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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.
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.
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
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
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
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
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
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
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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?
Answer: Mattel could have considered building the capability internally by leveraging its small, but growing
software division. Alternatively, Mattel could have considered creating a joint venture corporation with a leading
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?
Answer: Barriers to entry include the well-established distribution channels of the major manufacturers, based on
5, What could Mattel have done to protect itself against risks uncovered during due diligence?
Answer: Mattel could have protected itself by shifting some of the risk to The Learning Company (TLC). This
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
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.
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
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
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
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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.
Answer: In a true merger of equals, the synergy created by combining the firms is about equally attributable to
each firm and the size and market capitalization of the two firms involved are usually comparable. Consequently,
the resulting combination of the firms is such that the target firm’s shareholders do not receive a significant
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.
Answer: The use of the cross-option was a particularly onerous defensive tactic designed to ensure the
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?
Answer: Big banks typically justified the payment of huge premiums by touting the anticipated huge cost savings
that could be realized by eliminating overlapping operations. While this is true in theory, there is little evidence
4. What integration challenges do you believe these two banks will encounter as they attempt to consolidate
operations?
Answer: Both banks had different cultures. Consequently, getting cooperation between management teams is
likely to prove daunting. Moreover, the power sharing arrangement at the CEO level is likely to slow the decision-
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,
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?
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.
39
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
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
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
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
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.
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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
Discussion Question:
1. What do you think are the major challenges faced by the buyer in financing small transactions transaction in this
manner?
Answer: Frequently, small transactions are more difficult to finance because the relative lack of sophistication of
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.
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
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.
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Answer: Mattel was more focused on the trend toward software-based toys, Mattel that the additional revenue
2. Why was Gore Technology Group able to do what Mattel could not do in a year.?
Answer: Gore specialized in turnarounds and restructuring and had skills not readily available inside Mattel.
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
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.
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.
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.
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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
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
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
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.
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
synergy. Since 96 percent of the projected combined firms revenues in fiscal year 2004 were expected to come from K2,
43
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
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
immediate concerns.
Discussion Questions:
1. How did K2’s acquisition plan objective support the realization of its corporate mission and strategic objectives?
Answer: K2’s overarching financial objective for an acquisition was to earn at least its cost of capital. This
financial objective dovetails directly with the overarching business objective of meeting or exceeding its corporate
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?
Answer: K2 employed a series of incentive plans and performance monitoring systems to increase the likelihood
that their business strategy would be implemented successfully. The incentive plans were designed to motivate
4. How did the K2 negotiating strategy seek to meet the primary needs of the Fotoball shareholders
and employees?
Answer: K2 employed a share for share exchange such that the transaction would qualify as a tax-free transaction
