The pace of mergers and acquisitions has fallen off drastically in the past few years, but, this author says, we are on the cusp of another wave of M&A activity. As always, there will be few winners and many losers, which is why CEOs must know exactly where there industry sits on the M&A curve and plan their strategy accordingly.
CEOs have plenty to worry about these days: a slowing economy, turbulent equity markets, corruption and scandal throughout the business community, and the dual threats of war and terrorism. Mergers and acquisitions rarely make the headlines anymore, and industry consolidation seems to have faded from many CEOs’ playbooks. It seems out of place, then, that new research from A.T. Kearney predicts that we are on the verge of unprecedented merger and consolidation activity in some of the biggest industries in the world. This article describes our research and suggests strategies for success in this new wave of merger activity.
The Endgame curve
Imagine a merger that forms a bank with more than a trillion dollars of assets. Or, consider the ramifications if the top five automakers were to consolidate, leaving two or three players. We believe these are distinct possibilities. But, can CEOs predict how industry structures will evolve? Moreover, what strategies should they adopt as consolidation occurs? And most important, how can a CEO ensure that his or her company emerges as an industry leader?
To answer these questions, A.T. Kearney analyzed mergers and acquisitions involving some 25,000 companies globally, from 1988 to 2001. These companies accounted for 98 percent of the world’s market capitalization. As we focused on 1,345 of the largest mergers and acquisitions, M&As that involved by 945 companies and had a value of more than US$500 million, we began to see a pattern emerging. This pattern took the shape of an S-curve, or what we call the Endgames curve. It was so dubbed because under closer scrutiny, it seemed that every company that followed the curve, regardless of industry, was a participant in the Endgame.
Using this data, we determined that, whether industries advanced or fell back on the curve, all moved between and among four different stages-opening, scale, focus, and balance and alliance (see figure 1). Determining which stage your company or industry falls in is the first step in developing a winning strategy for making it to the top of the curve-to outperform your competitors and become a global powerhouse. The following offers a closer look at each stage of the Endgames curve, explaining where industries fall on the curve and why:
The four stages
Opening stage. Start-up and spin-off industries, and industries that are regulated or protected by tariff barriers or foreign ownership restrictions are found in the opening stage. This is the frontier of industry consolidation: an expanse of limitless innovation, opportunity and risk, particularly when protectionist restrictions are lifted through privatization and deregulation.
Current stage 1 industries include utilities, online retailers and recruiters, and biotechnology and telecommunications companies. Entry barriers are generally low or government-controlled, 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 stay in the opening stage until large industry consolidators emerge and begin to change the rules of the game by using their scale to dominate others. In this stage, there is excitement, plenty of venture capital and a buzz around opportunities. Heavy consolidation through mergers and acquisitions begins, poising the industry for the next stage.
Scale stage. Having moved through Stage 1, companies have laid claim to all of the available territory; consolidation rates can reach as high as 45 percent 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 the one in which industry leaders stand tall. Whether or not they are conscious of their Endgames strategy, 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, restaurants and fast food chains. The race to capture market-share comes into full swing and, as it progresses, positioning of the leaders frequently changes.
Despite the recent downturn, there have been a number of significant acquisitions in stage 2 industries. Industry leaders, in fact, are taking advantage of their strength to open their lead on weaker competitors. Pfizer’s acquisition of Pharmacia, HSBC’s buyout of Household International, Kraft’s purchase of Nabisco, and IBM’s takeover of PwC are all examples of this Stage 2 trend.
Focus 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 now is to emerge as one of the small number of global industry powerhouses. Typical industries in the Focus stage include electric power and gas companies, steel producers, glass manufacturers, coal producers, magazine publishers, ship builders and distillers. The rules of the game are well established at this point, and only an outside event or an industry incumbent may be able to effect significant change.
The number of mergers begins to drop, but their size continues to rise as competitors battle to be among the last standing. Unlike Stage 2 acquisitions, where larger competitors usually gobble up smaller, weaker players, Stage 3 consolidation plays are usually “mergers of equals.” The integration risks of such large deals are exponentially higher, and Stage 3 mergers tend to make headlines for destroying shareholder value.
DaimlerChrysler and the merger between Hewlett Packard and Compaq are recent examples.
Balance and alliance stage. The top of the endgames curve, the balance and alliance stage, is the final step in the Endgames journey. The landscape in Stage 4 includes such heavily consolidated industries as tobacco, aerospace and defense, shoe manufacturing and soft drinks. These industries are populated by a very few, very large companies that have won 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 scrutiny because of being part of a perceived oligopoly or monopoly. As a result, alliances and spin-offs become much more attractive strategies.
Endgames strategies for CEOs
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, the CEO and the board of directors can only realize its potential through strong execution. 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. 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 mega-merger, and mastering portfolio management become paramount.
Strategies: Stages 1 and 2
The path to success in the early Endgames stages is relatively straightforward and consists of three stages.
1. 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 successful model for acquisitions and to identify the most promising acquisition candidates-in other words, to develop a vision.
2. 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 stages 1 or 2 will be busy closing dozens of deals a year. The key differentiating success factor, however, is its ability to successfully integrate the high volume of acquisitions into its core business. To manage this, leading companies build what is often referred to as an “integration engine” to quickly and seamlessly absorb their acquisitions.
CEOs must also ensure that Wall Street understands and supports their 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 makes acquisitions, for example, it generally leaves the incumbent management team in place. Even if acquired companies compete in the same industry, they are rarely integrated.
3. Prepare for Endgames stages 3 and 4. Sometime during Stage 2 or the early part of Stage 3, competitors must begin to think about a defining, standard-setting mega-merger that will reshape the industry. Companies also 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.
An interesting case study of a company migrating through stages 1 and 2 is the metamorphosis of NCNB to NationsBank to Bank of America. NCNB, under the then-CEO Hugh McColl, began an amazing series of acquisitions of small regional banks in the southern U.S. in the late 1980s and early 1990s. The pace and size of his acquisitions quickened dramatically as barriers to interstate banking fell and the scope of businesses available to NCNB (which was by then called Nations Bank) increased. During this phase of NationsBank’s strategy, it and the U.S. banking industry as a whole was moving rapidly through the second Endgames stage. Finally, in 1998, NationsBank surged into the next stage by acquiring BankAmerica to form the new Bank of America, the second largest bank in the United States. This marked the beginning of Stage 3 for both the bank and the industry; since then, the pace of acquisitions has slowed dramatically as major competitors digest their acquisitions and prepare themselves for the next round of consolidation.
Strategies: Stages 3 and 4
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. Although each company faces its own unique circumstances, the force of the business cycle establishes rules that apply to all. A.T. Kearney’s Endgames research shows that companies must undergo a major strategic transition as their industries move from Endgames Stage 2 to Stage 3. This transition can wreak havoc on 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 plan to ensure its strategies will lead to success in the stage 3-environment.
Unlike the dealmaker skills and bold leadership traits required in stages 1 and 2, the prototypical stages 3 and 4 CEO is a shrewd chess player and portfolio manager. 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 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 soft drink business (Stage 4), PepsiCo identified two new spin-off industries: the sports drink and bottled water sub industries.
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. Altria (formerly Philip Morris), for example, has set the standard for excellent management in the tobacco industry, a particularly tough stage 4-business. When it became clear that the tobacco industry was advancing toward stage 4 in the late 1980s and early 1990s, Altria diversified into the stage 2-food industry. With the acquisition of Kraft, General Foods, Jacob Suchard and others, Altria diversified into a food industry powerhouse.
How endgames can serve as a crystal ball
While it is interesting to know where your industry is on the Endgames curve, it is more important to predict the future course of industries, and even industrial policy. For many CEOs, the Endgames model is a predictive tool, offering valuable insight into the shape of things to come.
One relatively easy prediction that can be made from the Endgames curve is that the global banking industry will undergo a breathtaking transformation and global consolidation over the next five to 10 years. The industry is currently the least consolidated, but biggest, in the world. However, over the past few years, the pieces have fallen into place that portend consolidation on a massive scale:
- The French government has encouraged mergers among major French banks, enabling them to become globally competitive
- The German government is encouraging mergers and consolidation among state and rural banks
- U.K. banks have already largely consolidated and are now looking for attractive cross-border mergers
- Singapore has permitted consolidation from six major banks down to two, and is promoting aggressive regional expansion for domestic banks across Southeast Asia
- Due to their weakened loan portfolios, Japanese banks have been-and continue to be-bought and consolidated by foreign financial institutions
- Although consolidation in the U.S. banking industry has taken a breather during the current economic downturn, it seems poised for another round of large, Stage 3 “mergers of equals”
As these pieces begin to fit together, the ripple effect will begin to appear in countries including Canada and Australia, whose governments have resisted bank industry consolidation and acquisitions by foreign competitors. Will this be the next wave of consolidation in the industry?
Another interesting area to speculate on is the public and industrial policy implications of industry consolidation. In Canada, for example, the industrial base is significantly skewed towards mature industries, compared to the global average (see figure 2). In part, this is because Canada has a resource-based economy that is largely comprised of late stage 2- and early stage 3-companies. But dig further, and other issues quickly emerge. Is Canada lagging in privatization and innovation (Stage 1 companies )? What structural challenges and barriers encourage late Stage 2 companies to sell out to foreign competitors? While Canada has some winners in the global consolidation game (Alcan in aluminum and Potash Corporation in fertilizers, for example), it has more than its fair share of companies that sell out rather than take the final step to industry leadership (Seagram’s in the liquor industry, Labatt’s in beer, in addition to numerous oil and gas companies, auto parts companies and food and clothing retailers). What does this hold in store for leading Canadian companies such as Loblaws, EnCana, and the five major Canadian banks? And beyond the impact on individual companies, are there broader implications on Canada’s policies on privatization, innovation and the structure of capital markets?
Mastering the endgame
Industry consolidation has the potential to be one of the most interesting business issues on the horizon. The next decade may witness an unprecedented surge in big acquisitions. Boards of directors and CEOs must begin to take ownership for the successful execution of an Endgames strategy through detailed, hands-on deliberation and decision-making. 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 leadership strategies carefully and proactively.