When Mega - Mergers Don't Make Sense.

Last year more than 20,000 U.S. companies paired up to add value. The result? They're barely surviving the morning after.

THE WAVE OF MERGER MANIA that's been going strong for several years now may subside--some day. But CEO obsession with size will not. Despite mounting evidence that life after mergers is less than idyllic, no one in Corporate America seems willing to challenge the old adage that bigger is better.

This merger lust has been explained so often that few executives bother justifying their decisions to merge. Deregulation, consolidation, globalism, cross-selling--the usual explanations for mergers--have already become hoary Wall Street clich[acute{e}]s. But they are having an undeniable impact. In 1998 there were more than 11,000 mergers in the U.S. with a total value of $1.62 trillion and that figure climbed to $1.72 trillion last year. In the first quarter of this year, merger activity has already reached the $600 billion level in the U.S.

Despite all this activity, a host of financial studies suggest there is good reason to doubt that mergers will create tomorrow's new wealth. Mark L. Sirower, a business professor at New York University, conducted a study of 100 large corporate mergers during the mid-1990s. Two-thirds triggered negative market reaction and were still underperforming a year later. More recently, KPMG completed a study that showed that only 17 percent of mergers added value and more than 50 percent actually destroyed value.

These figures add statistical fuel to merger skeptics. They overlook a deeper reason to be wary, however. Two large companies that join together are typically so focused on market domination or operational integration that they have no time to think about strategic innovation. Instead of creating entirely new business models, post-merger supersize companies prefer to use their new bulk to coast on the fumes of past glory and brand name. Mergers of equals often turn our to be mergers of the equally uninspired.

Let's face it, there is nothing "visionary" about Exxon and Mobil joining forces. Ditto British Petroleum and Amoco. The Union Pacific and Southern Pacific railroads succeeded largely in creating headaches, not synergy. The strategists behind mega-mergers like these don't think in terms of creating new wealth, building new industries, or writing new rules of the game. Instead, they think like accountants and efficiency experts who view mergers as a way to cut costs, gain marker share, boost stock price, and build economies of scale. In a global market, consolidation has become a survival strategy, not a route for risk-taking.

That's not to say that large-scale mergers are always unimaginative. It's the largest companies that have the resources to rake on the industry orthodoxies that they themselves may have created. Clearly, in the auto industry, big is malting sense. DaimlerChrysler is not the first international auto company, but it is malting a real attempt to develop a new approach to auto production with its emphasis on style and its focus on urban vehicles.

But deeper problems often remain after the thrill of a merger. Management must now focus on bringing together two highly complex, large, and not necessarily like-minded companies. It leaves few opportunities for creative thinking about how to conquer the world. Integration, cost cutting, leadership, and succession issues are all consuming. Although these newly enlarged companies have the scale to set a new course for an industry, they rarely have the time. That's why so many mergers introduce only incremental changes, if any.

The New Telecom Empires

SBC Communications is one high-profile example of a company aggressively pursuing market dominance through sheer size. In 1998 its $72 billion acquisition of Ameritech was the third largest merger of the year. A year earlier the company purchased Pacific Telesis, the old California Bell. Last year, SBC's voracious appetite again surfaced when it announced that Ameritech will buy a 20 percent stake in Bell Canada for $3.4 billion. SBC is now an impressive national network on its way to recreating part of the old Ma Bell empire.

In that sense, SBC seems more nostalgic than pathbreaking. That may be its problem. SBC has already boasted about the "business synergies" it has derived from its union with Pacific Telesis, despite any evidence that it is delivering the next generation of communications to its customers. SBC's dilemma is a typical one: how to become an innovative, low-cost provider after having paid a hefty premium for its newly acquired empire. It remains to be seen whether SBC can move beyond the task of cobbling together a new monopoly and actually approach the telecom industry in a new way. No wonder David Goodtree of Forrester Research described the SBC-Ameritech merger as "dinosaurs dancing."

The good news for SBC may have come in its most recent agreement to merge wireless businesses with BellSouth. The merger will help create the second largest wireless company in the country and analysts are already calling it a "match made in heaven."

To see if that optimism is justified, one will have to compare the eventual results of SBC's deals with the latest "deal of the century" in Europe: VodafoneAirTouch's hostile takeover of Mannesmann. Valued at $180 billion, it's the largest merger Europe has ever seen. But what makes the Vodafone deal interesting is its potential for innovation. The company helped lead the way in creating a uniform standard for cellular phones, a step that has helped Europe leapfrog over the U.S. in wireless. Vodafone was also the first company to reach a standard on the third-generation phones capable of data traffic. In acquiring Mannesman Vodafone effectively positioned itself as the leader of a worldwide standard in mobile communications just as "in-commerce" is poised to overshadow "e-commerce."

Can these ambitious wireless mergers work? Vodafone has a history of telecom innovation, SBC a history of telecom acquisition and integration. Still, it remains uncertain whether their recently acquired bulk will help or hinder new breakthroughs in the next stage of the telecom revolution.

Innovation vs. Acquisitions

What we're seeing in the telecom market applies to all industries. The real challenge is nor simply to get big, but to get innovative. Although some mergers are clearly dynamic creative partnerships, they are often the strategy of convenience for the unimaginative CEO. They yield far more headlines than ideas.

Of course, mergers are often driven by external forces. That still doesn't eliminate the desperate need for internal innovation. Global consolidation and competitiveness undoubtedly prodded Rolf Breuer, the self-confident chief of Deutsche Bank, to announce his plans for a $30 billion merger with Frankfurt rival DresdnerBank. At a time when American investment banks were leading the new wave of European M&A, Breuer's move could be understood as a shrewd way of revitalizing German banking.

But Breuer apparently gave little thought to how Dresdner's investment banking arm, Dresdner Kleinwort Benson, would combine with Deutsche's own London-based bankers. There was even confusion about whether Dresdner Kleinwort Benson was part of the deal. The Deutsche-Dresdner fiasco should remind us that merger integration is a difficult, time-consuming process.

The Citicorp-Travelers merger of 1998 is another example of post-merger difficulties. At this point, it seems to be creating value but only after a very slow start. This merger also suffered through severe culture clashes and endured a nasty power struggle at the top when Citicorp's John Reed departed.

So, is giving in to the acquisition impulse the only competitive option for financial services firms? Consider a relatively smaller institution like the Bank of Scotland, which lost its attempt to acquire NatWest. It reports income as a percent of assets of over 8 percent while the newly consolidated Bank of America reports a figure of only 1.2 percent.

Or one could ask Charles Schwab & Co. In 1995 Schwab was the country's leading "discount broker" in an industry dominated by Wall Street giants. But rather than continue to build on the advantages of being a low-cost alternative, Schwab reinvented its basic business model and dove headfirst into online trading. Five years later it has approximately 25 percent of the online trading business. Its closest competitor, E-Trade, hovers near 18 percent of the market. The company now does more than $3 billion in trading weekly and last year it briefly eclipsed Merrill Lynch in market capitalization. Today, it has some 6.6 million active accounts and 85 percent conduct trades over the Web. While more established brokerage houses were content to be purchased by the oversized European banks during the past few years, Schwab demonstrated that innovation is not for sale.

Finding The Silicon Valley Within

Among some firms, the notion that bigger isn't always better is already deeply understood. Old conglomerates like Rockwell have learned that spinning off the most high-powered divisions of their business is often the best way to unleash creativity and cash in on Wall Street's high valuations. It's a strategy diametrically opposed to the merge-and-purge philosophy behind most acquisitions. As a recent cover story in Red Herring pointed out, letting a visionary division out from under the layers of bureaucracy that are found in any large organization frees the new spin-off to play by its own rules rather than someone else's.

General Motors spun off Delphi Automotive, its auto parts division, in February 1999. Now the company has become the high-tech leader in mobile communications for the auto industry while creating a more streamlined auto supply chain driven by IT. It has also expanded its business, creating alliances that were never possible when it was within the GM family (it makes dashboards for Mercedes and circuitry for Ericsson mobile phones). Watching all this from down the road, Ford has decided to do the same with its parts division.

Spin-offs aren't essential for innovation. The goal is to bring the dynamism of Silicon Valley inside a company. Nokia, the Finnish mobile-phone giant, began to truly soar when it applied entrepreneurial rather than M&A strategy to its everyday work. Few realize that the company is 130 years old and had a massive portfolio of unrelated businesses in tires, paper, aluminum, and power generation until relatively recently. Rather than look to mergers to create scale, the company pursues a relentless march toward continuous innovation.

In addition to engaging their employees in a company-wide conversation on innovation on a regular basis, Nokia has established a $100 million venture capital fund for ideas developed both outside and inside the company. The purpose is to generate and support new thinking at every level. One result has been a smart-car project that is developing integrated navigation systems for the auto industry. Only by letting strategy become an open process of cross-fertilization was Nokia able to bring together the various disciplines to enter a new line of business.

Even the largest, most established firms are discovering that size and scope can be leveraged to create imaginative, market-shaking breakthrough. When the food giant Kraft bought the fledgling DiGiorno rising crust pizza in 1995, it was seen as another Johnny-come-lately to the frozen pizza industry. Kraft saw it as an opening for innovation and a chance to marry its expertise in "convenient food" to the huge pizza market. Using its ability to promote a brand and its vast food technology experience to create a superior product, Kraft created a new supermarket product that could compete directly with home delivery pizza. In 1997 DiGiorno broke $200 million in sales, the fastest a Kraft product has ever reached that level.

The High Cost of Missing Innovations

Unlike acquisitions, innovations are not easy to see. They are not already out on the market where they can be analyzed and "costed out" using traditional business metrics. The financial due diligence applied to merger strategy doesn't work when trying to embark on an untested business plan.

CBS fell into this trap. In the late 1970s, it was a giant in both television broadcasting and music publishing. But while Viacom was launching MTV--which generated $2.4 billion in revenue last year--CBS pursued flight-of-fancy acquisitions, including nuclear power facilities. This is a dramatic illustration of an "innovation shortfall," but one that surely does not show up on the CBS books.

CBS's shortsightedness about its very own business reaffirms the most compelling business lesson of the past two decades: immense resources and powerful brand names rarely guarantee innovation. More often, companies encrusted by tradition and bureaucracy are too rigid and inhospitable to radical thinking.

Sotheby's was once the most revered name in auction houses. Yet, apparently no one banging the gavel at this 250-year-old institution was far-sighted enough to see the potential of the Internet; eBay did. The online auctioneer hosts 4 million auctions a day. In April the company had a marker cap in excess of $19 billion. While eBay has no shortage of skeptics, Sotheby's is not among them. Last year the British auction house belatedly launched its own Web site as it scrambled to catch up. Its main rival, Christie's, soon followed.

Sotheby's income last year was $32 million, nearly three times eBay's, yet girth is no longer the gateway to greatness. Many of the conventional metrics used to measure a company's fiscal success, including EVA, are driven by conventional understandings of what makes a company successful.

That is the problem with the current merger-lust. There are few examples of companies entering into a merger with a conscious plan to redesign the rules of their industry. Buying "content" doesn't make you innovative.

Ultimately, innovation requires a carefully conceived plan to do things differently. To listen to new voices within one's own company. To open up the strategy process. To devise new measurement tools for determining whether a company is innovating, rather than merely getting bulkier.

Peter Skarzynski is CEO of Strategos, a global strategy innovation services firm with offices in Silicon Valley, Chicago, and London.