Netflix, Warner, and Vertical Integration

News broke this morning that Paramount, led by David Ellison, has made a hostile takeover bid for Warner.  Paramount has made this move after Netflix announced it had agreed to purchase Warner (including HBO) for $72 billion.  Investors did not react well initially to the Netflix deal.   The stock price dropped upon the acquisition announcement (as often occurs for the acquiring firm when mergers are announced).  

In this post, I'm not providing an overall evaluation of the deal.  However, I would like to focus on one facet of the potential acquisition that will be challenging for Netflix.   For years now, Netflix has been a vertically integrated entertainment company.  In other words, they have created content in their studios and distributed that content on their own streaming platform.  However, they have not distributed content on other platforms.  It has been a closed system.  Now, they are acquiring Warner.  That studio produces content for many different distribution outlets, not just HBO Max.  The question becomes:  What will other content buyers think when Netflix becomes the owner of Warner?  Might they wonder why Netflix would be willing to put some content up for sale/distribution on other platforms?  Might they think: If the content is so good, why not stream it on Netflix?  Will they ponder: Are we getting access to lesser quality shows that Netflix does not want to stream on its own platforms?   

Herein lies a key challenge with vertical integration.  You may find yourself competing with your customers (Netflix competes with other media distribution outlets such as other streaming platforms, cable networks, broadcast networks, etc.).  When you compete with your customers, it creates potential conflicts of interest.  Making the Warner acquisition a success will require navigating these challenging relationships.  Others in the entertainment business do it, but some have found it very difficult at times.  Netflix does not have much experience with this type of arrangement to this point.  

Of course, you might argue that they could avoid this problem if they simply distribute all Warner content on their own platforms (Netflix and HBO Max).  However, you then have to ask: Did they have to spend $72 billion on an acquisition to gain access to that valuable content?  Perhaps, but you do have to apply the ownership test.  In other words, would some other organizational arrangement have accomplished similar goals without the hefty price tag?

Breaking up Kraft Heinz: When Will Executives Learn?

Another corporate breakup. Ho-hum. Another mega-merger that is being unwound. Ho-hum. When will CEOs ever learn? Today's news: Kraft Heinz will split into two companies. As Jesse Newman reports in the Wall Street Journal, "The food giant said it plans to split its business into two companies, unwinding an industry megamerger that married two packaged-food behemoths."  

Why the breakup? We read a few explanations in the Wall Street Journal article:

• Miguel Patricio, Executive Chairman of Kraft Heinz: “We can allocate the right level of attention and resources to unlock the potential of each brand to drive better performance."
• TD Cowen analyst Robert Moskow: “Food companies have found that their breadth of influence in the grocery store does not necessarily yield the advantages they expected."
• Kraft Heinz CEO Carlos Abrams-Rivera: “Scale by itself is not the answer, but having scale along with focus creates opportunities."

For me, the lessons are simple, yet many leaders do not seem to recognize them as they rush headlong into these megamergers:

1. CEOs often overestimate the economies of scale and scope, and they discount or downplay the diseconomies. 
2. Leaders often overestimate the extent to which more market power will lead to huge benefits as they bargain with suppliers and buyers.  
3. The benefits of simplicity and focus are often underrated by executives. 
4. Merging two companies with inherent weaknesses does not automatically make them stronger together. 
5. The challenges of merger integration often overwhelm top management teams and distract them from giving critical strategic issues the attention they need and deserve. 

Learning Through Acquisition: Admit What You Don't Know

Source: https://www.thekitchn.com/

I've been reading John Mackey's book, The Whole Story, about his journey as co-founder and long-time CEO of Whole Foods Market.   The book certainly reads quite differently than many other CEO books, as it documents in detail his experimentation with various psychedelic drugs alongside his retelling of the founding and growth of the organic foods retailer.  

One key lesson jumped out at me from Mackey's story of the early years at Whole Foods Market.  He described how Whole Foods grew by acquisition, but the most important part of those deals was not the growth in revenue,  expansion into new geographic regions, or achievement of scale economies.  Instead, many of those early deals involved incredible amounts of learning about key facets of the business.  Mackey seemed to recognize what he did not know, or what he did not do well.  He went searching quite explicitly for those who were better than him at key elements of the business, and he brought them onboard.  Many of the owners of those businesses stayed with the company and became key executives as the retailer grew.  

For example, Whole Foods Market acquired Bread and Circus, an organic foods retailer in the Boston area.  While studying the company closely, Mackey noted that they had strong sales, but weak profitability.  However, he realized that they had mastered the retailing of perishables.  In fact, they did a far better job than his own company.  Similarly, he bought Walter Robbs' business in northern California because he recognized Robbs' talent and passion for creating a truly beautiful retail environment and refining the processes needed to operate those stores efficiently.  Robbs went on to become co-CEO of Whole Foods Market years later.   Mackey acquired Wellspring, a retailer in North Carolina, because its leader, Lex Alexander, brought a different approach to natural foods.  He had expanded beyond the original focus on health and wellness characterized by many firms such as Whole Foods Market.  Lex brought a "foodies" mindset with an emphasis on foods that were delicious, hand-crafted, and beautiful - e.g., specialty coffees, artisan olive oils, handmade pasta, etc.   Each time Whole Foods Market acquired one of these businesses, it expanded its capabilities and added brilliant, talented individuals to the team.  

In some sense, there's nothing new here.  We hear about learning through acquisition all the time.  Yet, in so many cases, it is the intention, but the reality never meets expectations.  Why?  The acquiring CEO has to be open to the new ideas, and open to learning from others at the acquired company.  In my experience, I've found that many executives end up frustrating the leaders from the acquired company. They don't listen effectively, and they emphasize economies of scale and scope, rather than learning and capability enhancement.  They talk a good talk about learning from others, but they ended up concluding that they know better than the managers at the acquired organization.   Knowledge and expertise ends up just walking out the door.  Therefore, to me, the lesson is clear: Take a hard look at your own expertise and capabilities before an acquisition, and admit what you don't know.  It will make that deal so much more fruitful moving forward. 

Does Merging Two Struggling Firms Create Value?

https://dealroom.net/

Fortune's Chris Morris has reported that Neiman Marcus has rebuffed an acquisition offer from Saks, a competitor in the luxury retail market.  Apparently, merger talks continue, with Neiman Marcus hoping that Saks will increase its $3 billion offer.

This potential merger raises an interesting question for me:  Will merging two struggling firms create value?  Both brick-and-mortar retailers are struggling to compete as e-commerce rivals soar, and specialty retailers such as Zara and Lululemon outperform them.  Morris explains some of the challenges at each firm: 

The potential matchup comes at a time when luxury retail is in a down cycle, as consumers focus on bargain hunting and economic headwinds continue to keep them on edge. Neiman, in 2002, filed for bankruptcy, but has emerged in a better position, with less debt. Saks has reportedly been late with several payments to vendors, some of whom temporarily halted shipments. Hudson Bay Company, which owns Saks, sold real estate holdings recently, raising $340 million to help pay bills.

Saks believes that some synergies will be created as a result of the deal.  According to the article, management believes that combined entity will have more negotiating leverage with powerful luxury brands, particularly those that have become part of very large luxury conglomerates such as LVMH in recent years.  Moreover, management believes that the elimination of certain duplicative functions will reduce costs.  

These synergies may be real, and cost savings may result.  However, a fundamental question is:  Will merging the firms help them turn their revenue problem around?  Can they develop a stronger competitive advantage that enables them to grow in the face of strong headwinds in the brick-and-mortar retail industry?  It seems unlikely that a merger solves the growth problem at these firms.  In addition, one has to wonder about the burden of merger integration hoisted upon two organizations that are already struggling in many ways.  Will the merger integration effort make them more inwardly focused, when they should be paying ever-closer attention to changing consumers?  How much distraction will an integration effort create?  

Two wrongs don't make a right, and two weak firms don't necessarily make one stronger one after a merger.  If this deal does occur, it may lead to value creation, but formidable challenges lie before them if they are to create and sustain value and competitive advantage for the long haul. 

Will Rao's Thrive After Acquisition by Campbell's?

This week, Campbell's announced the $2.7 billion acquisition of Sovos Brands, a firm whose most famous and successful brand is Rao's.  If you aren't familiar with the brand, you should be.  It's simply the very best tomato sauce sold in the United States, and frankly, there shouldn't even be a moment of debate.  I should know.  As the son of Italian immigrants, I grew up never eating tomato sauce from a jar. We had a huge vegetable garden, and my parents grew tomatoes and made their own sauce. Still today, I grow my own tomatoes and store sauce for the winter, though I don't jar enough to last the entire year. When I have to purchase sauce, there's only one brand that I will purchase in a jar - Rao's marinara sauce. As a fan of the brand, I'm hardly alone. Ben Cohen of the Wall Street Journal writes, "Rao’s deliciousness is undeniable. Bon Appétit magazine called it “the best jarred pasta sauce there ever was.” When the Washington Post convened a panel of taste-testers, the judges tried a dozen brands and declared Rao’s their favorite."   Rao's is hardly a bargain though.  It's a premium brand.  A 32 ounce jar of Rao's currently sells for $10.29 at Stop & Shop.  You can purchase a 24 ounce jar of Ragu for $1.99.   Now you might think that I'm crazy to pay that kind of a premium for tomato sauce, but you would be wrong.  It's absolutely worth it! 

The Campbell's acquisition may be beneficial, but it understandably generates some concern.  Campbell's is known for selling a very affordable line of soups.  How will the premium brand Rao's fare within the Campbell's portfolio?  The company's track record of acquisitions is decidedly mixed.  In the late 1960s, it acquired Godiva's chocolates.  That brand thrived under Campbell's ownership for many years, but ultimately, the company divested Godiva because it didn't fit very well with the other products in the portfolio.  More recently, the company divested Bolthouse Farms at a steep discount to the price they had acquired the brand for just seven years earlier.  

The question remains whether valuable synergies exist between Campbell's and Rao's.  Why are these firms more valuable together than apart?  Can Campbell's manage the brand more successfully than it has already been managed?  That seems unlikely, given the parent company's lack of recent familiarity and success with super premium brands.  Moreover, they aren't buying a brand in distress; they are purchasing a brand that is already performing at a very high level.

Any attempt to drive synergies must be taken with caution as it may dilute the quality of the premium tomato sauce brand. For now, Campbell's has assured customers and investors that it won't change the taste and quality of the popular tomato sauce. Still,  we should expect some pressure to justify the acquisition premium by creating synergies.  That pressure can be counterproductive at times when mainstream companies acquire much more premium brands.  

Optimistic CEO, Pessimistic CFO: Optimal Pairing?

Source: maxpixet.net

Insead Professor Guoli Chen and University of Miami Professor Wei Shi have conducted some fascinating new research on mergers and acquisitions.  They examined the nature of the relationship between the CEO and CFO, and how that affects merger performance.   They studied 2,356 companies between 2002 and 2013.  They discovered, not surprisingly, that the optimal pairing includes an optimistic CEO and a pessimistic CFO.  Here's their description of the research: 

We culled transcripts of conference calls between 2002 and 2013 involving both the CEOs and CFOs, and measured the executives’ optimism and pessimism by analysing their use of positive and negative words. Positive words included “achieve”, “assure” and “successful”; negative ones covered “flaw”, “penalise” and “unavoidable”. CEO optimism was calculated as the difference between a CEO’s use of positive words and negative words, and CFO pessimism was calculated as the difference between a CFO’s use of negative words and positive words.

Our data showed that CEOs generally used more positive words and were more optimistic than CFOs. CFOs used more negative words and were more pessimistic than CEOs. We then used the ratio of CEO optimism to CFO pessimism to derive what we call the CEO-CFO relative optimism. This value is then matched with the firm’s number of M&As and operating performance, assessed in our study as return on assets (ROA) a year later.

We found that the more optimistic a firm’s CEO-CFO pair was (high-optimism CEO with low-pessimism CFO), the more M&As it undertook. High CEO-CFO optimism also correlated with lower ROA a year after M&As. Conversely, low CEO-CFO relative optimism was associated with fewer M&As but higher ROA.

Does this mean that a pessimistic CFO is always a positive for organizations?  Not necessarily.  I often speak to audiences of finance executives about playing the role of the devil's advocate on the top management team.  CFOs often embrace this role, seeking to poke holes in proposals and find the potential flaws and risks in any course of action.  Such critical thinking can be quite helpful at times.  However, CFOs can take such behavior too far, and then devil's advocacy no longer proves constructive.   The CFO can become "Dr. No" - always finding reasons not to try new things, and always arguing why a new idea won't work.   CFOs need to maintain a healthy balance when they look at the downside of new ideas.  They should be critical, but they should also ask:  How might we make this proposal work?  What other options could help us achieve the same goal?  How could we move forward in a less risky manner?   They can't simply say no to everything.  They have to help find other ways to move forward if the proposed course of action seems inadvisable.  For more on how to play the devil's advocate constructively, you can read my article here.   I also have a chapter dedicated to this topic in Unlocking Creativity.  

Mergers and the Winner's Curse

We often hear people talk about the winner's curse. What does that term mean? Imagine that people are bidding in an auction, and they do not know the market value of the item being sold. Each bidder consults experts to provide them estimates of the value of the item. Naturally, the experts will provide a range of values. Who wins the auction? The highest bidder, of course. That person's experts would have provided estimates at the high end of the range of values. If the item's actual market value equals roughly the average of the expert estimates, then the winning bidder would have paid a price higher than the actual market value. Behavioral economists call this phenomenon the winner's curse. Many people have noted that the winner's curse provides an explanation for why many companies overpay for acquisitions, and thereby do not achieve their desired return on investment.

A new empirical study examines the actual returns to a merger in a novel way.  Ulrike Malmendier, Enrico Moretti, and Florian Peters examined the pre and post-merger performance of both the acquiring firm in a deal and the other firms that failed to provide the highest bid and therefore lost out on the deal.  Interestingly, the winners of the bidding war and losers did not differ significantly in terms of stock price performance prior to the deals.  However, after the deal, the losers' stock returns were 24% better than the winners during the three years after the deal.   Apparently, losing out on the deal did not turn out to be a bad thing at all.  Perhaps the winners really were cursed.  

The Disney-Fox Deal: Scale is NOT the Most Important Rationale

This week, Disney acquired a significant portion of the 21st Century Fox business for $52.4 billion. What is the rationale for the deal? Fortune's Andrew Nusca took a crack at explaining why this deal makes sense. He begins by arguing that, "scale matters."

The traditional entertainment industry is consolidating (see: Comcast-owned NBCUniversal; Verizon-owned AOL and Yahoo; the pending AT&T-Time Warner deal) as new entrants from Silicon Valley and beyond—Netflix, Apple, Amazon, Google and Facebook—enter the fray. Size is an important leverage point to control pricing and distribution. 

Hmmm... I'm not so sure that scale should be the primary rationale for this deal. Does Netflix have the type of scale that some of these other firms have? Has that stopped them from disrupting the industry and generating strong growth and profits? To me, scale seems to be a far too simplistic explanation for this deal. Scale alone will not solve the problem of customers defecting from ESPN and depriving Disney of substantial cable fee revenue streams.  

The article goes to discuss the importance of franchises. Nusca cites the acquistion of franchises such as X-Men, Avatar, Fantastic Four, Deadpool, and The Simpsons.   Ok, now we are talking.  Disney CEO Bob Iger has had a great deal of success acquiring characters and franchises (Pixar, Marvel, Lucas Films), and then leveraging those franchises using the broad array of businesses in the Disney portfolio.  

Nusca also cites technology. He writes, "Disney’s acquisition of Fox’s interest in Hulu gives it majority interest in streaming-media player Hulu. It also allows Disney to apply streaming technology from BAMTech, an earlier acquisition, to Fox assets."   We have all been reading about the struggles in Disney's television business, particularly at ESPN.   They have been discussing several experiments with streaming services, and they have removed content from Netflix and will be moving it to their own streaming service in the near future.  In the end, Disney has to solve this problem with regard to cord cutting and streaming.  Perhaps the Fox deal will help them do that.  The scale achieved through the deal isn't the solution though... success will come if they find a new way to distribute content to consumers in a world of Netflix, Amazon Prime, and rampant cord cutting, skinny bundles, etc.   That's the strategic challenge that will shape Disney's future and ultimately affect the outcome of this bold acquisition.  

What's the Rationale for the AT&T Acquisition of Time Warner?

This week AT&T announced the acquisition of Time Warner in an $85 billion cash-and-stock deal.  Investors did not exactly dance in the streets.  Why the concern from investors about this acquisition, and what's the possible rationale for this deal?  The proposed deal is an example of vertical integration, marrying a content creator (Time Warner) with a distribution system (AT&T).   When we hear about vertical integration, we should ask:  Why will these two entities create value by working together, AND why must they merge to achieve this value creation?  In other words, why can they not achieve certain synergistic benefits through other types of organizational arrangements (e.g., contracts, licensing, strategic alliance)?   AT&T CEO Randall Stephenson certainly understands why investors and analysts will ask if a merger was necessary to capture certain benefits of cooperation between the two entities.  Here is an excerpt from yesterday's Wall Street Journal:

AT&T’s Mr. Stephenson said owning content would make it easier for the carrier to adapt to various platforms quickly in a way that is time-consuming and difficult when it has to negotiate contracts with content partners. “It’s slow, it’s painful, just the contracting itself takes a lot of time whereas when it’s completely owned, you just move a lot faster,” he said Monday.

He might be right, but has he captured the whole story?   Stephenson essentially is arguing that the transaction costs of using market mechanisms (such as contracts) to work with content partners are very high.  He believes that the costs of such coordination are lower if the two entities are part of the same corporation.  Simply put, he believes you can accomplish coordination more easily and more quickly through managerial mechanisms than through market mechanisms.   Is that right?  Well, anyone with experience managing a large vertically integrated firm will tell you that coordination between business units owned by the same parent company is not always so easy or fast.  Bureaucracy, transfer pricing disputes, silo rivalry, and other problems can make life pretty difficult. Moreover, vertical integration reduces flexibility at times to work with desirable outside partners or to change business models, and it puts you in the awkward position of competing with your own customers.   The regulatory landscape also complicates the deal.  As the Wall Street Journal explains, "Analysts note that many of the attractive aspects of owning content—such as keeping it out of the hands of other distributors or giving it free distribution—would be barred by regulators."

In addition to examining AT&T's rationale, I've been considering the perspective of Time Warner in this deal. Time Warner CEO Jeff Bewkes has spent the past decade dismantling a prior failed attempt at vertical integration at his firm. He broke apart the AOL-Time Warner combination, and he divested Time Warner's cable operations. Why then sell yourself to a distribution company now? (ok, the hefty takeover premium is the obvious financial reason!). In particular, it seems odd given that Time Warner has begun to sell its premium content directly to consumers, bypassing the traditional cable operators (e.g., HBO Now). I understand that the content creators have been worried about millennials cutting the cord. Witness ESPN's shrinking subscriber base - clearly a concern at Disney these days. Time Warner surely faces such concerns with some of its content, though perhaps not with a premium network such as HBO. I'm not sure, though, that selling to AT&T solves this fundamental problem. Do we think that innovative new entertainment industry business models will emerge from such a large complex entity, or is it more likely to occur from newer, more nimble players in the industry?

Microsoft Acquires LinkedIn: Separate or Together?

Chris O'Brien has written a thought-provoking piece for Venture Beat about the Microsoft acquisition of LinkedIn.  O'Brien has a bearish outlook on the deal.    In his article, he cites many reasons why the deal may not work out, including the fact that Microsoft has had a less-than-stellar record of making major deals (Skype, Nokia, Yammer).    I don't know if I'm quite as bearish as O'Brien on the deal, but I certainly have some doubts.   What I found most interesting, though, was O'Brien's take on the issue of how Microsoft will manage LinkedIn going forward.  Here's an excerpt, in which O'Brien describes the "acquisition double-talk" taking place at Microsoft:

Acquisition double-talk, part 1: On the one hand, this deal is all about the oft-vaunted idea of “synergy” (even if that word is not used). The idea is presumably to build LinkedIn into all sorts of Microsoft products. Great! But, does this mean I’m going to get all sorts of messages suddenly asking if I want to share my Word doc through LinkedIn or have some LinkedIn integration with an Excel spreadsheet…or…what? There’s a lot of talk today about how this is going to broaden Microsoft’s reach into all sorts of new channels for selling stuff like cloud services. But does one of the largest tech companies in the world really need to spend $26 billion to reach new customers?

Acquisition double talk, part 2: Structurally, LinkedIn is going to remain independent. Per the Nadella memo:

“LinkedIn will retain its distinct brand and independence, as well as their culture which is very much aligned with ours. Jeff (Weiner) will continue to be CEO of LinkedIn, he’ll report to me and join our senior leadership team. In essence, what I’ve asked Jeff to do is manage LinkedIn with key performance metrics that accrue to our overall success. He’ll decide from there what makes sense to integrate and what does not.”

So, we will all work together. But we will work together while remaining separate. We call it: Separate Togetherness. (I’m going to copyright that and write a book on it one day.)

O'Brien raises an interesting issue that arises in many acquisitions.   On the one hand, the acquirer wishes to realize substantial synergies.  After all, those synergies are the very reason why the acquirer pays a large premium to purchase the target firm.  On the other hand, the acquirer does not want to spoil all that is good about the target firm.  Thus, they promise to provide the target firm a great deal of autonomy moving forward.  They promise to keep it separate.   You can see the conundrum here.  Keeping it separate means probably forgoing key synergy opportunities.  Pressing for too many synergies too quickly might alienate employees at the target firm, infringe on the innovative culture of the target, etc.   One also has to raise a broader question though:  If you are going to manage the target separately, then could you have achieved many of the collaborative benefits without actually acquiring the firm.  Could you have pursued some other organizational arrangement, such as a strategic alliance?  Could you collaborate, but without the risks and costs associated with a merger?   

The Inbev Acquisition of SAB Miller

Major consolidation in the beer industry continued this week, as Inbev agreed to acquire SAB Miller for over $100 billion.  The deal continues a long track record of acquisition by Inbev.  Several years ago, they took over Anheuser Busch, for instance.   Here are a few thoughts about this deal, with lessons that apply to many mergers and acquisitions:

1.  Divestitures of certain brands are highly likely due to antitrust concerns.  Therefore, other major brewers could be able to acquire some important brands during this process. 

Broader lesson:  Will rivals be strengthened at all as a result of an acquisition that we do? 

2.  Economies of scale and scope are a major driver of beer industry consolidation.  However, one has to ask:  How big is big enough?  At what point do diseconomies kick in?  Moreover, some research suggests that economies of scale in the beer business are largely about achieving scale within a particular country as opposed to achieving global scale. 

Broader lesson:  How confident are we that diseconomies of scale will not hamper us?

3.   Acquisition integration will be challenging, as with many complex cross-border deals.  The firms will have to account for "anti-synergies" i.e. the costs associated with trying to put the two firms together and achieve synergies.  Put another way,  many deals include detailed valuations of potential synergies without examining the true cost of putting in place processes and systems to achieve those economies of scope.

Broader lesson:  Value synergies and anti-synergies in every deal you make.

4.  Cost synergies are easier to achieve than revenue synergies.  They are much more concrete and predictable.  Inbev has a great history of achieving cost synergies.  To really make this deal worthwhile, they will have to drive revenue synergies as well.

Broader lesson:  Is your deal based on the somewhat hard-to-quantify hope and promise of revenue synergies or the more concrete and predictable cost synergies of bringing two firms together?

Breaking Up Isn't Always the Optimal Solution: The Curious Case of Dan Loeb and Amgen

Corporate breakups seem to happening every other day.   I blogged last week about some of the reasons for the recent surge in breakup activity.   In general, I think many of these breakups make sense, as firms tend to prosper when they are more focused.  Moreover, many of these firms are experiencing significant diseconomies of scale and scope.   However, I think we may be taking it too far in some cases.

Let's take the case of hedge fund investor Dan Loeb pushing Amgen to break into two independent firms.   Loeb proposes that Amgen split into one business focused on its mature products and another focused on its high growth products.   Typically, when investors propose such splits, they want the mature business to generate lots of cash and return much of it to shareholders.  They want the growth business to reinvest profits to stimulate even more growth.   

Here's the problem with proposals such as the Amgen deal though.   In the old BCG model of corporate strategy, firms were supposed to milk the cash cow and use those proceeds to fund promising growth businesses.   That model has since been completely debunked.  Cross-subsidization amongst unrelated business units makes no sense if external markets are reasonably efficient.  Chas cows should return excess cash to shareholders, and growth businesses should find their own sources of funds from private equity, venture capital, or public equity and bond markets.  Note the word "unrelated" though.  The BCG model is faulty if we are talking about using it to justify an unrelated diversification strategy.  However, a firm such as Amgen is clearly not an unrelated diversifier.  It has a set of highly related businesses.  Strong synergies exist among its lines of business.  In fact, some would say that it's a focused firm, not even a related diversifier.  Thus, Amgen is not in any way inappropriately using funds from a cash cow to fund a growth business. They are managing multiple products that each have stronger competitive advantage because they co-exist together in the same firm.  I don't see how you create real value by splitting a firm such as Amgen in two.  In fact, you may destroy value by doing so, because synergies are lost.  You create real value if you split an unrelated diversifier in two. 

Should Burger King Acquire Tim Horton's? Does This Deal Make Sense?

The Wall Street Journal reports that Burger King is pondering an acquisition of Canadian coffee/donut chain Tim Horton's.   The newspaper reports that the firms may be pursuing "a so-called tax inversion and move the hamburger seller's base to Canada."   Recently, tax inversions have been on the rise, as firms establish headquarters overseas in an attempt to lower their overall tax burden.   The newspaper reports, "A move by Burger King to seal one is sure to intensify criticism of them, since it is such a well-known and distinctly American brand."  I found that sentence particularly funny, given that Burger King has been owned by a foreign company in the past!  Diageo, the UK-based producer of alcoholic beverages such as Guinness, Smirnoff, and Johnnie Walker, owned Burger King until 2002. 

Putting aside the political debate about tax inversions, let's take a look at whether this deal makes strategic sense.   Are there sufficient synergies to justify a deal between Burger King and Tim Horton's?  I'm skeptical.  Why?  For years, Wendy's - a primary competitor to Burger King - owned the Tim Horton's chain.  Under investor pressure, they ultimately divested the coffee/donut chain.  Why?  Investors argued that the sum of the parts exceeded the whole.  In other words, Tim Horton's was more valuable on its own than as a part of Wendy's.  Given that history, what makes us think that Tim Horton's will now be more valuable as part of Burger King than it is on its own?   I believe that management at Burger King will have to make this case to persuade investors and other analysts/observers that this deal makes sense. 

Fox, Time Warner, and the Perils of Vertical Integration

The news broke this week about a possible Fox takeover of Time Warner.   As you read these reports, you may have noticed many of the key arguments for why this deal would make sense, i.e. powerful synergies exist between the two media/entertainment companies.  However, yesterday's Wall Street Journal featured a terrific article examining the perils of vertical integration with respect to this  deal.   Note that Time Warner is a major producer of television shows, which it sells to various broadcast networks.    Fox, of course, owns a major television network (and a variety of cable channels).  Warner Brothers is one of the only major TV studios not connected to a major broadcast network (Sony is another).  In the article,  Time Warner CEO Jeff Bewkes says, " Being the leading independent supplier to all the broadcast networks makes us the preferred home to the top writers and producers on TV which, in turn, makes us indispensable to those networks."  Lee Dinstman, a partner at the Agency for the Performing Arts, explained, "The fact that [Warner] has the freedom to take a creative idea to the proper home, instead of just selling to a captive network, can be incredibly attractive." 

What happens if the two firms merge?  Will the loss of independence hurt the Warner production studios?  Put yourself in the position of a programming chief at one of the other major broadcast networks.  When Warner Brothers studios comes pitching a new TV show, what will you think?  You might wonder:  "If it's such a great show, why is it now being broadcast on Fox?"   You may conclude that Warner Brothers is trying to push lower quality shows out to your network.  Note that many firms are vertically integrated in the industry.   Many of the in-house studios at other firms place most of their shows on their own networks. For instance, the article notes that Fox studios has 18 shows on major networks at this time; 14 of them are on the Fox network, while only 4 have been sold to other networks.   Is that because it's the most profitable decision, or is it because other networks are reluctant to buy from the competition?   That, in a nutshell, is one of the perils of vertical integration.  A firm such as Warner Brothers ends up competing with its own customers, creating some challenging conflicts of interest. 

Older CEOs More Likely to Sell Publicly Traded Companies

Stanford's Dirk Jenter and and Dartmouth's Katharina Lewellen have conducted a new study about corporate takeovers.   The two scholars examined more than 9,000 publicly traded American companies over a nearly twenty year period.   They found that companies with older CEOs tended to receive more successful takeover bids.   In fact, CEOs ages 64-66 experienced a 32% increase in successful takeover bids relative to CEOs ages 59-63.  Note that the shareholders did just as well in the deals that occurred for both age groups.  Thus, older CEOs are not accepting lower quality deals.  However, they are doing many more deals.  We should not be surprised, of course.  Younger CEOs still have more years left in their working lives, and they know that selling their companies probably means the loss of their positions.  The key question is:  Are younger CEOs spurning potentially good deals, or are we simply seeing more acquirers focus on companies with older CEOs because they know that those executives are more likely to sell? 

The Winner's Curse in Mergers and Acquisitions

Many mergers and acquisitions actually destroy shareholder value.  We understand that it's challenging to make a deal work.   Integration can be difficult.  Cultures clash.   Most importantly, though, we have to understand that acquirers often overpay.  They are subject to the winner's curse, as described by economist Richard Thaler.  Basically, if you think about an acquisition as the result of an auction, then you can understand why acquirers tend to overpay.  In an auction of a target firm, you will see a range of bids.  The average bid tends to mirror the actual underlying value of the target company.  However, the winning bid is naturally well above the average.  Thus, the winner is "cursed" - they tend to pay more than the true value of the assets.   

As you think about this bidding process, you begin to realize why acquiring firms often do not achieve the synergies that they project at the time of the deal.  Yes, synergies are hard to achieve.  However, it may also be the case that acquirers rationalize paying a higher price than they might have liked.  They up their estimate of the synergies during the bidding process, to justify the higher price that they have chosen to bid.  Meanwhile, acquirers often do not think about the "anti-synergies" as one firm described them to me.  Anti-synergies represent the losses associated with meshing two firms together, as well as the costs to be incurred so as to achieve some of the real synergies that may exist. 

Jos. A. Bank to Acquire Eddie Bauer: What Does "Related" Mean?

The Wall Street Journal reports that Jos. A. Bank has agreed to acquire Eddie Bauer for $825 million.  As you may recall, Jos. A. Bank has been in a back-and-forth contentious situation with Men's Warehouse, with each firm trying to take over the other over the past few months.  Now, Jos. A. Bank has moved in a different direction.   Does it make sense? Are there true economies of scope here between the retailer of men's suits and the seller of outerwear and sportswear? 

As an outsider, it's hard to determine if the synergies justify such a merger.  However, I would argue that we should be cautious about such a deal.  When we think about mergers, we often look for signs that the firms are engaging in "related" diversification, i.e. that significant synergies exist.   At first glance, we might conclude that these two firms are related, since they both sell apparel.  However, we should be much more disciplined about what "related" truly means.  Consider the cases from a decade ago, when many companies who sold alcoholic beverages combined in a wave of mergers and acquisitions.  Many people initially endorsed these deals.  After all, a beer producer buying a winemaker looked like "related" diversification . Surely, significant synergies existed.  Yet, it turns out that beer and wine companies are not as related as we might think, even though both are in the business of selling alcohol.  The synergies turned out to be much less substantial than many players thought.  The challenges of integration were substantial.   That lesson should be applied here, before we jump to the conclusion that these two apparel companies can easily combine to achieve significant synergies.  

The Proposed Comcast - Time Warner Cable Merger

Comcast has announced that it intends to acquire Time Warner Cable for $45 billion.  We really should not be surprised by this deal.  As industries mature and growth declines (or evaporates), firms look to consolidation as a means of cutting costs and enhancing the bottom line.  With cord-cutting a potentially growing phenomenon, the cable companies have to be wondering how they will grow profits moving forward.   Finding cost savings through consolidation may be a reasonable strategy.  Beyond that, the news raises several interesting questions for the key players in the media and entertainment business. 

1. Will federal authorities intervene to stop the merger on antitrust grounds?  

2. Will Comcast agree to expand its net neutrality agreement to cover TWC subscribers as well?

3.  Will cable television networks find themselves in a disadvantageous position as they try to negotiate with Comcast-TWC?  How much will the enhanced bargaining power of Comcast-TWC affect profit margins for the major entertainment content providers?

4.  Perhaps most interestingly, will this hasten or dampen efforts to crack the dominant position that cable has in distributing content?   Will firms such as HBO become more reluctant to strike new deals to distribute content, or will they become more emboldened to find new distribution avenues given the increased clout of Comcast-TWC?  In other words, is HBO now going to be more willing to sell HBO Go subscriptions directly to consumers?   Similarly, will ESPN become more or less willing to consider selling Watch ESPN subscriptions to consumers directly?  What about Netflix?  What are the implications for that firm, as the cable players are clearly concerned about cord-cutters that rely on Netflix for a large portion of their entertainment viewing?  

5.  What about Apple?  Many people, including me, believe that Apple has the means to build a great television, but they are limited in their ability to provide great content.  Apple does not want to simply build a TV; after all, that business is intensely competitive.  They will only enter the market if they can have access to content, as they did with iTunes.  In the music business, the key players struck deals with Apple because selling their songs for 99 cents was better than watching their songs stolen.   With movies and television, the major content providers have been reluctant to offer their content to Apple.  Will things change, as the cable companies gain even more clout?

CEOs: Building Empires and Selling Shares at the Same Time?

Many CEOs like doing deals.  Mergers and acquisitions happen for many reasons.   Typically, CEOs argue that synergies exist between the acquiring firm and the target that is being purchased.  However, we sometimes wonder whether CEOs are just as interested in empire building as they are in creating long term shareholder value.   A splashy merger means that their faces end up on the cover of leading periodicals, and in many cases, their compensation packages rise as they come to run larger enterprises.   Do these deals actually create value?  In many cases, they do not.   

Interestingly, Tulane Professor Cynthia Devers and her colleagues have discovered something interesting about the behavior of CEOs involved in acquisitions.  They examined more than 2,000 companies over a 12 year period. They found that acquiring company CEOs are 28% more likely to exercise stock options and 24% more likely to sell shares within three months following acquisition announcements than they are during other periods in which no acquisitions are taking place.  

Hmm... why would these CEOs be selling shares if they were so confident of the synergies that can be achieved as a result of these deals?  Are CEOs telling Wall Street that the whole is worth more than the sum of the parts, while at the same time, they are selling shares because they know that it will be hard to generate enough synergies to justify the takeover premium that has been paid? 

The study of more than 2,000 companies over a period of 12 years finds that CEOs are 28 percent more likely to exercise stock options and 24 percent more likely to sell company stock within three months following acquisition announcements than they are at times in which no acquisitions are announced. - See more at: http://freemanblog.freeman.tulane.edu/freemannews/index.php/tag/cynthia-devers/#sthash.M2FlaTCO.dpuf

The study of more than 2,000 companies over a period of 12 years finds that CEOs are 28 percent more likely to exercise stock options and 24 percent more likely to sell company stock within three months following acquisition announcements than they are at times in which no acquisitions are announced. - See more at: http://freemanblog.freeman.tulane.edu/freemannews/index.php/tag/cynthia-devers/#sthash.M2FlaTCO.dpuf

The study of more than 2,000 companies over a period of 12 years finds that CEOs are 28 percent more likely to exercise stock options and 24 percent more likely to sell company stock within three months following acquisition announcements than they are at times in which no acquisitions are announced.
“Although executives exercise options and sell shares for all sorts of reasons, it does seem odd that they’re especially likely to do so in the aftermath of acquisitions that they presumably engineer for the future good of the company,” says Devers, an associate professor of management at the Freeman School, who carried out the research with Gerry McNamara of Michigan State University, Michele E. Yoder of the University of Wisconsin, Madison and Jerayr Haleblian of the University of California, Riverside.
In the words of the study, “Our findings show that in the quarters following acquisition announcements, CEOs reduced their equity-based holdings by cashing out stock options and selling firm stock…presumably to reduce the exposure of their equity-based holdings to potential firm stock price decreases. Thus, their behavior is inconsistent with the idea that CEOs are confident that their acquisitions will generate substantial long-term shareholder value.”
- See more at: http://freemanblog.freeman.tulane.edu/freemannews/index.php/tag/cynthia-devers/#sthash.M2FlaTCO.dpuf

The study of more than 2,000 companies over a period of 12 years finds that CEOs are 28 percent more likely to exercise stock options and 24 percent more likely to sell company stock within three months following acquisition announcements than they are at times in which no acquisitions are announced.
“Although executives exercise options and sell shares for all sorts of reasons, it does seem odd that they’re especially likely to do so in the aftermath of acquisitions that they presumably engineer for the future good of the company,” says Devers, an associate professor of management at the Freeman School, who carried out the research with Gerry McNamara of Michigan State University, Michele E. Yoder of the University of Wisconsin, Madison and Jerayr Haleblian of the University of California, Riverside.
In the words of the study, “Our findings show that in the quarters following acquisition announcements, CEOs reduced their equity-based holdings by cashing out stock options and selling firm stock…presumably to reduce the exposure of their equity-based holdings to potential firm stock price decreases. Thus, their behavior is inconsistent with the idea that CEOs are confident that their acquisitions will generate substantial long-term shareholder value.”
- See more at: http://freemanblog.freeman.tulane.edu/freemannews/index.php/tag/cynthia-devers/#sthash.M2FlaTCO.dpuf

The study of more than 2,000 companies over a period of 12 years finds that CEOs are 28 percent more likely to exercise stock options and 24 percent more likely to sell company stock within three months following acquisition announcements than they are at times in which no acquisitions are announced.
“Although executives exercise options and sell shares for all sorts of reasons, it does seem odd that they’re especially likely to do so in the aftermath of acquisitions that they presumably engineer for the future good of the company,” says Devers, an associate professor of management at the Freeman School, who carried out the research with Gerry McNamara of Michigan State University, Michele E. Yoder of the University of Wisconsin, Madison and Jerayr Haleblian of the University of California, Riverside.
In the words of the study, “Our findings show that in the quarters following acquisition announcements, CEOs reduced their equity-based holdings by cashing out stock options and selling firm stock…presumably to reduce the exposure of their equity-based holdings to potential firm stock price decreases. Thus, their behavior is inconsistent with the idea that CEOs are confident that their acquisitions will generate substantial long-term shareholder value.”
- See more at: http://freemanblog.freeman.tulane.edu/freemannews/index.php/tag/cynthia-devers/#sthash.M2FlaTCO.dpuf

OfficeMax and Office Depot Merger

The Wall Street Journal reports that OfficeMax and Office Depot are in advanced discussions regarding a potential merger.   The article, by Anupreeta Das, Ryan Dezember, and Ann Zimmerman cites many of the benefits of the deal.  For instance, the authors note that experts estimate roughly $500 million in synergies may emerge from the deal.  The article also cites Staples founder Tom Stemberg, who says, ""This should have happened a long time ago.  It's healthy for the industry. It takes out excess capacity.''  (note: I worked at Staples in the mid-1990s, when Stemberg served as CEO). 

I would agree that the merger will yield some significant cost synergies, provided merger integration is  managed well (a major caveat).  Moreover, the industry does have excess brick-and-mortar capacity.   Online players such as Amazon have taken a significant bite out of the traditional office supply industry in recent years.  The companies have closed some stores in response to the shift toward e-commerce, but more rationalization of the store base needs to occur.   The article points out that many experts think the three major office supply retailers have not downsized their brick-and-mortar footprints fast enough. 

I do have some concerns though.   I would ask the following question: Why will a merger drive out more excess store capacity than otherwise should have been eliminated by the companies individually?   The answer: Perhaps the merger's promises of cost synergies will create the public accountability that will drive necessary rationalization.   In other words, maybe you need the merger to push management to do what they otherwise have been slow to do. 

I also have a second question to pose:  How about the issue of taking on the e-commerce challengers?  Does the merger make these companies more formidable competitors relative to the Amazons of the world?  Perhaps, but I'm not so sure.  Again, the question for management is clear:  Why will a merged entity do the things to be successful against online competitors that the two firms have not otherwise been able to do to this point?  

Finally, I would offer one other concern.   In many industries, mergers that drive out excess capacity can help prop up prices.  When excess capacity exists, price wars often occur as firms try to fill that capacity and cover fixed costs.  However, in this industry, removing excess capacity may not yield major price gains.  Why?  The competitors setting the price level are not the brick-and-mortar players;  Amazon and other e-commerce players are pushing down prices.  That pressure won't change due to this merger.