Garza, “The History of Cisco,” Bright Hub, January 9, 2011, accessed October 9, 2011, from http://www.brighthub.com/computing/enterprise-security/articles/65663.aspx

Revenue Synergies in M&A – Part I

Superior value and associated risks in revenue-based M&A

(Excerpts from Chapter 3 of “The Art of M&A Strategy”, Smith & Lajoux, McGraw-Hill, New York, 2012.)

Revenue growth remains a key driver of strategy for most companies despite the challenges it brings. To be sure, bigger is not necessarily better, as the bankruptcies of titans have taught us. Yet growth in revenues does tend to be associated over time with growth in value—measured as returns to shareholders. In Grow to be Great: Breaking the Downsizing Cycle,[1] authors Dwight Gertz and Joao Baptista foresaw the limits of profit improvement without growth. When the book was written in the mid-1990s, many American corporations were obsessed with cost cutting to improve profits and boost stock performance.. However, they were not seeing a commensurate improvement in shareholder value over time. The book demonstrated conclusively that the most successful companies achieve top-line as well as bottom-line growth, and the market disproportionately rewards growth in revenue over growth in profit.

Importance of Revenue Growth

When the market values a company, it is valuing both its current performance and its future potential. Because the potential for cost cutting is finite (i.e., limited by the cost base), cost cutting offers at best a diminishing return without corporate growth. As Gertz and Baptista put it, “You can’t shrink to greatness.” However, as the top line grows so grows the potential for future returns.

This observation is borne out by the mathematics of valuation. While companies use a variety of approaches to valuing a company,[2] most valuation experts emphasize the net present value of future free cash flows.[3] Free cash flows (FCFs) are the cash a company will have left after debt payments, taxes paid, operating expenses, and capital expenditures.[4] While FCF is correlated with earnings in the long run, FCF is “real money,” whereas earnings are based on the particular accounting applied to cash and noncash items such as deferred revenue and capital depreciation.

Intrinsic value is generally calculated based on a few years of known or predictable FCF performance, plus the continuing value, where continuing value is the present value of ongoing FCFs based on certain assumptions about sustainable growth and performance trends. The standard formula for continuing value is FCF/(WACC – g), where

• FCF is the first year FCF is expected to grow at rate g
• WACC is the weighted average cost of capital (i.e., the discount rate to be applied in the net present value (NPV) calculation)

Note that FCF’s relationship with continuing value is linear. For example, a 10% higher assumption on FCF yields a 10% higher continuing value. However, continuing value is affected geometrically by g. In fact, as g approaches WACC, the continuing value approaches infinity.

Mathematics aside, this also makes intuitive sense. Potential returns are bounded by revenue. Growth in revenue releases that constraint. So an expectation of strong and continuing growth in revenue represents substantially more value creation potential, provided profitability is maintained.

The Risk Associated with a Growth Focus

Many companies that have put growth ahead of profitability have failed. Indeed, bankruptcies have resulted when good ideas have grown the company beyond its financial capacity, whether organically or through acquisitions. To cite an old proverb, the companies’ reach exceeded their grasp. Two examples will illustrate this point: Olympia & York and Allied Federated. 

Olympia & York

The Olympia & York Canary Wharf story illustrates the risks in organic growth. Olympia & York grew from a porcelain tile company in the 1960s into a highly successful commercial real estate developer by the late 1980s. It had major development projects in Toronto (First Canadian Place, the largest office development in Canada at the time); Manhattan (245 Park Avenue in midtown, three of the four towers of the World Financial Center, as well as One Liberty Plaza), and Boston (53 State Street). They also had corporate holdings including controlling interest in Sante Fe Railroad and the pulp and paper company Abitibi-Price.

The next big project was the development of Canary Wharf in London, a well-conceived but ill-timed project. Olympia & York acquired 71 acres along the Thames to expand London’s financial services industry beyond the City of London. The project was to build nine million square feet of office space that would accommodate nearly 50,000 office workers.[5]

This strategy proved overly ambitious. First there came the recession in late 1989. Second, somewhat related to the recession, London delayed the development of the London Underground to Canary Wharf—postponing a public transit link that was critical to gaining advanced lease commitments from tenants. Third, the recession so affected the value of Olympia & York’s other holdings that it could not access invested capital. Notwithstanding what has since proven to be truly visionary development of London’s Canary Wharf, the company ran out of cash and had to file for bankruptcy protection in 1991. (The company has since reemerged as a smaller player in real estate development but no longer holds most of its earlier prized properties.)

Note that this was not a reckless company; it was an otherwise well-run company highly respected in the financial communities of Bay Street, Wall Street, and the City of London. However, any investment in growth comes with some risk, and in this case the company was bankrupted by a confluence of negative events its leaders failed to anticipate and plan for.

Allied–Federated

The Allied–Federated department store merger serves as one example among many of the risks of growth through M&A. Allied had been founded in 1935 to succeed Hahn Department Stores, Inc., a holding company that managed Boston’s Jordan Marsh stores, among others. In 1950, Allied had been instrumental in the establishment of the first regional shopping center in the United States and had acquired the Stern Brothers and Block’s department stores over the course of its history. Federated had also grown through acquisition. Founded in 1929, it subsequently acquired the Bloomingdales and Burdines chains.

In 1986, Campeau Corporation saw the opportunity to merge Allied with Federated Department Stores. Allied was acquired for $3.6 billion in a hostile, debt-financed takeover. The combined company then acquired Federated in 1988, also financed with debt. This created a massive retail conglomerate with opportunity for significant cost and revenue synergies. However, as already noted, in 1989 a recession cooled the retail market and depressed the cash flows intended to finance the debt. Federated and Allied filed the second-largest nonbank bankruptcy on record and entered the largest, most complex restructuring in the retail trade. Federated emerged from bankruptcy protection in 1992 and subsequently acquired Macy’s, Broadway Stores, and Fingerhut. The company was renamed Macy’s Inc. in 2007.[6]

While the circumstances of these two examples were very different, these bankruptcies have the following in common: (1) good concepts with high potential for value creation through growth, (2) large upfront investment required exposing the company to unforeseen circumstances, (3) a confluence of events delaying the cash flows.

Short-termism Drives a Focus on Cost Cutting

With the constant pressure on CEOs to improve performance, cost cutting offers short-term results that can be directly achieved by management. Top down direction can accomplish staff reduction and reductions in marketing and expense budgets almost immediately, whether or not such reductions are in the best interests of the corporation over the long term.

In contrast, revenue growth takes time and investment and usually introduces additional risks. Organic growth may require investment in new products or facilities, the launch of new marketing or branding initiatives, expansion of the sales force, or entry into new markets, all of which require time to make an impact and none of which are guaranteed to work. Even if successful, such initiatives often pay off for the successors of the current management team. For example, many of the CEOs that took their corporations into China in the 1990s, such as Jack Welch of GE in 2001 and Matt Barrett of Bank of Montreal in 1997, were well ahead of their competitors and the payoff. They knew they had little hope of a return on their watch, but these investments ultimately paid off handsomely for their successors or their successors’ successors. Few leaders today take such a long-term view, due in part to the short-term nature of the markets.

Even in acquisitions that offer both revenue growth and cost reduction opportunities, the greater focus is usually put on the cost reduction opportunities introduced by the merger. The cost reduction measures can be directed top down and have immediate impact. For the experienced acquirers in the US bank consolidation, for example, postdeal staff reduction was down to a routine. Signet Bank employees were notified within 48 hours of the close of the acquisition by First Union in 1997 as to which day employees at each level of the hierarchy would find out their fates—top level week 1, second level week 2, and so forth, whereas the revenue synergies in these mergers were seldom achieved at all.

Given the challenges and risks, in Part II we look at specific revenue-based M&A strategies that work, including successful examples.

Notes

[1]. Dwight Gertz and Joao Baptista, Grow to be Great – Breaking the Downsizing Cycle, (New York: Free Press, 1995) .

[2]. For an explanation of all the accepted approaches, see Robert A. G. Monks and Alexandra R. Lajoux, Corporate Valuation for Portfolio Investment: Analyzing Assets, Earnings, Cash Flow, Market Value, Governance, and Special Situations (New York: Bloomberg/Wiley, 2011). For data on prevalence of use among public companes, see the 2011 Public Company Governance Survey, reporting the following usage of valuation techniques for 1,300 public companies (multiple choices allowed) for the purpose of compensation. The survey asked “When linking pay to corporate performance, how do you define ‘performance.’” The answers were as follows: profits 67.5 percent, sales 45.2 percent, ratios such as EPS 34.8 percent, cash flow 33.9 percent, stock price 30 percent, hybrid measures such as EVA or CFROI 16.1 percent, assets, 11.3 percent, other 21.5 percent. The survey aslo reported on the prevalence of nonfinancial metrics such as customer satisfaction, employee morale, and diversity.

[3]. See Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies (New York: Wiley, 2010). Valuation provides an explanation along with empirical evidence that market valuations correlate strongly with intrinsic value, calculated as the net present value (NPV) of future cash flows.

[4]. Of course, the challenge in valuing future cash flow lies in predicting the future in the first place. As William Phillips has observed, “cash flow analysis is in essence discounting a series of known or estimated payments and receipts, ranged over a time scale, at interest either to obtain a present value (positive or negative) at a given interest rate, or valuing them at various rates to derive a yield that equates the present values of payments and receipts.” Cited in Monks and Lajoux, op. cit, note 3

[5]. “Olympia and York Moves into London,” New York Times, July 18, 1987, accessed October 9, 2011 from http://www.nytimes.com/1987/07/18/business/olympia-york-moves-into-london.html?scp=10&sq=Olympia%20and%20York&st=cse

[6]. “Federated Shareholders Approve Name Change to Macy’s Inc.”, company press release May 18, 2007, accessed October 9, 2011 from http://phx.corporate-ir.net/phoenix.zhtml?c=84477&p=irol-newsArticle&ID=1004322&highlight

Strategy for a Consolidating Industry

(From “The Art of M&A Strategy”, Smith & Lajoux, McGraw-Hill, New York, 2012)

Many industries undergo periods of consolidation in which some companies identify opportunity to achieve competitive advantage through increased scale or scope, and others must follow in order to remain competitive. The opportunities are often triggered by changes in the market related to technology, globalization, or regulation that make larger scale or scope possible or more important.

It’s a compelling opportunity.  When companies in the same industry buy others to increase scale or scope, revenues are typically additive while costs are not. Simply put, it usually takes less than twice the costs to run a company twice the size in the same business. The availability of such cost savings has been the principal motivation of many corporate combinations.

However, such acquisitions have high failure rates, as measured by the shareholders of the acquiring company. Over the last 20 years of study, large acquisitions of in-market, like companies have proven 40% more likely to fail than other deals. It seems the greater the opportunity for cost synergies, the greater the failure rates. This is not to say that these combinations have not created value. Rather, the value has been transferred overwhelmingly to the sellers.

To develop successful M&A strategy for a consolidating industry, it is important to first understand why the industry will consolidate and what will drive value creation, and then to determine how to play based on opportunity and skills.

Triggers of industry consolidation

Most industry consolidations are the result of the natural progression of an industry through its life cycle from differentiation in growth to similarity in a mature or declining market. When companies start up, their value usually lies in offering something new and different to the marketplace. However, innovations tend to attract imitations, and profitable markets attract competitors. Products and services that were once unique become standard or even commoditized. Examples range from resource-based industries such as paper to consumer goods such as cell phones.

In fact, the economies of scale are so compelling in manufacturing that competing brands will source from the same factory in many industries (e.g., auto parts, home appliances, computer chips). Industries with expensive networks of infrastructure are natural monopolies, which is why regulators watch the consolidation of the railways and airlines, and why AT&T once had to be broken up.

Understanding what might trigger consolidation, or the next round of consolidation, can put a company in a position to influence or anticipate the change, and can therefore be the source of strategic advantage.

A downturn in the economic cycle is the most frequent trigger of consolidation as industry capacity suddenly becomes underutilized. That there will be another economic downturn is as certain as the next sunset, yet, when times are good, many players behave as if high prices will last forever. Those that plan for the next cycle and invest in efficiencies when they don’t have to, are more resilient to the cycles and typically become the buyers when the next downturn comes along.

Change in the relevant market is another common trigger of consolidation. Markets can become larger as a result of market integration across geographies or product categories. Free trade agreements, such as NAFTA, have triggered cross-border acquisitions. The emergence of larger consumer markets due to globalization has led to global brands and, in turn, advantages for global companies.  US bank consolidation, still ongoing, is the result of changes in interstate banking regulations twenty years ago. At the same time, integration of banking and insurance products has triggered bank-brokerage acquisitions in the US and bank-insurance mergers in Europe.

Value creation strategies, risks, and required skills

Opportunities to create value through consolidation exist along the value chain:

• In research and product development
• In operations,
• In sales and marketing.

Each of these three key areas warrants careful strategic consideration.

Research and development: While combining research and development functions across two companies reduces the cost of overhead in the short term, the more significant benefits come from managing R&D effectively across a larger, more diversified portfolio. This is best exemplified in the consolidation of pharmaceutical industry where strengthening the R&D pipeline has often been a primary motivator for mergers.

The primary benefit in the consolidation of R&D, (and most socially important in the pharmaceutical industry), is potential integration of good science to advance development. In addition to good science, however, there are several components of effective R&D management that can provide the strategic rationale for consolidation. There is first the opportunity to have a more proportional number of drugs at every stage of the pipeline. If one company has gaps in the R&D pipeline, then it cannot achieve a consistent pattern of revenue growth longer term. This clearly diminishes the net present value of that company through a lower growth rate and higher volatility (or beta) in future cash flows, and therefore a higher discount rate when projecting future cash flows. However, if the company combines with one that has drugs at complementary stages of the R&D pipeline, then the combined pipeline provides for both higher growth and lower volatility, and hence a lower discount rate. So complementary drug pipelines have more than an additive affect on value: 1 + 1 = 3.

The second R&D consolidation benefit lies in the fact that a larger laboratory provides more degrees of freedom for R&D optimization. One of the core competencies of R&D management is the ability to stop probable failures early and redeploy resources to higher-probability projects. The larger the lab, the more opportunities there are for effective redeployment, so all other things being equal, a larger lab, managed well, is more efficient.

Ultimately, the strategic opportunities in R&D consolidations relate to the ability to manage along a well-balanced pipeline, to better optimize deployment, and to diversify R&D risk. Mergers that fail in R&D consolidation can often be traced to poor skills in the fundamentals of R&D management applied to a larger combined lab or product development function.  Effective management of the integration process is also important and is a particularly subtle task in R&D, where culture and motivation are so fundamental to success.

Operations: Operations consolidation is usually about reducing unit costs through larger scale. Larger-scale operations can purchase more cheaply and benefit from scale economies in fixed manufacturing, distribution, head office and back office costs.

Cost synergies such as these are the most obvious and, ironically, the most illusive. The fundamental problem with operating-cost synergies is that, especially in a consolidating industry, the cost-synergy potential is easy to calculate and thus transparent to all possible bidders. A clear example is bank consolidation, where every bidder can count the branches and determine which ones would be rationalized. Since the market for corporate control is competitive, the value of these clear and calculable synergies will tend to be negotiated away in the bidding process. The “winning” bidder has often been the most aggressive about what synergies can be achieved and how quickly, and has bid accordingly, thereby transferring much or all of the value of the synergies to the seller and simultaneously setting savings goals that are nearly impossible to achieve.

Therefore, the operations consolidator must have superior implementation skills to win the bid and still create value.  Competitive advantage is most likely to reside in functions that are more difficult, and therefore less common, than simple asset rationalization.  For example, cost savings in purchased goods and services (e.g. office supplies, computer equipment and software, professional services, etc.) will be greater for the buyer with superior sourcing capability, where the best in the industry is often spending 15 to 20% less than others.

Another difficult function to consolidate is IT.   IT costs are somewhat less transparent than fixed assets and purchasing costs, and for most companies implementation of IT integration takes longer and achieves less than expected.  So again, the company with superior IT management skills and, in particular, a successful track record of IT integration, has a competitive advantage in a consolidating industry.

Marketing and sales: The cost synergies in marketing start with elimination of redundancies in the organization as the two organizations combine sales staffs. The savings in sales staff can be very substantial if there is a large sales force, whether it is a company sales force or is outsourced. Mergers of consumer goods companies illustrate this well. For example, if both companies market confectionary products, even if these products are not directly competitive, the merger can reduce sales calls by up to 50% because one visit to each retailer replaces what were two visits when the companies were separate.

There are also savings in marketing costs from consolidation of advertising agencies and, depending on how much the products were competing with each other, savings in advertising and promotion.

When the products and markets of the merging companies are complementary rather than overlapping, there are fewer cost synergies but the revenue synergies can be substantial. For example, the globalization of consumer goods markets provides many opportunities for merging companies with complementary product and geographic strengths to use each others’ marketing and sales channels to enter or better penetrate new markets. For example, the reach of Adam’s Brands expanded when Adam’s Brands was acquired by Cadbury in 2002 and again when Kraft acquired Cadbury in 2010.

Note that this is not a cost synergy, but a positive revenue synergy stemming from market integration. The revenue gain results from the companies’ products being somewhat different but with potential in each others’ market channels.

Notwithstanding the generally positive revenue synergies in complementary product–market combinations, the sales and marketing synergies in consolidation plays often turn negative due to revenue losses. Unlike cost synergies, which are under the control of the merging companies, revenue synergies are ultimately under the control of the customer. Again, superior marketing skills are required to derive such benefits and achieve strategic advantage in a consolidating industry.

Buy, sell or get out of the way

Companies can grow and prosper without acquiring or merging. McCain Foods Limited, Wal-Mart, and Research In Motion Limited (RIM) built leading international companies in food, retail, and technology, respectively, mostly organically. However, each of these companies had a new and distinct product or business model and was prepared to invest heavily in expansion.

Companies in consolidating industries that lack such a distinct advantage must buy or they will eventually be targets. Selling into a consolidating industry is not necessarily a bad strategy if the company believes that it can capture more value by selling and if the company prepares to be an attractive target.  Alternatively, some companies in consolidating industries retreat into a defendable niche, less subject to commoditization.  For example, some fine paper companies and ethnic banks continue to operate profitably without the economies of scale of the larger players.

However, the companies that can lead consolidation have the greatest potential to create value. For example, in the consolidating mining sector, handsome premiums were paid for Alcan, INCO, and Falconbridge, but these premiums pale in comparison to the value created in the development of mining consolidators such as Xstrata, BHP Billiton, and Barrick Gold. Belgium’s InBev Brewing grew from $3 billion to $60 billion by leading the consolidation of global brewing, eventually accumulating the financial strength to acquire America’s brewing giant Anheuser-Busch. There are many other successful acquirers that have built shareholder value in a range of consolidating industries: R.R. Donnelley & Sons Company in graphics, Magna in automotive supply, Thomson-Reuters in information services, Deutsche Telekom in telecommunications, Kraft in consumer goods and others.

Acquisitions are considered high risk, but in a consolidating industry, there may be greater risk for companies that choose not to participate. They will become subscale in the consolidated industry and, unless they operate in a defendable niche, they will become uncompetitive and ultimately unattractive as a target.

A more comprehensive treatment and examples can be found in Chapter 2 of “The Art of M&A Strategy”, Ken Smith and Alexandra Reed Lajoux, McGraw-Hill, New York, 2012.

BLACKBERRY SALE AND WHY EVERY COMPANY NEEDS AN EXIT STRATEGY

(Excerpts from The Art of M&A Strategy, Smith & Lajoux, McGraw Hill, New York, 2011, updated)

 

“You got to know when to hold ’em, know when to fold ’em,

Know when to walk away and know when to run.”

Kenny Rogers—The Gambler

 

Most companies have to consider acquisitions and divestitures at different stages of development. Ultimately, most companies will also be faced with an opportunity to sell the entire company, and in some cases there will be little choice if shareholders like the premium being offered.  Yet, many companies do not consider acquisitions, divestures or, in particular, the ultimate sale of the company as part of strategy development.

How should a company decide to be a buyer or a seller and when? A case in the business press at the time of writing serves to illustrate the importance and difficulty of these questions.

Research in Motion/Blackberry

Research in Motion (RIM), now known as Blackberry, is the company that invented the Blackberry pager. By any measure, the company was hugely successful up to 2010. The very idea of “push” wireless e-mail exchange on handheld devices was new when RIM was founded and launched the Blackberry in 1999.[i] The product quickly became an essential business communications device and was indeed the sole means of communications for thousands in the financial industry two years later during the tragedy of 9/11.

A tech startup from Waterloo, Canada, RIM passed $1 billion in revenue in less than five years and was operating worldwide. Wall Street was so dependent on and comfortable with the Blackberry that even as smartphones added e-mail capabilities at the millennium, the money men preferred to carry two devices on their belts rather than give up their Blackberries. Ultimately, RIM added telephony to the Blackberry, initially with a device that required a headset and then with integrated speaker and microphones in 2003. By 2006, the Blackberry was second to only Nokia in smartphones globally and dominated the US market.[ii]

RIM’s success to this point was in part due to its singular focus on serving the business segment. For example, RIM’s 2006 annual report stated that it provided “software and services to keep mobile professionals globally connected to the people, data and resources that drive their day” (emphasis added).

However, perhaps reluctantly, RIM was drawn in to compete with consumer offerings. In particular, Apple’s iPhone bridged the consumer and business markets and surpassed RIM and Nokia in sales.[iii] Blackberry responded with more consumer-friendly smartphones and a tablet to compete with Apple’s iPad. In the 2010 annual report, the earlier emphasis on the professional is muted, and RIM speaks more of “customers” and “consumers.”[iv]

By the middle of 2011, the market was indicating considerable pessimism about RIM’s future in this new competitive arena. RIM’s valuation fell about 50% from a year earlier,[v] and there was speculation that RIM could be a takeover target. Now, two years later, it has declared a refocus on professionals and laid off thousands of staff, discussions of stock value have turned to the value of patents versus a going concern, and it is desperately seeking a buyer to avoid a continuing death spiral.

This leads to a series of questions about if and when RIM should have sold or found a partner.

Should RIM have sold their patent or their company when they had merely proven the success of the idea? Most tech startups sell early, and the inventors and investors make a few million, perhaps to invest in their next venture. They leave the business-building and its rewards to others. The founders of RIM went on to create billions in value for shareholders by commercializing their invention, ultimately revolutionizing modern business communications.

Should RIM have sold when telephony became an expected feature of PDAs? While somewhat slow to respond, RIM developed telephony capability and became the leading smartphone in the United States for a time. Whether or not it was the intent at that time, the Blackberry smartphone also succeeded in penetrating the high-end consumer market.

Should RIM have sold when it became clear that the business and consumer markets would converge? This forced RIM out of its comfort zone and placed it in direct competition with the consumer tech giants.

Or should RIM have bought or merged? When its stock was a valuable currency, should RIM have sought business combinations in anticipation of the business-consumer market convergence? And if such foresight is unreasonable to expect, should it have acquired simply because it could, and because with the high valuations of its stock it could have acquired real options covering a range of market outcomes along with building greater scale and R&D capacity?

Moreover, did RIM need an exit strategy and/or an M&A strategy beyond its singular focus on the professional market well before facing the challenges of the past 3 years?

Our purpose is not to second-guess RIM’s strategy, which is too easy and perhaps unfair to do in hindsight, but rather to illustrate that these questions are relevant even for the most successful companies.

Learn from the Portfolio Companies

Portfolio companies buy and sell companies as a primary business activity. Their top executives have the advantage of being one step removed from the businesses in the portfolio, which can bring greater objectivity. They also face buy and sell decisions as often in a year as most executives do in a career.

Successful portfolio companies have a clear idea of how they will add value, well matched to the interests and competencies of the parent company. They understand the value of growth – how the cumulative size of such a company provides it with the means to raise cash and with the financial scale to look at larger deals. For the portfolio companies that are publicly held, a value-creating growth trajectory also supports high stock valuations, which reduces the likelihood of unwanted takeover.

Most successful portfolio companies define exit strategies in advance, with the possible exception of companies that actively develop synergies between or among their holdings. Berkshire Hathaway, for example, will hold an asset “as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations.”[vi] GE’s mantra is to be first or second in each industry or get out. In the past three decades, GE has sold six out of ten acquisitions. Newscorp has grown by acquisition but has also sold hundreds of companies along the way.  Thomson’s transformation to an information services company (now Thomson-Reuters) was in part funded through the sale of its newspaper assets.

In all these examples of portfolio companies, there is a long-term view of shareholder value creation through pursuit of growth by acquisition, including defined sale criteria so that funds can be redeployed to the best use within the defined growth strategy.

The approach of the successful portfolio companies can be applied in most businesses. Looking at the company as a portfolio of assets can lead to new ideas for value optimization, including acquisitions and asset sales. Such an outside-in, objective view puts management in the role of the parent company of a portfolio of assets; that is, considering what the company is worth and what a dispassionate new owner would do to maximize value.

Consider the Sale Value of Every Asset

In theory, if selling an asset maximizes value then sale should be considered. Considering all assets as salable can change how they are managed, usually for the better. Public companies concerned about takeover sometimes conduct a portfolio review or “Raider Analysis” to pinpoint value gaps and divesture options. Most companies that undertake to restructure in this way don’t sell everything that could fetch a premium, but they usually improve financial performance of retained assets, become more tightly focused, and are better positioned for growth.

This also applies to the total enterprise. If the sale value is higher than the value the company can achieve by remaining independent, then sale or merger should be considered.  However, too many companies are let go for a premium over value “as is”, i.e. without adequate consideration for potential value.

The question really comes down to timing. On the one hand, consider that virtually every company will ultimately be sold in whole or in parts in the long run. Of the Fortune 500, only 62 companies have appeared on the list every year since the magazine began publishing it in 1955. Another 2,000 or so have come and gone. In a little more than half a century, 88% of what were the largest companies were gone from the original list: acquired, broken up, or shrunken. So in one sense it is not a question of if but when.

Taking a cue from the portfolio companies, the exit strategy should be considered even if there is no intention to sell in the short term. Considering the exit strategy can lead to good questions about how to maximize value. Every company that considers exit can then consider the optimal time and circumstances, and how to get to the optimal position and performance. In most cases, consideration of exit will result in more aggressive growth plans. Once a company determines that a strategic partner (i.e., a merger or sale) is necessary ultimately, it might accelerate growth and performance improvement programs so that they could be positioned well for a desirable partner.

On the other hand, most companies sell too early or cede industry leadership to a more ambitious competitor. More often than not, there is more value created in corporate growth than in invention and early-stage development. For example, when it comes to intellectual property, patents are valuable, but it is what a company does about its patents that determines long-term success. Part of the power of Thomas A. Edison was that he was not only in the laboratory inventing things, but he was also in the boardroom leveraging them.[vii] So his legacy is not only the light bulb but also in General Electric.

For mature companies in restructuring industries, there is yet more value created by industry leaders. Companies like Xstrata in mining, InBev in brewing, Kraft in consumer goods, Manulife in financial services, and Thomson-Reuters in information services have all created more value than the premiums of all the companies that sold to them combined.

Not every company can come out on top—there must be buyers and sellers—but every company should evaluate the buyer/consolidator option as well as the exit option and then weigh the returns against their competencies; the ambition of the company, its board, and its shareholders; the risks of trying and failing; the risk of selling too late; and the opportunity cost of selling too early.

By Ken Smith, Corporate Development advisor and author of “The Art of M&A Strategy” with Alexandra Lajoux, McGraw-Hill, New York, 2012 

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[i]. http://us.blackberry.com/newsroom/news/press/release.jsp?id=702.

[ii]. Research in Motion, 2006 Annual Report; share as reported by Gartner Group.

[iii]. Matt Hartley, “Apple Tops Global Smartphone Rankings, RIM Slides to No. 4,” Financial Post, August 5, 2011.

[iv]. Research in Motion, 2010 Annual Report.

[v]. Research in Motion (RIM) report in the Global and Mail website. http://www.theglobeandmail.com/globe-investor/markets/stocks/chart/?q=rim-T

[vi]. “Letter to Shareholders,” Berkshire Hathaway Inc., 2009 Annual Report.

[vii]. Julie L. Davis and Suzanne Harrison, Edison in the Boardroom: How Leading Companies Realize Value from their Intellectual Assets (Hoboken, NJ: John Wiley, 2001); Suzanne Harrison and Patrick Sullivan, Edison in the Boardroom Again (Hoboken, NJ: John Wiley, 2012).

Canadian Telecom Policy Overreaching, Again

With apologies to Sir Walter Scott, what a tangled web of policy we create when first we practice to manipulate.

Getting the policy right for the Canadian telecom industry is difficult now largely because we’ve had it wrong for so long in so many ways.

First, the industry was protected long after it was necessary to protect it for national security (the initial basis of protection of the telecom industry in most western jurisdictions).  With no foreign competition, the CRTC and The Competition Bureau had to make sure there was adequate domestic competition and thus limited the scale of domestic players.  As recently as 2007 when Bell was in play, the merger of Bell and Telus was discouraged.  So decades of protection of the Canadian industry left Canadian companies with uncompetitive scale relative to international players.

In the same period, American telecom players were able to merge and then grow internationally on the strength of their much larger domestic scale.  Other markets opened up to international competition and grew international competitors.  For example, Deutsche Telekom, once a bloated, German utility, was protected just long enough for it to become internationally competitive and only then were foreign competitors unfettered in Germany, which resulted in a competitive German market and an internationally competitive national champion.

Second, a belated effort to open the Canadian market gradually by offering spectrum only to new players in 2008, failed to recognize the importance of scale within Canada.  Spectrum granted to small players created a flurry of new consumer offers, but no viable competitors to Telus, Bell and Rogers.  Unable to grow fast enough against entrenched players, these new entrants are on the ropes now seeking more policy favours, merger partners or perhaps bankruptcy protection in the future. 

This has now led to the policy change to allow foreign acquisitions of up to a 10% market share limit, inviting the Verizon proposal to acquire Wind Mobile.  Now, the industry is claiming that the policy favours such foreign competitors:  they have access to spectrum not available to the major Canadian players; they can acquire companies that the Canadian players are forbidden to acquire; and they can piggyback on the pre-built infrastructure.  In addition, buyers like Verizon have scale that the Canadian players were not allowed to achieve historically. 

A playing field now tilted in favour of foreign competitors is the unintended consequence of policy that over-reached, trying to construct a desired outcome.

How do we untangle this mess? 

Policy should provide a framework of competition, i.e. the rules for a fair fight and a referee; it should not strike blows for one side or the other.  The Canadian telecom policy framework needs to change but should not be used to manipulate the industry toward a particular outcome.

If it is desirable to have more large-scale competitors, then they will have to come from abroad.  However, the same access to spectrum and acquisitions should be available to all.   If Verizon is allowed to enter and does, (and it would surely be followed by others), then there would no longer be a case to keep Bell, Telus, Rogers or others apart.  If it deemed no longer necessary to protect the Canadian industry, then let them fight on a level playing field for spectrum, acquisition targets and foreign partners. 

In the latter case, we could expect most, if not all, of the Canadian industry to be sold to larger scale international competitors – perhaps a poetic consequence of decades of protective policy, but it would be yet another Canadian industry sold off and regulators would then be left with the task of forcing affordable service coverage to the far corners of the nation.

 

As printed in the Toronto Star, August 25, 2013.

Shuanghui-Smithfield an important test case for US foreign takeover policy

The proposed $4.7 billion takeover of Smithfield Foods by China’s Shuanghui International Holdings raises important questions for US policy makers regarding foreign takeovers:

1. Should food and agriculture be regarded as a strategic industry for which some level of ownership control matters?
2. Is this a takeover by an independent foreign business or by a company controlled by a foreign state?
3. In this industry as in others, why is the US losing in the global market for corporate control?

 

1. Strategic Industries:

Which industries, if any, are strategic to US interests and worth protecting?  Washington can block deals if they are regarded as a threat to national security.  For example, many components of the defence industry are kept in US hands to protect secrets and ensure US control of US defence.  Washington has also discouraged foreign acquisitions of ports and energy assets.

So what about food and agriculture?  Surely, to say that food and agriculture is a strategic industry is stating the obvious.  Food, shelter and security are at the bottom of Maslow’s hierarchy of needs, i.e. the most basic.  Blessed as we are, we may take it for granted, but for those countries that lack self-sufficiency in food or suffer from unreliable or unsafe agricultural supply chains, food shortages are the source of great misery, division and civil conflict.

In particular, food safety is a growing concern.  The standards for food safety in the US and other western countries are more difficult to meet than those elsewhere.  In addition, the industry is currently making significant investments in food tracing technologies, as consumers seek greater transparency of sources, and regulators and industry need to trace problems to source for crisis management and in order to better ensure accountability for safe practices and safe products.

The acquisition of Smithfield Foods in and of itself is no threat to America.  US regulations will still apply and US management will stay in place (for now).  As company president Larry Pope said: “Nothing’s going to change.”[1]  However, policy makers need to decide where and how to draw the line.  Smithfield Foods is the world’s largest pork producer, with 46,000 employees in 25 states[2].  How many Smithfields will it take before the US is overly dependent on food and agriculture decisions made by foreign controlled enterprises? 

Note that regulation alone does not ensure food safety.  In fact, as any food-processing expert will tell you, the culture of safety within the corporation is more important than regulations.  Post audits of crises here and elsewhere have borne this out.  So it is not enough to say that Smithfield Foods will be subject to the same regulations if the safety culture of the organization could ultimately be homogenized with China’s.

 

2. State Owned/Controlled Enterprises (SOEs):

Is Shuanghui an independent business enterprise as it appears to be or is it unduly controlled by a foreign government?  One reason to ask is that state owned or state controlled enterprises (SOEs) can have unfair competitive advantages, especially in the M&A markets, such as lower cost of capital, direct or indirect policy support at home (e.g. protection from takeovers), and active government promotion abroad.  Another reason is that it just doesn’t sit well to have critical resources in energy, mining and agriculture controlled by foreign governments.  In times of peace and plenty it may not matter, but in times of conflict or shortages it could matter a great deal. 

Many countries now draw this distinction in review of foreign takeovers and apply different rules to SOEs.  Most recently Canada announced new policies for SOEs and as Prime Minister Harper put it, “Canadians have not spent years reducing the ownership of sectors of the economy by our own governments, only to see them bought and controlled by foreign governments instead.”[3]

So while the US needs to be “open for business”, perhaps it should be more open to real businesses than to SOEs, especially in strategic sectors such as food and agriculture.  Like many Chinese companies, the degree to which Shuanghui International Holdings is state controlled is a matter for study, and policy makers will need to look beyond simply ownership positions and board seats to understand CEO Wan Long’s political involvement and to determine the true nature of the enterprise and its importance to China.

 

3. The Market for Corporate Control:

While the US was once at the forefront of global business development and growth, it is now losing in the global market for corporate control.  In the previous decade, the US was the world’s largest net seller of corporate assets[4], selling control of over $300 billion more in corporate assets than it acquired.  The US is followed by the UK and Canada as the countries selling more than buying, as industries restructure on a global basis.

Policy is a factor.  The buyers are increasingly from developing economies, but the countries of continental Europe were the biggest net buyers in the last decade, acquiring in the US and globally.  Notably, continental Europe and the M&A active developing countries each have less bidder friendly policies than the US.  Differences in securities law, foreign investment policy and governance practices make it more difficult to acquire in France, Germany, or Italy, for example, than in the US, UK or Canada.[5]  In some of the largest developing economies, such as India, China and Brazil, many industries are protected and acquisitions without a local partner range from difficult to impossible.   So all other things being equal, these policies support a continuing trend of net losses in corporate ownership for the more open US, UK and Canadian economies. 

Policy makers and corporate leaders should reflect on this trend.  Notwithstanding the benefits of foreign investment to the US economy, the position of US companies on the global stage is also valuable.  The corporate headquarters positions and supporting professional services, (e.g. investment banking, corporate law, accounting and audit, consulting), are among the highest paying jobs in America and support the core of most American cities.  These are real headquarters, not regional division offices or titular edifices.

Shareholders are also often losing out when companies sell into a global consolidation.  The price premiums paid to shareholders in a takeover pale in comparison to the shareholder value created by successful global growth.  Directors take note – the long-term interests of shareholders are often traded off for the short thrill of a one-time takeover premium.

US competitiveness in international M&A is highly relevant to the fortunes of all strategic industries, including the food industry.  Is the imbalance in takeover policies leaving American companies more vulnerable to takeover than their international competitors?  Are corporate leaders, especially in the food industry, too content with the American market?  The global food industry is ripe with opportunity – are companies like Smithfield selling when they should be buying?

Ken Smith

KenSmith@DundeeStrategy.com

Twitter @smithkennethw

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[1] Chinese takeover questioned, by Doug Palmer for Reuters, as published in the National Post, July 11, 2013.

[2] Ibid

[3] The Globe and Mail, Published Sunday, Dec. 09 2012, 10:47 PM EST.

[4] See Losing (Ownership) Control, Smith, Harvard Business Review, June 2009; data was later updated to include the entire decade.

[5] See Chapter 9 of The Art of M&A Strategy, Smith & Lajoux, McGraw-Hill, New York, December 2011

Canadian securities policies on takeovers need to be updated to the global M&A context

Canadian securities policies have made Canada a very “bidder friendly” environment in which defensive measures are restricted.  When a takeover offer is presented, Canadian corporate boards have little option but to auction the company.

Canadian Securities Administrators (CSA) has proposed some incremental changes to policy with respect to the use of shareholder rights plans.  These changes are directional improvements, but the Autorité des Marchés Financiers (AMF) of Quebec has proposed a more substantial review to give back the responsibility and accountability for corporate control transactions to Boards of Directors.  The CSA and AMF requested comment on their respective proposals:

• CANADIAN SECURITIES ADMINISTRATORS REQUEST FOR COMMENTS REGARDING PROPOSED NATIONAL INSTRUMENT 62-105 SECURITY HOLDER RIGHTS PLANS DATED MARCH 14, 2013
• AUTORITÉ DES MARCHÉS FINANCIERS CONSULTATION PAPER: AN ALTERNATIVE APPROACH TO SECURITIES REGULATORS’ INTERVENTION IN DEFENSIVE TACTICS DATED MARCH 14, 2013.

As this blog site is dedicated to matters of business and public policy related to restructuring industries, I thought this matter to be relevant and I am sharing below the comments I offered to the CSA and AMF.

The Relevant Context is Global

The M&A market has become a global market in which Canadian companies have been losing ground under current policies.  Note that:

• More than 50% of all transactions globally (by value) are now international[1]; going forward, international deals are expected to dominate the M&A market[2].
• In the last decade Canada was among the largest net sellers of corporate assets, following only the US and the UK.[3]  Relative to the size of our economy, Canada has been the largest net seller of corporate assets in the world.
• The biggest net buyers of Canadian corporate assets have been from Europe and the developing economies, ahead of the US.

Policy has been a contributing factor to Canada’s poor performance in the market for corporate control.  A combination of securities policies and takeover review policies and practices relative to other jurisdictions made Canada the most bidder-friendly jurisdiction of the major economies in the last decade.  I emphasize that while the policies may or may not have been rational in a Canadian context, it is the differences in policies that have tilted the playing field in favour of foreign buyers.

As a result, many Canadian companies that might have pursued global growth strategies have been acquired.  While a one-time premium was paid to shareholders in each case, these premiums pale in comparison to the value created by global growth.[4]

This distinction between one-time acquisition premiums and long-term value creation brings us to the issues at hand.  On the one hand, directors’ duties are to the corporation and, as such, directors are responsible to act in the long-term interests of the company and its shareholders.  Current policies unduly limit the exercise of independent director judgment in one of the most important decisions in the life of a  company – a change of control transaction, whether domestic or foreign. 

On the other hand, in the context of a change of control transaction, shareholder interests are more short term.  This is principally due to two factors:  1. The possibility of a transaction attracts many new shareholders only interested in the short-term; 2. Even long-standing shareholders are not privy to the long-term potential of the company that may be based on confidential strategic plans.

So, ironically, by providing the shareholders with greater influence relative to directors, the potential long-term shareholder value creation is blunted.  This is evidenced by the relative ease with which Canadian companies can be put into play under today’s policies, the resulting disadvantaged position of Canadian companies versus foreign competitors, and the ongoing net sell-off of Canadian corporate assets.

It is from this context of the global M&A market, Canada’s disadvantaged position, and the undermining of the directors’ duties to the corporation in change of control transactions that I wish to comment on the proposed policy changes. 

AMF Proposal 

The AMF Proposal takes a fresh look at defensive tools available to Canadian companies, respecting the duties of directors to the corporation and putting the onus on the courts to rule on the discharge of directors’ duties:

• Decisions regarding defensive tactics would reside with directors who are obliged under Canadian corporate law to act in the best interests of the corporation, including long-term shareholder value creation.
• Courts would determine the propriety of defensive tactics as part of their jurisdiction over the discharge of directors’ fiduciary duties.  
• Securities regulators would intervene only where a board’s actions or decisions are clearly abusive of shareholder rights or negatively impact the efficiency of capital markets.

Increasingly, Canadian boards are engaging with shareholders to learn their perspectives and share information.  Shareholders have the opportunity to sell their shares, vote for changes on the makeup of the board or to challenge in the courts. 

The AMF approach would put decisions regarding change of control transactions with directors who have a legal responsibility to act in the best (long term) interests of the corporation.  As a result, a hostile bid, whether domestic or foreign, would no longer automatically put the company in play. 

In particular, the AMF Proposal would close some of the gap between Canada’s available defensive tactics and those of other relevant jurisdictions.  However, it would by no means be protectionist – Canada would remain more open than the US, most of Europe, Japan, Australia and the developing economies.[5]

The CSA Proposal 

The CSA proposal is a directional improvement but is limited in scope and potential impact. 

By providing a comprehensive regulatory framework for rights plans and more discretion over the use of rights plans as proposed by CSA, there would be less need and less frequent need for regulator intervention.  Moreover, the CSA Proposal has the CSA exiting the business of regulating individual shareholder rights plans, which would be a positive development.

However, the CSA proposal is too limited in scope to impact Canada’s position:

• Extending rights plans to 90 days leaves companies vulnerable to short-term holders voting for the termination of the plan, pushing the company into auction.  This remains contrary to the board’s legal fiduciary duty, underscored by the Supreme Court of Canada decision in the BCE case.
• Annual shareholder approval of rights plans would define rights plans as short-term measures, contrary to the board’s responsibility for the long-term interests of the corporation.
• Other defensive tactics commonly employed in other jurisdictions are not addressed.

Summary and Conclusion 

The market for corporate control has become a global market.  Canada’s regulations and policies regarding takeovers are outdated and not aligned with international policies and practices, and as a result Canadian companies are disadvantaged. 

A comprehensive rewrite of policies is, therefore, required to address the new global context for M&A.  The AMF proposal considers the duties of directors and seeks to position boards to consider the long-term interests of the corporation and its shareholders in change of control transactions.  The CSA proposal is a relatively minor improvement on one defensive tactic, but it would leave Canadian companies subject to auction in the event of any opportunistic bid. 

In particular, the AMF proposal would keep Canada an open market for foreign investment while making more normative defensive tactics available.  However, the CSA proposal would not materially alter the disadvantaged position of Canadian companies in the global market for corporate control.

References:

1. Positioning Canadian Firms for the Global Market for Corporate Control, SECOR Consulting’s submission to Canada’s Competition Policy Review Panel, February 2008.  (SECOR was acquired by KPMG in 2012; the report remains available on line (search by title) or from the author).
2. Compete to Win, Final Report of Canada’s Competition Policy Review Panel, June 2008; see especially pp 76-78 titled Strengthening the Role of Directors in Mergers and Acquisitions.
3. Losing (Ownership) Control, Ken Smith, Harvard Business Review, June 2009.
4. The Art of M&A Strategy, Ken Smith & Alexandra Reed Lajoux, McGraw Hill, New York, 2012; See Chapter 9 Global Industry Restructuring for review of international policies and practices.

Footnotes

[1] Bloomberg M&A Outlook, available at http://www.bloomberg.com

[2] ibid

[3] “Losing (Ownership) Control”, Ken Smith, Harvard Business Review, June 2009

[4] “The Art of M&A Strategy”, by Ken Smith and Alexandra Reed Lajoux, McGraw Hill, New York, 2012

[5] See The Art of M&A Strategy, pp 194 to 203 for a summary of international defensive tactics

Introduction to bizpolicy

The globalization of the economy is presenting many new challenges in business and public policy.  In developed economies, companies find themselves in changed markets facing new competitors, and public policy that was largely developed to manage local economies is proving naïve as industries restructure on a global basis.  In developing economies, there are tremendous growth opportunities but patience is required to form new partnerships, and to develop new business models to serve local needs and that do not leave the poor behind.

Much good can come of global industry restructuring for business and society, but it’s a new world and businesses, governments, and social enterprises are all encumbered by rules and norms of the past.  For example, it is clear to most businesses that the developing economies are the growth markets of the future, but faced with constant pressure for short-term performance many have been reluctant to invest in international growth, particularly in developing economies.   It is clear to most governments that industries are restructuring on a global basis, but encumbered by outdated constitutions and local public opinion, many governments continue to develop policy with a focus on domestic market structures, failing to facilitate international competitiveness.  It is clear to most NGOs that sustainable solutions to hunger and poverty require working business models, but the social damage of profit-driven business ventures littering the history of international development has left deep-rooted skepticism of business.

This space is intended as a place to dialogue on the development of business and public policy in the context of global industry restructuring.  At times it will perhaps seem eclectic as it moves from business issues such as acquisition strategies to social issues such as food security.  However, all will be connected directly or indirectly with the challenges presented by the globalization of markets, the consequent restructuring of industries, and the need for new models to serve both business and societal needs.  As a bi-product, perhaps a broad spectrum of readers will find common ground some of the time, the basis for healthy debate at other times, and at all times a greater appreciation for alternate perspectives and the need for business, government, and social enterprise to work together.

Next Post:  Imperatives for companies in restructuring industries.