How to Win the Consolidation Game: Determining which consolidation stage your company or industry falls in is key to developing a winning merger strategy for your firm.

Mergers and acquisitions statistics for 2002 were undeniably bleak: The overall value of deals declined 26% – over the already sluggish 2001 numbers – while the number of deals dropped by 13%. But just as standing too closely to a Seurat painting can reveal little more than random brush strokes, standing too close to these numbers reveals little about the larger m&a picture. A.T. Kearney has been looking at the larger m&a picture for years. In the process, we’ve discovered that from a distance, m&a activity resembles an S-curve, derived from a pattern of industry consolidation over the past decade. The curve, which we call the Endgames curve, was drawn from an analysis of more than 25,000 firms. These companies represent 98% of the world market capitalization, thus making it possible to assess the buildup of industry concentration over time. Our analysis focused on 1,345 of the largest mergers and acquisitions (with a value of more than $500 million) by 945 acquiring companies from 1990 to 1999. Using this data, we determined that whether industries advanced or fell back on the curve, all moved between and among four different stages (see Figure 1). Determining which stage your company or industry falls in is the first step to developing a winning strategy to make it to the top of the curve – to outperform your competitors and become a global powerhouse. In this article, we outline the four stages of the Endgame, examine what CEOs must do to successfully carry out an Endgames strategy for their company, and explain the new burden placed on boards of directors to manage the Endgames strategy execution. The Four Stages of the Endgame Stage 1: Opening. Newly deregulated, start-up, and spin-off industries occupy the opening stage. This is the frontier of industry consolidation: an expanse of limitless innovation, opportunity, and risk. Current Stage 1 industries include utilities, online retailers, biotechnology, and telecommunications. Entry barriers are low in Stage 1, which explains why there are so many companies in this stage. As opportunities begin to pan out, however, competition heats up as companies begin a race to gain – and then secure – market footholds. Overall, this is a period of unparalleled new activity, and the smell of opportunity whets the appetites of venture capitalists and entrepreneurs alike. Industries with low entry barriers stay in the opening stage until a large industry consolidator changes the rules of the game by using its scale to dominate the others. In the beginning there is excitement, plenty of venture capital, and a buzz around opportunities. Eventually, however, imitators and improved versions of the original business model begin to horn in on the venture capital action. Before long, there are so many companies serving the same market that all the ideas are out on the table – and the venture capital spigot turns off. Heavy consolidation through cutthroat competition and m&a begins, poising the industry for the next stage. Stage 2: Scale. Having risen through Stage 1, companies have laid claim to all of the available territory; consolidation rates can reach as high as 45% in some industries. Leaders must devise new strategies to expand, grow, capture market share, and protect their turf-all to continue their climb up the Endgames curve. Stage 2 is when industry leaders stand tall. Whether or not they are conscious of their Endgames strategy, as they look across the landscape they must constantly analyze their next acquisition target or assess a new growth plan. Typical Stage 2 industries include hotel chains, breweries, banks, homebuilders, automotive suppliers, and restaurants and fast-food chains. The race for position and capturing market share comes into full swing and, as it progresses, positioning of the leaders frequently changes. Even the partners that the leaders choose for customers, suppliers, and allies may change. Stage 3: Focus. The third Endgames stage, the focus stage, is characterized not so much by a blizzard of merger activity, as in Stages 1 and 2, but by megadeals and large-scale consolidation plays. The goal at this stage is to emerge as one of the small number of global industry powerhouses. Typical industries in the focus stage include steel producers, glass manufacturers, food manufacturers, magazine publishers, shipbuilders, and distillers. The rules of the game have been well established at this point, and only an outside event or an industry incumbent may be able to effect significant change. In this stage the number of mergers and acquisitions begins to drop, but the size of deals continues to rise as competitors battle to be among the last ones standing. The race is far from over, but the strategy changes as future Endgames winners begin acquiring competitors with an economic return in mind, rather than with an eye primarily toward gaining market share. Companies that have made a lot of acquisitions in the past will begin fine-tuning their business portfolios to peel off units that are outside their core competencies. Some of these spin-offs will generate new businesses – and even new industries – as the number of industry players dwindles to those that are the most efficient operators. Unfortunately, companies in the focus stage often pay more attention to operational efficiencies and survival and less attention to satisfying their customers. The balance beam that bridges the gap to the final stage of consolidation is progressively more challenging. Stage 4: Balance and Alliance. The top of the Endgames curve, the balance and alliance stage, is the final step in the Endgames journey. The industry landscape in Stage 4 includes such heavy hitters as tobacco, aerospace and defense, shoe manufacturing, and soft drinks. These industries are populated by a very few, very large companies that are winners in their industry consolidation race. They are the unquestioned leaders in their field and can be successful for a long time depending on how they handle and protect their prime position. But the room to maneuver is considerably smaller, and strategic opportunities are increasingly hard to come by. In this stage, big mergers are no longer a significant option simply because the industry has already been consolidated. Instead, Stage 4 companies harvest their competitive position by maximizing their cash flow, protecting their market position, and reacting and adapting to changes in industry structure and new technological advances. Stage 4 companies often experience difficulty in growing market share because they have maximized their market penetration. And they are often subject to government regulation or scrutiny because of their perceived oligopoly or monopoly market position. The Curve as a Crystal Ball While it is interesting to know where your industry is on the Endgames curve, it is more important to use the information effectively. For many CEOs, the Endgames model is a predictive tool. Two overarching predictions, for example, suggest that a soaring stock market and the first $1 trillion-dollar merger are likely on the horizon sooner than most would expect. Over the next decade, the stock market is poised to increase roughly fourfold from where it stands today – despite the recent downturn. The sharp decline in merger activity in 2001 and 2002, over previous years, both in the number of deals and in the total value means that consolidation activity shifts from mergers and acquisitions to industry shakeouts, with the weaker competitors unable to ride out the downturn. We can go on to predict this decline as a temporary setback. The upward trend will resume, and exponential growth will accompany it. Indeed, with the Endgames consolidation trend increasing in velocity and scale, by 2010 the first $1 trillion merger will become a reality. Today’s highest-market-cap companies are well below $500 billion; however, the positive trends developing in the stock market along with globalization of the Endgames scenario are catalysts certain to bring about this megamerger. It’s only a matter of time. There are other predictions, as well, that are just as critical for executives to anticipate. For example, we see Endgames Stages 3 and 4 as the battlegrounds of the next decade. Industries that exhibited high growth rates in the 1980s and 1990s will run out of steam in a lower-growth global economy. Many of the traditional preferred growth engines – geographic expansion and buying up and consolidating smaller competitors – have been exhausted. In the late 1990s and early 2000s, the extreme focus placed on maximizing stock prices and quarterly results will soon take its toll as consumers become disillusioned. This trend will no doubt commoditize those companies (and industries) that neglected product innovation and customer service for so long. As a result, companies in the major Stage 2 industries today – automotive suppliers, airlines, consumer products, banking, paper, and others – will gradually move to Stages 3 and 4 over the next decade. Merger activity and, in particular, merger size will be unprecedented as the biggest players in these industries acquire their competitors in bids for industry dominance. Spin-offs will also become rampant as companies try to assemble a winning portfolio of businesses. New industries of outsourcers designed to serve these global behemoths will be created. Finally, roll-ups will become even more popular as Stage 2 firms try to grow rapidly through m&a so as not to miss the opportunity to attain the perceived superior economic returns by moving into Stages 3 and 4. Strategies for CEOs in Stages 1 and 2 The most important aspect of Endgames consolidation is its inevitability. The reality is that every company in every industry will go through the four Endgames stages – or disappear. Some industries may consolidate faster or slower than others, and one Endgames stage may last longer than another, but Endgames consolidation will happen. Although the beauty of the Endgames model is its promise as a predictive tool, this potential will be realized only through strong execution by the CEO and the board of directors. Senior leaders must always be aware of where their industry and company lie on the Endgames curve and plan their strategies accordingly. The key question, then, becomes how the CEO and the board should react to and lead through Endgames consolidation dynamics. Our research reveals that the skills required from a CEO vary according to a company’s position on the Endgames curve. From Stage 1 through Stage 2, the best CEOs drive aggressive growth and lead their industry in consolidation: brute force, bold leadership, and vision are key success factors. In Stage 3 through Stage 4, however, CEOs become more like master chess players: careful planning, anticipating competitors’ strategies, identifying and implementing a megamerger, and mastering portfolio management become paramount. The path to success in the early Endgames stages is relatively straightforward and comprises the following three elements: Develop a Vision In many industries, the necessity of consolidation is apparent. In steel, paper, and chemicals, the economics of scale argue compellingly in favor of consolidation as one of the few strategic levers to achieve superior profits. However, in other industries, CEOs must have a rare talent to gain first-mover advantage by spotting an Endgames play before any other competitor. In these situations, the Endgames vision is not so obvious. It is imperative for CEOs to develop a success model for acquisitions and to identify the most promising acquisition candidates – in other words, to develop a vision. Take the case of Hugh McColl. In the early 1980s when McColl became CEO of NCNB Corp., a small bank based in North Carolina, interstate banking was not permitted under U.S. law. This clearly positioned the U.S. banking industry in the Opening stage of the Endgames curve. McColl believed that the only way for NCNB to control its destiny and achieve superior returns was to create a regional, multi-state bank. In 1982, NCNB began its interstate banking m&a activities by exploiting a regulatory loophole and acquired a bank in Florida. He successfully lobbied regulators in the southern United States and eventually, in 1985, the law changed to permit regional bank holding companies. In 1992, NCNB merged with C&S/Sovran Corp. to become NationsBank Corp., the fourth-largest bank in the United States. McColl completed more than 40 acquisitions and grew the bank’s assets twenty fold to $120 billion. With a new federal interstate banking law in place, McColl’s strategy kicked into a new gear and, in 1998, McColl completed his biggest deal ever: the $60 billion merger with BankAmerica Corp. to create Bank of America Corp. At this point, the original NCNB had gone from a single state bank with less than $20 billion in assets to the largest depository bank in the United States, with $570 billion in assets, $10 billion in earnings, and operations in 22 states-clearly McColl had a well-developed vision for Endgames consolidation. Create a Merger Integration Engine Once a company’s board of directors embraces an acquisition strategy and the first wave of deals is completed, the vision is usually validated. This marks the beginning of the Scale stage. At this point, a company in Stage 1 or Stage 2 on the Endgames curve will be busy closing dozens of deals a year. The key differentiating success factor, however, is a company’s ability to successfully integrate the high volume of acquisitions into its core business. Most successful companies build what is often referred to as an “integration engine.” Again, we can look to Hugh McColl and NCNB as an example. He aggressively integrated acquisitions to fit NCNB’s core business model, developing an integration template for each core function and process of the business. He deluged a newly acquired company on day one with integration specialists whose job was to unite the new company in all areas, from IT to lending systems and processes to credit scoring systems. “[McColl] gave us two things: an airline ticket and a red book with the battle plan,” said one senior NCNB executive. In some of its acquisitions, NCNB was prepared to lose 20% to 30% of the acquired company’s customer base as well as a certain portion of the management team. Senior management accepted this as a necessary part of achieving the company’s objectives, and believed that a 70% retention rate added to its core business was good progress. This brings up an important point: A critical success factor for executing an Endgames strategy is ensuring that Wall Street understands and supports the Endgames rationale. Not every merger will be a complete success, but investors will be more patient if management takes the time to get buy-in for an Endgames strategy. Finally, it is important to note that conglomerates and companies executing roll-up strategies sometimes take a different approach and delegate merger integration issues down the chain of command. When Berkshire Hathaway Inc. makes acquisitions, for example, the incumbent management team is generally left in place. Even if acquired companies compete in the same industry, they are rarely integrated. By comparison, Cisco Systems Inc. is an integration powerhouse. As an industry leader, Cisco focused on smaller acquisitions during its consolidation phase. The company’s guiding belief is that acquisitions should be friendly, not hostile, and that acquired companies should be fully integrated into the Cisco business model immediately. SVP Peter Solvik explains, “We’ve learned, sometimes the hard way, that the only way to make an acquisition is to fully and seamlessly integrate all aspects of the new company into Cisco. There are no exceptions.” One of the most striking examples of this, Solvik relates, is that one acquired company had just upgraded all of its employees’ computers – more than 1,000 of them. Nevertheless, Cisco replaced them all after the acquisition to ensure compatibility within the Cisco business model. Prepare for Endgames Stages 3 and 4 Sometime during Stage 2 or the early part of Stage 3 competitors begin to think about a defining, industry standard-setting megamerger. Companies in these stages typically face several new competitive realities. Their market share has grown substantially and their largest industry competitors are taking notice. There aren’t as many deals available because targets are too big and competitors also become “deal hungry.” Companies experience a “stick to their knitting” renaissance and the core business performance becomes the key driver of a company’s stock price. Once companies arrive at Stage 3, they have reached a crossroads: either they continue along the path to glory or they die by the sword. At NCNB, McColl’s dealmaking prowess ultimately became the driver of NationsBank’s stock price; NationsBank had to sign bigger deals, faster, to keep increasing its share price. As the size and pace of deals increased, management’s ability to integrate the acquired companies became compromised. At the same time, the acquisition price per dollar of assets acquired increased substantially, almost quintupling between the C&S/Sovran deal in 1991 and the acquisition of Barnett Banks Inc. in 1998. These issues came to a head with the BankAmerica deal and the stock price has been flat, never regaining its $70-per-share peak since the announcement of the transaction. In retrospect, the BankAmerica deal signified the bank’s arrival into Stage 3. However, the size and scope of the post-merger integration overwhelmed McColl and his senior management team, forcing the company into a protracted transition period. Since the merger, Bank of America has reorganized and gone through a major senior management and CEO change. It has had to realign its strategy and objectives to adjust to its new position in Stage 3. In addition, the economic slowdown of 2001 and 2002 has delayed the realization of the merger benefits, and it is not yet clear whether the merger will create significant incremental shareholder value. While each company has its own unique circumstances, and the force of the business cycle always is a shaping factor, A.T. Kearney’s Endgames research shows that companies must undergo a major strategic transition when their industries move from Endgames Stage 2 to Stage 3. This transition can wreak havoc with a company’s business strategy and management processes. It may forewarn of the need for a company’s senior management team to seriously rethink its medium-to-long-term strategic plan to ensure its strategies will lead to success in the Stage 3 environment. Warning Signs Some of the warning signals and red flags that management and their boards should watch for include: * Mergers and consolidation become the focal point of corporate strategy (the means instead of the end) and of share price performance. * Operating managers are so burdened by integration issues that they neglect core business performance. * The company slowly becomes “too big to manage” as a result of the cumulative effect of so many mergers. * The CEO achieves a certain degree of fame or notoriety in the business community, usually accompanied by a significant bonus or stock award (hundreds of millions of dollars). * The CEO evolves into a “one-trick wonder” rather than an industry visionary. * The CEO makes one deal too many…or too big…or both. Any of these trends can signal the end of Stage 2 and indicate the need for a new strategy. But the complication is that they are often realized simultaneously, sometimes with disastrous effects. CEOs must read the Endgames tealeaves, heed the Endgames warning signals, and adjust their companies’ strategy for the realities of Stages 3 and 4 or risk disastrous consequences for their shareholders and their tenure as the organizations’ leaders. Strategies for CEOs in Stages 3 and 4 Managing Stages 3 and 4 of the Endgames curve requires a particular set of CEO attributes. Unlike the dealmaker skills and bold leadership traits required in Stages 1 and 2, the prototypical Stage 3 and Stage 4 CEO is a shrewd chess player and portfolio manager. Consider Johnson & Johnson, a leader in the pharmaceutical and health care industry, which is transitioning into Stage 3. Johnson & Johnson has carried out more than 30 acquisitions over the past 10 years but has always stuck to its core businesses – prescription and over-the-counter pharmaceutical products, medical devices and diagnostics, and consumer and baby products. Well-known for being a decentralized company, J&J empowers each business head to identify and execute acquisitions. As a result, J&J has acquired companies across its entire portfolio of businesses. While J&J has carried out some big deals over the years, the company has stayed away from deals big enough to risk changing its culture or business model. In addition, J&J has pursued its acquisition strategy over the tenure of several CEOs, which has meant that m&a and consolidation have become embedded as an integral part of the company strategy. Finally, the board of directors reviews J&J’s portfolio of businesses on a regular basis to assess whether J&J should shed underperforming businesses and whether J&J as an overall entity is more valuable to shareholders as is or as separate companies. In other words, through regular meetings, the board validates J&J’s Endgames strategy. Many companies in Endgames Stage 4 industries adopt a strategy of creating spin-off growth businesses from their core business. Typically, these spin-off businesses launch new industries or sub-industries that are in an earlier Endgames stage and lead to new opportunities for these companies to fuel their future growth. PepsiCo Inc. is a good example of a Stage 4 company that took advantage of this strategy. Faced with the prospects of low growth in its core (Stage 4) soft drink business, it identified two new spin-off industries – sports drinks and bottled water. These sub-segments were both much less concentrated and had stronger growth potential than the soft drink industry, showing characteristics of Endgames Stage 1 or 2. PepsiCo managers believed that both of these sub-industries could provide growth to boost the top line of the overall company. The company gained control of the Gatorade sports drink business it its acquisition of Quaker Oats Co., paying a significant premium over a competing offer from Coca-Cola Co., and has since used Gatorade as a focal point for developing its sports drink business. Another Stage 4 management strategy is to “isolate” a Stage 4 business in a portfolio company and use the cash thrown off from it to either fuel other businesses in the portfolio or return it to investors. In this light, Philip Morris Cos. has set the standard for excellent management of a particularly tough Stage 4 business – tobacco. In the late 1980s and early 1990s, when it became clear that the tobacco industry was advancing toward Stage 4, Philip Morris diversified into the Stage 2 food industry. With the acquisition of Kraft Inc., General Foods Corp., Jacob Suchard AG, and others, Philip Morris diversified into a food industry powerhouse. In the late 1990s, though, the impact of government regulation of the tobacco industry for health-related reasons led Philip Morris to change its Stage 4 strategy. It is now in the process of isolating its tobacco business, with a strategy of containing it with respect to litigation claims and maximizing its cash dividend payments to shareholders. In the process, it sold 16% of its Kraft shares in an IPO, is spinning off other businesses, and has sold its Miller Brewing Co. unit. This type of bold, shareholder-focused leadership in Stage 4 led shareholders to give retiring CEO Geoffrey Bible a 10-minute standing ovation at Philip Morris’ 2002 annual shareholder meeting. Implications for Endgames Success In the coming years, the scale, pace, and complexity of business will surely increase as more and more industries consolidate and move along the Endgames curve. What can CEOs do to lead a successful Endgames strategy? Three key implications of our research will guide CEOs in mastering the Endgames environment: Take a global view and adjust your strategy to reflect your position on the Endgames curve. Endgames consolidation is a global phenomenon. It may be a cliche, but it’s no longer enough for CEOs to think local, regional, or even national in strategic planning. Scope must be global and corporate strategy has to be significantly adjusted several times over the course of the Endgames journey. Ignoring this concept leaves you vulnerable to being surpassed, or acquired, by your competitors. Capitalize on cross-industry opportunities. Because consolidation is universal and all industries consolidate, you should look beyond your own industry to see what can be learned from others. If necessary, look for fresh views from the outside to incorporate into cross-industry thinking. At the same time, the strategy of creating new products that lead to sub-industries in earlier Endgames stages can be a growth accelerator for any company, and CEOs need to be creative and innovative in identifying these new potential growth engines. Leverage the board of directors. Although the CEO has been the focal point of this article, the board of directors must also take on new roles in the successful execution of the Endgames strategy. This represents a renewed vision for how a board carries out its duties and reinforces the need for CEOs and shareholders alike to ensure that boards are structured for success. Some imperatives include: * Contributing deep expertise and relationships in customer and supplier industries, as well as adjacent industries. The board must be able to assist the CEO in determining when one Endgames stage is over and when another is beginning. In addition, board members should become a source of acquisition ideas and contacts and be able to assist in closing deals. * Assessing the strengths and weaknesses of a CEO in managing in a particular Endgames stage. The board must ensure that the CEO has the appropriate skills to lead the transition from one Endgames stage to another and, if necessary, determine whether the CEO should be replaced. * Thinking carefully about how to appropriately reward a CEO in each Endgames stage. Best practice suggests that big payouts or tying compensation to the number or size of deals completed should be avoided at all costs. Rather, focusing on the health and success of a company’s core business should continue to be the focal point. Some of these imperatives may require many boards to significantly restructure their current objectives and membership. Ultimately, however, the board and the CEO must take ownership for the successful execution of an Endgames strategy through detailed, hands-on deliberation and decisionmaking. The bottom line on managing through the stages of the Merger Endgame is that there are few winners and many losers. CEOs must accept the position of their industry on the Endgames curve and plan their strategy accordingly. A few brilliant strategic insights can make a CEO famous in these stages. Graeme Deans is the head of A.T. Kearney Inc.’s global strategy practice and chairman of A.T. Kearney Canada. Fritz Kroeger is Vice President of A.T. Kearney in Germany. Stefan Zeisel is an A.T. Kearney consultant based in Germany. This article has been adapted from the authors’ book, “Winning the Merger Endgame: A Playbook for Profiting from Industry Consolidation,” which was recently published by McGraw-Hill. Copyright 2003 Thomson Media Inc. All Rights Reserved.