Customer Profitability A Key to M&A Success
Often overlooked by the numbers crunchers in the urge to merge is a crucial principle of modern marketing – analysis of customer profitability.
The concept of customer profitability as it pertains to mergers & acquisitions (M&A) is advanced by Larry Selden (professor emeritus of finance and economics, Columbia Graduate School of Business and founder of Selden & Associates, a consulting firm) and Geoffrey Colvin (senior editor at large for FORTUNE magazine and co-anchor of PBS’ WALL STREET WEEK) in “M&A Needn’t Be a Loser’s Game,” (Harvard Business Review, June 2003).
Seiden/Colvin report that during the big M&A surge that took place between 1995 and 2000 where volume totaled more than $12 trillion, some $1 trillion in share-owner wealth vaporized. “Stupid takeovers did more damage to investors than did all the dot-comes combined.”
Which is even more remarkable, according to the authors, is that these failed mergers were the work of the “best and the brightest,” the world’s most successful corporations advised by highly educated Wall Street investment bankers.
After analyzing these failed mergers, Selden/Colvin conclude what is needed is a “fundamentally new approach to buying companies, a re-conception of M&A through a customer perspective.” They add that managers analyzing acquisitions must understand the true economic profitability of customers and company value is a function of the aggregated value of their customers.
The basis of their research is an analysis of 40 companies in various industries around the world. They discovered that customer profitability varies widely and where a small group of customers might account for all of a company’s capitalization, and another group of customers actually reduced the company’s value significantly.
“This research brings a whole new perspective to M&A,” they write. “By understanding the economics of customer profitability, companies can avoid making deals that hurt their shareholders, can identify surprising deals that do create wealth, and can salvage deals that would otherwise be losers.”
Balance Sheets and Cost Cutting
“It’s ignoring the balance sheet that causes so many acquisitions to destroy shareholders’ wealth,” write Selden/Colvin. They urge looking beyond the lure of profits in examining the potential acquisition.
When a company considers an acquisition, write Selden/Colvin, the CEO of the acquiring company often is reacting to Wall Street pressures to reinvest cash and grow earnings. Often the CEO is pressured into the deal when investment bankers tell the CEO if he doesn’t make the deal a competitor will. The deal is often seen as an end in itself and that’s one of the reasons, according to the authors, that so many acquirers ignore the balance sheet effect, which often reduces the return on invested capital (ROIC) to value-destroying levels.
To increase ROIC, Selden and Colvin observe, companies will often resort to cost-cutting. The acquirer often sees duplication in the merged entity. If two banks merge and they both have adjacent branches, one can be closed. Or, if there are two CFOs, one can be eliminated. However, Selden./Colvin observe that merged companies are sometimes overly optimistic about the effects of cost-cutting. “Such substantial savings usually don’t materialize,” they write, “because acquirers, caught up in the excitment of the deal, tend to overestimate what’s possible.
Another reason why cost-cutting doesn’t work, they add, “is that the savings might have already been bargained away in the negotiation of the selling price.”
Fallacy of Increased Revenues
If cost-cutting doesn’t make the deal compelling, increasing revenue is yet another way dealmakers believe they can make high-priced mergers pay off, according to Selden and Colvin. “Probably the most frequent claim for big deals is that they will create enormous opportunities for cross-selling.” They point out that when Citicorp and Travelers merged, Citicorp thought they would be able to sell insurance and investor services to the Citicorp customers. In another famous merger, AOL and Time Warner saw the possibility of selling ads and subscriptions to each other.
“Cross-selling does happen,” write Selden and Colvin, “but almost never to the extent the acquirer hopes.”
Ad Agency Mergers Provide an Example
While Selden and Colvin do not address advertising agency mergers in their article, such mergers and acquisitions provide a vivid example of their thesis. While advertising agencies look for efficiencies i.e. one media buying department, one traffic department, one research department, etc., the new agency can not have clients competing with one another.
Thus if two agencies merged and each agency had a distinctive competency of working in the automotive industry and one agency did work for Ford and another did work for General Motors, a decision would have to be made on which account to resign. Using this example, a significant amount of billing would be eliminated thanks to merger.
Thus understanding the value of customer relationships was perhaps lost in the excitement of bringing together the two advertising agencies.
Customers Hold the Key
What makes the deal work, according to the authors, is the acquisition of customers. While there are aspects of acquisitions that are somewhat compelling like the purchase of real estate, production facilities, intellectual property or technology, Selden and Colvin believe “ultimately, it’s still about the customers. The acquirer buys those capabilities to help serve existing customers better and to help it acquire new ones.
“Once the managers of an acquiring company understand that they’re really buying customers, they can take the next, far more revealing step in the analysis: understanding that some customers are more profitable than others,” write Selden and Colvin.
Rather than cost-cutting, Selden and Colvin recommend “customer cutting.”
“Just by shutting down some of the target company’s worst customers and redeploying asserts to other customer segments where they can be better utilized, the acquirer changes the deal from a big loser to a big winner.”
Another alternative is to transform unprofitable customers to profitable ones. Selden and Colvin use the example of Fidelity Investments who discovered that many of its unprofitable customers were draining call center resources by staying on the phone too long. By routing these calls into longer queues and by training phone reps to educate customers about using the Web, many of these underachieving customers became profitable.
The authors point out that buying customers is like buying apples in a supermarket. On one rack are the handsome polished apples that can be easily inspected. On another table are apples already packaged in brown bags where the only visible apples are the ones on the top of the bag. “When one company buys another, it is buying customers in a big brown paper bag; and it usually can’t even see the ones on top,” write Selden/Colvin.
They conclude that the buyer that understands customer profitability can avoid this blunder.
Is M&A the Solution?
In analyzing a dozen successful acquirers (ADP, Bed Bath & Beyond, Dell, Harley-Davidson, Johnson & Johnson, Kohl’s, Medtronic, Microsoft, Pfizer, Starbucks, Walgreens and Wal-Mart”) Selden and Colvin believe the success of these “dynamic dozen” lies with their insightful understanding of customer profitability.
While M&As often produce drastic losses in shareholder equity, Selden and Colvin do not believe acquisitions are a bad idea. However, they are locked into the concept of “creating shareholder value through customers.”
“Before entering into any deal, prospective acquirers must ask and answer the following questions,” according to Selden and Colvin:
- At what price would the deal create economic profit and payoff for the share owners?
- What are the customer financial traits of the prospective target, including the distribution of customer profitability?
- Would it make more sense to buy just some of a prospective target’s customer segments rather than the whole company?