Billion-Dollar Lessons

Adjacent-market strategies attempt to build on core organizational strengths to expand the business in a significant way while taking minimal risk. The strategy might entail selling new products to existing customers or selling existing products to new customers. Sometimes it could mean selling new products to new customers. A move into adjacent markets generally seems quite sensible and is often regarded as the logical next step when organic growth in existing markets slows. “Long-term winners sustain their growth by edging out from their core,” said George Day, a professor at the Wharton School.²

At GE, Welch combined the concept of adjacent markets with another of his key management principles, that GE business units had to either dominate their markets or get out of them. “Challenging the organization to continually redefine their markets in a fashion that decreases their share opens their eyes to opportunities in adjacent markets,” Welch said.³ GE managers turned to adjacency strategies as one of their primary methods for satisfying GE’s thirst for growth. For example, in the late 1990s, GE Aircraft Engines redefined its market from one of selling aircraft engines and replacement parts to that of providing the services necessary to keeping airplanes aloft. To meet that need, GE sold “power by the hour,” which packaged equipment, maintenance, certification, and financing. GE Aircraft Engines’ market share, revenue, and profit margin grew tremendously.

Empirical research supports Welch’s view about the potential of adjacent markets. Perhaps the most thorough study is by Bain Company, and reported in Chris Zook’s Beyond the Core. Bain’s five-year study of 1,850 companies concluded that most sustained profitable growth comes when a company pushes out the boundaries of its core business into an adjacent space.

Unfortunately, the research also shows that adjacency moves usually fail. Of the companies Bain studied, 75 percent saw their moves into adjacent markets fail. Only 13 percent achieved what Bain called “even a modest level of sustained and profitable growth.” These companies grew earnings and revenues at least 5.5 percent a year (adjusted for inflation) and earned their cost of capital over ten years. A far smaller number achieved “sustainable growth performance far in excess of their peer groups.”

The problem is that the only thing the successful companies had in common is, well, that they were successful. Each built on core strengths. Each found rich veins of profitability. Each achieved market-leading economics. At a more detailed level, each evolved an approach that improved with multiple attempts and, over time, crystallized into a fairly repeatable process. But each approach was different, driven in large part by unique organizational and competitive circumstances. None offered a formula that others could simply follow.

There’s another problem, too. Adjacency moves are not only hard to pull off; they are risky. Another Bain study looked at the twenty-five most costly business disasters from 1997 through 2002 (excluding those caused by the dot-com bubble). That study concluded that in 75 percent of those failures, the root cause or a major contributing factor was an attempt to enter an adjacent market. Those twenty-five companies lost $1.1 trillion in stock-market value, about 88 percent of their total.⁴

As it turns out, the failures have a number of common characteristics, so even if you can’t know for sure which strategies will be big successes you can at least avoid many of the strategies that are doomed to fail. To explain what those common characteristics are, we’ll begin with the story of Oglebay Norton, a cautionary tale that shows how an ill-thought-out move into an adjacent market can bring down even a firm with a long, storied history.

Slow-growth, steel-related businesses still supplied 60 percent of Oglebay’s revenue. Oglebay’s shipping division, for example, mostly hauled iron ore, coal, and limestone for major steelmakers and accounted for about half of the company’s total revenue. As Green acknowledged at the time, “Shipping remains strong, but it’s not a growth business.”⁶

Under Green—a thirty-two-year employee and the last direct descendant of the Oglebay and Norton families to run the company—Oglebay had delivered five consecutive years of earnings growth and increased stock prices. Yet, in late 1997, Oglebay’s board, no doubt envious of the economic boom around them, replaced Green with John Lauer. Lauer, a former president and chief operating officer of BFGoodrich, came onto the scene with a splash worthy of the dot-com times. It didn’t seem to matter that he was taking over the helm of a company about as far from an Internet-related business as one might imagine.

Lauer said in a company press release, “My objective will be to create an aggressive but doable growth strategy.” That “doable growth strategy” called for Oglebay to have a $1 billion market value in three years, a fivefold increase. In that time, Lauer planned to grow revenues more than threefold, to $600 million.

With a flourish that led the AFL-CIO to declare him a “CEO pay hero,” Lauer crafted a five-year contract with no cash pay. Instead, he was granted an options package that gave him rights to buy as many as 383,000 shares, equal to 8 percent of the company, if he met performance targets. Lauer also bought $1 million of Oglebay stock at market value, which was in the mid-$30s. “When we put the deal together,” Lauer said, “the way we designed it was that I wouldn’t get credit for market momentum. I’d get credit for true growth.”⁷

Lauer focused on limestone. Oglebay already hauled limestone for steel mills. The material had growth opportunities beyond steel, including applications in road construction, environmental applications such as cleaning power-plant emissions and water filtration, and consumer lawn and garden applications. Rather than just transporting limestone, Lauer would buy up quarries within a region to become a dominant supplier. With quarries located fairly close to customers, Oglebay’s lower shipping costs would give it a competitive edge over rivals based outside the region.

By mid-1998, within six months of his arrival, Lauer had made three major acquisitions and doubled Oglebay’s size. The stock market initially responded with enthusiasm, briefly bidding Oglebay’s share price to $50.50. But all of the acquisitions were financed through debt; none of the sellers would take Oglebay stock. In a foreshadowing of the troubles to come, Oglebay’s debt increased by $250 million to just over $300 million. By the end of 1998, Oglebay’s share price was down to the mid-$20s.

Oglebay completed a number of other acquisitions through the end of 2000. The company acquired its way to be the fifth-largest producer of limestone in North America and one of the top twenty-five mineral producers overall. Revenue grew quickly, with limestone now representing about half of Oglebay’s total. Oglebay ended 2000 with $393 million in revenue—not the $600 million Lauer predicted, but still more than twice the level before Lauer arrived.

In its rush to grow, Oglebay paid peak prices for its acquisitions, both because the market for minerals was hot and because of Oglebay’s desire to corner local supplies—after one company was purchased in a market, the others knew they could raise their asking prices. To justify those high prices, Oglebay made ill-considered judgments about the strengths of its core business, about the strengths of the new limestone business, and about the dynamics of the limestone market.

Oglebay assumed that it would be able to integrate its acquisitions and improve its efficiency, but it had never accomplished such a task before and didn’t have the expertise to do so. Oglebay also overestimated the pricing power that its limestone business would have. Being the fifth-largest producer of limestone just didn’t carry much weight. In addition, Lauer’s hopes about the power of being an integrated producer and shipper of limestone didn’t pan out. With the decline of the steelmakers, there was lots of extra capacity available to ship limestone around the Great Lakes. Oglebay didn’t get as much shipping business as it had hoped, and it couldn’t raise prices. In addition, Oglebay’s background in shipping iron ore didn’t prepare it for one aspect of the limestone market: Limestone often needed to travel on rivers to get closer to customers. That meant being loaded on six-hundred- to seven-hundred-foot river-class vessels. But Oglebay’s fleet was mostly thousand-footers designed to transport iron ore on the Great Lakes.

The minerals industry was, in fact, enjoying brisk sales, even in the face of an economy that started slumping in 2000. For example, market leader Vulcan Materials Co. had record sales in 2000, then posted a 7 percent increase for 2001. Martin Marietta Materials Incorporated, another competitor, reported a 13 percent increase for 2001. But Oglebay didn’t share in the good times. Struggling to integrate its acquisitions and hampered by an enormous debt load, Oglebay’s mineral sales were flat or down in 2000 and 2001.

Lauer began glossing over problems. John Weil, a former board member, reported that Lauer would forecast record earnings—but his numbers wouldn’t include major costs, such as routine off-season maintenance at Oglebay’s largest limestone operations. More fatally, Weil recalls, forecasts did not take into account that the economy was showing signs of softening.⁹

Although it takes a lot to stand up to a dynamic CEO, Weil and another board member, Brent Baird, challenged Lauer. Baird says that the first time he raised his concerns, Lauer talked about growth and diversification. The next time Baird asked questions, Lauer got “nasty.” Weil recalled that Lauer’s response to Baird’s skepticism was, “Why’d you hire me if you wanted me to be a custodial manager?”

Douglas Barr, a former major shareholder, said he initially “thought Lauer’s plan was fine. Everyone agreed [iron-ore mining and shipping] was probably not long-term.” However, he continued, “If you need a new car, it’s a prudent thing to go out and get one. But you don’t buy eight of them and pay sticker price for each.”¹¹

Oglebay had weathered challenges before. You don’t last 150 years in the steel business—or any business, for that matter—without overcoming problems. So Oglebay had tried-and-true methods it could use to outlast the latest problems, and it used some. It moved, for example, to pool its Great Lakes shipping fleet with that of American Steamship Company, a similar-sized rival. The arrangement allowed the two fleets to operate more efficiently by coordinating dispatching and other fleet operations. Oglebay also cut costs by closing some regional headquarters and discontinuing several underperforming operations. It also sold some business units.

The rest was just a slow march to the end. Oglebay directors appointed a new president and chief operating officer in November 2001. By January 2003, Lauer was out as CEO. In April 2003, with the stock trading at $3, Lauer resigned as chairman. The company declared bankruptcy on February 23, 2004, with $440 million of debt. Shareholders like Douglas Barr, whose family had three hundred thousand shares and whose wife was a great-granddaughter of cofounder David Z. Norton, recouped pennies per share.

RED FLAGS

While Bain found that successful adjacency strategies are one-offs, not capable of being used as a template for other companies’ moves into adjacent markets, our research found four patterns that show up in many strategies that fail. They are:

• The move is being driven more by a change in a company’s core business rather than by some great opportunity in the adjacent market.

• The company lacks expertise in the adjacent market, leading the company to misjudge acquisitions and mismanage the competitive challenges of the new market.

• The company overestimates the strength or importance its core business’s capabilities will have in the new market.

• A company overestimates its hold on customers, leading to expectations of cross-selling or up-selling that won’t materialize.

Fleeing from the Core

FLYi Incorporated felt similar pressure. It had prospered for years as a regional airline that operated flights along the East Coast in what’s known as a code-sharing arrangement with United Airlines Incorporated and Delta Air Lines Incorporated. The arrangement meant that customers of the bigger airlines could book an entire itinerary through them even if that meant going to a city where Delta and United didn’t fly. FLYi would operate the flights to the smaller cities and would give United and Delta a share of the revenue for steering the business in its direction. Then, United filed for bankruptcy in 2002. It tried to renegotiate rates with FLYi. FLYi could have accepted a lower share of revenue and attempted to cut costs. As it happened, FLYi also had a chance to sell out to fellow regional carrier, Mesa Air Group Incorporated, which made an unsolicited $512 million buyout offer. Instead, FLYi decided to remake itself as an independent carrier.

FLYi thought it had plenty of expertise. After all, it had operated an airline for years. It was just going to operate that same airline while dealing directly with customers, rather than working under the umbrella provided by United and Delta. Yet, as many analysts predicted at the time, FLYi was woefully unprepared for the ferocity of open competition in the airline business. FLYi, which defiantly named its new incarnation Independence Air, promised to be “the polar opposite of the lumbering, arrogant major carriers.” But those major carriers were not so lumbering when it came to slapping down this upstart. As a FLYi court filing explained, “These competitors . . . have reacted by matching fares, reducing restrictions [on airline tickets], offering additional frequent flier incentives, increasing advertising, and by taking aggressive steps to reduce their own costs.”¹² Desperate for cash flow, FLYi’s only option was to rely on money-losing fares that were often as low as a Greyhound bus ticket. Smelling blood, competitors matched those fares route for route, never letting them rise to sustainable levels.

Besides, FLYi’s aircraft weren’t cost-efficient for an independent airline. FLYi’s planes had been selected based on the numbers of passengers it could get through its arrangements with United and Delta. The planes weren’t suited for the larger loads that FLYi would attempt to serve as an independent carrier. As a result, FLYi’s planes cost about three times as much to operate per seat per mile as those of JetBlue, a direct competitor.

FLYi also lacked expertise in direct-to-consumer marketing, sales, and service, because it had always piggybacked on others’ reservation systems. FLYi encountered problems with ticket sales, and customers complained of poor service. Yet FLYi couldn’t afford to back off and take the new business slowly while it learned the ropes. It had leases on eighty-seven small regional jets. It could not afford to keep any idle. So FLYi began life as an independent carrier with service to thirty-nine cities, too many for a newcomer to handle without major logistical problems.

One of the company’s largest shareholders says he warned FLYi executives not to become an independent carrier. “They had opportunities to preserve value, and they decided to completely shun them,” he said. “Their argument to me was that renegotiating with United ‘would have produced a lousy margin, and we couldn’t have made any money.’ That may be true. But versus what? Versus the negative operating margins” they wound up with as an independent?¹³

Similarly, Xerox went into financial services because of problems with its core business, copiers, in the early 1980s. Xerox’s revolutionary Model 914 plain paper copier was, at its peak, the bestselling industrial product of all time. It enjoyed 95 percent market share and 70 percent gross margins. But by 1982, Xerox’s U.S. market share had dwindled to 13 percent.

In a desperate attempt to offset the failing copier business, Xerox decided to move into what it considered to be an adjacent market. But the way Xerox formulated its strategy practically guaranteed that it would move into businesses where it had no expertise and thus would have a high likelihood of failure. Rather than risk a repeat of the problems it was having keeping up with foreign manufacturers of copiers, Xerox decided to move into a market that would not involve manufacturing and that had little foreign competition. Yet Xerox’s management team’s whole recent experience had been developing expertise in just those areas that Xerox decided to avoid—manufacturing and confronting foreign competition.

Rather than trying to build on some core competency, Xerox decided to leverage its balance sheet. Xerox moved into financial services, based on two strains of logic. Xerox reasoned that many of its customers financed their purchases, so it wouldn’t be much of a stretch for Xerox to add other kinds of financing. In addition, Xerox hoped the financial-services business would generate cash that it could then use to finance research and development of copiers.

Xerox spent more than $2 billion to acquire Crum & Forster Incorporated, a property and casualty insurer; Van Kampen Merritt, an investment adviser; and Furman Selz Incorporated, a brokerage house. After some initial problems, the investment seemed to pay off. In 1988, the financial-services arm accounted for half of Xerox’s profit. A significant portion of that profit came from financing Xerox equipment sales. But because Xerox didn’t have the experience to properly vet the acquisitions, it had bought headaches as well as cash flow. Several Crum & Forster units had been guilty of sloppy underwriting before the acquisition, and the problems were surfacing as claims mounted. For good measure, the whole industry went into a downturn. As one reporter described it at the time, Xerox management “turned pale” as they tallied up the potential losses.¹⁴ Unwinding the problems required Xerox CFO Melvin Howard to take personal charge of the insurer, commuting for a year between Xerox headquarters in Stamford, Connecticut, and Crum & Forster’s headquarters in Morristown, New Jersey.

Even if Crum & Forster hadn’t cratered, Xerox had overstated how much cash it could get from its financial-services business. What Xerox didn’t realize was that, even during periods when the financial-services arm delivered strong results, most of the cash flow was unavailable. Insurers, for instance, typically have to retain considerable cash to meet regulatory requirements.

Lack of Expertise

Avon Products Incorporated had its own tough lesson in the 1980s. The problems actually began with an acute insight and a big success: Avon saw that, with more women out working, fewer prospective customers were at home to buy beauty products from its famed door-to-door sales force. Avon decided to add health-care products to the traditional line of Avon cosmetics, reasoning that it might be able to sell more products to each customer, even if the customer base was shrinking. Sales boomed. Avon then went one step too far, by taking a larger step into health care. In 1984, Avon bought Foster Medical Corporation, a medical equipment-rental company. In 1985, Avon bought Retirement Inns of America Incorporated and Mediplex Group Incorporated, both of which operated nursing homes. The strategic rationale, as expressed in Avon’s annual report, was that health care fit into the company’s “culture of caring.” Maybe, but the strategy was a disaster. The move did nothing to build on Avon’s core asset, its sales force, and Avon simply didn’t have the expertise to manage the new acquisitions. In 1988, Avon took a total charge of $545 million for dismantling its health-care business.

While Avon thought its decision to sell health-care products meant it knew something about other parts of the health-care business, the equipment-rental business faced regulatory issues Avon didn’t foresee. The acquisition initially seemed brilliant, because Foster Medical revenues proceeded to double for each of the next two years. But the growth was short-lived. In fact, it was partly an illusion. In 1985, the government changed reimbursement policies for home oxygen therapy, a treatment that represented more than $100 million in annual revenue for Foster and more than 20 percent of its profit. Doctors had to recertify patients to qualify their treatment for reimbursement. Foster—now overseen by a cosmetics company that lacked experience in regulated environments—failed to do the necessary paperwork to recertify patients. Much of the revenue booked in 1986 was disallowed because the government wouldn’t reimburse Foster. Even once Foster adapted to the regulatory changes, its reimbursements continued to be squeezed. Avon sold Foster in 1988.

Avon’s lack of industry insight also played out in the inept management of Mediplex Group. Mediplex was a profitable system of twenty-seven long-term-care and substance-abuse centers when Avon bought it in 1985 for $245 million. On Avon’s watch, however, Mediplex failed to navigate the quickly changing health-care space. Profits turned to losses. Four years after the acquisition, Avon sold Mediplex back to the previous owners for $48 million. Within a few years, the new owners had the business nicely profitable once more. In 1994, they sold Mediplex again, this time for $315 million.

American Standard Companies, a maker of plumbing supplies, air-conditioning systems, and automotive systems, also fell victim to a lack of expertise. American Standard was solidly profitable, but in our growth-oriented investment culture it was hard to get too excited about the prospects for toilets. So, in the sort of strategic-planning exercise that many companies undergo, American Standard looked for faster-growing markets and then tried to find a way into them. Health care certainly seemed to fit the bill. It was riding a decades-long, demographically powered growth curve. Medical devices offered the promise of patent-protected revenue streams, and big industrial companies such as GE, 3M Company, and Siemens AG had shown that manufacturing expertise and deep pockets could eventually overcome a lack of initial expertise in medical devices. Once American Standard identified an in-house manufacturing technology that held potential for medical devices, it decided to make the leap into the new market.

But American Standard management lacked experience in diagnostics, so it couldn’t manage the businesses it acquired. The hoped-for new product, an in vitro diagnostics device targeted for laboratories and small hospitals, was rife with problems. American Standard also struggled with regulatory control that it had never previously experienced. The company didn’t have the right kind of investors, either. Its investors were looking for consistent quarterly earnings and dividend growth. The investors wanted nothing to do with the long product-development cycles and heavy up-front investments that came with medical devices.

It’s not just health care that trips up newcomers, either. CanWest Global Communications Corporation, one of Canada’s largest media companies, decided in 1998 to move beyond distribution. The company decided to produce original film and television content for both its Canadian and international channels. CanWest found, however, that operating television stations was much different from the creative side of the business. European customers didn’t take to the new content. In 2004, the company discontinued film production and recorded total losses of $294 million.

Overestimating the Core’s Strengths

When railroads failed to foresee the impact of the automobile in the early 1900s, they lost their position as the go-go stocks of the era and never regained it. The conventional wisdom has become that the railroads’ problem was that they saw themselves as being in the railroad business; they should have seen themselves as being in the transportation business. How many times have we heard that bromide? “Railroads weren’t in the railroad business. They were in the transportation business.”

That’s fair enough—until you think about it for a minute. Just what exactly did railroads and automobiles have in common? Not much. The railroads sold tickets for pennies apiece; they had no experience selling consumer items for hundreds of dollars each. The railroads had limited experience with consumer tastes; decorating a passenger railcar didn’t have much to do with designing a roadster that some young swell could use to go sparking with his lovely damsel. The customer bases were very different; everybody rode the trains, while, for a long time, only the affluent could afford cars. The distribution channels were different; railroads sold tickets in offices, while cars needed to be displayed in stores or on lots. The technology was different; the coal-fired engines used on trains bore little resemblance to the internal combustion engine used in cars.

All the railroads really had to bring to the car business were brand names and cash. The odds are high that any move into cars would have reached the same end that almost every other carmaker reached—the railroads’ ventures would have been acquired by Ford Motor Company or General Motors Corporation or one of the other handful of carmakers that survived the early days. Sure, the railroads could have done a better job of foreseeing the impact of cars and perhaps could have sold out before railroad stocks suffered. But to imply that railroads should have dominated the car business strikes us as naïve.

Studies suggest that these overestimation problems are common. Building on existing assets gives managers a false sense of security. Some capabilities are indeed built upon, but other critical variables are different. Chris Zook, in Beyond the Core, calls this the “trap of false enthusiasm,” referring to adjacency moves for which managers feel confidence because they are close to their core business while not realizing that the differences are significant enough to be problematic. Overestimation may actually occur more often in successful companies, based on what Stanford researchers William Barnett and Elizabeth Pontikes call the “Red Queen” syndrome. The term comes from Lewis Carroll’s Through the Looking Glass, in which the Red Queen says, “It takes all the running you can do, to keep in the same place.” Applied to a business setting, the Red Queen syndrome occurs at companies that work incredibly hard to adapt to their environment. That’s why they’re successful. The problem, as expressed by Barnett and Pontikes, is that the adaptation means the companies are less prepared for other markets, which operate under different rules—and, here’s the key part, they don’t know it. In fact, companies with success in one market become overly confident that they’ll be successful in the next market, even though their Red Queen adaptations make it more likely that they’ll fail.

Comdisco Incorporated is an even better example. It thrived for more than twenty-five years, primarily as a lessor of mainframe computers. It withstood withering competition from IBM, as powerful an adversary as has ever existed—well into the 1980s, the rule of thumb was that IBM accounted for half the revenue of the entire computer industry, two-thirds of the profit, and three-quarters of the stock-market capitalization.

Much had changed in the five years since Ken Pontikes died. After many years during which the death of the mainframe was greatly exaggerated, technology changes meant that the mainframe leasing business was clearly past its prime. In 1994, 75 percent of Comdisco’s profits came from leasing mainframes. By 1999, the share was just 10 percent.

Nick Pontikes, a former investment banker, began acting like, well, an investment banker. He sold the mainframe-leasing business to IBM for $485 million. He also did the classic sort of analysis that bankers and strategists do to identify markets with better growth prospects—leaving for later the question of whether a company has the capability to succeed in the high-growth markets. Pontikes decided he would move Comdisco into telecommunications. He reasoned that the company’s long history of dealing with complex mainframe technology would carry over into the telecom marketplace. Pontikes also moved the company into venture capital. He felt that Comdisco’s experience with sophisticated leases gave it the financial expertise to manage investments.

Pontikes had made the Red Queen mistake. (Oddly enough, he is a second cousin to Elizabeth Pontikes, coauthor of the Red Queen work; she says their fathers grew up together on the west side of Chicago. We’re not saying, though, that her work should have given him pause. She is much younger than he is, and she did her work well after the problems occurred at Comdisco.)

Nick Pontikes seriously misjudged the dynamics of telecommunications. Comdisco entered the market with a service called Prism and a promise that it would become “a leading integrated telecommunications provider.” Prism planned to build a nationwide network offering voice, data, video, Internet, and secure business applications via high-speed Internet access. Comdisco couldn’t afford to spend the tens of billions of dollars that would be necessary to build a thoroughly nationwide network from scratch, so it piggybacked its services on existing local telephone company networks. Regulators required that operators of those existing networks had to provide access to new services like Prism—but, as Comdisco learned, regulators couldn’t make the operators like what Prism was doing. Many of those companies were either offering or planning to offer similar services, so they had every incentive to make Prism fail. The network operators worked only to the letter of the law. The service they provided to Prism customers was awful, resulting in long delays in getting service initiated. Given the competitiveness of the market, and the fact that a former mainframe lessor had no particular claim to the affections of consumers and small businesses who wanted a bundle of Internet services, Prism’s service problems chased customers away.

Comdisco also faced trouble because its sales force had no experience selling to consumers and small businesses. While Comdisco executives assumed the sales force could make the transition, they didn’t even want to make the transition. The sales force didn’t even try to bundle Prism’s low-cost services with the other services they were selling to corporations. Comdisco tried to gin up interest through a $12 million branding campaign that included a Super Bowl commercial. But at the time Comdisco pulled the plug in 2000, Prism’s total investment of nearly $500 million had garnered it only about two thousand customers. In other words, Comdisco had spent $250,000 per customer. To shut down the business, Comdisco took a write-off of $600 million.

Comdisco’s ventures arm invested nearly $3 billion in nine hundred start-ups, but it learned that wizardry with leases doesn’t carry over into venture capital. The evaluation of mainframe leases depended primarily on how quickly new technology would reduce the value of existing machines, and that new technology appeared at a predictable rate. Picking winners in the venture-capital market, by contrast, involved evaluating the quality of people in the company. VCs need to have great gut instincts about radically disruptive technologies, not generate precise calculations about predictable technologies, as lessors do. The disciplines of the businesses differ, too. When Goldman Sachs evaluated Comdisco’s investment portfolio in late 2000, Goldman found Comdisco had no active credit-scoring system or fundamental systems to track how its portfolio was allocated—basic tools employed by venture capitalists to estimate the risk in their holdings.¹⁶ A Comdisco court filing said corporate executives were surprised to learn that the ventures group did little or no due diligence before funding prospects. Instead, the filing said, the VCs had a “follow the smart money” strategy, where they invested blindly in deals along with “A-list” venture-capital funds. (Comdisco Ventures executives, who sued and eventually extracted almost $30 million in unpaid bonuses from the bankrupt company, countered that senior management was fully briefed on all investments. “Whatever was being done was always reviewed by parties at levels above our clients,” the lawyer for the ventures executives said.)¹⁷

Laidlaw Incorporated, North America’s largest school bus operator, also fell victim to the Red Queen syndrome. Laidlaw figured it could leverage its considerable expertise in logistics and move into health care. The first move was into ambulance services, where Laidlaw went on a more than $4 billion buying spree. What Laidlaw found, however, was that the new business was just too different, that expertise in logistics wasn’t nearly enough.

With buses, Laidlaw negotiated a reasonably small number of large contracts. With ambulances, however, the situation was far more complicated. Medicare and private insurance plans set complex rates and restrictions, and changing Medicare regulations cut much of the reimbursement for ambulance services. Laidlaw had to negotiate contracts with innumerable city and county governmental agencies. Each had its own regulations about response times, training, and licensing. Laidlaw had to provide its service to whomever called, then hope to be reimbursed. Yet the company often could guess that it wouldn’t be repaid. Sometimes paramedics can’t even get needed billing information from patients, who may be unconscious or otherwise unable to communicate. In fiscal year 1998, the last year before Laidlaw discontinued its ambulance operations, bad receivables amounted to $700 million, almost 40 percent of the total billed.

Laidlaw tried to navigate the complexity by shifting its focus away from municipal contracts and lining up large contracts with managed-care plans—moving to the sort of contractual setup that Laidlaw had long followed in its bus business. Laidlaw signed a five-year, $600 million contract to provide all ambulance services to Kaiser Permanente’s 8.5 million members. But not so fast. The system provoked sharp criticism from local authorities and other ambulance providers because it side-stepped local 911 contracts—those contracts specified that a caller to 911 would be handled in a certain way, but the Laidlaw-Kaiser contract required that Kaiser members’ calls be routed to Laidlaw. Some cities, such as Aurora, Colorado, ended up dealing with the confusion by banning Laidlaw from responding to emergency calls.

In another run-in with regulators—of the kind Laidlaw never saw in its sedate bus business—the Connecticut state attorney general found that the company had violated antitrust laws by buying up smaller ambulance companies across the state and taking over their contracts. Laidlaw had to give up 40 percent of Hartford’s 911 business and agree not to trample on the business of smaller companies.

James Bullock, the Laidlaw CEO who launched the strategy, said he thought the ambulance business was “a transportation business that was aligned with many of the skill sets associated with our bus business. We’ve come to realize it is quite a different business than the bus business.” ¹⁸ John Grainger, who replaced James Bullock as CEO, underscored the point at a Laidlaw shareholders meeting. Grainger said Laidlaw realized too late that ambulances are a health-care business, with complex regulatory issues, and not a transport business.

When Laidlaw focused on how its logistical expertise in buses would translate to the market for ambulance services, Laidlaw also overlooked that it was missing one crucial type of expertise: the ability to consolidate numerous acquisitions. That expertise is hard to come by—witness our discussion on rollups in chapter 3—but Laidlaw just assumed the expertise was there and went about buying dozens of ambulance businesses. After several years of high-paced acquisitions, Laidlaw was the third-largest operator of ambulances. It proceeded to buy the two larger ones, including American Medical Response Incorporated, the industry leader, for $1.2 billion in cash. AMR itself was the product of massive consolidation; it was made up of 250 small ambulance operations across the country. That left Laidlaw with an enormous problem of consolidation, which turned out to be more than Laidlaw could handle.

Problems surfaced almost immediately. The ambulance industry was already in the midst of major consolidation, so Laidlaw had paid high premiums to buy companies. Many had troubles. Some were shut down soon after purchase. As a Laidlaw executive later observed, “In retrospect, it should have been done more slowly, but, when you’re consolidating, speed is part of the strategy.”¹⁹

Laidlaw tried centralizing operations such as collection centers, which did cut costs but also led to reduced revenue by diminishing the role of local contacts that generated business. Laidlaw wound up with excessive layers of management and bloated costs. Like many rollups, Laidlaw achieved scale but not the economies of scale.

For good measure, Laidlaw also committed the kind of mistake that we cover in chapter 2 on financial engineering. Laidlaw, a Canadian company, partially financed its U.S. acquisitions through intracompany loans to its U.S. subsidiaries from a Dutch financing subsidiary. The arrangement let the U.S. subsidiaries deduct interest payments on their U.S. tax returns. The Dutch financing subsidiary reported profits but paid very low taxes on them, taking advantage of laws in the Netherlands that were designed to attract foreign finance facilities. Essentially, Laidlaw transferred profits from a high-tax U.S. environment to a low-tax Dutch one. The problem was that a U.S. tax court ruled in 1998 that the almost $1 billion transferred to the United States from the Netherlands was really a capital infusion, not a bona fide loan. Unlike with real loans, the principal wasn’t repaid on maturity. In addition, the interest payments that the U.S. subsidiaries made to their Dutch counterpart were immediately refunded back in the form of new loans. “What these guys tried to do with the tax code is off the charts,” said Robert Willens, a Lehman Brothers tax expert.²⁰ The tax court issued an initial judgment of $141 million against Laidlaw for “loans” made between 1986 and 1988—and investors were even tougher. Fearing even larger tax liabilities for loans made in subsequent years, investors drove Laidlaw shares down 28 percent. The doubt lingered over the company for several years. Laidlaw ultimately paid almost $300 million in back taxes and interest.

The Fickle Customer

Oglebay Norton suffered a bit of this problem when it mistakenly assumed its customers would buy both its ore and its shipping services. Electrical utilities provide a more robust example, because of mistakes they made when they were awash with cash in the mid-1980s. The industry had just gone through a building boom, and rates had been set to finance even more building. But that additional capacity was not needed. Regulators across the country were making noises about reducing rates. In response, utilities everywhere went shopping. They decided they could buy businesses that would yield better returns than the utility industry did, partly because loyal customers would support the utilities’ efforts. But, as the utilities learned the hard way, having a bunch of cash to spend and having a deadline for spending it may not lead to the best decisions.

Florida Power & Light, a subsidiary of FPL Group Incorporated that provides electricity to much of southern Florida, attempted to move into insurance. In 1985, FPL paid $565 million for Colonial Penn Life Insurance Company, which focused on senior citizens. FPL reasoned that there was a sizable overlap between Colonial Penn’s target market and the utility’s captive utility customers, and that the utility’s brand recognition would help Colonial Penn’s sales. In its eagerness to get into the market, FPL paid a 50 percent premium over Colonial Penn’s book value. Wall Street applauded the move. One analyst noted that “FPL may decide to stuff its utility bills with promotional material on Colonial Penn insurance products, thus taking advantage of already established business relationships.”²¹

Florida Power & Light has been known for good management. It has been on Fortune’s list of Most Admired Companies and has won the prestigious Deming Award for quality control. But FPL added little to Colonial Penn’s management skills, and Colonial Penn suffered from industrywide pressure that stemmed from litigation and natural disasters. Colonial Penn was hurting more than most, having recently lost a key marketing alliance with the American Association of Retired Persons.

FPL’s strategic rationale for adding an insurance company to an electric utility wasn’t even close to the flimsiest among utilities of that era. An executive with Florida Progress Corporation, another Florida utility, for example, explained his company’s purchase of a life-insurance company by saying, “Utilities tend to be very good at all different kinds of service. So, it seemed logical to steer our diversification activity toward other kinds of service businesses.”²² Florida Progress also joined a group seeking to buy a major league baseball franchise. Its rationale? The proposed stadium would be a big user of electricity.²³

The mistakes by electric utilities continued well past the 1980s. In the late 1990s, Montana Power Company expanded into telecommunications, initially by creating a microwave communications system to save on internal telecommunications costs. The company expanded this service and sold telecommunications services to external customers. Eventually management came to believe that the telecommunications business had more value than the monopoly electricity business. In 2000, Montana Power sold its energy assets for more than $1 billion and used the proceeds to build a nationwide fiber-optic network. The company laid almost twenty-four thousand miles of fiber, under the brand name Touch America. Unfortunately, many others were also laying fiber at the same time, and software advances were dramatically expanding the capacity of existing cables. The company soon found itself with massive overcapacity and a lack of customers. Touch America filed for bankruptcy in 2003. Its core assets and businesses would eventually be sold for less than $30 million.

But, while electric utilities may have a monopoly on a local market, they don’t have a monopoly on assuming too much loyalty by customers. In the late 1980s, Blue Circle Industries PLC, one of the world’s biggest cement makers, moved into property management, brick production, waste management, industrial minerals, gas cookers, bathroom furnishings, and lawn mowers—seeing all of those markets as being adjacent to the cement market and assuming its customers would see things that way, too. Blue Circle’s rationale went like this, according to a retired senior executive: “We started out believing that our business was not just the cement business but the supply of building products, one of which is cement. This led us into the bricks business and then soon after that into cooking appliances and central heating boilers—after all, these are all products you need when you build your house with our bricks and cement. The culmination of this strategy was our move into lawn mowers, based on the logic that you need a lawn mower for your garden, which is after all next to the house our materials built!”²⁴

As you can imagine, the idea that Blue Circle should sell lawn mowers because they would be used near its cement was a disaster. Blue Circle’s strength in cement did nothing to help it in selling gas cookers, bathroom furnishings, and lawn mowers, whose only connection to Blue Circle’s core business was a semantic one. Blue Circle later unwound its diversification moves. In the meantime, it lost ground to its competitors in the cement market and was acquired by Lafarge SA in 2001.

Norelco made almost the same mistake when it decided that its electric razors meant that it could also sell coffeepots, toaster ovens, and can openers, as well as home-security systems and vacuum cleaners. The reasoning was that Norelco would just move from the bathroom to “other rooms of the house.” But razors had nothing to do with kitchen appliances or home-security systems. Dick Kress, who had achieved stardom because of his successes with electric razors during the eighteen years he was president of the Norelco division of North American Philips, left the company. Norelco discontinued all his attempts at product extensions.

Oglebay Norton: From John D. Rockefeller to Gordon Lightfoot

Fleeing from the Core

Lack of Expertise

Overestimating the Core’s Strengths

The Fickle Customer

Tough Questions