Industry consolidation has been a perilous endeavor for defense
contractors in the United States. On average, shareholders have
experienced poor returns during the past five years, partially as
a result of the problems that have arisen as firms attempted to
integrate acquisitions and rationalize operations.
For many companies, including industry leaders such as the Raytheon
Company and Lockheed Martin, the acquisition integration process
has not gone smoothly.
From July 31, 1995, through July 31, 2000, the Standard & Poor’s
500 Index has risen by more than 250 percent, while the Dow Jones
Aerospace Industry Index has risen by just 21 percent. The past
two years have been even more troubling for defense firm shareholders.
While the S&P 500 Index has climbed 25 percent over the past
two years, the Dow Jones Aerospace Industry Index has fallen by
15 percent.
Defense contractor executives may wish to consider this disappointing
track record as the pace of global industry consolidation increases.
Managers need to be aware of certain pitfalls that they may encounter
in their acquisition decision-making processes.
Mergers and acquisitions seemed like an attractive strategic option
for managers in an industry with declining demand, such as the defense
industry in the 1990s.
In this context, executives pursued mergers as a vehicle for consolidating
operations, eliminating excess capacity, and improving productivity.
However, acquisition integration can be difficult to manage, and
operating synergies can prove quite elusive. Consequently, acquiring
firms may not generate economic returns that justify the original
cost of the acquisition.
Integration problems often can be traced back to the acquisition
decision-making process. Many firms make faulty assumptions regarding
potential cost savings, fail to perform adequate due diligence,
or prematurely converge on a particular acquisition candidate rather
than examine a wide range of alternatives.
These deficiencies in the decision-making process may explain why
integration and consolidation do not proceed smoothly in many cases,
and why some firms fail to deliver the economic returns that their
shareholders expect.
Consequences of Consolidation
U.S. defense industry executives have experienced these difficulties
firsthand over the past several years. As the Defense Department
reduced spending dramatically in the early to mid-1990s, merger
and acquisition activity increased rapidly. The industry quickly
became more concentrated as a result of these mergers. In 1991,
the top four firms accounted for 17 percent of the dollar volume
of defense prime contract awards. By 1999, the top four firms accounted
for 28 percent of these awards.
In particular sectors, the effects of this wave of merger activity
have been even more dramatic. In the early 1990s, six major naval
shipyards competed for U.S. Navy new ship construction contracts.
Today, as a result of a series of mergers and acquisitions, three
corporations (General Dynamics, Litton Industries, and Newport News
Shipbuilding) own those six shipyards. Similarly, in aircraft production,
the Northrop-Grumman and Boeing-McDonnell Douglas mergers, as well
as Lockheed’s purchase of General Dynamics’ fighter
jet division, have reduced the number of major competitors significantly.
Potential Flaws
Three potential flaws in the acquisition decision-making process
relate to the development of alternatives, assumptions and analysis.
First, executives need to avoid converging prematurely on a single
alternative. Management scholars Philippe Haspelagh and David Jemison
have discovered that the process of deciding to acquire another
firm often is characterized by a great deal of momentum.
In this situation, managers often do not step back to consider
a variety of potential acquisition candidates. Instead, they focus
quickly on a single target firm, because they feel pressured to
make a swift decision as to whether or not to “do the deal.”
However, the failure to consider multiple alternatives can be problematic.
A great deal of research suggests that firms make better strategic
decisions when they consider multiple options. In particular, decision-making
expert Irving Janis has shown that strong pressures for conformity
often arise when an organization converges quickly on a single alternative.
In other words, people who oppose the acquisition may not feel comfortable
expressing their dissenting opinion. They withhold their concerns
regarding the deal, despite the fact that these concerns are quite
valid.
In this situation, managers may fail to engage in an adequate level
of debate regarding the pros and cons of a potential acquisition.
The lack of critical evaluation causes managers to overlook key
disadvantages of the proposed merger, as well as critical problems
that could arise during the acquisition integration process.
In addition to not considering multiple alternatives, some decision-makers
do not identify or probe key assumptions adequately. In acquisitions,
managers often have to presume a great deal about a target firm,
because they do not have complete information about the company’s
internal operations. Moreover, managers have to project the level
of cost savings and other operating synergies that they believe
will occur as a result of post-merger consolidation. These assumptions
have a significant impact on the attractiveness of a potential acquisition,
as well as on the price that the acquirer is willing to pay for
the target firm’s shares.
It can become easy to take certain presumptions for granted, or
to begin to treat assumptions as facts. Consequently, managers fail
to test thoroughly the validity of their assumptions. In acquisitions,
this means that managers can develop overly optimistic projections
of the value of synergies, or they may fail to identify the obstacles
and risks associated with attempting to realize savings through
post-merger consolidation. In addition, managers may make faulty
assumptions regarding the effect that the acquisition will have
on customers, suppliers, and competitor behavior.
Finally, acquisition decision-making processes often falter because
the formal analysis of the deal is inherently biased. During many
capital investment decisions, including acquisitions, managers conduct
“net present value” analyses. These systematic financial
evaluations attempt to determine whether an investment will yield
adequate returns.
Research shows that managers often employ sophisticated analysis
to justify and legitimize a decision, rather than to evaluate a
proposal in an objective manner. This occurs because a strong advocate
for the proposal takes control of the analytical process. Advocates
know the outcome that they wish to achieve, and they steer the analysis
so that the results will support the conclusion that they wish to
hear.
In acquisitions, this means that managers often treat the due diligence
process as a vehicle for justifying an acquisition, rather than
as a means of gathering more complete information to support an
objective evaluation of the deal. In other words, by the time that
due diligence occurs, the decision to acquire is often pre-ordained.
If managers treat due diligence in this manner, they will almost
certainly fail to surface key problems and risks associated with
a proposed merger.
Keys to Success
As defense firms pursue global consolidation, they can employ certain
practices in order to avoid an inadequate search for alternatives,
the development of flawed assumptions, and the use of biased analysis.
In particular, managers can take three steps to improve acquisition
decision-making.
Research demonstrates that managers make more effective strategic
choices when they define their decision criteria in a clear and
precise manner. Clear criteria can be especially important when
screening potential acquisitions, particularly for firms that are
doing many deals in a short period of time. For example, experienced
acquirers such as Emerson Electric, Newell and Cisco Systems all
employ a well-defined set of criteria for evaluating potential acquisition
candidates. Clear screening criteria provide a structured means
of evaluating alternatives for these firms, and help to develop
a common managerial understanding of the rationale for a particular
acquisition strategy.
Moreover, successful acquirers do not judge target firms based
solely on financial criteria such as return on investment or expected
impact on earnings per share. Instead, firms such as Emerson, Newell,
and Cisco tend to establish strategic, organizational, and financial
criteria for screening target firms. In other words, potential acquisitions
must fit the corporation’s well-defined competitive strategy,
and they must be compatible with the organization’s culture
and values. In addition, the acquisition must be expected to generate
attractive financial returns.
Successful organizations also tend to generate healthy conflict
and debate within their senior management teams. This facilitates
the generation of multiple alternatives, and insures that everyone
probes assumptions in a more critical manner. For example, Kathleen
Eisenhardt, of Stanford University, has shown that the managers
within the more successful computer firms in Silicon Valley tend
to encourage substantive debate, but they take steps to insure that
it does not become personal.
When considering acquisitions, managers can employ several strategies
for insuring adequate internal debate. For example, they can appoint
someone as the “devil’s advocate” during the decision-making
process. This person’s responsibility would be to try to point
out the problems and risks associated with a proposed merger. In
addition, they might employ what Alfred Sloan, former chairman of
General Motors, once called a “second chance meeting,”
in order to mitigate the negative effects of organizational momentum.
When executives appear to have arrived at a decision to acquire
another firm, they might wait a short period of time, and reconvene
the management team to reconsider the decision. This brief delay
provides people an opportunity to consider whether they may have
agreed prematurely with the proposed merger.
Finally, managers will make more effective acquisition decisions
if they identify and evaluate key contingencies and risks as soon
as possible. Scholars such as Edward Russo and Paul Schoemaker have
shown that individuals systematically exhibit overconfidence when
they make decisions.
Overconfidence can cause managers to systematically underestimate
the difficulties and risks associated with acquisition integration.
To enhance the effectiveness of their acquisition decisions, defense
industry executives need to engage in contingency planning while
they evaluate the attractiveness of an acquisition candidate, rather
than waiting until the deal is done. Managers will make better acquisition
decisions if they identify what might go wrong during the integration
process, try to determine how significant and likely that risk may
be, and then devise ways to avoid or reduce that risk. In some cases,
this proactive contingency planning may cause managers to reject
a proposed acquisition that is likely to fail, when they might otherwise
not identify key problems until after the merger has been executed.
Now, a new wave of consolidation has begun, and it entails international
mergers and acquisitions. For example, General Dynamics recently
bought ENSB of Spain. Similarly, BAE Systems, a U.K.-based conglomerate,
is seeking to purchase Lockheed Martin Aerospace Electronics Systems.
As firms make these acquisitions, they need to be aware that more
effective decision-making processes will result in smoother integration
and reduced operating costs. Flawed decision-making will lead to
a poor match between acquirer and target, difficult and expensive
integration efforts, and low returns for shareholders.
Michael A. Roberto is an assistant professor of competitive strategy
at Harvard Business School, Boston, Mass.