Organic growth is not the only lever available to growth-seeking companies. Many companies use acquisitions as tools to strengthen their position in existing markets or to enter new ones. Some companies are legendary for their acquisitive bent. General Electric acquires dozens of companies a year. Cisco Systems has made more than 100 acquisitions in its 20-year history.
Using acquisitions as a growth tactic is tempting. Creating new growth organically is far from a sure bet, and new businesses can take years to mature. Acquisitions can be a way to quickly goose sales and make sure the market has already identified the emerging company that is most likely to succeed.
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Yet, significant research reveals a stark conclusion: Acquisitions, particularly large ones, tend to disappoint. One study found that managers reported more than 70 per ecnt of all acquisitions fail to create value and up to half actually destroy value. High-profile struggles by the likes of auto giants DaimlerBenz and Chrysler or America Online's $180 billion acquisition of Time Warner provide stark examples of mergers and acquisitions gone bad.
However, when done right, acquisitions can be valuable disruptive tools. We believe that disruptive-minded companies ought to consider acquisitions in the following four circumstances:
To consolidate an overshot market
Consolidation is a practical response strategy for incumbents in overshot circumstances. In these cases, investments in improvements along historically important performance dimensions promise diminishing returns. In these circumstances, consolidating an industry and squeezing out costs can be a way to growth profits.
While consolidation plays aren't necessarily the most glamorous of strategies, they can create substantial value. Consider Exxon's merger with Mobil in 1999. Back in the late 1990s, the price of oil was plunging. Analysts suggested that the era of growth for big oil companies was over. The combination of the two largest US oil companies created ExxonMobil, the world's third largest company.
The combined entity saved close to $5 billion in the two years after the merger; between 1999 and 2004, ExxonMobile earned $75 billion in net profit and generated more than $100 billion in free cash flow. This success created a wave of mergers: British Petroleum merged with Amoco and Atlantic Richfield, Chevron merged with Texaco, and Phillips Petroleum merged with Tosco and then with Conoco. As the combined giants consolidated operations to take advantage of scale economics, they produced huge savings, and increased their market shares profitability.
Similar stories could be told in the banking industry (with Citibank snatching up Travelers, and Bank of America purchasing Fleet) and the telecommunications industry (with SBC purchasing AT&T and Verizon purchasing MCI). These companies realized that pushing for incremental advancements in saturated markets wouldn't be sufficient for growth.
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Joining forces to gain scale economies was the only way to continue to push profits ever higher. One challenge with this approach is that, while it provides a temporary boost to the merged entity's fortunes, it doesn't fundamentally change industry dynamics. Once the glow of the merger wears off, the combined company faces continuing challenges to create even more growth. And the strategy is not sustainable: Acquisition targets that are meaningful enough to materially impact financial results become progressively harder to find and more expensive.
To buy time
Acquisition activity can also make sense when the acquisition allows an incumbent to "buy time" for its organic efforts to bear fruit. The Innovator's Solution argues that companies need to start creating new growth businesses before they need to create new growth businesses. Why? Once it is clear that companies need to grow, they become very impatient. This impatience forces them to try to make new businesses get very big very fast, an approach that actually lessens their chances of success.
Growth-ravenous companies naturally set their sights on large, lucrative markets populated by powerful incumbents, but these markets tend to be inhospitable for truly disruptive growth strategies. Impatient companies can become trapped in a "growth-gap death spiral" when actions to quickly fill a growth gap result in an even wider growth gap. Because of the perverse dynamics of the death spiral from inadequate growth, achieving growth requires an almost Zen-like ability to pursue growth when it is not necessary.
But what about companies that recognize that, although the time to be a Zen master was years earlier, they need to change now? Should they simply pack up their bags and go home? For these companies, moderate-to-large acquisitions can provide "air cover" for the corporation's organic innovation efforts.
For example, IBM acquired Lotus for $3.3 billion in early 1995. Lotus's growth had stagnated as it fought against emerging e-mail providers. Buoyed by IBM's topflight sales force, deep relationships with key enterprise customers, and willingness to spend big bucks on marketing campaigns, Lotus experienced significant growth after the acquisition. Lotus sold roughly 3 million units of its flagship Lotus Notes application prior to the acquisition; by 1998 the division had sold close to 30 million units.
That growth couldn't have come at a better time for IBM. Lotus's growth provided cover for IBM's emerging move into services. In fact, Lotus helped to facilitate that move--by 1998 IBM estimated that it received $5 in service, support, consulting and hardware revenues for every $1 of Lotus Notes sold. It is possible that IBM would not have been able to make the seemingly seamless move into services if Lotus had not grown so robustly during the 1990s.
Pharmaceutical companies are increasingly eyeing acquisition as a tactic to fill emerging gaps in their product pipelines. Many large pharmaceutical companies are organized to create "blockbuster" drugs that produce billions of dollars in revenues. They invest heavily in research and development, and take advantage of patent protection to recoup their investment. However, the unpredictable nature of the discovery process can leave companies in an awkward situation. Just as a company's key drugs are coming off patent--enabling competition from providers of low-cost generics--it's near-term pipeline can be barren. In these circumstances, acquisitions can be a viable "stall tactic."
To acquire disruptive seeds
Acquiring big companies tends to produce poor returns because the market can appropriately recognize the value in a large company. In these situations, the only way a company can create value is by spotting value that the market doesn't see. This is an incredibly tough challenge, especially for multibillion- dollar companies in established markets that are covered by scores of analysts.
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However, while the average return for a small acquisition is similarly meager, the range of results is much wider. The odds of betting wrong are high, but the odds of getting a smashing success are much higher as well. Our belief is that an understanding of the patterns of disruptive innovation--looking with "disruptive lenses"--can help companies more reliably spot the potential winners. Companies can in essence get predictably higher returns on small acquisitions by using disruptive lenses.
There are a number of classic stories of companies acquiring small disruptive companies at relatively modest price points. A great example of a company prospering with a small acquisition is electronics retailer Best Buy.
In 2002, the company purchased a 50-person company in its backyard of Minneapolis called Geek Squad. The company provided information technology services for individuals, sending technicians to help consumers repair computers, set up networks, and install and manage high-end equipment. Geek Squad's strategy followed a classic disruptive approach, making it simple and affordable for individual consumers to tap into IT expertise. Best Buy paid roughly $3 million to purchase the company.
Analysts estimated that in 2006, Geek Squad had more than 10,000 employees, produced close to $1 billion in revenues, and generated $280 million in operating profits. Buoyed by its success with Geek Squad, Best Buy expanded its services-focused efforts. By 2007, it offered home entertainment installation and design services through Magnolia and home remodeling services through Pacific Sales.
Both are offered through a store-within-a-store concept, similar to how Best Buy grew Geek Squad. In 2005, Best Buy acquired two more companies--AV Audiovisions (for about $7 million) and Howell & Associates (for about $1 million)--to augment its Magnolia offering. In early 2007, Best Buy extended its services strategy to small business customers with its $97 million acquisition of Speakeasy, a digital subscriber line and voice-over-Internet Protocol provider. These small acquisitions have allowed Best Buy to create disruptive offerings that allow individuals and small businesses to affordably obtain world-class service.
In the early days of a disruptive innovator's journey, the market is likely to undervalue its potential. Innosight Director Richard Foster describes how the traditional "S-curve" that most innovations follow leads to substantial forecasting error. Before the innovation begins to march up the S-curve, analysts that base their valuation on extrapolation of past trends can dramatically underestimate the innovation's potential, because analysts' techniques are generally less effective in measuring non-existent markets.
Companies that spot disruptive developments early can meet the challenge of acquiring legitimately disruptive, high-growth companies at reasonable prices, before the market recognizes its disruptive potential. If the market does catch on, the price tag goes up substantially, such as when eBay had to pay more than $2.5 billion for Skype in 2005.
To acquire enabling technologies
Finally, companies can seek to acquire a key enabling technology that promises to power a disruptive movement. The acquiring company can use the technology to power its own disruptive offerings and sell it to other would-be disruptors. For example, by 2006 it was clear that newspaper companies seeking to respond to the disruptive forces in their industry had to move beyond providing "news.com" Web sites to create better ways to organize and present local information.
While Google and Yahoo unquestionably owned the national search space, consumers looking for local information had to rely on word of mouth or the Yellow Pages. Newspaper companies seeking to move into these markets had to develop Web offerings that had rich, easily searched information databases. A company called Planet Discover emerged as a key enabler of these applications. In May 2006, newspaper publisher Gannett acquired Planet Discover for an undisclosed sum.
The president of Gannett's digital arm said at the time, "Gannett truly understands the importance of local information, which is why Planet Discover is such a perfect fit for us. With this new relationship, we will move more emphatically into deep, robust local search for our Web sites. This fits well with our mission: to be the go-to provider of must-have local news and information across all media."
Cisco also followed this approach when it purchased set-top box manufacturer Scientific Atlanta for close to $7 billion in late 2005. Cisco recognized that the computing and television worlds were converging and that it would have to couple its competency in the data networking world with competency in the video world. Scientific Atlanta, a leading provider of video equipment, could help Cisco move into the video space.
Companies that are attuned to disruptive developments can spot these key enablers early, before the rest of the market sees their value. They can then pay reasonable prices to improve their own disruptive ability, while profiting by selling the capability to other would-be disruptors.
Acquisition as strategic tool
Statistics suggest betting against companies that seek to use acquisitions to boost returns. However, in the right circumstances--when markets are ripe for consolidation, when the acquisition provides air cover for organic efforts, when a company spots a disruptor before the market, or when the acquisition enables disruptive growth--acquisitions can be a valuable strategic tool.
