getting the disparate software applications to work together. Although some buyers still prefer to purchase the “best of
breed” software, many are moving to purchase suites of applications that are compatible.
In response to these industry changes and the maturing of its database product line, which accounted for three-fourths of
its revenue, Oracle moved into enterprise applications with its 2004 $10.3 billion purchase of PeopleSoft. From there,
Oracle proceeded to acquire 55 firms, with more than one–half focused on strengthening the firm’s software applications
business. Revenues almost doubled by 2009 to $23 billion, growing through the 2008–2009 recession.
Oracle, like most successful software firms, generates substantial and sustainable cash flow as a result of the way in
which business software is sold. Customers buy licenses to obtain the right to utilize a vendor’s software and periodically
renew the license in order to receive upgrades. Healthy cash flow minimized the need for Oracle to borrow. Consequently,
it was able to sustain its acquisitions by borrowing and paying cash for companies rather than having to issue stock and
potentially diluting existing shareholders.
In helping to satisfy its customers’ challenges, Oracle has had substantial experience in streamlining other firms’ supply
chains and in reducing costs. For most software firms, the largest single cost is the cost of sales. Consequently, in acquiring
other software firms, Oracle has been able to apply this experience to achieve substantial cost reduction by pruning
unprofitable products and redundant overhead during the integration of the acquired firms. Oracle’s existing overhead
structure would then be used to support the additional revenue gained through acquisitions. Consequently, most of the
additional revenue would fall to the bottom line.
For example, since acquiring Sun, Oracle has rationalized and consolidated Sun’s manufacturing operations and
substantially reduced the number of products the firm offers. Fewer products results in less administrative and support
overhead. Furthermore, Oracle has introduced a “build to order” mentality rather than a “build to inventory” marketing
approach. With a focus on “build to order,” hardware is manufactured only when orders are received rather than for
inventory in anticipation of future orders. By aligning production with actual orders, Oracle is able to reduce substantially
the cost of carrying inventory; however, it does run the risk of lost sales from customers who need their orders satisfied
immediately. Oracle has also pared down the number of suppliers in order to realize savings from volume purchase
discounts. While lowering its cost position in this manner, Oracle has sought to distinguish itself from its competitors by
being known as a full-service provider of integrated software solutions.
Prior to the Sun acquisition, Oracle’s primary competitor in the enterprise software market was the German software
giant SAP. However, the acquisition of Sun’s vast hardware business pits Oracle for the first time against Hewlett-Packard,
IBM, Dell Computer, and Cisco Systems, all of which have made acquisitions of software services companies in recent
years, moving well beyond their traditional specialties in computers or networking equipment. In 2009, Cisco Systems
diversified from its networking roots and began selling computer servers. Traditionally, Cisco had teamed with hardware
vendors HP, Dell, and IBM. HP countered Cisco by investing more in its existing networking products and by acquiring the
networking company 3Com for $2.7 billion in November 2009. HP had purchased EDS in 2008 for $13.8 billion in an
effort to sell more equipment and services to customers often served by IBM. Each firm seems to be pursuing a “me too”
strategy in which they can claim to their customers that they and they alone have all the capabilities to be an end–to–end
service provider. Which firm is most successful in the long run may well be the one that successfully integrates their
acquisitions the best.
Investors’ concern about Oracle’s strategy is that the frequent acquisitions make it difficult to measure how well the
company is growing. With many of the acquisitions falling in the $5 million to $100 million range, relatively few of
Oracle’s acquisitions have been viewed as material for financial reporting purposes. Consequently, Oracle is not obligated
to provide pro forma financial data about these acquisitions, and investors have found it difficult to ascertain the extent to
which Oracle has grown organically (i.e., grown the revenue resulting from prior acquisitions) versus simply by acquiring
new revenue streams. Ironically, in the short run, Oracle’s acquisition binge has resulted in increased complexity as each
new acquisition means more products must be integrated. The rapid revenue growth from acquisitions may indeed simply
be masking underlying problems brought about by this growing complexity.
Discussion Questions and Answers:
1. How would you characterize the Oracle business strategy (i.e., cost leadership, differentiation, niche, or some
combination of all three)? Explain your answer.
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2. Conduct an external and internal analysis of Oracle. Briefly describe those factors that influenced the
development of Oracle’s business strategy. Be specific.
3. In what way do you think the Oracle strategy was targeting key competitors? Be specific.
4. What other benefits for Oracle, and for the remaining competitors such as SAP, do you see from further industry
consolidation? Be specific.
Cingular Acquires AT&T Wireless in a Record-Setting Cash Transaction
Cingular outbid Vodafone to acquire AT&T Wireless, the nation’s third largest cellular telephone company, for $41 billion
in cash plus $6 billion in assumed debt in February 2004. This represented the largest all-cash transaction in history. The
combined companies, which surpass Verizon Wireless as the largest U.S. provider, have a network that covers the top 100
U.S. markets and span 49 of the 50 U.S. states. While Cingular’s management seemed elated with their victory, investors
soon began questioning the wisdom of the acquisition.
By entering the bidding at the last moment, Vodafone, an investor in Verizon Wireless, forced Cingular’s parents, SBC
Communications and BellSouth, to pay a 37 percent premium over their initial bid. By possibly paying too much, Cingular
put itself at a major disadvantage in the U.S. cellular phone market. The merger did not close until October 26, 2004, due to
the need to get regulatory and shareholder approvals. This gave Verizon, the industry leader in terms of operating margins,
time to woo away customers from AT&T Wireless, which was already hemorrhaging a loss of subscribers because of poor
customer service. By paying $11 billion more than its initial bid, Cingular would have to execute the integration, expected
to take at least 18 months, flawlessly to make the merger pay for its shareholders.
With AT&T Wireless, Cingular would have a combined subscriber base of 46 million, as compared to Verizon
Wireless’s 37.5 million subscribers. Together, Cingular and Verizon control almost one half of the nation’s 170 million
wireless customers. The transaction gives SBC and BellSouth the opportunity to have a greater stake in the rapidly
expanding wireless industry. Cingular was assuming it would be able to achieve substantial operating synergies and a
reduction in capital outlays by melding AT&T Wireless’s network into its own. Cingular expected to trim combined capital
costs by $600 to $900 million in 2005 and $800 million to $1.2 billion annually thereafter. However, Cingular might feel
pressure from Verizon Wireless, which was investing heavily in new mobile wireless services. If Cingular were forced to
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offer such services quickly, it might not be able to realize the reduction in projected capital outlays. Operational savings
might be even more difficult to realize. Cingular expected to save $100 to $400 million in 2005, $500 to $800 million in
2006, and $1.2 billion in each successive year. However, in view of AT&T Wireless‘s continued loss of customers,
Cingular might have to increase spending to improve customer service. To gain regulatory approval, Cingular agreed to sell
assets in 13 markets in 11 states. The firm would have six months to sell the assets before a trustee appointed by the FCC
would become responsible for disposing of the assets.
SBC and BellSouth, Cingular’s parents, would have limited flexibility in financing new spending if it were required by
Cingular. SBC and BellSouth each borrowed $10 billion to finance the transaction. With the added debt, S&P put SBC,
BellSouth, and Cingular on credit watch, which often is a prelude in a downgrade of a firm’s credit rating.
Discussion Questions:
1. What is the total purchase price of the merger?
2. What are some of the reasons Cingular used cash rather than stock or some combination to acquire AT&T
Wireless? Explain your answer.
3. How might the amount and composition of the purchase price affect Cingular’s, SBC’s, and BellSouth’s cost of
capital?
4. With substantially higher operating margins than Cingular, what strategies would you expect Verizon Wireless to
pursue? Explain your answer.
Bank of America Acquires Merrill Lynch
Against the backdrop of the Lehman Brothers’ Chapter 11 bankruptcy filing, Bank of America (BofA) CEO Kenneth Lewis
announced on September 15, 2008, that the bank had reached agreement to acquire mega–retail broker and investment bank
Merrill Lynch. Hammered out in a few days, investors expressed concern that the BofA’s swift action on the all-stock $50
billion transaction would saddle the firm with billions of dollars in problem assets by pushing BofA’s share price down by
21 percent.
BofA saw the takeover of Merrill as an important step toward achieving its long-held vision of becoming the number 1
provider of financial services in its domestic market. The firm’s business strategy was to focus its efforts on the U.S. market
by expanding its product offering and geographic coverage. The firm implemented its business strategy by acquiring
selected financial services companies to fill gaps in its product offering and geographic coverage. The existence of a clear
and measurable vision for the future enabled BofA to make acquisitions as the opportunity arose.
Since 2001, the firm completed a series of acquisitions valued at more than $150 billion. The firm acquired FleetBoston
Financial, greatly expanding its network of branches on the East Coast, and LaSalle Bank to improve its coverage in the
Midwest. The acquisitions of credit card–issuing powerhouse MBNA, U.S. Trust (a major private wealth manager), and
Countrywide (the nation’s largest residential mortgage loan company) were made to broaden the firm’s financial services
offering.
The acquisition of Merrill makes BofA the country’s largest provider of wealth management services to go with its
current status as the nation’s largest branch banking network and the largest issuer of small business, home equity, credit
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card, and residential mortgage loans. The deal creates the largest domestic retail brokerage and puts the bank among the top
five largest global investment banks. Merrill also owns 45 percent of the profitable asset manager BlackRock Inc., worth an
estimated $10 billion. BofA expects its retail network to help sell Merrill and BlackRock’s investment products to BofA
customers.
The hurried takeover encouraged by the U.S. Treasury and Federal Reserve did not allow for proper due diligence. The
extent of the troubled assets on Merrill’s books was largely unknown. While the losses at Merrill proved to be stunning in
the short run—$15 billion alone in the fourth quarter of 2008—the acquisition by Bank of America averted the possible
demise of Merrill Lynch. By the end of the first quarter of 2009, the U.S. government had injected $45 billion in loans and
capital into BofA in an effort to offset some of the asset write–offs associated with the acquisition. Later that year, Lewis
announced his retirement from the bank.
Mortgage loan losses and foreclosures continued to mount throughout 2010, with a disproportionately large amount of
such losses attributable to the acquisition of the Countrywide mortgage loan portfolio. While BofA’s vision and strategy
may still prove to be sound, the rushed execution of the Merrill acquisition, coupled with problems surfacing from other
acquisitions, could hobble the financial performance of BofA for years to come.
When Companies Overpay—Mattel Acquires The Learning Company
Mattel, Inc. is the world’s largest designer, manufacturer, and marketer of a broad variety of children’s products selling
directly to retailers and consumers. Most people recognize Mattel as the maker of the famous Barbie, the best-selling
fashion doll in the world, generating sales of $1.7 billion annually. The company also manufactures a variety of other well-
known toys and owns the primary toy license for the most popular kids’ educational program “Sesame Street.” In 1988,
Mattel revived its previous association with The Walt Disney Company and signed a multiyear deal with them for the
worldwide toy rights for all of Disney’s television and film properties
Business Plan
Mission Statement and Strategy
Mattel’s mission is to maintain its position in the toy market as the largest and most profitable family products
marketer and manufacturer in the world. Mattel will continue to create new products and innovate in their existing toy lines
to satisfy the constant changes of the family-products market. Its business strategy is to diversify Mattel beyond the market
for traditional toys at a time when the toy industry is changing rapidly. This will be achieved by pursuing the high-growth
and highly profitable children’s technology market, while continuing to enhance Mattel’s popular toys to gain market share
and increase earnings in the toy market. Mattel believes that its current software division, Mattel Interactive, lacks the
technical expertise and resources to penetrate the software market as quickly as the company desires. Consequently, Mattel
seeks to acquire a software business that will be able to manufacture and market children’s software that Mattel will
distribute through its existing channels and through its Website (Mattel.com).
Defining the Marketplace
The toy market is a major segment within the leisure time industry. Included in this segment are many diverse
companies, ranging from amusement parks to yacht manufacturers. Mattel is one of the largest manufacturers within the toy
segment of the leisure time industry. Other leading toy companies are Hasbro, Nintendo, and Lego. Annual toy industry
sales in recent years have exceeded $21 billion. Approximately one-half of all sales are made in the fourth quarter,
reflecting the Christmas holiday.
Customers. Mattel’s major customers are the large retail and e-commerce stores that distribute their products. These
retailers and e–commerce stores in 1999 included Toys “R” Us Inc., Wal-Mart Stores Inc., Kmart Corp., Target,
Consolidated Stores Corp., E-toys, ToyTime.com, Toysmart.com, and Toystore.com. The retailers are Mattel’s direct
customers; however, the ultimate buyers are the parents, grandparents, and children who purchase the toys from these
retailers.
Competitors. The two largest toy manufacturers are Mattel and Hasbro, which together account for almost one-half of
industry sales. In the past few years, Hasbro has acquired several companies whose primary products include electronic or
interactive toys and games. On December 8, 1999, Hasbro announced that it would shift its focus to software and other
electronic toys. Traditional games, such as Monopoly, would be converted into software.
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Potential Entrants. Potential entrants face substantial barriers to entry in the toy business. Current competitors, such as
Mattel and Hasbro, already have secured distribution channels for their products based on longstanding relationships with
key customers such as Wal–Mart and Toys “R” Us. It would be costly for new entrants to replicate these relationships.
Moreover, brand recognition of such toys as Barbie, Nintendo, and Lego makes it difficult for new entrants to penetrate
certain product segments within the toy market. Proprietary knowledge and patent protection provide additional barriers to
entering these product lines. The large toymakers have licensing agreements that grant them the right to market toys based
on the products of the major entertainment companies.
Product Substitutes. One of the major substitutes for traditional toys such as dolls and cars are video games and
computer software. Other product substitutes include virtually all kinds of entertainment including books, athletic wear,
tapes, and TV. However, these entertainment products are less of a concern for toy companies than the Internet or
electronic games because they are not direct substitutes for traditional toys.
Suppliers. An estimated 80% of toy production is manufactured abroad. Both Mattel and Hasbro own factories in the Far
East and Mexico to take advantage of low labor costs. Parts, such as software and microchips, often are outsourced to non-
Mattel manufacturing plants in other countries and then imported for the assembly of such products as Barbie within
Mattel-owned factories. Although outsourcing has resulted in labor cost savings, it also has resulted in inconsistent quality.
Opportunities and Threats
Opportunities
New Distribution Channels. Mattel.com represents 80 separate toy and software offerings. Mattel hopes to spin this
operation off as a separate company when it becomes profitable. Mattel.com lost about $70 million in 1999. The other new
channel for distributing toys is directly to consumers through catalogs. The so-called direct channels offered by the internet
and catalog sales help Mattel reduce its dependence on a few mass retailers.
Aging Population. Grandparents accounted for 14% of U.S. toy purchases in 1999. The number of grandparents is
expected to grow from 58 million in 1999 to 76 million in 2005.
Interactive Media. As children have increasing access to computers, the demand for interactive computer games is
expected to accelerate. The “high–tech” toy market segment is growing 20% annually, compared with the modest 5%
growth in the traditional toy business.
International Growth. In 1999, 44% of Mattel’s sales came from its international operations. Mattel already has
redesigned its Barbie doll for the Asian and the South American market by changing Barbie’s face and clothes.
Threats
Decreasing Demand for Traditional Toys. Children’s tastes are changing. Popular items are now more likely to include
athletic clothes and children’s software and video games rather than more traditional items such as dolls and stuffed
animals.
Distributor Returns. Distributors may return toys found to be unsafe or unpopular. A quality problem with the Cabbage
Patch Doll could cost Mattel more than $10 million in returns and in settling lawsuits.
Shrinking Target Market. Historically, the toy industry has considered their prime market to be children from birth to
age 14. Today, the top toy-purchasing years for a child range from birth to age 10.
Just-In-Time Inventory Management. Changing customer inventory practices make it difficult to accurately forecast
reorders, which has resulted in lost sales as unanticipated increases in orders could not be filled from current manufacturer
inventories.
Internal Assessment
Strengths
Mattel’s key strengths lie in its relatively low manufacturing cost position, with 85% of its toys manufactured in low–
labor-cost countries like China and Indonesia, and its established distribution channels. Moreover, licensing agreements
with Disney enable Mattel to add popular new characters to its product lines.
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Weaknesses
Mattel’s Barbie and Hot Wheels product lines are mature, but the company has been slow to reposition these core
brands. The lack of technical expertise to create software–based products limits Mattel’s ability to exploit the shift away
from traditional toys to video or interactive games.
Acquisition Plan
Objectives and Strategy
Mattel’s corporate strategy is to diversify Mattel beyond the mature traditional toys segment into high-growth segments.
Mattel believed that it had to acquire a recognized brand identity in the children’s software and entertainment segment of
the toy industry, sometimes called the “edutainment” segment, to participate in the rapid shift to interactive, software-based
toys that are both entertaining and educational. Mattel believed that such an acquisition would remove some of the
seasonality from sales and broaden their global revenue base. Key acquisition objectives included building a global brand
strategy, doubling international sales, and creating a $1 billion software business by January 2001.
Defining the Target Industry
The “edutainment” segment has been experiencing strong growth predominantly in the entertainment segment. Parents
are seeing the importance of technology in the workplace and want to familiarize their children with the technology as early
as possible. In 1998, more than 40% of households had computers and, of those households with children, 70% had
educational software. As the number of homes with PCs continues to increase worldwide and with the proliferation of
video games, the demand for educational and entertainment software is expected to accelerate.
Management Preferences
Mattel was looking for an independent children’s software company with a strong brand identity and more than $400
million in annual sales. Mattel preferred not to acquire a business that was part of another competitor (e.g., Hasbro
Interactive). Mattel’s management stated that the target must have brands that complement Mattel’s business strategy and
the technology to support their existing brands, as well as to develop new brands. Mattel preferred to engage in a stock-for-
stock exchange in any transaction to maintain manageable debt levels and to ensure that it preserved the rights to all
software patents and licenses. Moreover, Mattel reasoned that such a transaction would be more attractive to potential
targets because it would enable target shareholders to defer the payment of taxes.
Potential Targets
Game and edutainment development divisions are often part of software conglomerates, such as Cendant, Electronic
Arts, and GT Interactive, which produce software for diverse markets including games, systems platforms, business
management, home improvement, and pure educational applications. Other firms may be subsidiaries of large book, CD–
ROM, or game publishers. The parent firms showed little inclination to sell these businesses at what Mattel believed were
reasonable prices. Therefore, Mattel focused on five publicly traded firms: Acclaim Entertainment, Inc., Activision, Inc.,
Interplay Entertainment Corp, The Learning Company, Inc. (TLC), and Take-Two Interactive Software. Of these, only
Acclaim, Activision, and The Learning Company had their own established brands in the games and edutainment sectors
and the size sufficient to meet Mattel’s revenue criterion.
In 1999, TLC was the second largest consumer software company in the world, behind Microsoft. TLC was the leader
in educational software, with a 42% market share, and in-home productivity software (i.e., home improvement software),
with a 44% market share. The company has been following an aggressive expansion strategy, having completed 14
acquisitions since 1994. At 68%, TLC also had the highest gross profit margin of the target companies reviewed. TLC
owned the most recognized titles and appeared to have the management and technical skills in place to handle the kind of
volume that Mattel desired. Their sales were almost $1 billion, which would enable Mattel to achieve its objective in this
“high–tech” market. Thus, TLC seemed the best suited to satisfy Mattel’s acquisition objectives.
Completing the Acquisition
Despite disturbing discoveries during due diligence, Mattel acquired TLC in a stock-for-stock transaction valued at $3.8
billion on May 13, 1999. Mattel had determined that TLC’s receivables were overstated because product returns from
distributors were not deducted from receivables and its allowance for bad debt was inadequate. A $50 billion licensing deal
also had been prematurely put on the balance sheet. Finally, TLC’s brands were becoming outdated. TLC had substantially
exaggerated the amount of money put into research and development for new software products. Nevertheless, driven by
the appeal of rapidly becoming a big player in the children’s software market, Mattel closed on the transaction aware that
TLC’s cash flows were overstated.
Epilogue
For all of 1999, TLC represented a pretax loss of $206 million. After restructuring charges, Mattel’s consolidated 1999
net loss was $82.4 million on sales of $5.5 billion. TLC’s top executives left Mattel and sold their Mattel shares in August,
just before the third quarter’s financial performance was released. Mattel’s stock fell by more than 35% during 1999 to end
the year at about $14 per share. On February 3, 2000, Mattel announced that its chief executive officer (CEO), Jill Barrad,
was leaving the company.
On September 30, 2000, Mattel virtually gave away The Learning Company to rid itself of what had become a
seemingly intractable problem. This ended what had become a disastrous foray into software publishing that had cost the
firm literally hundreds of millions of dollars. Mattel, which had paid $3.5 billion for the firm in 1999, sold the unit to an
affiliate of Gores Technology Group for rights to a share of future profits. Essentially, the deal consisted of no cash upfront
and only a share of potential future revenues. In lieu of cash, Gores agreed to give Mattel 50% of any profits and part of any
future sale of TLC. In a matter of weeks, Gores was able to do what Mattel could not do in a year. Gores restructured
TLC’s seven units into three, set strong controls on spending, sifted through 467 software titles to focus on the key brands,
and repaired relationships with distributors. Gores also has sold the entertainment division and is seeking buyers for the
remainder of TLC.
Discussion Questions:
1. Why was Mattel interested in diversification?
2. What alternatives to acquisition could Mattel have considered? Discuss the pros and cons of each
alternative?
3. How might the internet affect the toy industry? What potential conflicts with customers might be
created?
4. What are the primary barriers to entering the toy industry?
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5, What could Mattel have done to protect itself against risks uncovered during due diligence?
First Union Buys Wachovia Bank: A Merger of Equals?
First Union announced on April 17, 2001, that an agreement had been reached to acquire Wachovia Corporation for about
$13 billion in stock, thus uniting two fiercely independent rivals. With total assets of about $324 billion, the combination
created the fourth largest bank in the United States behind Citigroup, Bank of America, and J.P. Morgan Chase. The merger
also represents the joining of two banks with vastly different corporate cultures. Because both banks have substantial
overlapping operations and branches in many southeastern U.S. cities, the combined banks are expected to be able to add to
earnings in the first 2 years following closing. Wachovia, which is much smaller than First Union, agreed to the merger for
only a small 6% premium.
The deal is being structured as a merger of equals. That is a rare step given that the merger of equals’ framework usually
is used when two companies are similar in size and market capitalization. L. M. Baker, chair and CEO of Wachovia, will be
chair of the new bank and G. Kennedy Thompson, First Union’s chair and CEO, will be CEO and president. The name
Wachovia will survive. Of the other top executives, six will be from First Union and four from Wachovia. The board of
directors will be evenly split, with nine coming form each bank. Wachovia shareholders own about 27% of the combined
companies and received a special one-time dividend of $.48 per share because First Union recently had slashed its dividend.
To discourage a breakup, First Union and Wachovia used a fairly common mechanism called a “cross option,” which
gives each bank the right to buy a 19.9% stake in the other using cash, stock, and other property including such assets as
distressed loans, real estate, or less appealing assets. (At less than 20% ownership, neither bank would have to show the
investment on its balance sheet for financial reporting purposes.) Thus, the bank exercising the option would not only be
able to get a stake in the merged bank but also would be able to unload its least attractive assets. A hostile bidder would
have to deal with the idea that another big bank owned a chunk of the stock and that it might be saddled with unattractive
assets.
The deal structure also involved an unusual fee if First Union and Wachovia parted ways. Each bank is entitled to 6% of
the $13 billion merger value, or about $780 million in cash and stock. The 6% is about twice the standard breakup fee. The
cross-option and 6% fee were intended to discourage other last-minute suitors from making a bid for Wachovia.
According to a First Union filing with the Securities and Exchange Commission, Wachovia rebuffed an overture from
an unidentified bank just 24 hours before accepting First Union’s offer. Analysts identified the bank as SunTrust Bank.
SunTrust had been long considered a likely buyer of Wachovia after having pursued Wachovia unsuccessfully in late 2000.
Wachovia’s board dismissed the offer as not being in the best interests of the Wachovia’s shareholders.
The transaction brings together two regional banking franchises. In the mid-1980s, First Union was much smaller than
Wachovia. That was to change quickly, however. In the late 1980s and early 1990s, First Union went on an acquisition
spree that made it much larger and better known than Wachovia. Under the direction of now-retired CEO Edward
Crutchfield, First Union bought 90 banks. Mr. Crutchfield became known in banking circles as “fast Eddie.” However,
acquisitions of the Money Store and CoreStates Financial Corporation hurt bank earnings in late 1990s, causing First
Union’s stock to fall from $60 to less than $30 in 1999. First Union had paid $19.8 billion for CoreStates Financial in 1998
and then had trouble integrating the acquisition. Customers left in droves. Ill, Mr. Crutchfield resigned in 2000 and was
replaced by G. Kennedy Thompson. He immediately took action to close the Money Store operation and exited the credit
card business, resulting in a charge to earnings of $2.8 billion and the layoff of 2300 in 2000.
In contrast, Wachovia assiduously avoided buying up its competitors and its top executives frequently expressed shock
at the premiums that were being paid for rival banks. Wachovia had a reputation as a cautious lender.
Whereas big banks like First Union did stumble mightily from acquisitions, Wachovia also suffered during the 1990s.
Although Wachovia did acquire several small banks in Virginia and Florida in the mid-1990s, it remained a mid-tier player
at a time when the size and scope of its bigger competitors put it at a sharp cost disadvantage. This was especially true with
respect to credit cards and mortgages, which require the economies of scale associated with large operations. Moreover,
Wachovia remained locked in the Southeast. Consequently, it was unable to diversify its portfolio geographically to
minimize the effects of different regional growth rates across the United States.
In the past, big bank deals prompted a rash of buying of bank stocks, as investors bet on the next takeover in the banking
sector. Banks such as First Union, Bank of America (formerly NationsBank), and Bank One acquired midsize regional
banks at lofty premiums, expanding their franchises. They rationalized these premiums by noting the need for economies of
scale and bigger branch networks. Many midsize banks that were obvious targets refused to sell themselves without
receiving premiums bigger than previous transactions. However, things have changed.
Back in 1995 buyers of banks paid 1.94 times book value and 13.1 times after-tax earnings. By 1997, these multiples
rose to 3.4 times book value and 22.2 times after-tax earnings. However, by 2000, buyers paid far less, averaging 2.3 times
book value and 16.3 times earnings. First Union paid 2.47 times book value and 15.7 times after-tax earnings. The
declining bank premiums reflect the declining demand for banks. Most of the big acquirers of the 1990s (e.g., Wells Fargo,
Bank of America, and Bank One) now feel that they have reached an appropriate size.
Banking went through a wave of consolidation in the late 1990s, but many of the deals did not turn out well for the
acquirers’ shareholders. Consequently, most buyers were unwilling to pay much of a premium for regional banks unless
they had some unique characteristics. The First Union–Wachovia deal is remarkable in that it showed how banks that were
considered prized entities in the late 1990s could barely command any premium at all by early 2001.
Discussion Questions:
1. In your judgment, was this merger a true merger of equals? Why might this framework have been used in this
instance? Do you think it was a fair deal for Wachovia stockholders? Explain your answer.
2. Do you believe the cross option and unusual fee structure in this transaction were in the best interests of the
Wachovia shareholders? Explain your answer.
3. How did big banks during the 1990s justify paying lofty premiums for smaller, regional banks? Why do you think
their subsequent financial performance was hurt by these acquisitions?
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4. What integration challenges do you believe these two banks will encounter as they attempt to consolidate
operations?
5. Speculate on why Wachovia’s management rebuffed the offer from SunTrust Banks with the ambiguous statement
that it was not in the best interests of Wachovia’s shareholders?
McKesson HBOC Restates Revenue
McKesson Corporation, the nation’s largest drug wholesaler, acquired medical software provider HBO & Co. in a $14.1
billion stock deal in early 1999. The transaction was touted as having created the country’s largest comprehensive health
care services company. McKesson had annual sales of $18.1 billion in fiscal year 1998, and HBO & Co. had fiscal 1998
revenue of $1.2 billion. HBO & Co. makes information systems that include clinical, financial, billing, physician practice,
and medical records software. Charles W. McCall, the chair, president, and chief executive of HBO & Co., was named the
new chair of McKesson HBOC.
As one of the decade’s hottest stocks, it had soared 38–fold since early 1992. McKesson’s first attempt to acquire HBO
in mid-1998 collapsed following a news leak. However, McKesson’s persistence culminated in a completed transaction in
January 1999. In its haste, McKesson closed the deal even before an in–depth audit of HBO’s books had been completed. In
fact, the audit did not begin until after the close of the 1999 fiscal year. McKesson was so confident that its auditing firm,
Deloitte & Touche, would not find anything that it released unaudited results that included the impact of HBO shortly after
the close of the 1999 fiscal year on March 31, 1999. Within days, indications that contracts had been backdated began to
surface.
By May, McKesson hired forensic accountants skilled at reconstructing computer records. By early June, the
accountants were able to reconstruct deleted computer files, which revealed a list of improperly recorded contracts. This
evidence underscored HBO’s efforts to deliberately accelerate revenues by backdating contracts that were not final.
Moreover, HBO shipped software to customers that they had not ordered, while knowing that it would be returned. In doing
so, they were able to boost reported earnings, the company’s share price, and ultimately the purchase price paid by
McKesson.
In mid-July, McKesson announced that it would have to reduce revenue by $327 million and net income by $191.5
million for the past 3 fiscal years to correct for accounting irregularities. The company’s stock had fallen by 48% since late
April when it first announced that it would have to restate earnings. McKesson’s senior management had to contend with
rebuilding McKesson’s reputation, resolving more than 50 lawsuits, and attempting to recover $9.5 billion in market value
lost since the need to restate earnings was first announced. When asked how such a thing could happen, McKesson
spokespeople said they were intentionally kept from the due diligence process before the transaction closed. Despite not
having adequate access to HBO’s records, McKesson decided to close the transaction anyway.
Discussion Questions:
1. Why do you think McKesson may have been in such a hurry to acquire HBO without completing an appropriate
due diligence?
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2. Assume an audit had been conducted and HBO’s financial statements had been declared to be in accordance with
GAAP. Would McKesson have been justified in believing that HBO’s revenue and profit figures were 100%
accurate?
3. McKesson, a drug wholesaler, acquired HBO, a software firm. How do you think the fact that the two firms were
in different businesses may have contributed to what happened?
4. Describe the measurable and non-measurable damages to McKesson’s shareholders resulting from HBO’s
fraudulent accounting activities.
The Cash Impact of Product Warranties
Reliable Appliances, a leading manufacturer of washing machines and dryers, acquired a marginal competitor, Quality–
Built, which had been losing money during the last several years. To help minimize losses, Quality-Built reduced its
quality-control expenditures and began to purchase cheaper parts. Quality–Built knew that this would hurt business in the
long run, but it was more focused on improving its current financial performance to increase the firm’s prospects for
eventual sale. Reliable Appliances saw an acquisition of the competitor as a way of obtaining market share quickly at a time
when Quality–Built’s market value was the lowest in 3 years. The sale was completed quickly at a very small premium to
the current market price.
Quality-Built had been selling its appliances with a standard industry 3-year warranty. Claims for the types of appliances
sold tended to increase gradually as the appliance aged. Quality-Built’s warranty claims’ history was in line with the
industry experience and did not appear to be a cause for alarm. Not surprisingly, in view of Quality–Built’s cutback in
quality-control practices and downgrading of purchased parts, warranty claims began to escalate sharply within 12 months
of Reliable Appliances’s acquisition of Quality-Built. Over the next several years, Reliable Appliances paid out $15 million
in warranty claims. The intangible damage may have been much higher because Reliable Appliances’s reputation had been
damaged in the marketplace.
Discussion Questions:
1. Should Reliable Appliances have been able to anticipate this problem from its due diligence of Quality-Built?
Explain how this might have been accomplished.
2. How could Reliable have protected itself from the outstanding warranty claims in the definitive agreement of
purchase and sale?
The Downside of Earnouts
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In the mid-1980s, a well-known aerospace conglomerate acquired a high-growth systems integration company by paying a
huge multiple of earnings. The purchase price ultimately could become much larger if certain earnout objectives, including
both sales and earnings targets, were achieved during the 4 years following closing. However, the buyer’s business plan
assumed close cooperation between the two firms, despite holding the system integrator as a wholly owned but largely
autonomous subsidiary. The dramatic difference in the cultures of the two firms was a major impediment to building trust
and achieving the cooperation necessary to make the acquisition successful. Years of squabbling over policies and practices
tended to delay the development and implementation of new systems. The absence of new systems made it difficult to gain
market share. Moreover, because the earnout objectives were partially defined in terms of revenue growth, many of the
new customer contracts added substantial amounts of revenue but could not be completed profitably under the terms of
these contracts. The buyer was slow to introduce new management into its wholly owned subsidiary for fear of violating the
earnout agreement. Finally, market conditions changed, and what had been the acquired company’s unique set of skills
became commonplace. Eventually, the aerospace company wrote off most of the purchase price and merged the remaining
assets of the acquired company into one of its other product lines after the earnout agreement expired.
Discussion Questions:
1. Describe conditions under which an earnout might be most appropriate.
2. In your opinion, are earnouts more appropriate for firms in certain types of industries than for others? If so, give
examples. Explain your answer.
distant future.
Case Study: Sleepless in Philadelphia
Closings can take on a somewhat surreal atmosphere. In one transaction valued at $20 million, the buyer intended to
finance the transaction with $10 million in secured bank loans, a $5 million loan from the seller, and $5 million in equity.
However, the equity was to be provided by wealthy individual investors (i.e., “angel” investors) in amounts of $100,000
each. The closing took place in Philadelphia around a long conference room table in the law offices of the firm hired by the
buyer, with lawyers and business people representing the buyer, the seller, and several banks reviewing the final
documents. Throughout the day and late into the evening, wealthy investors (some in chauffeur-driven limousines) and
their attorneys would stop by to provide cashiers’ checks, mostly in $100,000 amounts, and to sign the appropriate legal
documents. The sheer number of people involved created an almost circus-like environment. Because of the lateness of the
hour, it was not possible to deposit the checks on the same day. The next morning a briefcase full of cashiers’ checks was
taken to the local bank.
Discussion Question:
1. What do you think are the major challenges faced by the buyer in financing small transactions transaction in this
manner?
Case Study: Mattel Overpays for the Learning Company
Despite disturbing discoveries during due diligence, Mattel acquired The Learning Company (TLC), a leading developer of
software for toys, in a stock-for-stock transaction valued at $3.5 billion on May 13, 1999. Mattel had determined that
TLC’s receivables were overstated because product returns from distributors were not deducted from receivables and its
allowance for bad debt was inadequate. A $50 million licensing deal also had been prematurely put on the balance sheet.
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Finally, TLC’s brands were becoming outdated. TLC had substantially exaggerated the amount of money put into research
and development for new software products. Nevertheless, driven by the appeal of rapidly becoming a big player in the
children’s software market, Mattel closed on the transaction aware that TLC’s cash flows were overstated.
For all of 1999, TLC represented a pretax loss of $206 million. After restructuring charges, Mattel’s consolidated 1999
net loss was $82.4 million on sales of $5.5 billion. TLC’s top executives left Mattel and sold their Mattel shares in August,
just before the third quarter’s financial performance was released. Mattel’s stock fell by more than 35% during 1999 to end
the year at about $14 per share. On February 3, 2000, Mattel announced that its chief executive officer (CEO), Jill Barrad,
was leaving the company.
On September 30, 2000, Mattel virtually gave away The Learning Company to rid itself of what had become a
seemingly intractable problem. This ended what had become a disastrous foray into software publishing that had cost the
firm literally hundreds of millions of dollars. Mattel, which had paid $3.5 billion for the firm in 1999, sold the unit to an
affiliate of Gores Technology Group (GTG) for rights to a share of future profits. Essentially, the deal consisted of no cash
upfront and only a share of potential future revenues. In lieu of cash, GTG agreed to give Mattel 50 percent of any profits
and part of any future sale of TLC. In a matter of weeks, GTG was able to do what Mattel could not do in a year. GTG
restructured TLC’s seven units into three, put strong controls on spending, sifted through 467 software titles to focus on the
key brands, and repaired relationships with distributors. GTG also sold the entertainment division.
Discussion Questions:
1. Despite being aware of extensive problems, Mattel proceeded to acquire The Learning Company. Why? What
could Mattel to better protect its interests? Be specific.
2. Why was Gore Technology Group able to do what Mattel could not do in a year.?
The Anatomy of a Transaction: K2 Incorporated Acquires Fotoball USA
Our story begins in the early 2000s. K2 is a sporting goods equipment manufacturer whose portfolio of brands includes
Rawlings, Worth, Shakespeare, Pflueger, Stearns, K2, Ride, Olin, Morrow, Tubbs and Atlas. The company’s diversified
mix of products is used primarily in team and individual sports activities, and its primary customers are sporting goods
retailers, many of which are not strongly capitalized. Historically, the firm has been able to achieve profitable growth by
introducing new products into fast-growing markets. Most K2 products are manufactured in China, which helps ensure cost
competitiveness but also potentially subjects the company to a variety of global uncertainties.
K2’s success depends on its ability to keep abreast of changes in taste and style and to offer competitive prices. The
company’s external analysis at the time showed that the most successful sporting goods suppliers will be those with the
greatest resources, including both management talent and capital, the ability to produce or source high-quality, low-cost
products and deliver them on a timely basis, and access to distribution channels with a broad array of products and brands.
Management expected that large retailers would prefer to rely on fewer and larger sporting goods suppliers to help them
manage the supply of products and the allocation of shelf space.
The firm’s primary customers are sporting goods retailers. Many of K2’s smaller retailers and some larger retailers were
not strongly capitalized. Adverse conditions in the sporting goods retail industry could adversely impact the ability of
retailers to purchase K2 products. Secondary customers included individuals, both hobbyists as well as professionals.
The firm had a few top competitors, but there were other large sporting goods suppliers with substantial brand
recognition and financial resources with whom K2 did not compete. However, they could easily enter K2’s currently served
markets. In the company’s secondary business, sports apparel, it did face stiff competition from some of these same
suppliers, including Nike and Reebok.
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K2’s internal analysis showed that the firm was susceptible to imitation, despite strong brand names, and that some
potential competitors had substantially greater financial resources than K2. One key strength was the relationships K2 had
built with collegiate and professional leagues and teams, not easily usurped. Larger competitors may have had the capacity
to take some of these away, but K2 had so many that it could withstand the loss of one or two. The primary weakness of K2
was its relatively small size in comparison to major competitors.
As a long-term, strategic objective, K2 set out to be number one in market share in the markets it served by becoming
the low-cost supplier. To that end, K2 wanted to meet or exceed its corporate cost of capital of 15 percent; achieve
sustained double-digit revenue growth, gross profit margins above 35 percent, and net profit margins in excess of 5 percent
within five years; and reduce its debt–to-equity ratio to the industry average of 25 percent in the same period. The business
strategy for meeting this objective was to become the low-cost supplier in new niche segments of the sporting goods and
recreational markets. The firm would use its existing administrative and logistical infrastructure to support entry into these
new segments, new distribution channels, and new product launches through existing distribution channels. Also, K2
planned to continue its aggressive cost cutting and expand its global sourcing to include low-cost countries other than
China.
All this required an implementation strategy. K2 decided to avoid product or market extension through partnering
because of the potential for loss of control and for creating competitors once such agreements lapse. Rather, the strategy
would build on the firm’s great success, in recent years, acquiring and integrating smaller sporting goods companies with
well-established brands and complementary distribution channels. To that end, M&A-related functional strategies were
developed. A potential target for acquisition would be a company that holds many licenses with professional sports teams.
Through its relationship with those teams, K2 could further promote its line of sporting gear and equipment.
In addition, K2 planned to increase its R&D budget by 10 percent annually over five years to focus on developing
equipment and apparel that could be offered to the customer base of firms it acquired during the period. Existing licensing
agreements between a target firm and its partners could be enhanced to include the many products K2 now offers. If
feasible, the sales force of a target firm would be merged with that of K2 to realize significant cost savings.
K2 also thought through the issue of strategic controls. The company had incentive systems in place to motivate work
towards implementing its business strategy. There were also monitoring systems to track the actual performance of the firm
against the business plan.
In its acquisition plan, K2’s overarching financial objective was to earn at least its cost of capital. The plan’s primary
non-financial objective was to acquire a firm with well-established brands and complementary distribution channels. More
specifically, K2 sought an acquisition with a successful franchise in the marketing and manufacturing of souvenir and
promotional products that could be easily integrated into K2’s current operations.
The acquisition plan included an evaluation of resources and capabilities. K2 established that after completion of a
merger, the target’s sourcing and manufacturing capabilities must be integrated with those of K2, which would also retain
management, key employees, customers, distributors, vendors and other business partners of both companies. An
evaluation of financial risk showed that borrowing under K2’s existing $205 million revolving credit facility and under its
$20 million term loan, as well as potential future financings, could substantially increase current leverage, which could –
among other things – adversely affect the cost and availability of funds from commercial lenders and K2’s ability to expand
its business, market its products, and make needed infrastructure investments. If new shares of K2 stock were issued to pay
for the target firm, K2 determined that its earnings per share could be diluted unless anticipated synergies were realized in a
timely fashion. Moreover, overpaying for any firm could result in K2 failing to earn its cost of capital.
Ultimately, management set some specific preferences: the target should be smaller than $100 million in market
capitalization and should have positive cash flows, and it should be focused on the sports or outdoor activities market. The
initial search, by K2’s experienced acquisition team, would involve analyzing current competitors. The acquisition would
be made through a stock purchase – and K2 chose to consider only friendly takeovers involving 100 percent of the target’s
stock – and the form of payment would be new K2 non–voting common stock. The target firm’s current year P/E should not
exceed 20.
After an exhaustive search, K2 identified Fotoball USA as its most attractive target due to its size, predictable cash
flows, complementary product offering, and many licenses with most of the major sports leagues and college teams.
Fotoball USA represented a premier platform for expansion of K2’s marketing capabilities because of its expertise in the
industry and place as an industry leader in many sports and entertainment souvenir and promotional product categories. K2
believed the fit with the Rawlings division would make both companies stronger in the marketplace. Fotoball also had
proven expertise in licensing programs, which would assist K2 in developing additional revenue sources for its portfolio of
brands. In 2003, Fotoball had lost $3.2 million, so it was anticipated that they would be receptive to an acquisition proposal
and that a stock-for-stock exchange offer would be very attractive to Fotoball shareholders because of the anticipated high
earning growth rate of the combined firms.
Negotiations ensued, and the stock-for-stock offer contained a significant premium, which was well received. Fotoball is
a very young company and many of its investors were looking to make their profits through the growth of the stock. The
offer would allow Fotoball shareholders to defer taxes until they decided to sell their stocks and be taxed at the capital gains
rate. An earn-out was also included in the deal to give management incentives to run the company effectively and meet
deadlines in a timely order.
Valuations for both K2 and Fotoball reflected anticipated synergies due to economies of scale and scope, namely,
reductions in selling expenses of approximately $1 million per year, in distribution expenses of approximately $500,000 per
year, and in annual G&A expenses of approximately $470,000. The combined market value of the two firms was estimated
at $909 million – an increase of $82.7 million over the sum of the standalone values of the two firms.
Based on Fotoball’s outstanding common stock of 3.6 million shares, and the stock price of $4.02 at that time, a
minimum offer price was determined by multiplying the stock price by the number of shares outstanding. The minimum
offer price was $14.5 million. Were K2 to concede 100 percent of the value of synergy to Fotoball, the value of the firm
would be $97.2 million. However, sharing more than 45 percent of synergy with Fotoball would have caused a serious
dilution of earnings. To determine the amount of synergy to share with Fotoball’s shareholders, K2 looked at what portion
of the combined firms revenues would be contributed by each of the players and then applied that proportion to the
synergy. Since 96 percent of the projected combined firms revenues in fiscal year 2004 were expected to come from K2,
only 4 percent of the synergy value was added to the minimum offer price to come up with an initial offer price of $17.8
million, or $4.94 per share. That represented a premium of 23 percent over the market value of Fotoball’s stock at the time.
The synergies and the Fotoball’s relatively small size compared to K2 made it unlikely that the merger would endanger
K2’s credit worthiness or near-term profitability. Although the contribution to earnings would be relatively small, the
addition of Fotoball would help diversify and smooth K2’s revenue stream, which had been subject to seasonality in the
past.
Organizationally, the integration of Fotoball into K2 would be achieved by operating Fotoball as a wholly owned
subsidiary of K2, with current Fotoball management remaining in place. All key employees would receive retention
bonuses as a condition of closing. Integration teams consisting of employees from both firms were set to move
expeditiously according to a schedule established prior to closing the deal. The objective would be to implement the best
practices of both firms.
On January 26, 2004, K2 Inc. completed the purchase of Fotoball USA in an all-stock transaction. Immediately after,
senior K2 managers communicated (on-site, where possible) with Fotoball customers, suppliers, and employees to allay any
immediate concerns.
Discussion Questions:
1. How did K2’s acquisition plan objective support the realization of its corporate mission and strategic objectives?
2. What alternatives to M&As could K2 have employed to pursue its growth strategy? Why were the
alternatives rejected?
3. What was the role of “strategic controls” in implementing the K2 business plan?
4. How did the K2 negotiating strategy seek to meet the primary needs of the Fotoball shareholders
and employees?