Constructing A Synergistic Base For Premier DealsPart II :Unless all cornerstones of synergy – vision, strategy, systems integration, and culture – are in place, an acquisition is off to a rickety start.

How can acquirers know when they are likely to realize little value gain from an acquisition even at a zero acquisition premium? Here, we put the contestability conditions within a managerial framework. Figure 1 illustrates the cornerstones of synergy. The four cornerstones represent the major elements of an acquisition strategy that must be in place for there to be any likelihood of synergy. The diagram is presented in the context of the premium decision and competitor reactions. If any of these four cornerstones is missing when the deal is done, synergy will be a trap; the premium is likely to represent a total loss for the shareholders of the acquirer. As with the contestability conditions, these cornerstones are necessary but not sufficient components to ensure performance gains. Achieving significant synergy is fundamentally difficult and even at a zero acquisition premium, synergy will be limited. Acquirers can easily destroy value in the stand-alone businesses by attempting to gain synergies that have little chance of occurring. Executives who are making the costly mistake of throwing additional resources at a failing acquisition strategy can decrease the value of their businesses and make them more vulnerable to competitive attacks. A poor understanding of the fundamentals of synergy can hurt acquirers in three important ways: nPostacquisition planning will be a disappointing waste of managerial resources. nThe limits to performance improvements will not be understood, so overpayment will be predictable; valuation will consist of hollow and spurious assumptions. nOriginal values of the acquiring and target firms will be severely jeopardized. The premium will be lost, and additional investments to achieve synergy will subtract shareholder value. Strategic Vision Strategic vision is where all acquisitions begin. Management’s vision of the acquisition is shared with suppliers, customers, lenders, and employees as a framework for planning, discussions, decisions, and reactions to changes. The vision must be clear to large constituent groups and adaptable to many unknown circumstances. Viacom’s vision to be the “premier globally branded content provider” is a clear communicable vision, as was AT&T’s vision for the NCR acquisition to “link people, organizations, and their information in a seamless global computer network.” Sears’ one-stop shopping concept in financial services was really a wonderful vision. A 1989 Harvard case study put it this way: “Just imagine, with virtual one-stop shopping, a customer could find and buy a house, through Sears; finance and insure it, with Sears; furnish it, decorate it, and fill it with well-serviced appliances, from Sears; and contract for a new fence and a home security system, by Sears. Later, he or she could obtain a second mortgage to remodel the kitchen or build an addition, purchase insurance to cover that second mortgage, and then buy the paint, tools, and cabinets for that home improvement – all from Sears, In addition, they could invest in the stock market or buy an IRA, from Sears; or rent a car or subscribe to home movies, at Sears; plus pay bills, order flowers for a relative, deposit a weekly paycheck, and even have their income tax figured, all at Sears.” Unfortunately for Sears, the vision that customers actually wanted to or would buy these different products and services in one place and improve the core merchandising business was a mirage. Investment bankers and executives are usually very good at coming up with a compelling and attractive strategic vision statement. Without the other three cornerstones, however, the vision has little use. The vision must be a continuous guide to the actual operating plans of the acquisition. If the vision does not translate into real actions, it can provoke damaging reactions from competitors. Visions clue competitors in to the acquirer’s actual operating strategies. What better time for a competitor to launch an attack on a major market of an acquirer or the target than on the announcement of a major acquisition? American Airlines took critical share points away from United in its major Chicago hub soon after United’s (now divested) acquisitions of Hilton Hotels and Hertz in the mid-1980s. At point of sale it might seem intuitive that an airline, hotel chain, and rental car company could create an integrated travel strategy. In fact, these three businesses have little in common in the preceding parts of their business value chains, and the hotel and car rental businesses diverted valuable management attention away from the core airline business. The Quaker Oats acquisition of Snapple began with a promising vision and a zero premium. The November 1994 acquisition was, at $1.7 billion, the largest in Quaker’s history. William Smithburg, chairman and CEO of Quaker, pronounced that the acquisition “brings together the marketing muscle and growth potential of two of the great brands in an increasingly health-conscious America: Gatorade in sports drinks and Snapple in ice teas and juice drinks.” The stock market didn’t get it though. Quaker paid a zero premium for Snapple yet lost 10% of its market value, or nearly $500 million, on announcement of the acquisition. Snapple went on to lose $100 million in 1995 and even decreased its planned marketing budget. Why? Quaker was not the only company to notice the iced tea and fruit juices market. PepsiCo re-launched its Lipton’s Brew brand of ready-to-drink iced teas and Coca-Cola launched its Frutopia brand of fruit drinks with $30 million of advertising and $150 million in increased production capacity for the brand. In July 1996, Quaker announced a plan to give away $40 million of Snapple to shore up projected market share losses to the new products of Coca-Cola and PepsiCo. This was in addition to a planned $30 million in advertising. If synergies ever emerge from the Quaker-Snapple acquisition, it is highly unlikely that they will come from the product market. Vision is only the beginning. Operating Strategy Management’s operating strategy must respond to the contestability questions posed earlier: What can be further sustained or improved along the value chains of the businesses that competitors cannot challenge, and how can competitors be attacked and disabled? The operating strategy cornerstone determines where any contestability gains can occur. Given that most major acquisitions involve little preacquisition planning, most acquisitions have no real operating strategy on the day the deal is completed. Instead there is a restatement of the vision with comments about how good the “fit” is between the assets of the acquirer and the target. But actions speak louder than words, and without an operating strategy the vision is just words. For example, Time Warner’s acquisition of Turner Broadcasting System leaves much in doubt concerning the changes in the competitive strength of the companies. Chairman Gerald Levin has claimed that 35% of the new company will be owned by people who “understand the media business and the powerful nature of where it’s going.” Does this mean that the companies will be managed better than before? An operating strategy arising out of the acquisition must address how it will be more difficult for Viacom, Westinghouse, Disney, and News Corp. to attack Time Warner-TBS along the value chains of the businesses in which they all compete. Shareholders lost over $2.2 billion of market value in just two months following the announcement of this acquisition (over $1 billion on announcement), so the challenge for Levin is to convince the markets, current and potential customers, and competitors that positive change will occur. Simply having a “compelling fit” among the businesses, even where the businesses may have great competitive competencies, will not generate improvements in performance. The operating strategy must address how the new company will be more competitive along the entire value chain of the businesses. Acquisitions are often an attempt to divert attention away from a failing core business with the hope that the acquisition might provide a miracle for the acquirer. If answers are not forthcoming to the contestability questions, what becomes obvious is a vision with no strategy that will increase competitiveness or generate performance gains. The following examples clearly illustrate this problem. Sears, Roebuck and American Can A telling contrast is that of Sears’ experiment in an integrated financial services strategy with that of American Can’s transformation into Primerica. The major moves of both of these companies into financial services, following prolonged weakness in their core businesses, occurred at about the same time but represented very different strategies. After years of declining market share and performance in merchandising, Sears considered a number of diversification opportunities. It had a history of success with Allstate as a stand-alone insurance business, and Allstate itself had made several diversifying acquisitions during the 1970s. These included a California savings and loan, a mortgage origination and insurance company, and a significant investment in Coldwell Banker, a commercial and residential real estate firm. In October 1981, Sears acquired Dean Witter Reynolds and Coldwell Banker in the same week. From the one-stop shopping vision described earlier, Edward Telling, then chairman of Sears, explained the Sears Financial Centers strategy: “The synergy comes in when we develop products in one business that another can sell. The sophisticated investor now expects to be taken through the entire spectrum of financial products, from insurance, credit, real estate, to financial instruments such as equities and commercial paper…I hope that we will quickly start to cross-pollinate the deserving, promotable people through the different businesses, so that all of us have a better understanding of the business.” The problems of the strategy quickly became apparent in different parts of the value chain and in the different businesses. The merchandising group, the core business, performed progressively worse through the 1980s and achieved dismal results by the end of the decade. Net synergies in the Sears Financial Centers never materialized. There were four major reasons: First, as Sears learned, real estate and mutual funds do not sell well in high-stimuli environments. It seemed reasonable to put a financial counter near high-traffic areas, such as automotive and sporting goods, but these are not the types of distractions that real estate or securities brokers would identify as sales enhancers. Second, different types of financial services require different marketing, sales, and distribution channels. Mutual funds are mass marketed and tend to be sold to investors. Real estate and mortgages are purchased and require a very different customer approach and service. There is little commonality between these businesses even at the product market. Third, for there to be any possibility of synergy, cross-marketing had to occur, and these businesses would have to share information. This turned out be an unrealistic expectation because these are highly entrepreneurial businesses. Finally, the development of the Sears Financial Centers required more than $250 million of expenditures above the initial purchase price of the acquisitions. Because the free-standing offices of Dean Witter and Coldwell Banker remained intact and were where most of the business was actually done, the Sears Financial Centers were actually expensive prospecting locations. In September 1992, after intense pressure from institutional investors, Sears announced the spin-off of Dean Witter and Coldwell Banker and decided to focus on its troubled merchandising business. Dean Witter and Coldwell Banker were not bad businesses, but Sears’ strategy did not yield synergy. Instead, the company allowed its core merchandising business to deteriorate while it tried to create a synergistic financial supermarket. Unlike Sears, American Can did not search for synergy with the core canning business but aimed at replacing the core business. American Can began to withdraw from canning in the late 1970s when it realized that remaining competitive in the mature can manufacturing business would require major capital investments, low growth, and low returns to capital. Like Sears, the company’s strategy led to the financial sector. William Woodside, the chairman of American Can, wanted to reallocate assets from the capital-intensive businesses to focused, specialized businesses that were distribution-intensive and required low capital investment. After American Can sold its paper business in 1982, it acquired Associated Madison, a life insurance holding company owned and managed by famed investor Gerald Tsai. Following this acquisition, Tsai was put in charge of the investment committee and future acquisitions in financial services. Rather than acquire businesses that would compete with companies such as Sears or Merrill Lynch, Tsai focused on buying companies that filled the needs of clearly defined groups. These companies were operated as independent companies but used low fixed-cost delivery systems such as A.L. Williams’ 110,000 part-time agents and third-party endorsed sales. By the beginning of 1987, American Can’s stock price increased four times as it divested itself of the packaging business and changed the company name to Primerica. Synergy was not a goal here. But moving capital to higher-valued uses where individual businesses could push more product at a lower cost than they could before being acquired yielded success. AT&T and NCR The AT&T acquisition of NCR in 1991 is a lesson on the absence of the operating strategy cornerstone. It is a mystery why, after losing an estimated $2 billion in its own computer business between 1985 and 1990, AT&T’s directors were willing to approve the payment of a $4.2 billion premium for the NCR acquisition – a 125% premium above the pre-bid share price of the company. Charles Exley, chairman and CEO of NCR at the time, accused AT&T of merely trying to bail out its own failed strategy for marketing computers. He may have been right on target. After paying the extraordinary premium for NCR, AT&T voluntarily left NCR executives in place to conduct business as usual for two years after the acquisition. In fact, they were even put in charge of AT&T’s old computer production and marketing business. NCR executives were merely asked by AT&T to “look” for synergy. The vision was that there would be “convergence” between computers and communications, but AT&T’s technological advantage was in telecom switches, not in the corporate or consumer computer business. By 1993, when earnings began to decline, AT&T signaled somewhat belatedly that it had a strategy for NCR after all. It appointed its own executive, Jerre Stead, to run the computer division, but synergies did not materialize. In fact, between 1993 and 1995 most of NCR’s top managers left the company. Costs increased dramatically as hundreds of new sales teams in over 100 countries were set up and the company was pushed into new markets and industries where it had little experience. The result was that AT&T shareholders lost the entire premium and racked up losses of $720 million in 1995 alone. Vision and operating strategy are necessary but not sufficient to ensure performance gains from an acquisition. The other two cornerstones – systems integration, and power and culture – are closely related. Systems integration focuses on the physical integration plans that must be in place to implement the strategy (such as integration of sales forces, distribution systems, information and control systems, and R&D and marketing efforts). The power and culture cornerstone focuses on the reward and incentive systems and the control of information and decision processes at various levels of the organization. It is important to note that these cornerstones cannot be treated in isolation. In fact, the effectiveness of power and culture planning will depend largely on properly identifying the systems integration issue. When these cornerstones are missing, the consequences go far beyond a failure to generate synergy. Systems Integration The problem of systems integration is a component of the implementation side of acquisitions. Systems integration must be carefully considered before the acquisition and must support a clearly defined operating strategy. Management must decide which operations will be integrated and which will be stand-alone, while maintaining awareness of the pre-existing performance targets. It is much like driving a car 100 miles per hour and trying to make adjustments to the engine while moving. The folklore that mergers that are strategically related should outperform those that are not is rooted in systems integration. If synergies are expected to come from cost savings in large organizations, they must emerge from eliminating duplication. Systems integration planning must lie at the heart of this strategy. This means that future systems integrations plans must be planned in advance, and in considerable detail, before the acquirer calculates a bid price for the target. Otherwise the acquirer will not know what it is paying for and, even worse, will not know when the acquisition is simply a resource drain on stand-alone operations. In short, postacquisition is the wrong time to do preacquisition planning. Acquirers must understand that there can be very distinct postacquisition integration environments. There are several possible scenarios: *The company is acquired as a stand-alone. *The company is acquired as a stand-alone but with a change in strategy. *The target is to become part of the acquirer’s operations. *The target and acquirer are to be completely integrated. *The target takes over the acquirer’s existing business and is integrated into the target’s operations. Different degrees of integration can pose different types of problems. If they are poorly considered, they can damage the underlying businesses. Northwest Airlines and Republic Airlines In 1986, Northwest Airlines completed what was then the largest acquisition ever in the airline industry: the $884 million acquisition of Republic Airlines. The acquisition nearly doubled the size of NWA, making it the fifth-largest domestic airline. But within two hours of completion of the acquisition, the airline’s Twin Cities operation had ground to a standstill. NWA and Republic had been prohibited from engaging in detailed pricing and scheduling discussions prior to the acquisition because of federal antitrust regulations. Senior management had little idea how the two computer systems interfaced, and when they put the two systems together, neither pilots nor passengers knew what was going on. But integration of crew and gate scheduling was only the beginning of a long-term problem. Human resources integration was a disaster. The unions representing NWA employees were different from those representing Republic, and power struggles ensued. Having only recently made severe wage concessions, Republic’s employees came to the merger with lower pay schedules than those of NWA. At the Detroit hub, disgruntled baggage handlers tore off destination tags, and employees in Memphis mounted an unofficial work slowdown that destroyed on-time performance. A story even emerged that former Republic employees in Detroit shut down the sewage system by simultaneously flushing their “People, Pride, Performance” buttons down the toilets. Northwest was dubbed “Northworst” by frequent flyers. Less than a year after the merger, it topped the government’s list of passenger complaints. Complicating these matters, on Aug. 16, 1987, Northwest flight 255 crashed after takeoff from Detroit due to pilot error – the second-worst disaster in American aviation history. In 1989, NWA was bought out by a group of private investors, and senior management resigned. Unisys Corp. The merger of computer makers Burroughs Corp. and Sperry Corp. in 1986, the largest computer industry merger in history, is an example of how integrating certain pieces well will have little effect if others are poorly executed. The chairman of Burroughs, W. Michael Blumenthal, justified the decision to pay a 50% premium for Sperry “because through this merger we will realize economies of scale, procurement efficiencies, product rationalization, and in the end, further price competitiveness.” The plan was to maintain both companies’ computer architectures but integrate all other aspects of the company, renamed Unisys. The human side of the merger was orchestrated by well-known organizational psychologists Philip Mirvis and Mitchell Lee Marks. Unisys was touted as an example of a major merger where careful consideration was given to employee attitudes of both companies and the making of credible pledges to employees of partnership and meritocracy. But the integration of the distribution systems, a critical piece of the value chain for any company, particularly for a computer company, was a catastrophe. Because of the pressure to meet the performance numbers that Blumenthal had promised, Unisys rushed the implementation of a new corporate-wide centralized distribution system that combined the very different order-entry and billing procedures of the two companies. A former Unisys executive described the ensuing turmoil in this way: “We pulled the switch and brought everything to its knees and it is still limping. We put a massive overload on the system. We probably did things we probably should not have. For instance, the amount of money we will save by not developing a new order-entry and billing system for the company we are going to more than blow on our inability to track our product shipments. It is a classic problem of the two systems being too big to run parallel. If I had really thought things through, I would have dug my heels in and said add a year to all your plans and let’s do it right.” As a result, equipment orders were notoriously late, and customers were regularly frustrated by missing parts and slow customer service – not the recipe for success in the viciously competitive computer business of the late 1980s. By November 1990, the stock price of Unisys was less than $3 per share – over 90% of shareholder value was destroyed. Sony and Columbia-TriStar Vertical integration acquisitions carry with them a unique integration problem, as Sony learned with its $3.4 billion acquisition of Columbia Pictures Entertainment from Coca-Cola in 1989. In vertical integration acquisitions, the integration begins at the link between the two companies. Since this is almost by definition a new business, the acquirer may not have an executive team or an appropriate control system in place to run the acquisition – and costs can veer out of control. Sony’s strategy rested on the assumption that having a commanding position in the software business (movies) could influence consumption patterns in the hardware market, such as high-definition television. But first, Sony needed executives to run Columbia. Sony hired Peter Guber and Jon Peters at a cost of $700 million – $200 million in salary plus $500 million to settle a breach of a long-term production agreement Guber and Peters had with Warner Bros. Guber and Peters, neither having studio management experience, went out to find executives with experience to run Columbia and TriStar Pictures (which was acquired along with Columbia). Their spending did not stop there. As part of the settlement with Warner Bros., Columbia had to trade its Burbank studios for an old M-G-M production facility, which cost an additional $100 million to upgrade at the lavish standard of Guber and Peters. Additional expenses included a fleet of jets and the purchase of a florist shop so that Columbia’s executives could enjoy fresh flowers delivered daily. Synergies never materialized between hardware and software. The company ranked last in market share among the large Hollywood studios. And in November 1994, only five years later, Sony announced that it was taking a loss of $3.2 billion on the studios. Power and Culture For almost 30 years, numerous articles, both academic and popular, have discussed the potential troubles of power and culture clashes between merging organizations. Most of these, however, lament that managers are more concerned about the financials than the soft side of acquisition management. The danger of isolated power and culture approaches to acquisitions is that they can often be used as an alibi for anything that goes wrong. In fact, the issue of culture in acquisitions has not been studied in the context of how it would improve performance. The implicit assumption has been that if only the cultures were managed well, performance gains would occur. Thus, culture and power issues have remained soft issues, easily dismissed by many parties involved. We need to consider the “why” (the economics) of culture to put this cornerstone in the context of synergy. Cultural tensions can undercut mergers and imperil synergies. Consider the following anecdote: When Warner Bros. CEO Robert Daly walked into the first postmerger gathering of senior Time Warner management in the Bahamas nearly five years ago, he felt a hand on his shoulder. It was a Time Inc. Brahmin whom he had never met. The magazine man asked the studio exec if he ever considered that General Motors buys $30 million worth of advertising in Time Inc. publications before Daly acquired “Roger & Me,” a scathing cinematic indictment of the auto maker. Daly replied: “No. Did you consider that Warner Bros. spent over $50 million on Batman’ before Time ran its lousy review of the movie?” The Time exec smiled, patted his new colleague’s shoulder, and suggested they both continue their jobs their own way. Anthropologists and sociologists have over 100 definitions of culture, but the classic definition is a “shared set of norms, values, beliefs, and expectations.” This shared set of norms, values, beliefs, and expectations is developed over time and passed down or forward through the generations of managers. Although a corporate culture may have developed slowly, it is acquired as a whole, on the spot, in a merger. And these companies may have very different information and decision processes and incentive and reward systems. But the issue for acquirers is not whether the cultures are similar or different but whether the changes necessary to support the strategy will clash with either culture. Two questions about culture are particularly relevant to mergers and acquisitions: nWhen will problems of conflict and cooperation arise? nHow will they be solved? Some problems may arise from what would be considered differences in standard operating procedures, such as conduct of performance evaluations, chain of command, methods of communication, and capital allocation approvals. The larger problems stem from the reshuffling of power and the unwritten expectations of payoffs of cooperating versus competing in the course of doing business in the new company. It is the uncertainty and ambiguity surrounding acquisition events that will cause executives and employees in general to defend positions they may have taken years to build. Key executives or knowledge workers who are crucial to the business as a stand-alone may leave in anticipation of these problems and join the competition. The solution to the problems will lie in the incentive and other reward systems established for the new company. Are there clearly defined incentives that will drive the desired cooperation and coordination between previously independent businesses? In other words, if one side cooperates, will the other side honor its implied commitment or will it cheat when there is an incentive? That people will defect in anticipation of others’ defection spells disaster in acquisitions where cooperation may be essential. In the Time Warner example, the players agreed to maintain their individual power rather than work together in a common strategy to generate performance improvements (assuming a strategy existed). Unless rewards and incentives support a real strategy with real integration plans, management of culture means little with regard to generating performance improvements. As Gerald Levin of Time Warner has said, “My philosophy is to let things happen naturally so that they make sense from the ground up instead of hammering it in from the top down.” Cooperation will not magically occur in entrepreneurial-based cultures unless incentives and rewards are created that will induce changes in behavior. On the other hand, the inappropriate change of incentive systems can cause problems of its own. In 1990, two years after the Commercial Credit acquisition of Primerica, Sandy Weill, chairman and CEO, moved to change the incentive systems of the 110,000-strong part-time sales organization of the A.L. Williams insurance division by establishing specific targets and comparative evaluations by which to measure performance. It backfired immediately, and for two years, the writing of new insurance business was in a free fall. An A.L. Williams manager explained: “Controls don’t work here because they imply a downside – they don’t just reward good performance, but imply negative consequences for low performance. That doesn’t sit well with most of our agents. If they feel that they’re going to be subjected to quotas and performance evaluations, they might as well stay home.” Careless changes in decision authority can also result in unexpected changes in profitability, as AT&T learned in its NCR acquisition. In 1993, when AT&T executives took over the NCR division after having been left under the control of former NCR management, Jerre Stead moved to flatten the old NCR hierarchy and “empower” more people. Sales representatives then had more authority to approve contracts that actually represented lower-margin business. Previously these contracts would have been rejected, but sales representatives who were compensated on revenues and not on margin had tremendous incentive to push through the business. The result was more business but lower profits. Predictable Overpayment The intensity of the challenge of generating synergies should now be apparent. Price does not represent poten-tial value – and thus it becomes a predictor of acquisition value losses. This conclusion goes well beyond the simple prediction that acquirers overpay because of a winner’s curse in a bidding auction. Let us consider the following five acquisitions with two different synergy scenarios: These two scenarios (A and B) represent two categories of postacquisition performance gains expressed as a percentage of the premium recovered. If a price on average represents value, then synergy should occur in the amount dictated by the premium. In other words, a 60% premium should be associated, on average, with a 60% increase in value through actual performance gains. But suppose that in acquisitions, price is not correlated with potential value. In other words, suppose that this potential is in fact limited across acquisitions. Predictions about overpayment up front would then be possible, and integration issues could be considered within more of a performance context. From an after-the-fact perspective, “overpayment” occurs in each of the five cases in both scenarios. However, in synergy scenario A, the level of the premium gives no information about the amount of up-front risk of failure. A loss of 20% occurs in each acquisition. In this scenario, synergy is highly correlated with the premium, as would be predicted by the assumption of a competitive markets view. The result is consistent with what is often called the winner’s curse: You win the contest but don’t like the prize. Acquirers tend to overpay, but there seems to be good reason to make the acquisition if they paid just a little less. On the other hand, if synergy does not occur or there are limits to the realization of synergy, as in synergy scenario B, then the predictive power of the premium becomes meaningful. That is, the level of the acquisition premium predicts the amount of losses. It is scenario B that represents the likely payoffs of the acquisition game.