Chapter 4
Planning: Developing Business and Acquisition Plans
Phases 1 and 2 of the Acquisition Process
If you don't know where you are going, any road will get you there.
—Lewis Carroll, Alice in Wonderland
Inside M&A: Nokia's Gamble to Dominate the Smartphone Market Falters
The ultimate success or failure of any M&A transaction in satisfying expectations often is heavily dependent on the answer to a simple question. Was the justification for buying the target firm based on a sound business strategy? No matter how bold, innovative, or precedent-setting a bad strategy is, it is still a bad strategy.
In a bold move that is reminiscent of the rollout of Linux, Nokia, a Finnish phone handset manufacturer, announced in mid-2008 that it had reached an agreement to acquire Symbian, its supplier of smartphone operating system software.1 Nokia also announced its intention to give away Symbian's software for free in response to Google's decision in December 2008 to offer its Android operating system at no cost to handset makers.
This switch from a model in which developers had to pay a license fee to create devices using the Symbian operating system software to a free (open source) model was designed to supercharge the introduction of innovative handheld products that relied on Symbian software. Any individual or firm can use and modify the Symbian code for any purpose for free. In doing so, Nokia is hoping that a wave of new products using Symbian software would blunt the growth of Apple's proprietary system and Google's open source Android system.
Nokia is seeking to establish an industry standard based on the Symbian software, using it as a platform for providing online services to smartphone users, such as music and photo sharing. According to Forrester Research, the market for such services is expected to reach $92 billion in 2012 (almost twice its size when Nokia acquired Symbian), with an increasing portion of these services delivered via smartphones.
In its vision for the future, Nokia seems to be positioning itself as the premier supplier of online services to the smartphone market. Its business strategy or model is to dominate the smartphone market with handsets that rely on the Symbian operating system. Nokia hopes to exploit economies of scale by spreading any fixed cost associated with online services over an expanding customer base. Such fixed expenses could include a requirement by content service providers that Nokia pay a minimum level of royalties in addition to royalties that vary with usage.
Similarly, the development cost incurred by service providers can be defrayed by selling into a growing customer base. The implementation strategy involved the acquisition of the leading supplier of handset operating systems and subsequently to give away the Symbian software free. The success or failure of this vision, business strategy, and implementation strategy depends on whether Symbian can do a better job of recruiting other handset makers, service providers, and consumers than Nokia's competitors.
The strategy to date seems to be unraveling. At the time of the acquisition, Symbian supplied almost 60% of the operating system software for smartphones worldwide. Market researcher Ovum estimates that the firm's global market share fell to less than 50% in 2010 and predicts the figure could decline to one-third by 2015, reflecting the growing popularity of Google's Android software.2 Android has had excellent success in the U.S. market, leapfrogging over Apple's 24% share to capture 27% of the smartphone market, according to the NPD Group. Research-In-Motion (RIM), the maker of the Blackberry, remained the U.S. market share leader in 2010 at 33%.
Chapter Overview
A poorly designed or inappropriate business strategy is among the reasons most frequently given when mergers and acquisitions fail to satisfy expectations. Too often, the overarching role that planning should take in conceptualizing and implementing business combinations is ignored. Some companies view mergers and acquisitions as a business growth strategy. Here, in accord with the view of many successful acquirers,3 M&As are not considered a business strategy but rather a means of implementing a business strategy. While firms may accelerate overall growth in the short run through acquisition, the higher growth rate often is not sustainable without a business plan—which serves as a road map for identifying additional acquisitions to fuel future growth. Moreover, the business plan facilitates the integration of the acquired firms and the realization of synergy.
This chapter focuses on the first two phases of the acquisition process—building the business and acquisition plans—and on the tools commonly used to evaluate, display, and communicate information to key constituencies both inside (e.g., board of directors and management) and outside (e.g., lenders and stockholders) of the corporation. Phases 3 through 10 are discussed in Chapter 5. Subsequent chapters detail the remaining phases of the M&A process.
The planning concepts described here are largely prescriptive in nature: They recommend certain strategies based on the results generated by applying specific tools (e.g., experience curves) and answering checklists of relevant questions. Although these tools introduce some degree of rigor to strategic planning, their application should not be viewed as a completion of the planning process. Business plans must be updated frequently to account for changes in the firm's operating environment and its competitive position within that environment. Indeed, business planning is not an event but an evolving process.4
A review of this chapter (including practice questions) is available in the file folder entitled Student Study Guide on the companion site to this book ( www.elsevierdirect.com/companions/9780123854858 ). The companion site also contains a Learning Interactions Library, which gives students the opportunity to test their knowledge of this chapter in a “real-time” environment.
A Planning-Based Approach to M&As
The acquisition process envisioned here can be separated into two stages. The planning stage comprises developing business and acquisition plans. The implementation stage (discussed in Chapter 5) includes search, screening, target contact negotiation, integration planning, closing, integration, and evaluation activities.
Key Business Planning Concepts
A planning-based acquisition process is comprised of both a business plan and a merger/acquisition plan, which together drive all subsequent phases of the acquisition process. The business plan articulates a mission or vision for the firm and a business strategy for realizing that mission for all of the firm's stakeholders. Stakeholders are constituent groups such as customers, shareholders, employees, suppliers, lenders, regulators, and communities. The business strategy is oriented to the long term and usually cuts across organizational lines to affect many different functional areas. Typically, it is broadly defined and provides relatively little detail.
With respect to business strategy, it can be important to distinguish between the corporate level and the business level. Corporate-level strategies are set by the management of a diversified or multiproduct firm and generally cross business unit organizational lines. They entail decisions about financing the growth of certain businesses, operating others to generate cash, divesting some units, or pursuing diversification. Business-level strategies are set by the management of a specific operating unit within the corporate organizational structure and may involve that unit attempting to achieve a low-cost position in the markets it serves, differentiating its product offering, or narrowing its operational focus to a specific market niche.
The implementation strategy refers to the way in which the firm chooses to execute the business strategy. It is usually far more detailed than the business strategy. The merger/acquisition plan is a specific type of implementation strategy and describes in detail the motivation for the acquisition and how and when it will be achieved. Functional strategies describe in detail how each major function within the firm (e.g., manufacturing, marketing, and human resources) will support the business strategy. Contingency plans are actions that are taken as an alternative to the firm's current business strategy.
The selection of which alternative action to pursue may be contingent on certain events called trigger points (e.g., failure to realize revenue targets or cost savings), at which point a firm faces a number of alternatives, sometimes referred to as real options. These include abandoning, delaying, or accelerating an investment strategy. Unlike the strategic options discussed later in this chapter, real options are decisions that can be made after a business strategy has been implemented.
The Merger and Acquisition Process
A merger and acquisition process can be thought of as a series of activities culminating in the transfer of ownership from the seller to the buyer. Some individuals shudder at the thought of following a structured process because they believe it may delay responding to opportunities, both anticipated and unanticipated. Anticipated opportunities are those identified as a result of the business planning process: understanding the firm's external operating environment, assessing internal resources, reviewing a range of reasonable options, and articulating a clear vision of the future of the business and a realistic strategy for achieving that vision.5 Unanticipated opportunities may emerge as new information becomes available. Having a well-designed business plan does not delay pursuing opportunities; rather, it provides a way to evaluate the opportunity, rapidly and substantively, by determining the extent to which the opportunity supports realization of the business plan.
Figure 4.1 illustrates the ten phases of the M&A process described in this and subsequent chapters. These phases fall into two distinct sets of activities: pre- and postpurchase decision activities. Negotiation, with its four largely concurrent and interrelated activities, is the crucial phase of the acquisition process. The decision to purchase or walk away is determined as a result of continuous iteration through the four activities comprising the negotiation phase.
Figure 4.1 The acquisition process flow diagram.
The phases of the M&A process are summarized as follows:
Phase 1: Business Plan—Develop a strategic plan for the entire business.
Phase 2: Acquisitions Plan—Develop the acquisition plan supporting the business plan.
Phase 3: Search—Actively search for acquisition candidates.
Phase 4: Screen—Screen and prioritize potential candidates.
Phase 5: First Contact—Initiate contact with the target.
Phase 6: Negotiation—Refine valuation, structure the deal, perform due diligence, and develop the financing plan.
Phase 7: Integration Plan—Develop a plan for integrating the acquired business.
Phase 8: Closing—Obtain the necessary approvals, resolve postclosing issues, and execute the closing.
Phase 9: Integration—Implement the postclosing integration.
Phase 10: Evaluation—Conduct the postclosing evaluation of acquisition.
Phase 1: Building the Business Plan
A well-designed business plan results from eight key activities, summarized below. In practice, the process of developing a business plan can be facilitated by addressing a number of detailed questions corresponding to each of these activities.6
The first activity is external analysis to determine where to compete—that is, which industry or market(s)—and how to compete—that is, how the firm can most effectively compete in its chosen market(s)). This is followed by internal analysis, or self-assessment of the firm's strengths and weaknesses relative to its competition. The combination of these two activities—the external and internal analyses—is often called SWOT analysis because it determines the strengths, weaknesses, opportunities, and threats of a business. Once this exhaustive analysis is completed, management has a clearer understanding of emerging opportunities and threats to the firm and of the firm's primary internal strengths and weaknesses. Information gleaned from the external and internal analyses drives the development of business, implementation, and functional strategies.
The third activity is to define a mission statement that summarizes where and how the firm has chosen to compete, based on the external analysis, as well as management's basic operating beliefs and values. Fourth, objectives are set, and quantitative measures of financial and nonfinancial performance are developed. Having completed these steps, the firm is ready to select a business strategy that is most likely to achieve the objectives in an acceptable period, subject to constraints identified in the self-assessment. The business strategy defines, in general terms, how the business intends to compete (i.e., through cost leadership, differentiation, or increased focus).
Next, an implementation strategy is selected that articulates the best way to implement the business strategy from among a range of reasonable options. It may be that the firm opts to act on its own, partner with others, or acquire/merge with another firm. This is followed by development of a functional strategy that defines the roles, responsibilities, and resource requirements of each major functional area within the firm needed to support the business strategy.
The final step is to establish strategic controls to monitor actual performance to plan, implement incentive systems, and take corrective actions as necessary. These controls are put in place to heighten the prospect that the mission, objectives, and strategies will be realized on schedule. They may involve establishing bonus plans and other incentive mechanisms to motivate all employees to achieve their individual objectives on or ahead of schedule. Systems are also put in place to track the firm's actual performance to plan. Significant deviations from the implementation plan may require switching to contingency plans. Let's look at each of these steps in greater detail.
External Analysis
The external analysis involves the development of an understanding of the business's customers and their needs, the market/industry competitive dynamics or factors determining profitability and cash flow, and emerging trends that affect customer needs and industry competition. This analysis begins with answering two basic questions: where to compete and how to compete. The primary output of the external analysis is the identification of important growth opportunities and competitive threats.
Determining Where to Compete
There is no more important activity in building a business plan than deciding where a firm should compete. It begins with identifying the firm's current and potential customers and their primary needs, and it is based on the process of market segmentation, which involves identifying customers with common characteristics and needs.
Whether it is made up of individual consumers or other firms, collections of customers comprise markets. A collection of markets is said to comprise an industry—for example, the automotive industry, which comprises the new and used car markets as well as the after-market for replacement parts. Markets may be further subdivided by examining cars by makes and model years. The automotive market could also be defined regionally (e.g., New England, North America, Europe) or by country. Each subdivision, whether by product or geographic area, defines a new market within the automotive industry.
Identifying a target market involves a three-step process. First, the firm establishes evaluation criteria to distinguish the attractiveness of multiple potential target markets. These criteria may include market size and growth rate, profitability, cyclicality, the price sensitivity of customers, the amount of regulation, the degree of unionization, and entry and exit barriers. The second step is to subdivide industries and the markets within these industries repeatedly and analyze the overall attractiveness of these markets in terms of the evaluation criteria. For each market, each of the criteria is given a numerical weight (some even at zero) reflecting the firm's perception of their relative importance as applied to that market. Higher numbers imply greater perceived importance. The markets are then ranked from 1 to 5 according to the evaluation criteria, with 5 indicating that the firm finds a market to be highly favorable in terms of a specific criterion. In the third step, a weighted average score is calculated for each market, and the markets are ranked according to their respective scores.
For an illustration of this process, see the document entitled “An Example of a Market-Attractiveness Matrix” on the companion site to this book.
Determining How to Compete
Determining how to compete requires a clear understanding of the factors that are critical for successfully competing in the targeted market. This outward-looking analysis applies to the primary factors governing the firm's external environment. Understanding the market/industry competitive dynamics (i.e., how profits and cash flow are determined) and knowing the areas in which the firm must excel in comparison with the competition (e.g., high-quality or low-cost products) are crucial if the firm is to compete effectively in its chosen market.
Market profiling entails collecting sufficient data to assess and characterize accurately a firm's competitive environment within its chosen markets. Using Michael Porter's well-known “Five Forces” framework (also known as the Porter or Modified Porter framework), the market or industry environment can be described in terms of competitive dynamics such as the firm's customers, suppliers, current competitors, potential competitors, and product or service substitutes.7
The three potential determinants of the intensity of competition in an industry include competition among existing firms, the threat of entry of new firms, and the threat of substitute products or services. While the degree of competition determines whether there is potential to earn abnormal profits (i.e., those in excess of what would be expected for the degree of assumed risk), the actual profits or cash flows are influenced by the relative bargaining power of the industry's customers and suppliers.
This framework may be modified to include other factors that determine actual industry profitability and cash flow, such as the severity of government regulation or the impact of global influences such as fluctuating exchange rates. Labor costs may also be included. While they represent a relatively small percentage of total expenses in many areas of manufacturing, they frequently constitute the largest expense in the nonmanufacturing sector. The analysis should also include factors such as the bargaining power of labor.
Figure 4.2 brings together these competitive dynamics. The data required to analyze industry competitive dynamics include types of products and services; market share (in terms of dollars and units); pricing metrics; selling and distribution channels and associated costs; type, location, and age of the production facilities; product quality metrics; customer service metrics; compensation by major labor category; research and development (R&D) expenditures; supplier performance metrics; and financial performance (in terms of growth and profitability). These data must be collected on all significant competitors in the firm's chosen markets.
Figure 4.2 Defining market/industry competitive dynamics.Source: Adapted from Palepu, Healy, and Bernard, 2004.
Determinants of the Intensity of Industry Competition
The overall intensity of industry competition is a function of different factors in several categories. The first category includes industry growth rate, industry concentration, degree of differentiation and switching costs, scale and scope economies, excess capacity, and exit barriers, all of which affect the intensity of competition among current industry competitors. If an industry is growing rapidly, existing firms have less need to compete for market share. If an industry is highly concentrated, firms can more easily coordinate their pricing activities; in contrast, this is more difficult in a highly fragmented industry in which price competition is likely to be very intense.
If the cost of switching from one supplier to another is minimal because of low perceived differentiation, customers are likely to switch based on relatively small differences in price. In industries in which production volume is important, companies may compete aggressively for market share to realize economies of scale. Moreover, firms in industries exhibiting substantial excess capacity often reduce prices to fill unused capacity. Finally, competition may be intensified in industries in which it is difficult for firms to exit due to high exit barriers, such as large unfunded pension liabilities and single-purpose assets.
The second category is the potential for new entrants offering products and services similar to those provided by firms currently competing in the industry. Current competitors within an industry characterized by low barriers to entry have limited pricing power. Attempts to raise prices resulting in abnormally large profits will attract new competitors, thereby adding to the industry's productive capacity. In contrast, high entry barriers may give existing competitors significant pricing power. Barriers to new entrants include situations in which the large-scale operations of existing competitors give them a potential cost advantage due to economies of scale. New entrants may enter only if they are willing to invest in substantial additional new capacity. The “first-mover advantage”—that is, being an early competitor in an industry—may also create entry barriers because first-movers achieve widespread brand recognition, establish industry standards, and/or develop exclusive relationships with key suppliers and distributors. Finally, legal constraints, such as copyrights and patents, may inhibit the entry of new firms.
The third category includes the potential for substitute products and services. The selling price of one product compared to a close substitute—called the relative price—determines the threat of substitution, along with the performance of competing products, perceived quality, and the willingness of the customer to switch. Potential substitutes could come from current or potential competitors and include those that are substantially similar to existing products and those performing the same function—for example, an MP3 rather than a CD, a Kindle wireless reading device rather than a book, or even a paperless airline ticket.
Determinants of Actual Profits and Cash Flow
The bargaining powers of customers, suppliers, and the labor force are all important factors that affect profits and cash flow. Others include the degree of government regulation and global exposure. The relative bargaining power of buyers depends on their primary buying criteria (i.e., price, quality/reliability, service, convenience, or some combination), price sensitivity or elasticity, switching costs, and their number and size compared to the number and size of suppliers. For example, a customer whose primary criterion for making a purchase is product quality and reliability may be willing to pay a premium for a BMW because it is perceived to have higher relative quality. Customers are more likely to be highly price sensitive in industries characterized by largely undifferentiated products and low switching costs. Finally, buyers are likely to have considerable bargaining power when there are relatively few large buyers relative to the number of suppliers.
The relative leverage of suppliers reflects the ease with which customers can switch suppliers, perceived differentiation, their number, and how critical they are to the customer. Switching costs are highest when customers must pay penalties to exit long-term supply contracts, or when new suppliers would have to undergo an intensive learning process to meet the customers' requirements. Moreover, reliance on a single or a small number of suppliers shifts pricing power from the buyer to the seller. Examples include Intel's global dominance of the microchip market and Microsoft's worldwide supremacy in the market for personal computer operating systems.
Work stoppages create opportunities for competitors to gain market share. Customers are forced to satisfy their product and service needs elsewhere. Although the loss of customers may be temporary, it may become permanent if the customer finds that another firm's product or service is superior. Frequent work stoppages also may have long-term impacts on productivity and production costs as a result of a less-motivated labor force and increased labor turnover.
Governments may choose to regulate industries that are heavily concentrated, that are natural monopolies (e.g., electric utilities), or that provide a potential risk to the public. Regulatory compliance adds significantly to an industry's operating costs. Regulations also create barriers to both entering and exiting an industry.
Global exposure is the extent to which participation in an industry necessitates having a multinational presence. For example, the automotive industry is widely viewed as a global industry in which participation requires having assembly plants and distribution networks in major markets throughout the world. As the major auto assemblers move abroad, they need their parts suppliers to build nearby facilities to ensure “just-in-time” delivery. Global exposure introduces the firm to significant currency risk as well as political risk that could result in the confiscation of the firm's properties.
Case Study 4.1 illustrates how a second-tier U.S. telecommunications company is attempting to adapt to secular changes in the telecommunications market.
Case Study 4.1
CenturyTel Buys Qwest Communications to Cut Costs and Buy Time as the Landline Market Shrinks
In what could best be described as a defensive acquisition, CenturyTel, the fifth largest local phone company in the United States, acquired Qwest Communications, the country's third largest, in mid-2010 in a stock swap valued at $10.6 billion. While both firms are dwarfed in size by AT&T and Verizon, these second-tier telecommunications firms will control a larger share of the shrinking landline market.
The combined firms will have about 17 million phone lines serving customers in 37 states. This compares to AT&T and Verizon with about 46 and 32 million landline customers, respectively. The deal would enable the firms to reduce expenses in the wake of the annual 10% decline in landline usage as people switch from landlines to wireless and cable connections. Expected annual cost savings total $575 million; additional revenue could come from upgrading Qwest's landlines to handle DSL Internet.
In 2010, about one-fourth of U.S. homes used only cell phones, and cable behemoth Comcast, with 7.6 million residential and business phone subscribers, ranked as the nation's fourth largest landline provider. CenturyTel has no intention of moving into the wireless and cable markets, which are maturing rapidly and are highly competitive.
While neither Qwest nor CenturyTel owns wireless networks and therefore cannot offset the decline in landline customers as AT&T and Verizon are attempting to do, the combined firms are expected to thrive in rural areas where they have extensive coverage. In such geographic areas, broadband cable Internet access and fiber-optics data transmission line coverage limited. The lack of fast cable and fiber-optics transmission makes voice over Internet protocol (VOIP)—Internet phone service offered by cable companies and independent firms such as Vonage—unavailable. Consequently, customers are forced to use landlines if they want a home phone. Furthermore, customers in these areas must use landlines to gain access to the Internet through dial-up access or through a digital subscriber line (DSL).
Internal Analysis
The primary output of internal analysis is to determine the firm's strengths and weaknesses. What are they compared to the competition? Can the firm's critical strengths be easily duplicated and surpassed by the competition? Can they be used to gain advantage in the firm's chosen market? Can competitors exploit the firm's key weaknesses? These questions must be answered as objectively as possible for the information to be useful in formulating a viable strategy.
Ultimately, competing successfully means doing a better job than the competitors of satisfying the needs of the firm's targeted customers. A self-assessment identifies those strengths or competencies—so-called success factors—necessary to compete successfully in the firm's chosen or targeted market. These may include high market share compared to the competition, product line breadth, cost-effective sales distribution channels, age and geographic location of production facilities, relative product quality, price competitiveness, R&D effectiveness, customer service effectiveness, corporate culture, and profitability.
Recall that the combination of external and internal analyses just detailed can be done as a SWOT analysis; it determines the strengths, weaknesses, opportunities, and threats of a business. Table 4.1 illustrates a hypothetical SWOT analysis—in this case for Amazon.com. It suggests that Amazon.com sees becoming an online department store as its greatest opportunity, while its greatest threat is the growing online presence of sophisticated competitors. The SWOT analysis then summarizes how Amazon.com might perceive its major strengths and weaknesses in the context of this opportunity and threat. This is the sort of information that allows management to set a direction in terms of where and how the firm intends to compete, which is then communicated to the firm's stakeholders in the form of a mission/vision statement and a set of quantifiable financial and nonfinancial objectives.
Table 4.1. Hypothetical Amazon.com SWOT Matrix
| Opportunity | Threat | |
| To be perceived by Internet users as the preferred online “department store” to exploit accelerating online retail sales | Wal-Mart, Best Buy, Costco, and so on, are all increasing their presence on the Internet | |
| Strengths | ||
| Weaknesses |
Defining the Mission Statement
In 2009, Apple Computer's board and management changed the way they wished to be perceived by the world by changing their company name to Apple Inc. The change was intended to be transformative, reflecting the firm's desire to change from being a computer hardware and software company to a higher-margin, faster-growing consumer electronics firm characterized by iPod and IPhone-like products. In a word, the firm was establishing a new corporate mission.
At a minimum, a corporate mission statement seeks to describe the corporation's purpose for being and where the corporation hopes to go. The mission statement should not be so general as to provide little practical direction. A good mission statement should include references to the firm's targeted markets, which should reflect the fit between the corporation's primary strengths and competencies, and its ability to satisfy customer needs better than the competition. It should define the product or service offering relatively broadly to allow for the introduction of new products that might be derived from the firm's core competencies. Distribution channels—how the firm chooses to distribute its products—should be identified, as should the customers targeted by the firm's products and services. The mission statement should state management beliefs with respect to the firm's primary stakeholders; these establish the underpinnings of how the firm intends to behave toward those stakeholders.
Setting Strategic or Long-Term Business Objectives
A business objective is what must be accomplished within a specific period. A good business objective is measurable and has a set time frame in which to be realized. Typical corporate objectives include revenue growth rates, minimum acceptable financial returns, and market share; these and several others are discussed in more detail below. A good business objective might state that the firm seeks to increase revenue from the current $1 billion to $5 billion by a given year. A poorly written objective would simply state that the firm seeks to increase revenue substantially.
Common Business Objectives
Corporations typically adopt a number of common business objectives. For instance, the firm may seek to achieve a rate of return that will equal or exceed the return required by its shareholders (cost of equity), lenders (cost of debt), or the combination of the two (cost of capital) by a given year. The firm may set a size objective, seeking to achieve some critical mass defined in terms of sales volume to realize economies of scale by a given year.
Several common objectives relate to growth. Accounting-related growth objectives include seeking to grow earnings per share (EPS), revenue, or assets at a specific rate of growth per year. Valuation-related growth objectives may be expressed in terms of the firm's price-to-earnings ratio, book value, cash flow, or revenue.
Diversification objectives are those where the firm desires to sell current products in new markets, new products in current markets, or new products in new markets. For example, the firm may set an objective to derive 25% of its revenue from new products by a given year. It is also common for firms to set flexibility objectives, aiming to possess production facilities and distribution capabilities that can be shifted rapidly to exploit new opportunities as they arise. For example, the major automotive companies have increasingly standardized parts across car and truck platforms to reduce the time required to introduce new products, giving them greater flexibility to facilitate a shift in production from one region to another. Technology objectives may reflect a firm's desire to possess capabilities in core or rapidly advancing technologies. Microchip and software manufacturers, as well as defense contractors, are good examples of industries in which keeping current with, and even getting ahead of, new technologies is a prerequisite for survival.
Selecting the Appropriate Corporate, Business, and Implementation Strategies
Each level of strategy serves a specific purpose. Implementation strategies, which are necessarily more detailed than corporate-level strategies, provide specific guidance for a firm's business units.
Corporate-Level Strategies
Corporate-level strategies are adopted at the corporate level and may include all or some of the business units that are either wholly or partially owned by the corporation. A growth strategy entails a focus on accelerating the firm's consolidated revenue, profit, and cash-flow growth. This strategy may be implemented in many different ways, as is discussed later in this chapter. A diversification strategy involves a decision at the corporate level to enter new businesses. These businesses may be related or completely unrelated to the corporation's existing business portfolio.
An operational restructuring strategy, sometimes called a turnaround or defensive strategy, usually refers to the outright or partial sale of companies or product lines, downsizing by closing unprofitable or nonstrategic facilities, obtaining protection from creditors in bankruptcy court, or liquidation. A financial restructuring strategy describes actions by the firm to change its total debt and equity structure. The motivation for this strategy may be better utilization of excess corporate cash balances through share-repurchase programs, reducing the firm's cost of capital by increasing leverage or increasing management's control by acquiring a company's shares through a management buyout.
Business-Level Strategies
A firm should choose its business strategy from among the range of reasonable alternatives that will enable it to achieve its stated objectives in an acceptable period, subject to resource constraints. These include limitations on the availability of management talent and funds. Business strategies fall into one of four basic categories: price or cost leadership; product differentiation; focus or niche strategies; or hybrid strategies.
Price or Cost Leadership
The price or cost leadership strategy reflects the influence of a series of tools, including the experience curve and product life cycle, introduced and popularized by the Boston Consulting Group (BCG).8 This strategy is designed to make a firm the cost leader in its market by constructing efficient production facilities, tightly controlling overhead expenses, and eliminating marginally profitable customer accounts.
The experience curve postulates that as the cumulative historical volume of a firm's output increases, cost per unit of output decreases geometrically as the firm becomes more efficient in producing that product. Therefore, the firm with the largest historical output should also be the lowest-cost producer. This implies that the firm should enter markets as early as possible and reduce product prices aggressively to maximize market share. For an illustration of how to construct an experience curve, see the Word document entitled Example of Applying Experience Curves on the companion site to this book.
The applicability of the experience curve varies across industries. It seems to work best for largely commodity-type industries, in which scale economies can lead to substantial reductions in per unit production costs, such as PC or cell phone handset manufacturing. The strategy of continuously driving down production costs may make the most sense for the existing industry market share leader. If the leader already has a cost advantage over its competitors because of its significantly larger market share, it may be able to improve its cost advantage by pursuing market share more aggressively through price-cutting.
BCG's second major contribution is the product life cycle, which characterizes a product's evolution in four stages: embryonic, growth, maturity, and decline. Strong sales growth and low barriers to entry characterize the first two stages. Over time, however, entry becomes more costly as early entrants into the market accumulate market share and experience lower per unit production costs as a result of the effects of the experience curve. New entrants have substantially poorer cost positions thanks to their small market shares compared with earlier entrants, and they cannot catch up to the market leaders as overall market growth slows. During the later phases, characterized by slow market growth, falling product prices force marginal and unprofitable firms out of the market or force them to consolidate with other firms.
Management can obtain insight into the firm's probable future cash requirements and, in turn, its value by determining its position in its industry's product life cycle. During the high-growth phase, firms in the industry normally have high investment requirements associated with capacity expansion and increasing working capital needs. Operating cash flow is normally negative. During the mature and declining growth phases, investment requirements are lower, and cash flow becomes positive.
In addition to its applicability to valuing the firm, the product life cycle also can be useful in selecting the firm's business strategy. In the early stages of the product life cycle, the industry tends to be highly fragmented, with many participants having very small market shares. Often, firms in the early stages adopt a niche strategy in which they focus their marketing efforts on a relatively small and homogeneous customer group. If economies of scale are possible, the industry will begin to consolidate as firms aggressively pursue cost leadership strategies.
Product Differentiation
Differentiation encompasses a range of strategies in which the product offered is perceived by customers to be slightly different from other product offerings in the marketplace. Brand image is one way to accomplish differentiation. Another is to offer customers a range of features or functions. For example, many banks issue MasterCard or Visa credit cards, but each bank tries to differentiate its card by offering a higher credit line, a lower interest rate or annual fee, or awards programs. Apple Computer has used innovative technology to stay ahead of competitors selling MP3 players, most recently with the video capabilities of its newer iPods. Providing alternative distribution channels is another way to differentiate—for example, giving customers the ability to download products from online sites. Other firms compete on the basis of consistent product quality by providing excellent service or by offering customers outstanding convenience.
Focus or Niche Strategies
Firms adopting focus or niche strategies tend to concentrate their efforts by selling a few products or services to a single market, and they compete primarily by understanding their customers' needs better than the competition does. In this strategy, the firm seeks to carve a specific niche with respect to a certain group of customers, a narrow geographic area, or a particular use of a product. Examples include the major airlines, airplane manufacturers (e.g., Boeing), and major defense contractors (e.g., Lockheed-Martin).
Hybrid Strategies
Hybrid strategies involve some combination of the three strategies that were just discussed (Table 4.2). For example, Coca-Cola pursues both a differentiated and a highly market-focused strategy. The company derives the bulk of its revenues by focusing on the worldwide soft drink market, and its main product is differentiated in that consumers perceive it to have a distinctly refreshing taste. Fast-food industry giant McDonald's pursues a similarly focused yet differentiated strategy, competing on the basis of providing fast food of a consistent quality in a clean, comfortable environment.
Table 4.2. Hybrid Strategies
| Cost Leadership | Product Differentiation | |
| Niche focus approach | Cisco Systems, WD-40 | Coca-Cola, McDonald's |
| Multimarket approach | Wal-Mart, Oracle | America Online, Microsoft |
Implementation Strategies
Once a firm has determined the appropriate business strategy, it must turn its attention to deciding the best means of implementation. Generally, a firm has five choices: Implement the strategy based solely on internal resources (the solo venture, go it alone, or build approach); partner with others; invest; acquire; or swap assets. Each has significantly different implications. Table 4.3 compares the advantages and disadvantages of these options.
Table 4.3. Strategy Implementation
| Basic Options | Advantages | Disadvantages |
| Solo venture or build (organic growth) | • Capital/expensea requirements | |
| Partner (shared growth/shared control) | ||
| Invest (e.g., minority investments in other firms) | ||
| Acquire or merge | ||
| Swap assets |
a Expense investment refers to expenditures made on such things as application software development, database construction, research and development, training, and advertising to build brand recognition, which (unlike capital expenditures) usually are expensed in the year in which the monies are spent.
In theory, the decision to choose among alternative options should be made based on the discounting of the projected cash-flow stream to the firm resulting from each option. In practice, many other considerations are at work.
The Role of Intangible Factors
Although financial analyses are conducted to evaluate the various strategy implementation options, the ultimate choice may depend on unquantifiable factors such as the senior manager's risk profile, patience, and ego. The degree of control offered by the various alternatives is often the central issue senior management must confront as this choice is made. Although the solo venture and acquisition options offer the highest degree of control, they can be the most expensive, although for very different reasons. Typically, a build strategy will take considerably longer to realize key strategic objectives, and it may have a significantly lower current value than the alternatives—depending on the magnitude and timing of cash flows generated from the investments. Gaining control through acquisition can also be very expensive because of the substantial premium the acquirer normally has to pay to gain a controlling interest in another company.
The joint venture may be a practical alternative to either a build or an acquire strategy; it gives a firm access to skills, product distribution channels, proprietary processes, and patents at a lower initial expense than might otherwise be required. The joint venture is frequently a precursor to an acquisition because it gives both parties time to assess the compatibility of their respective corporate cultures and strategic objectives.
Asset swaps may be an attractive alternative to the other options, but in most industries they are generally very difficult to establish unless the physical characteristics and use of the assets are substantially similar. The practice is relatively common in the commercial and industrial real estate industry. Firms in the cable industry also use asset swaps to achieve strategic objectives. In recent years, cable companies have been swapping customers to allow a single company to dominate a specific geographic area and realize the full benefits of economies of scale and scope.9
Analyzing Assumptions
With the assumptions displayed, the reasonableness of the various options can be compared more readily. The option with the highest net present value is not necessarily the preferred strategy if the assumptions underlying the analysis strain credulity. Understanding the assumptions underlying the chosen strategy and those underlying alternative strategies forces senior management to make choices based on a discussion of the reasonableness of the assumptions associated with each option. This is generally preferable to placing a disproportionately high level of confidence in the numerical output of computer models.
In Case Study 4.2, Hewlett-Packard opportunistically acquired struggling smartphone maker Palm in an effort to exploit the growth and profit potential of that market. The case study illustrates how a firm can react to changes in its external environment and the recognition of its competitive disadvantage in not possessing the requisite core technologies and skills. A key question is whether the acquisition of a small player with an aging proprietary technology will enable the firm to leapfrog the “800-pound gorillas” that dominate the current market.
Case Study 4.2
HP Redirects Its Mobile Device Business Strategy with the Acquisition of Palm
With global PC market growth slowing, Hewlett-Packard (HP), number one in PC sales worldwide, sought to redirect its business strategy for mobile devices. Historically, the firm has relied on such partners as Microsoft to provide the operating systems for its mobile phones and tablet computer products. However, the strategy seems to have contributed to the firm's declining smartphone sales by limiting its ability to differentiate its products and by delaying new mobile product introductions.
HP has been selling a smartphone version of its iPaq handheld device since 2007, although few consumers even knew HP made such devices, since its products were aimed at business people. Sales of iPaq products fell to $172 million in 2009 from $531 million in 2007 and to less than $100 million (excluding sales of Palm products) in 2010.
With smartphone sales expected to exceed laptop sales in 2012, according to industry consultant IDC, HP felt compelled to move aggressively into the market for handheld mobile devices. The major challenge facing HP is to overcome the substantial lead that Apple, Google, and Research-In-Motion (RIM) have in the smartphone market.
To implement the new business strategy, HP acquired Palm in mid-2010 in a deal valued at $1.4 billion (including warrants and convertible preferred stock). HP acquired Palm at a time when its smartphone sales were sliding, with Palm's share of the U.S. market dropping below 5% in 2010. Palm was slow to recognize the importance of applications (apps) designed specifically for smartphones in driving sales. Palm has several hundred apps, while the numbers for Apple's iPhone and Google's Android are in the tens of thousands.
HP is hoping to leverage Palm's smartphone operating system (webOS) to become a leading competitor in the rapidly growing smartphone market, a market that had been largely pioneered by Palm. HP hopes that webOS will provides an ideal common “platform” to link the firm's mobile devices and create a unique experience for the user of multiple HP mobile devices. The intent is to create an environment where users can get a common look and feel and a common set of services irrespective of the handset they choose.
HP also acquired 452 patents and another 406 applications on file. Palm offers one key potential competitive advantage in that its operating system can run several tasks at once, just as a PC does; however, other smartphones are expected to have this capability in the near future.
By buying Palm, HP signals a “go it alone” strategy in smartphones and tablet computers at the expense of Microsoft. HP is also hoping that by having a proprietary system, it will be able to differentiate its mobile products in a way that Apple and Google have in introducing their proprietary operating systems and distinguishing “look and feel.”
Through its sales of computer servers, software, and storage systems, HP has significant connections with telecommunications carriers like Verizon that could help promote devices based on Palm's technology. Also, because of its broad offering of PCs, printers, and other consumer electronics products, HP has leverage over electronics retailers for shelf space.
Functional Strategies
Functional strategies focus on short-term results and generally are developed by functional areas; they also tend to be very detailed and highly structured. These strategies result in a series of concrete actions for each function or business group, depending on the company's organization. It is common to see separate plans with specific goals and actions for the marketing, manufacturing, R&D, engineering, and financial and human resources functions. Functional strategies should include clearly defined objectives, actions, timetables for achieving those actions, resources required, and identifying the individual responsible for ensuring that the actions are completed on time and within budget.
Specific functional strategies might read as follows:
• Set up a product distribution network in the northeastern United States that is capable of handling a minimum of 1 million units of product annually by 12/31/20XX. (Individual responsible: Oliver Tran; estimated budget: $5 million.)
• Develop and execute an advertising campaign to support the sales effort in the northeastern United States by 10/31/20XX. (Individual responsible: Maria Gomez; estimated budget: $0.5 million.)
• Hire a logistics manager to administer the distribution network by 9/15/20XX. (Individual responsible: Patrick Petty; estimated budget: $250,000.)
• Acquire a manufacturing company with sufficient capacity to meet the projected demand for the next three years by 6/30/20XX at a purchase price not to exceed $250 million. (Individual responsible: Chang Lee.)
Perhaps an application software company is targeting the credit card industry. The following is an example of how the company's business mission, business strategy, implementation strategy, and functional strategies are related.
• Mission: To be recognized by our customers as the leader in providing accurate, high-speed, high-volume transactional software for processing credit card remittances by 20XX.
• Business Strategy: Upgrade our current software by adding the necessary features and functions to differentiate our product and service offering from our primary competitors and satisfy projected customer requirements through 20XX.
• Implementation Strategy: Purchase a software company at a price not to exceed $400 million that is capable of developing “state-of-the-art” remittance processing software by 12/21/20XX. (Individual responsible: Donald Stuckee.) (Note that this assumes that the firm has completed an analysis of available options, including internal development, collaborating, licensing, or acquisition.)
• Functional Strategies to Support the Implementation Strategy:
• Research and Development: Identify and develop new applications for remittance processing software.
• Marketing and Sales: Assess the impact of new product offerings on revenue generated from current and new customers.
• Human Resources: Determine appropriate staffing requirements to support the combined firms.
• Finance: Identify and quantify potential cost savings generated from improved productivity as a result of replacing existing software with the newly acquired software and from the elimination of duplicate personnel in our combined companies. Evaluate the impact of the acquisition on our combined companies' financial statements.
• Legal: Ensure that all target company customers have valid contracts and that these contracts are transferable without penalty. Also, ensure that we will have exclusive and unlimited rights to use the remittance processing software.
• Tax: Assess the tax impact of the acquisition on our cash flow.
Strategic Controls
Strategic controls include both incentive and monitoring systems. Incentive systems include bonus, profit sharing, or other performance-based payments made to motivate both acquirer and target company employees to work to implement the business strategy for the combined firms. Typically, these will have been agreed to during negotiation. Incentives often include retention bonuses for key employees of the target firm if they remain with the combined companies for a specific period following completion of the transaction.
Monitoring systems are implemented to track the actual performance of the combined firms against the business plan. They may be accounting-based and monitor financial measures such as revenue, profits, and cash flow, or they may be activity-based and monitor variables that drive financial performance. These include customer retention, average revenue per customer, employee turnover, and revenue per employee.
The Business Plan as a Communication Document
The necessary output of the planning process is a document that communicates effectively with key decision makers and stakeholders. A good business plan should be short, focused, and well documented. There are many ways to develop such a document. Exhibit 4.1 outlines the key features that should be addressed in a good business plan—one that is so well reasoned and compelling that decision makers accept its recommendations.
The executive summary may be the most important and difficult piece of the business plan to write. It must communicate succinctly and compellingly what is being proposed, why it is being proposed, how it is to be achieved, and by when. It must also identify the major resource requirements and risks associated with the critical assumptions underlying the plan. The executive summary is often the first and only portion of the business plan that is read by a time-constrained CEO, lender, or venture capitalist. As such, it may represent the first and last chance to catch the attention of the key decision maker. Supporting documentation should be referred to in the business plan text but presented in the appendices.
Exhibit 4.1 Typical Business Unit-Level Business Plan Format
1. Executive summary. In one or two pages, describe what you are proposing to do, why, how it will be accomplished, by what date, critical assumptions, risks, and major resource requirements.
2. Industry/market definition. Define the industry or market in which the firm competes in terms of size, growth rate, product offering, and other pertinent characteristics.
3. External analysis. Describe industry/market competitive dynamics in terms of the factors affecting customers, competitors, potential entrants, product or service substitutes, and suppliers, and how these factors interact to determine profitability and cash flow (e.g., Porter 5 forces model; see Figure 4.2). Discuss the major opportunities and threats that exist because of the industry's competitive dynamics. Information accumulated in this section should be used to develop the assumptions underlying revenue and cost projections in building financial statements.
4. Internal analysis. Describe the company's strengths and weaknesses and how they compare with the competition's. Identify which of these strengths and weaknesses are important to the firm's targeted customers, and explain why. These data can be used to develop cost and revenue assumptions underlying the businesses' projected financial statements.
5. Business mission/vision statement. Describe the purpose of the corporation, what it intends to achieve, and how it wishes to be perceived by its stakeholders. For example, an automotive parts manufacturer may envision itself as being perceived by the end of the decade as the leading supplier of high-quality components worldwide by its customers and as fair and honest by its employees, the communities in which it operates, and its suppliers.
6. Quantified strategic objectives (including completion dates). Indicate both financial (e.g., rates of return, sales, cash flow, share price) and nonfinancial goals (e.g., market share; being perceived by customers or investors as number 1 in the targeted market in terms of market share, product quality, price, innovation).
7. Business strategy. Identify how the mission and objectives will be achieved (e.g., become a cost leader, adopt a differentiation strategy, focus on a specific market segment, or some combination of these). Show how the chosen business strategy satisfies a key customer need or builds on a major strength possessed by the firm. For example, a firm whose targeted customers are highly price sensitive may pursue a cost leadership strategy to enable it to lower selling prices and increase market share and profitability. Alternatively, a firm with a well-established brand name may choose to pursue a differentiation strategy by adding features to its product that are perceived by its customers as valuable.
8. Implementation strategy. From a range of reasonable options (i.e., solo venture or “go it alone” strategy; partner via a joint venture or less formal business alliance, license, or minority investment; or acquire–merge), indicate which option will enable the firm to best implement its chosen business strategy. Indicate why the chosen implementation strategy is superior to alternative options. For example, an acquisition strategy may be appropriate if the perceived “window of opportunity” is believed to be brief. Alternatively, a solo venture may be preferable if there are few attractive acquisition opportunities or the firm believes it has the necessary resources to develop the needed processes or technologies.
9. Functional strategies. Identify plans and resources required by major functional areas, including manufacturing, engineering, sales and marketing, research and development, finance, legal, and human resources.
10. Business plan financials and valuation. Provide projected annual income, balance sheet, and cash-flow statements for the firm, and estimate the firm's value based on the projected cash flows. State key forecast assumptions underlying the projected financials and valuation.
11. Risk assessment. Evaluate the potential impact on valuation by changing selected key assumptions one at a time. Briefly identify contingency plans (i.e., alternative ways of achieving the firm's mission or objectives) that will be undertaken if critical assumptions prove inaccurate. Identify specific events that will cause the firm to pursue a contingency plan. Such “trigger points” can include deviations in revenue growth of more than x percent or the failure to acquire or develop a needed technology within a specific period.
Phase 2: Building the Merger–Acquisition Implementation Plan
If a firm decides to execute its strategy through an acquisition, it will need an acquisition plan. Here, the steps of the acquisition planning process are discussed, including detailed components of an acquisition plan, how to conduct an effective search process, and how to make initial contact with a potential target firm.10
The acquisition plan is a specific type of implementation strategy that focuses on tactical or short-term issues rather than strategic or longer-term issues. It includes management objectives, a resource assessment, a market analysis, senior management's preferences regarding management of the acquisition process, a timetable, and the name of the individual responsible for making it all happen. These and the criteria to use when searching acquisition targets are codified in the first part of the planning process; once a target has been identified, several additional steps must be taken, including contacting the target, developing a negotiation strategy, determining the initial offer price, and developing both financing and integration plans.
Development of the acquisition plan should be directed by the “deal owner”—typically a high-performing manager for the specific acquisition. Senior management should, very early in the process, appoint the deal owner to this full- or part-time position. It can be someone in the firm's business development unit, for example, or a member of the firm's business development team with substantial deal-making experience. Often, it is the individual who will be responsible for the operation and integration of the target, with an experienced deal maker playing a supporting role. The first steps in the acquisition planning process are undertaken prior to selecting the target firm and involve codifying the plan elements that are necessary before the search for an acquisition target can begin.
Plan Objectives
The acquisition plan's stated objectives should be completely consistent with the firm's strategic objectives. Financial and nonfinancial objectives alike should support realization of the business plan objectives. Moreover, as is true with business plan objectives, the acquisition plan objectives should be quantified and include a date when such objectives are expected to be realized.
Financial objectives in the acquisition plan could include a minimum rate of return or operating profit, revenue, and cash-flow targets to be achieved within a specified period. Minimum or required rates of return targets may be substantially higher than those specified in the business plan, which relate to the required return to shareholders or to total capital (i.e., debt plus equity). The required return for the acquisition may reflect a substantially higher level of risk as a result of the perceived variability of the amount and timing of the expected cash flows resulting from the acquisition.
Nonfinancial objectives address the motivations for making the acquisition that support the achievement of the financial returns stipulated in the business plan. They could include obtaining rights to specific products, patents, copyrights, or brand names; providing growth opportunities in the same or related markets; developing new distribution channels in the same or related markets; obtaining additional production capacity in strategically located facilities; adding R&D capabilities; and acquiring access to proprietary technologies, processes, and skills.11 Because these objectives identify the factors that ultimately determine whether a firm will achieve its desired financial returns, they may provide substantially more guidance than financial targets. Table 4.4 illustrates how these and other acquisition plan objectives can be linked with business plan objectives.
Table 4.4. Examples of Linkages between Business and Acquisition Plan Objectives
| Business Plan Objective | Acquisition Plan Objective |
| Financial: The firm will | Financial returns: The target firm should have |
| Size: The firm will be the number 1 or 2 market share leader by 20XX | Size: The target firm should be at least $x million in revenue |
| Growth: The firm will achieve through 20XX annual average | Growth: The target firm should |
| Diversification: The firm will reduce earnings variability by x% | Diversification: The target firm's earnings should be largely uncorrelated with the acquirer's earnings |
| Flexibility: The firm will achieve flexibility in manufacturing and design | Flexibility: The target firm should use flexible manufacturing techniques |
| Technology: The firm will be recognized by its customers as the industry's technology leader | Technology: The target firm should own important patents, copyrights, and other forms of intellectual property |
| Quality: The firm will be recognized by its customers as the industry's quality leader | Quality: The target firm's product defects must be less than x per million units manufactured |
| Service: The firm will be recognized by its customers as the industry's service leader | Warranty record: The target firm's customer claims per million units sold should be not greater than x |
| Cost: The firm will be recognized by its customers as the industry's low-cost provider | Labor costs: The target firm should be nonunion and not subject to significant government regulation |
| Innovation: The firm will be recognized by its customers as the industry's innovation leader | R&D capabilities: The target firm should have introduced new products accounting for at least x% of total revenue in the last two years |
Resource/Capability Evaluation
Early in the acquisition process, it is important to determine the maximum amount of the firm's available resources that senior management will commit to a merger or acquisition. This information is used when the firm develops target selection criteria before undertaking a search for target firms.
Financial resources that are potentially available to the acquirer include those provided by internally generated cash flow in excess of normal operating requirements, plus funds from the equity and debt markets. In cases where the target firm is known, the potential financing pool includes funds provided by the internal cash flow of the combined companies in excess of normal operating requirements, the capacity of the combined firms to issue equity or increase leverage, and the proceeds from selling assets not required for implementing the acquirer's business plan.
Financial theory suggests that an acquiring firm will always be able to attract sufficient funding for an acquisition if it can demonstrate that it can earn its cost of capital. In practice, senior management's risk tolerance plays an important role in determining what the acquirer believes it can afford to spend on a merger or acquisition. Consequently, risk-averse management may be inclined to commit only a small portion of the total financial resources that are potentially available to the firm.
There are three basic types of risk that confront any senior management team that is considering an acquisition, and they affect how management feels about the affordability of an acquisition opportunity. How these risks are perceived will determine how much of the potentially available resources management will be willing to commit to making an acquisition.
Operating risk addresses the ability of the buyer to manage the acquired company. Generally, it is perceived to be higher for M&As in markets unrelated to the acquirer's core business. The limited understanding of managers in the acquiring company of the competitive dynamics of the new market and the inner workings of the target firm may negatively affect the postmerger integration efforts, as well as the ongoing management of the combined companies.
Financial risk refers to the buyer's willingness and ability to leverage a transaction, as well as the willingness of shareholders to accept dilution of near-term earnings per share (EPS). To retain a specific credit rating, the acquiring company must maintain certain levels of financial ratios, such as debt-to-total capital and interest coverage (i.e., earnings before interest and taxes divided by interest expense).A firm's incremental debt capacity can be approximated by comparing the relevant financial ratios to those of comparable firms in the same industry that are rated by the credit rating agencies. The difference represents the amount the firm, in theory, could borrow without jeopardizing its current credit rating.12 Senior management could also gain insight into how much EPS dilution equity investors may be willing to tolerate through informal discussions with Wall Street analysts and an examination of comparable transactions financed by issuing stock.
Overpayment risk involves the dilution of EPS or a reduction in its growth rate resulting from paying significantly more than the economic value of the acquired company. The effects of overpayment on earnings dilution can last for years.13
Management Preferences
Senior management's preferences for conducting the acquisition process are usually expressed in terms of boundaries or limits. To ensure that the process is managed in a manner consistent with management's risk tolerance and biases, management must provide guidance to those responsible for finding and valuing the target as well as negotiating the transaction. Substantial upfront participation by management will help dramatically in the successful implementation of the acquisition process. Unfortunately, senior management frequently avoids providing significant input early in the process. This inevitably leads to miscommunication, confusion, and poor execution later. Exhibit 4.2 provides examples of the more common types of management guidance that might be found in an acquisition plan.
Timetable
The final component of a properly constructed acquisition plan is a schedule that recognizes all of the key events that must take place in the acquisition process. Each event should have beginning and ending dates and milestones along the way and should identify who is responsible for ensuring that each milestone is achieved. The timetable of events should be aggressive but realistic. It should be sufficiently aggressive to motivate all involved to work as expeditiously as possible to meet the plan's management objectives, while avoiding the overoptimism that may demotivate individuals if uncontrollable circumstances delay reaching certain milestones.
Exhibit 4.3 recaps the components of a typical acquisition planning process. The first four elements were discussed in detail in this chapter; the remaining items will be the subject of the next chapter.
Exhibit 4.2 Examples of Management Guidance Provided to Acquisition Teams
1. Determining the criteria used to evaluate prospective candidates (e.g., size, price range, current profitability, growth rate, geographic location, and cultural compatibility).
2. Specifying acceptable methods for finding candidates (e.g., soliciting board members; analyzing competitors; and contacting brokers, investment bankers, lenders, law firms, and the trade press).
3. Establishing roles and responsibilities for the acquisition team, including the use of outside consultants, and defining the team's budget.
4. Identifying acceptable sources of financing (e.g., equity issues, bank loans, unsecured bonds, seller financing, or asset sales).
5. Establishing preferences for an asset or stock purchase and form of payment (cash, stock, or debt).
6. Setting a level of tolerance for goodwill (i.e., the excess of the purchase price over the fair market value net acquired assets).
7. Indicating the degree of openness to partial rather than full ownership.
8. Specifying willingness to launch an unfriendly takeover.
9. Setting affordability limits (which can be expressed as a maximum price of after-tax earnings, earnings before interest and taxes, or cash flow multiple or maximum dollar amount).
10. Indicating any desire for related or unrelated acquisitions.
Exhibit 4.3 Acquisition Plan for the Acquiring Firm
1. Plan objectives. Identify the specific purpose of the acquisition. This should include specific goals to be achieved (e.g., cost reduction, access to new customers, distribution channels or proprietary technology, expanded production capacity) and how the achievement of these goals will better enable the acquiring firm to implement its business strategy.
2. Timetable. Establish a timetable for completing the acquisition, including integration if the target firm is to be merged with the acquiring firm's operations.
3. Resource/capability evaluation. Evaluate the acquirer's financial and managerial capability to complete an acquisition. Identify affordability limits in terms of the maximum amount the acquirer should pay for an acquisition. Explain how this figure is determined.
4. Management preferences. Indicate the acquirer's preferences for a “friendly” acquisition; controlling interest; using stock, debt, cash, or some combination; and so on.
5. Search plan. Develop criteria for identifying target firms and explain plans for conducting the search, why the target ultimately selected was chosen, and how you will make initial contact with the target firm. See Chapter 5.
6. Negotiation strategy. Identify key buyer/seller issues. Recommend a deal structure that addresses the primary needs of all parties involved. Comment on the characteristics of the deal structure. Such characteristics include the proposed acquisition vehicle (i.e., the legal structure used to acquire the target firm), the postclosing organization (i.e., the legal framework used to manage the combined businesses following closing), and the form of payment (i.e., cash, stock, or some combination). Other characteristics include the form of acquisition (i.e., whether assets or stock are being acquired) and tax structure (i.e., whether it is a taxable or a nontaxable transaction). Indicate how you might “close the gap” between the seller's price expectations and the offer price. These considerations will be discussed in more detail in Chapter 5.
7. Determination of initial offer price. Provide projected 5-year income, balance sheet, and cash-flow statements for the acquiring and target firms individually and for the consolidated acquirer and target firms with and without the effects of synergy. (Note that the projected forecast period can be longer than 5 years if deemed appropriate.) Develop a preliminary minimum and maximum purchase price range for the target. List key forecast assumptions. Identify an initial offer price, the composition (i.e., cash, stock, debt, or some combination) of the offer price, and why you believe this price is appropriate in terms of meeting the primary needs of both target and acquirer shareholders. The appropriateness of the offer price should reflect your preliminary thinking about the deal structure. See Chapters 11 and 12 for a detailed discussion of the deal-structuring process.
8. Financing plan. Determine if the proposed offer price can be financed without endangering the combined firm's creditworthiness or seriously eroding near-term profitability and cash flow. For publicly traded firms, pay particular attention to the near-term impact of the acquisition on the earnings per share of the combined firms.
9. Integration plan. Identify integration challenges and possible solutions. See Chapter 6 for a detailed discussion of how to develop integration strategies. For financial buyers, identify an “exit strategy.” Highly leveraged transactions are discussed in detail in Chapter 13.
Some Things to Remember
The success of an acquisition is frequently dependent on the focus, understanding, and discipline inherent in a thorough and viable business plan that addresses four overarching questions: Where should the firm compete? How should the firm compete? How can the firm satisfy customer needs better than the competition? Why is the chosen strategy preferable to other reasonable options?
An acquisition is only one of many options available for implementing a business strategy. The decision to pursue an acquisition often rests on the desire to achieve control and a perception that the acquisition will result in achieving the desired objectives more rapidly than other options. Once a firm has decided that an acquisition is critical to realizing the strategic direction defined in the business plan, a merger/acquisition plan should be developed.
Discussion Questions
4.1 Why is it important to think of an acquisition or merger in the context of a process rather than as a series of semirelated, discrete events?
4.2 How does planning facilitate the acquisition process?
4.3 What major activities should be undertaken in building a business plan?
4.4 What is market segmentation and why is it important?
4.5 What basic types of strategies do companies commonly pursue and how are they different?
4.6 What is the difference between a business plan and an acquisition plan?
4.7 What are the advantages and disadvantages of using an acquisition to implement a business strategy compared with a joint venture?
4.8 Why is it important to understand the assumptions underlying a business plan or an acquisition plan?
4.9 Why is it important to get senior management heavily involved early in the acquisition process?
4.10 In your judgment, which of the elements of the acquisition plan discussed in this chapter are the most important and why?
4.11 After having acquired the OfficeMax superstore chain in 2003, Boise Cascade announced the sale of its core paper and timber products operations in late 2004 to reduce its dependence on this highly cyclical business. Reflecting its new emphasis on distribution, the company changed its name to OfficeMax, Inc. How would you describe the OfficeMax mission and business strategy implicit in these actions?
4.12 Dell Computer is one of the best-known global technology companies. In your opinion, who are Dell's primary customers? Current and potential competitors? Suppliers? How would you assess Dell's bargaining power with respect to its customers and suppliers? What are Dell's strengths and weaknesses versus its current competitors?
4.13 In your opinion, what market need(s) was Dell Computer able to satisfy better than its competition? Be specific.
4.14 Discuss the types of analyses inside GE that may have preceded GE's 2008 announcement that it would spin off its consumer and industrial businesses to its shareholders.
4.15 Ashland Chemical, the largest U.S. chemical distributor, acquired chemical manufacturer Hercules Inc. for $3.3 billion in 2008. This move followed Dow Chemical Company's purchase of Rohm & Haas. The justification for both acquisitions was to diversify earnings and offset higher oil costs. How will this business combination offset escalating oil costs?
Answers to these Chapter Discussion Questions are available in the Online Instructor's Manual for instructors using this book.
Chapter Business Cases
Case Study 4.3
Adobe's Acquisition of Omniture: Field of Dreams Marketing?
On September 14, 2009, Adobe announced its acquisition of Omniture for $1.8 billion in cash or $21.50 per share. Adobe CEO Shantanu Narayen announced that the firm was pushing into new business at a time when customers were scaling back on purchases of the company's design software. Omniture would give Adobe a steady source of revenue, which could mean investors would focus less on Adobe's ability to migrate its customers to product upgrades such as Adobe Creative Suite.
Adobe's business strategy was to develop a new line of software that was compatible with Microsoft applications. As the world's largest developer of design software, Adobe licenses such software as Flash, Acrobat, Photoshop, and Creative Suite to website developers. Revenues grow as a result of increased market penetration and inducing current customers to upgrade to newer versions of the design software.
In recent years, a business model has emerged in which customers can “rent” software applications for a specific time period by directly accessing the vendors' servers online or downloading the software to the customer's site. Moreover, software users have shown a tendency to buy from vendors with multiple product offerings to achieve better product compatibility.
Omniture makes software designed to track the performance of websites and online advertising campaigns. Specifically, its Web analytic software allows its customers to measure the effectiveness of Adobe's content creation software. Advertising agencies and media companies use Omniture's software to analyze how consumers use websites. It competes with Google and other smaller participants. Omniture charges customers fees based on monthly website traffic, so sales are somewhat less sensitive than Adobe's. When the economy slows, Adobe has to rely on squeezing more revenue from existing customers. Omniture benefits from the takeover by gaining access to Adobe customers in different geographic areas and more capital for future product development. With annual revenues of more than $3 billion, Adobe is almost ten times the size of Omniture.
Immediately following the announcement, Adobe's stock fell 5.6% to $33.62, after having gained about 67% since the beginning of 2009. In contrast, Omniture shares jumped 25% to $21.63, slightly above the offer price of $21.50 per share. While Omniture's share price move reflected the significant premium of the offer price over the firm's preannouncement share price, the extent to which investors punished Adobe reflected widespread unease with the transaction.
Investors seem to be questioning the price paid for Omniture, whether the acquisition would actually accelerate and sustain revenue growth, the impact on the future cyclicality of the combined businesses, the ability to effectively integrate the two firms, and the potential profitability of future revenue growth. Each of these factors is considered next.
Adobe paid 18 times projected 2010 earnings before interest, taxes, depreciation, and amortization, a proxy for operating cash flow. Considering that other Web acquisitions were taking place at much lower multiples, investors reasoned that Adobe had little margin for error. If all went according to the plan, the firm would earn an appropriate return on its investment. However, the likelihood of any plan being executed flawlessly is problematic.
Adobe anticipates that the acquisition will expand its addressable market and growth potential. In addition, Adobe anticipates significant cross-selling opportunities in which Omniture products can be sold to Adobe customers. With its much larger customer base, this may represent a substantial new outlet for Omniture products. The presumption is that by combining the two firms, Adobe will be able to deliver more value to its customers. Adobe plans to merge its programs that create content for websites with Omniture's technology. For designers, developers, and online marketers, Adobe believes that integrated development software will streamline the creation and delivery of relevant content and applications.
The size of the market for such software is difficult to gauge. Not all of Adobe's customers will require the additional functionality that will be offered. Google Analytic Services, offered free of charge, has put significant pressure on Omniture's earnings. However, firms with large advertising budgets are less likely to rely on the viability of free analytic services.
Adobe also is attempting to diversify into less cyclical businesses. However, both Adobe and Omniture are impacted by fluctuations in the volume of retail spending. Less retail spending implies fewer new websites and fewer upgrades of existing websites, which directly impacts Adobe's design software business. Moreover, less advertising and retail activity on electronic commerce sites negatively impacts Omniture's revenues. Omniture receives fees based on the volume of activity on a customer's site.
Integrating the Omniture measurement capabilities into Adobe software design products and cross-selling Omniture products into the Adobe customer base require excellent coordination and cooperation between Adobe and Omniture managers and employees. Achieving such cooperation often is a major undertaking, especially when the Omniture shareholders, many of whom were employees, were paid in cash. The use of Adobe stock would have given them additional impetus to achieve these synergies in order to boost the value of their shares.
Achieving cooperation may be slowed by the lack of organizational integration of Omniture into Adobe. Omniture will become a new business unit within Adobe, with Omniture's CEO, Josh James, joining Adobe as a senior vice president of the new business. James will report to Narayen. This arrangement may have been made to preserve Omniture's corporate culture.
Adobe is betting that the potential increase in revenues will grow profits for the combined firms despite Omniture's lower margins. Whether the acquisition will contribute to overall profit growth or not depends on which products contribute to future revenue growth. The lower margins associated with Omniture's products will slow overall profit growth if the future growth in revenue comes largely from Omniture's Web analytic products.
Discussion Questions
1. Who are Adobe's and Omniture's customers and what are their needs?
2. Which factors external to Adobe and Omniture seem to be driving the transaction? Be specific.
3. Which factors internal to Adobe and Omniture seem to be driving the transaction? Be specific.
4. How will the combined firms be able to better satisfy these needs than the competition can?
5. Do you believe the transaction can be justified based on your understanding of the strengths and weaknesses of the two firms and perceived opportunities and threats to them in the marketplace? Be specific.
Answers to these questions are found in the Online Instructor's Manual available for instructors using this book.
Case Study 4.4
BofA Acquires Countrywide Financial Corporation
On July 1, 2008, Bank of America Corp. (BofA) announced that it had completed its acquisition of mortgage lender Countrywide Financial Corp. (Countrywide) for $4 billion, a 70% discount from the firm's book value at the end of 2007. Countrywide originates, purchases, and securitizes residential and commercial loans; provides loan closing services, such as appraisals and flood determinations; and performs other residential real estate–related services. This marked another major (but risky) acquisition by Bank of America's chief executive Kenneth Lewis in recent years.
BofA's long-term intent has been to become the nation's largest consumer bank while achieving double-digit earnings growth. The acquisition will help the firm realize that vision and create the second largest U.S. bank.
In 2003, BofA paid $48 billion for FleetBoston Financial, which gave it the most branches, customers, and checking deposits of any bank in the United States. In 2005, BofA became the largest credit card issuer when it bought MBNA for $35 billion.
The purchase of the troubled mortgage lender averted the threat of a collapse of a major financial institution because of the U.S. 2007–2008 subprime loan crisis. Regulators in the United States were quick to approve the takeover because of the potentially negative implications for U.S. capital markets of a major bank failure. Countrywide had lost $1.2 billion in the third quarter of 2007. Countrywide's exposure to the subprime loan market (i.e., residential loans made to borrowers with poor or nonexistent credit histories) had driven its shares down by almost 80% from year-earlier levels. The bank was widely viewed as teetering on the brink of bankruptcy as it lost access to short-term debt markets, its traditional source of borrowing.
Bank of America deployed 60 analysts to Countrywide's headquarters in Calabasas, California. After four weeks of analyzing Countrywide's legal and financial challenges and modeling how its loan portfolio was likely to perform, BofA offered an all-stock deal valued at $4 billion. The deal valued Countrywide at $7.16 per share, a 7.6 discount to its closing price the day before the announcement. BofA issued 0.18 shares of its stock for each Countrywide share. The deal could have been renegotiated if Countrywide had experienced a material change that adversely affected the business between the signing of the agreement of purchase and sale and the closing of the deal. BofA made its initial investment of $2 billion in Countrywide in August 2007, purchasing preferred shares convertible to a 16% stake in the company. By the time of the announced acquisition in early January 2008, Countrywide had a $1.3 billon paper loss on the investment.
The acquisition provided an opportunity to buy a market leader at a distressed price. The risks related to the amount of potential loan losses, the length of the U.S. housing slump, and potential lingering liabilities associated with Countrywide's questionable business practices. The purchase made BofA the nation's largest mortgage lender and servicer, consistent with the firm's business strategy, which is to help consumers meet all their financial needs. BofA has been one of the relatively few major banks to be successful in increasing revenue and profit following acquisitions by “cross-selling” its products to the acquired bank's customers. Countrywide's extensive retail distribution network enhances BofA's network of more than 6,100 banking centers throughout the United States. BofA had anticipated almost $700 million in after-tax cost savings in combining the two firms. Almost two-thirds of these savings had been realized by the end of 2010. In mid-2010, BofA agreed to pay $108 million to settle federal charges that Countrywide had incorrectly collected fees from 200,000 borrowers who had been facing foreclosure.
Discussion Questions
1. How did the acquisition of Countrywide fit BofA's business strategy? Be specific. What were the key assumptions implicit in BofA's business strategy? How did the existence of BofA's mission and business strategy help the firm move quickly in acquiring Countrywide?
2. How would you classify the BofA business strategy (cost leadership, differentiation, focus, or some combination)? Explain your answer.
3. Describe what the likely objectives of the BofA acquisition plan might have been. Be specific. What key assumptions were implicit in BofA's acquisition plan? What were some of the key risks associated with integrating Countrywide? In addition to the purchase price, how would you determine BofA's potential resource commitment in making this acquisition?
4. What capabilities did the acquisition of FleetBoston Financial and MBNA provide BofA? How did the acquisition of Countrywide complement previous acquisitions?
5. What alternatives to outright acquisition did BofA have? Why do you believe BofA chose to acquire Countrywide rather than to pursue an alternative strategy? Be specific.
Answers to these case discussion questions are available in the Online Instructor's Manual for instructors using this book.
Appendix
Common Sources of Economic, Industry, and Market Dat
Economic Information
Business Cycle Development (U.S. Department of Commerce)
Current Business Reports (U.S. Department of Commerce)
Economic Indicators (U.S. Department of Commerce)
Economic Report of the President to the Congress (U.S. Government Printing Office)
Long-Term Economic Growth (U.S. Department of Commerce)
Regional statistics and forecasts from large commercial banks
Monthly Labor Review (U.S. Department of Labor)
Monthly Bulletin of Statistics (United Nations)
Overseas Business Reports (By country, published by U.S. Department of Commerce)
World Trade Annual (United Nations)
U.S. Industrial Outlook (U.S. Department of Commerce)
Survey of Current Business (U.S. Department of Commerce)
Statistical Yearbook (United Nations)
Statistical Abstract of the United States (U.S. Department of Commerce)
Industry Information
Forbes (Mid-January issues provide performance data on firms in various industries)
Business Week (Provides weekly economic and business information, and quarterly profit and sales rankings of corporations)
Fortune (April issues include listings of financial information on corporations within selected industries)
Industry Survey (Published quarterly by Standard and Poor's Corporation)
Industry Week (March–April issue provides information on 14 industry groups)
Inc. (May and December issues give information on entrepreneurial firms)
1 A smartphone is a single handheld device that can take care of all of the user's handheld computing and communication needs.
2 For more information, see www.guardian.co.uk/business/2010/feb/04/symbian-smartphone-software-open-source.
4 For a more detailed discussion of business planning, see Hunger and Wheeler, 2007.
6 Extensive checklists can be found in Porter (1985). Answering these types of questions requires gathering substantial economic, industry, and market information.
8 Boston Consulting Group, 1985
9 There are many other examples of asset swaps. In 2005, Citigroup exchanged its fund management business for Legg Mason's brokerage and capital markets businesses, with the difference in the valuation of the businesses paid in cash and stock. Similarly, Royal Dutch Shell and Russia's Gazprom reached a deal to swap major natural gas-producing properties in late 2005. In 2007, British Petroleum swapped half of its stake in its Toledo, Ohio, oil refinery for half of Husky Energy's position in the Sunrise oil sands field in Alberta, Canada.
10 Note that if the implementation of the firm's business strategy required some other business combination, such as a joint venture or business alliance, the same logic of the acquisition planning process described here would apply.
12 For example, suppose the combined acquirer and target firms' interest coverage ratio is 3 and the combined firms' debt-to-total-capital ratio is 0.25. Assume further that other firms within the same industry with comparable interest coverage ratios have debt-to-total-capital ratios of 0.5. Consequently, the combined acquirer and target firms could increase borrowing without jeopardizing their combined credit rating until their debt-to-total-capital ratio equals 0.5.
13 To illustrate the effects of overpayment risk, assume that the acquiring company's shareholders are satisfied with the company's projected annual average increase in EPS of 20% annually for the next five years. The company announces it will be acquiring another company and that a series of “restructuring” expenses will slow EPS growth in the coming year to 10%. However, management argues that the savings resulting from combining the two companies will raise the combined companies' EPS growth rate to 30% in the second through fifth year of the forecast. The risk is that the savings cannot be realized in the time assumed by management and the slowdown in earnings will extend well beyond the first year.