M&A thinking may still be common, but does it make sense?

One of the principles of free market Capitalism is that the strong will devour the weak. And, in many cases this happens with a solid underlying financial and commercial logic. However, although the strong may devour the weak, this is no logical basis to infer that the mere act of devouring creates strength. Consequently, and all too often, Merger & Acquisition has been used by weak businesses to shore up or disguise their own lack of genuine strength.

Let us look at the mega M&A deals in the pharmaceutical sector announced in early March.

From The Times March 10, 2009

Takeovers rarely a tonic for pharmaceutical groups
Ian King: Business Commentary

Faced with some unpleasant ailments, the pharmaceutical industry's biggest players are reaching for a familiar old remedy in the medicine cabinet — M&A. In January Pfizer splashed out $68 billion for Wyeth, yesterday Merck agreed to pay $41.1 billion for Schering-Plough and last night Roche looked set to buy the 44 per cent of Genentech, the biotech giant, that it does not already own for $46.7 billion. ………

………….. The question is what happens next in the industry. With company values depressed, because of recent market falls, the big fear for executives is that they miss out on a wave of industry consolidation and, as a result, are pushed down the global pecking order.

This is why shares in GlaxoSmithKline fell yesterday. As the industry's second-biggest player, it is under more pressure than most to do a big deal, despite the protests of Andrew Witty, its chief executive, that he is not interested in M&A. It is also why shares in AstraZeneca and Shire Pharmaceuticals rose sharply. They, with Bristol-Myers Squibb, are all possible targets in any round of deals taking place soon.

Yet the scepticism of Mr Witty and others who are constantly being told that they need to do a deal, such as Novartis and Sanofi-Aventis, looks well-founded. The majority of mergers and takeovers destroy value and, in the case of the drugs industry, M&A activity has conspicuously failed to deliver the promised returns. This is because, more than most, pharmaceuticals is a “people” business, with scientists at its heart. Cost-cutting after a big merger or takeover, although giving earnings a short-term boost, is not compatible with research and development programmes stretching out over decades.

In any case, many big drug companies are already incredibly bureaucratic. Making them even bigger will not solve this problem. For that reason, it is to be hoped that Mr Witty will stick to his guns, concentrating not on delivering a small number of highly profitable blockbusters but on a larger number of less profitable new products. In doing so, Mr Witty will, rather like users of GSK's Nicorette quit-smoking gum, need formidable powers of willpower. He will face intense pressure to do a deal from investment banking advisers in the next few months.

Our emphasis in bold.

Ian King's inciteful article highlights once again how “investment banking advisers” are seen to be trying to steer company policies in directions for which the only certain benefit is to themselves. And, once again, some executives are described as being in fear of them, this time of being “pushed down the global pecking order”.

GSK, under Andrew Witty’s predecessor, the gifted and radical leader Jean-Pierre Garnier, was transformed from a monolithic, over-centralised, bureaucratic, under-responsive battleship into its current form as a well co-ordinated fleet of highly responsive, flexible, agile, and enterprising, commercially acute, gun-boats. J P Garnier left GSK able to generate a consistent and sustained stream of new products and consequent profits – no longer gambling on occasional massive windfalls. His legacy, so well understood by Witty, is substantial Comparative Competitive Strength, with very high changeability embedded in both depth and spread. This is Common Sense – but anathema to the “me-first-get-rich-quick” mentality of the “investment banking advisers” – what a surprise.

Why does anybody spend any time at all listening to people whose advice will deliver virtually guaranteed benefits to themselves but highly uncertain prospects for those acting on their advice?

Suppose a smartly dressed person turns up at your front door and tells you that they have an amazing and exclusive deal for you? They say that they are an Estate Agent (let’s forget any prejudices, please) and that because of their special and privileged relationship with a Mortgage Provider they can enable you to become wealthier by buying a bigger house whilst remaining within your current means – just like that!

And you, like an idiot, agree.

It seems reasonable that the house deals and the mortgage deal will be handled by the Estate Agent; that you pay some “arrangement fees”, and even that your payments although unchanged are now guaranteed only for a fixed period. And now you have a property that is “worth” 25% more than your previous home – you have become more wealthy!

However, it may have escaped your attention that you now own only 20% of the apparent equity in your new house compared to the 35% you held in your old home. The good news is that should property values rise, your equity level will increase disproportionately – you have “leverage”. The bad news is should property prices fall, then you could end up right where you started, or worse. The very bad news is should interest rates rise, then after your fixed term expires, you may face payment levels you cannot sustain and disaster.

The only certain winners in this scenario are the instigators, the Estate Agent, and their financial backers, the Mortgage Providers. The instigators take a slice of your money whilst ensuring that you take all the increased risk.

Wouldn’t you have to be an idiot to fall for such a deal?
Can you imagine that anyone might be stupid enough to do that?
That cannot be Common Sense – can it?

Now if we substitute “Investment Banking Adviser” for the words “Estate Agent” and “Investment Funds” for “Mortgage Provider” we might recognize the story on a larger scale – and if we swap “executive” for “you”, we complete the match. The instigators take a slice of the Shareholder’s money whilst ensuring that the Shareholders take all the increased risk.

Wouldn’t the executives have to be idiots to fall for such a deal?
Can you imagine that any shareholders might be stupid enough to support that?
That cannot be Common Sense – can it?

Well – hundreds of them did – tens of thousands of you did.

It was not Common Sense – commonality did not make it sensible – it never does.

The only way out from this madness is to return to a solid focus on tangible wealth creation – to get back to Common Sense. The only reliable indicator of tangible wealth is deep underlying sustained long term profitability – the investment criteria upon which Warren Buffet patiently, steadily and lengthily, built his own and many other’s fortunes. But, because history takes too long, you cannot spot the tangible wealth creators in advance – or can you?

The most reliable determinant of massive financial strength, potentially solid wealth, is Excellence. Robust academic research has proved beyond reasonable doubt that the very best businesses in the world can deliver financial returns that are 50% to 100% better than the average. Take care here about which is the chicken and which is the egg – it is being the very best in every aspect of what they do that delivers the exceptional financial results of these businesses – it is not the money that makes them the very best, that is simply an outcome of being the very best.

Whilst Excellence is a well researched concept its connection to superior financial performance and long-term business growth and sustainability is not widely understood, especially in the financial sector. Consequently the application of the thinking and disciplines needed for Excellence is patchy at best and far too many business leaders think that being Better than Average is good enough. Furthermore, many cannot tell the difference between Big and Excellent – maybe psychologists can help us understand whether these sad souls confuse “global pecking order” with “pecker order”?

If you want to know more about all this, how you can spot the tangible wealth creators in advance and why Common Sense pays off handsomely, please have a look at our website where you will find out about - Competitive Strength, what this is and why it is crucial to financial performance – and about Changeability, the essential attribute for Excellence.

Capitalism or .... Common Sense is brought to you by Steve Goodman and Tony Ericson. It is one of our "Excellence Quartet" of blogs promoting the cause of Excellence as the key to prosperity. Each blog has a new article each month using a recent business/financial topic to highlight different perspectives and conclusions from those obtained using conventional thinking and techniques. You can read the other three blogs at “Exceeding Expectations", "You're having a laugh ... Seriously?", "Business Bloop of the Month Award".

It's so obvious

From The Times February 19, 2009
Toyota to seek voluntary redundancies in Britain
Christine Buckley, Industrial Editor

Toyota's British operations are to shed jobs and may implement a pay cut, a reduced working week and a temporary suspension of workers, the company said yesterday after meeting unions.

Toyota said that it would put no target figure on job cuts from a voluntary redundancy programme and that the scheme had been suggested by employee representatives rather than by the company. It said: “Our philosophy is to make every possible effort to secure permanent employment. However, our employee representatives requested that we consider the introduction of a voluntary release programme. We have taken this into consideration and provided this opportunity.”

Toyota said that it had been hit in Europe last year by the wind-down of some models and few launches. The company said that it would not mount heavy discounts to try to win back customers, as some of its competitors have done, especially in the fleet market. It said: “This is not Toyota's strategy, as we want to develop our business in a profitable and sustainable way, with a long-term perspective.”

Now think about it, "develop our business in a profitable and sustainable way, with a long term perspective". Isn't this obvious, does it not make sense? The automotive sector has been one of the hardest hit by the recession. No company can be immune from the effects but let us contrast the prospects for Toyota with its competitors

In 2008 all vehicle manufacturers suffered a significant drop in sales but GM sales fell by nearly three times that of Toyota's. Toyota has said it will make a loss this year, the first time for 70 years! GM, along with Ford and Chrysler has been losing money for so long we can't remember when they last made a profit. They are only held together now by massive government bailouts and they want more! Now ask yourself, in a down turn where would you rather be? The answer is obvious.

That this would happen to the GMs of this world has been obvious for over 20 years, but apparently not to the Directors of GM, nor for that matter at Ford, Chrysler and now many others. Neither was it obvious apparently to their shareholders, investment analysts, bankers (well, what do we now expect of these?), rating agencies (well, what do we now expect of these?), HM Treasury (well, what do we now expect of this?), and, with a few honourable exceptions, financial journalists. All have bamboozled themselves by their specious fixation with sales volumes – “big is good” has been their idiotic mantra. Even now they continue to highlight the main benefit for the Lloyds TSB and HBOS merger as being the massive market share of the combined group in UK retail banking!

And whilst their attention has been so misdirected, the executives of these companies, with the connivance of the banking and financial community have whisked the lack of profitability, the failures in investment, the profligate waste of resources, the poverty of innovation and the cynical manipulation of the communities upon which they leach, back up their sleeves with another slice of complex financial engineering (was there ever such a slur on the word engineering?). And why have they done this? In order to continue to award themselves handsomely for the “brilliant results” that emerge from the financial manipulations that they themselves control.

None of this makes sense. Have they created genuine wealth? Probably not for 20 years or more, in most cases. Not for their shareholders nor their communities. What they have done is build an ever increasing sponge designed to soak up extra debt, more numbers to feed into their “financial engineering” to bamboozle more credulous Financial Industry “experts”. Where does this warped thinking come from when it is so obvious that it doesn't work? Here in the UK, we have to ask just how many of these experts are the result of the Scottish Education establishment – and given the moral intellectual and ethical quality of what we now see, HBOS, RBS, Numbers 10 and 11 Downing Street (both current and previous tenants) – what is wrong with it?

Toyota, where is their place in all this? We know that they have never pursued the goal of being “Number One”. They have concentrated on building the best quality vehicles in the world, straining to match them to each of the market sectors in which they trade, innovating where it makes a difference- new technologies that enable new levels of performance (e.g. the hybrid vehicles) and not for the sake of change. They have pursued excellence in every aspect of their business – operational superiority – elimination of waste – flexible resources. Every major managerial innovation that becomes fashionable – be it TQM, Lean, Green Practice – is something that Toyota will be found to have been doing for some considerable time. When asked why, they will respond “Because it is obvious, it makes sense”.

Toyota's strategy "to develop our business in a profitable and sustainable way, with a long term perspective" is more than a strategy, it is a philosophy. It this philosophy that drives the deep seated managerial values and behaviours throughout the company that have resulted in Toyota's superior Comparative Competitive Strength. Isn't it is obvious? The ability to beat seven bells out of your competition and to withstand setbacks better than anyone else are obvious indicators for long term financial prosperity - all without a single piece of "financial engineering" needed to achieve it.

To achieve the highest level of this brings considerable freedom of strategic choice. The route to this does not always allow for short term unrealistic financial results, it may require tough disciplines on margins, rewards and profit distribution – and that is why so many otherwise potentially strong businesses become undermined by the hysterical betting shop mentality of the Financial Industry. The City of London used to be a byword for financial probity, soberness and integrity – is there anyone left in the square mile that could even spell those words?

We need to get back to the basics of good business and wise investment – seek only excellence in every aspect of our operations, do the right things in the right way, love our customers to death, nurture our people, report our results honestly, borrow only the very minimum that we need, reward ourselves modestly and fairly, protect tomorrow and not just today and so much more. This is still Capitalism but it is also Common Sense. We need to concentrate on Comparative Competitive Strength because our competition is out there in the rest of the world and it will have different economic dynamics which we can outperform rather than seek to imitate. We can outperform the competition, there are examples here in the UK. What may be curious is how many of them are privately owned or led by majority shareholders – not a lot of The City here perhaps?

The Competitive Strength Report will tell you how your business compares with the very best in the world. It will help you decide what you need to do to match that standard and how you will handle your major threats. It does this better, faster and cheaper than any other analytical process in the world – your management team will need 2 hours of homework and up to a day of decision workshop – all can be completed within 4 weeks.

And, a message for all of the Financial Experts. Your credibility is at an all time low. The tools, techniques, values and processes that you have used have been found wanting – all look backwards. To be frank, you appear to have been judging the quality of the ship and its crew by looking at the wake – with no forward radar. The Competitive Strength Report is a forward looking tool - it will tell you whether or not your client, prospective borrower, potential merger partner, acquisition target is going to be a good bet.

What is more, it will enable the understanding of how Capitalism founded on Common Sense will deliver greater financial success and long term value.

If you would like to know more, please have a look at our website here.

Capitalism or .... Common Sense is brought to you by Steve Goodman & Tony Ericson. It is one of a quartet of blogs promoting the cause of Excellence as the key to prosperity. Each blog has a new article each month using a recent business/financial topic to highlight different perspectives and conclusions from those obtained using conventional thinking and techniques. You can read the other three blogs at Exceeding Expectations, You're having a laugh ... Seriously? and Business Bloop of the Month Award.