The M&A Risks in a Consolidating Industry

From The Art of M&A Strategy, by Ken Smith and Alexandra Reed 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 20 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 the 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.