Numerous studies have shown that roughly two out of three corporate acquisitions fail, as measured by the performance of the stock of the acquiring company. What if those odds could be flipped? What if it were possible to succeed two times out of three and just fail a third of the time?

Our research suggests this is possible. A 20-person team that spent two years investigating 2,500 major corporate failures from the past 25 years found that almost half stemmed from ill-conceived strategies that should never have been pursued. Applying the lessons derived from that research can help executives dodge problems and reshape strategies in ways that greatly increase the chances of success.

The issue is timely because there’s likely to be an awful lot of acquiring over the next few years. That’s because the sort of lull in activity that currently exists has historically been followed by a burst of M&A activity. The severity of the recession may, in fact, mean deal activity will be far greater this time around. The crisis is creating scads of targets, many of which never would have been in play before. And many companies that are available for purchase are especially attractive because they haven’t had time to really deteriorate; they just need a shot of liquidity, and they’ll be good to go again.

But the possible downside is enormous, too. Just ask Bank of America about its $50 billion acquisition of Merrill Lynch. Or ask private-equity fund Bay Harbour Management about its decision to buy the Steve & Barry’s retail clothing chain out of bankruptcy proceedings for $168 million last year, only to announce three months later that it would liquidate the chain. Based on our research, we identified both those deals as flawed at the time they were announced, but it was too late for BofA and for Bay Harbour. (For more on our thoughts on these and other deals, see our blog at blog.billiondollarlessons.com)

The time to get things right is now, not when the deal pipeline starts to fill. That’s because our research found that, once a deal is in the works, it’s hard to stop, even when it’s a bad idea. Companies need to agree ahead of time on the sorts of quality checks and process safeguards that will let them strengthen weak ideas and stop bad ones. In other words, executives can take advantage of the current lull to make sure that, when the deals start flowing again, they can have those two in three odds, not the one in three that have historically prevailed.

In this paper, we’ll lay out a quality assurance process that we call the Strategic Stress Test. Companies should be putting this process in place now, because good deals will make heroes of the acquiring companies and their senior executives while bad deals will sink others.

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In the process, Pfizer is raising numerous of the red flags that, according to our research, can mean a strategy is in peril. Pfizer seems to be seeing synergies that aren’t there; is underestimating the complexity that can come with additional size; may be paying too much; isn’t learning from prior mistakes; isn’t considering all its options; and is acting more because of problems in its core business than because of opportunities in a new one.

The issue seems to be that pharmaceutical companies and the securities analysts who follow them have framed the problem wrong. The problem is stated like this: “A company has a blockbuster drug whose patent is expiring in a few years. How can the company replace the revenue and profits from that drug?” That may sound like a reasonable question, but it can’t be the guide for investment decisions. Those decisions have to be based on whether spending a certain amount of money will generate an adequate return, from an internal research project, from an acquisition, or from whatever. Focusing on when a blockbuster patent expires can encourage drug companies to think they absolutely, positively must fill the hole that will result and can encourage them to spend money foolishly, especially on acquisitions.

The problem with trying to fill holes is that the solutions are temporary. Just because you buy a drug doesn’t mean you’ve solved the industry’s basic problem: that it isn’t generating enough blockbuster drugs fast enough. Buying a hot seller just means you may have postponed the day of reckoning. And you’ve probably overpaid for the privilege. The stock market is pretty good at valuing the streams of cash flow that will come from a blockbuster drug that’s been in the market a few years, so it’s hard to see how a company can justify paying the 30% premium that Pfizer has offered to pay for Wyeth. Can Pfizer really make Wyeth’s products 30% more valuable?

Pfizer should know better. Faced with expiring patents, Pfizer spent $110 billion to acquire Warner Lambert in 2000 and $60 billion to acquire Pharmacia in 2002. Pfizer ran into problems with both acquisitions. Its market capitalization is currently about $95 billion, a bit more than half what it spent just on buying those two companies. Even before the stock market began its severe slump last fall, Pfizer’s market value was only about 70% of the price paid for Warner Lambert and Pharmacia.

Pfizer, itself, seems confused about the rationale for the merger. Initially, reports said Pfizer would find cost synergies. More recently, Pfizer has said Wyeth will give it the sort of broad portfolio of products that it wants, seemingly implying that the acquisition will let it find synergies that will boost revenues more than the two companies could on their own. In fact, as often happens when companies go looking for synergies, both types will likely prove elusive.

Some cost-cutting is certainly possible. Pfizer has already said it will cut 20,000 jobs from the combined companies. But to cut as deeply as Pfizer must to justify the acquisition premium, there needs to be more overlap than there is in the product lines–Pfizer focuses on prescription drugs, while Wyeth has a broad array of offerings, including drugs for use by veterinarians and consumer products.

The necessary revenue synergies will be even tougher to come by, as usual. While talk of a portfolio of products can be seductive, in this case it doesn’t make much sense. Drugs for vets, for instance, have different technology than drugs for humans, are sold to different people, go through different sales channels, and are marketed differently. Consumer products, likewise, have little in common with prescription drugs.

Meanwhile, Pfizer may be taking on troubling complexity. Its senior management has no experience selling veterinary drugs, so the team may run into problems that Wyeth’s management would have avoided. In addition, Pfizer has sold off consumer businesses, apparently not finding them to be a good fit with its core operations, so it’s likely that Wyeth’s consumer businesses will also cause friction.

While we understand Pfizer’s concern about having its cholesterol-lowering drug Lipitor about to go off patent, we don’t believe that acquiring Wyeth is the right idea.

Somebody call a doctor. Pfizer needs a new prescription.

Diller says he realized IAC was “overly complex and unmanageable.” (That shows up in our research as one of the most commonly overlooked problems. The complications that come with scale can, by the way, be foreseen and assessed before a strategy to achieve scale is pursued.) He adds that “every mistake we’ve made in acquisitions has been outside our essential spheres of expertise”–underscoring the difficulties that we found when companies thought they were moving into an adjacent market, only to find that the new market is too different from the existing market where they operate.

Diller is now so relentless about the need for focus he even suggests that Disney sell its mega-success, ESPN. For the full interview, follow this link.

It’s important, however, not to let Diller off the hook completely.  He is, essentially, saying that he made some mistakes, but that he has it right now.  Some important questions are left unanswered:  But, why did you make those mistakes?  How can you be sure that you aren’t making them again?  Even if you’re doing something different, what makes you think that you’re right this time?

For a lesson on what not to do, take a look at the fate of Conseco Financial when it tried to take advantage of a subprime lending fiasco in the late 1990s. Green Tree Financial found itself in a life-threatening credit squeeze because the market has lost faith in its mortgage-backed securities and refused to refinance its short-term debt. The market’s skepticism was justified. Green Tree’s portfolio was generated by offering 30 years mortgages on trailer homes with a 10-year life. Green Tree’s profits were driven by loan origination fees and by selling huge bundles of securitized loans, rather than by the performance of the mortgages. It was a strategy that produced huge profits in the short term but was disastrous as the poor quality of the loans became apparent. (Sound familiar?)

Conseco swooped into the situation, buying Green Tree for $6 billion. The acquisition proved to be so toxic that Conseco soon took billions of dollars in writeoffs and then filed for bankruptcy protection. It was the third largest bankruptcy in US history to that time. In reflecting on the acquisition, one Conseco executive told us that it was like the many acquisitions that Conseco had done except for one notable exception. It was a business that they didn’t really understand. They weren’t able to assess the dangers that came with the acquisition, or deal with them later.

Fast forward to Bank of America’s acquisition of Merrill Lynch. B of A certainly has a strong track record in acquiring other banks and the deal gives it a long-coveted brokerage business. But Merrill Lynch is a business unlike B of A’s previous acquisitions. Questions remain about whether B of A management really understands the problems that it has bought, and how to deal with the continual deterioration due to those problems. (See this post for a longer discussion.) A better model might that of Barclay’s, which walked away from Lehman in the absence of a government guarantee and reemerged to buy part of the Lehman after the bankruptcy. Sure, in waiting until after bankruptcy, Barclay’s lost talent and customers. But it also avoided immense downside.

An even better lesson comes from the disk-drive industry. In 1995 Seagate, the industry leader bought the number three player, Maxtor, for $1.9 billion. It was a pure consolidation play. Seagate kept Maxtor’s brand but almost none of its technology or employees; Seagate moved all manufacturing into its plants. Seagate reckons the takeover a success. While it lost half of Maxtor’s market share, the market share that it kept, combined with the higher pricing for the industry as a whole, left Seagate better off than before the merger. But how much better to be Western Digital, the number two disk-drive maker? It picked up most of the Maxtor market share that Seagate lost. It benefited from the stronger pricing. And it didn’t have to pay $1.9 billion or take on the integration risk for the privilege. In the current environment, there are definitely some advantages to waiting.

Perhaps the most appropriate lesson comes from the ancient Persians. Herodotus, the Greek historian, reported that the ancient Persians always made important decisions twice—first when they were drunk, and then again when they were sober. Only if the Persians reached the same decision, drunk and sober, would they act on that decision. The approach apparently worked—the Persians dominated the much of the Middle East and Central Asia for three centuries.

Our two years of research into major business failures finds that companies could benefit widely from being more like the ancient Persians. Managers scrambling to react to the current crisis, while not drunken, are certainly in a state that psychiatrists call “hot.” “Hot” because, while business is generally thought of as highly rational, there is a lot of emotion involved—especially right now. People feel an urgency to act, so they may gloss over potential problems with major strategy choices. People get intimated by the stakes or by pressure from peers and bosses to proceed with a strategy, based on the idea that “we have to do something.” People may be afraid to voice objections, lest they seem ill-informed. In the current environment, executives won’t need to go drinking to revisit their decisions. They will need a cold, dispassionate environment that will let them reconsider their options carefully.

While it’s obviously too early to know just how the Merrill purchase will play out, Bank of America may be making one of the classic mistakes that can occur in a consolidating industry. B of A may be focusing so much on the positive attributes of Merrill, which B of A has long coveted, that it may be glossing over the problems. B of A loves the idea of increasing its size and adding Merrill’s huge retail brokerage operation and investment banking unit. Meanwhile, Merrill’s investment portfolio, which includes heavy doses of mortgage-related securities whose value has declined by $45 billion, may well continue to spiral downward.

B of A may also be overpaying. There’s little doubt that Merrill would have cost B of A far less a week from now than it did when the deal was negotiated over the weekend.

In addition, B of A may be making a common mistake associated with synergy strategies. The company seems to assume that there will be benefits from combining different types of financial services—that B of A’s banking operations will somehow benefit from, and benefit, Merrill’s brokerage and investment banking units. But that financial supermarket strategy has been widely discredited. Citigroup, the biggest proponent of supermarket-like synergies, is now under pressure to spin off some operations to streamline its structure.

There likely also will be a hangover from the mistakes Merrill made when it embarked on an adjacency strategy. Merrill seems to have had a bad case of Goldman Sachs envy or hedge-fund envy, watching how Goldman and the funds earned billions of dollars by investing in high-risk securities. Merrill looked at its thousands of brokers and its huge investment-banking operations and decided it had the expertise to move into the market for managing risk. But Merrill overestimated its strengths and underestimated the complexities of the new market. It turns out that managing risk is a highly specialized endeavor, requiring a certain type of person, a particular structure and seasoning that comes only after years of institutional experience with the market. Merrill was totally unprepared—and B of A has no more experience with managing risk than Merrill did.

Now, the tone in the market may turn to the positive, if regulators manage to bolster AIG and Washington Mutual. B of A may turn out to have engineered a bargain by acting decisively in the middle of a crisis. In addition, B of A has extensive experience with acquiring other businesses and integrating them into B of A’s core business, experience that mitigates some of the risk that normally comes with a big purchase.

But B of A has already tried once to call the bottom in the subprime mess, when it bought Countrywide Financial two months ago for $4 billion. As of the moment, that purchase looks rash—and it had a better strategic rationale than the Merrill takeover, given that Countrywide fit nicely with B of A’s existing mortgage operations. We’re afraid that the Merrill purchase may turn out worse.

The most interesting claim in the book is that acquisitions aren’t nearly as bad an idea as conventional wisdom suggests. Bruner acknowledges all the research showing that two-thirds of purchases reduce the market value of the acquirer, research that is usually treated as definitive. But he says the research is too narrow. He says researchers focus on purchases of publicly traded companies and ignore acquisitions of privately held businesses, deals that have a far greater success rate. When you look at public and private companies together, he says, “investments through acquisitions pay about as well as other forms of corporate investment. The mass of research suggests that, on average, buyers earn a reasonable return relative to their risks. M&A is no money pump. But neither is it a loser’s game.”

Bruner also argues that the focus on the failure rate lumps all companies together and fails to explore the more interesting question: What deals are likely to work, and which are likely to fail? He says:

–“In the best deals, buyers acquire targets in industrially related areas. In the worst deals, targets are in areas that are more distant.”
–“In successful deals, buyers acquire from strength—the performance attributes of buyers are stronger than their targets, suggesting that in good deals the buyer brings something important to the success of Newco.”
–“The worst deals have a propensity to occur in ‘hot’ market conditions,” such as the Internet bubble.
–“Better deals are associated with payment by cash and earnout schemes and the use of specialized deal terms. The worst deals are associated with payment by stock.”

To turn parochial for a moment, we’ll single out one final point, because it underscores the potentially enormous value of our efforts to help executives see that a strategy is misguided and to assist them in heading it off before it can be implemented. Bruner’s point is that mergers and acquisitions have acquired such a bad name partly because a small number of deals fail so spectacularly that they drag down the average results for M&A. He cites a study of 12,023 deals, in which the majority of losses were concentrated in just 87. He says the 87 occurred primarily in the hot M&A market of 1998-2001. So, he says, if businesses can avoid getting carried along by hot markets—the whole focus of our Devil’s Advocate process— and can eliminate even a modest number of the really bad deals like AOL-Time Warner, then “one reaches a very different conclusion about the profitability of M&A.”

As often happens in acquisitions that count on synergies, Riverdeep seems to have overpaid‚ deeply, if you will. The company will likely find itself in over its head, up the river without a paddle, or. . . you get the idea.

Riverdeep’s chief executive‚ who has built an equity stake over the past seven years that he values at as much as $2 billion, while putting up little or none of his own money‚ also seems to be engaging in some dangerously aggressive financial engineering.

Riverdeep is paying $3.4 billion for Houghton Mifflin. That is more than 2.5 times Houghton Mifflin’s annual revenue, even though revenue grew just 5.2% in 2005 and even though the business is unprofitable‚ Houghton Mifflin had a loss from continuing operations of $56.3 million in 2005 and $67.2 million in 2004.

To look at the numbers another way: Riverdeep is paying almost three times what private-equity funds paid for Houghton Mifflin just four years ago (after adjusting the 2002 price to account for the $435 million of dividends the funds paid themselves in the intervening years). It’s true that the stock market has risen since the funds bought Houghton Mifflin‚ but by a third, as measured by the Dow Jones Industrial Average, not by 200%. It’s also true that private-equity firms sometimes make wrenching changes in businesses and improve their fortunes drastically, but, if that happened in this case, the firms never told anyone about it. A record of Houghton Mifflin press releases shows the appointment of a new chief executive and a few other management changes since the takeover, but offers nothing about any broad restructuring of the business. In the meantime, textbook makers have come under pressure because students and school systems have complained about rising prices.

How can a $3.4 billion purchase price possibly be justified?

Riverdeep sees synergies. Although it isn’t terribly specific, the idea seems to be that educational software and textbooks will merge, creating a new sort of entity that schools and students will love and will buy from the pioneer in the field: Riverdeep. In the meantime, Riverdeep expects to benefit from Houghton Mifflin’s sales force and its relationships with school systems. Riverdeep also says it can save money by moving profits from the U.S. to Ireland, where corporate taxes are lower.

The sales force may, in fact, help some, but the U.S. takes a dim view of companies that artificially move profits offshore, so it can be expected to limit any tax savings. More importantly, history is fraught with examples of media that were clearly destined to merge but that took their good old time about it. If you go back far enough, you see that early television broadcasts were really just video versions of radio shows. It took many, many years for television shows to develop into their own form. (Decide for yourself whether the result is a good thing or a bad thing.) In the 1990s, makers of videogames were disappointed to find that they couldn’t just sell their existing products to the large audience of personal-computer users. Game companies had to develop products that took particular advantage of PCs, such as the fact that they are just about all connected to each other over the Internet. Some companies have recently had huge successes with massively multi-player games, which let tens of thousands or even hundreds of thousands of people immerse themselves in fantasy online worlds that players help create, but the successes came much more slowly and at much greater cost than anticipated. Today, media companies are finding that they won’t generate a huge audience by simply taking existing movies and television shows and making them available on cellphone screens. Companies are starting to experiment with shows designed specifically for cellphone users.

A saying has developed in Silicon Valley: “People often confuse a clear view with a short distance.” And that’s exactly what Riverdeep seems to be doing. Just because textbooks and software can enhance each other doesn’t mean they’ll do so broadly enough and soon enough to justify anything like a $3.4 billion takeover of Houghton Mifflin.

Usually, one major strategic mistake is enough to doom a takeover, but the Riverdeep deal with Houghton Mifflin seems to make a second, as well‚ relying on the sort of financial smoke and mirrors that we call “taking a shortcut through the numbers.”

To understand what’s going on, it helps to look at Riverdeep’s history and that of its CEO, Barry O’Callaghan. The company was founded in 1995 by an entrepreneur who saw potential in the market for educational software. In 1999, he brought in O’Callaghan, who was a 31-year-old investment banker at the time. O’Callaghan declared that Riverdeep would put its software online, not just on CDs, and was really an Internet company. By March 2000, O’Callaghan had marshaled an initial public offering and raised $150 million. The company had only $8 million in annual sales and was losing lots of money, according to Irish newspapers, but, in the best traditions of the Internet bubble, Riverdeep briefly carried a market capitalization of $2 billion. As it happens, Riverdeep went public on the very day that the Nasdaq index peaked, and it was just about all downhill from there. But, before too much market cap melted away, the nimble O’Callaghan managed to use his stock to buy seven companies, including the respected and profitable educational-software makers Edmark, The Learning Company, and Broderbund.

By 2002, the stock had fallen so far and so many questions were being raised about Riverdeep’s business that O’Callaghan lined up a small group that offered to buy the company for $373 million. Investors complained bitterly because the price per share that he offered was more than a third lower than the price Riverdeep set when it sold stock shortly beforehand, but investors were nervous enough that they sold. O’Callaghan wound up with almost a third of the equity. He borrowed money to buy his share, then set up a new capital structure for the company, which involved borrowing money and declaring a special dividend. The dividend let O’Callaghan repay his personal loan, essentially transferring his personal debt obligation into a corporate obligation.

O’Callaghan and the entrepreneur who founded Riverdeep bought out their partners, then, early this year, O’Callaghan bought out the founder. O’Callaghan paid $120 million for the founder’s 32% stake, meaning the total valuation of Riverdeep was still about $375 million. O’Callaghan’s 65% was thus valued at $244 million.

Flash forward to the current deal.

After announcing that Riverdeep would buy Houghton Mifflin, O’Callaghan said that deal would be accomplished by setting up a new company that would actually buy both Riverdeep and Houghton Mifflin. The new company, to be called Houghton Mifflin Riverdeep Group, will again have a new capital structure, which we assume will let O’Callaghan get out from under any debt he borrowed to buy out the founder, by turning that debt into some sort of loan to the company.

Here’s the screwy part: The formation of the new company assigns Riverdeep a value of $1.2 billion, more than 3.5 times the value that O’Callaghan and the founder agreed to less than a year earlier. Riverdeep also says that management will own 50% of the new company, which is claiming a value of $5 billion. No one is saying just what stake O’Callaghan will personally hold, but he’ll be the CEO, he already owns 65% of Riverdeep, and he’s been aggressive about looking after his own interests, so it seems fair to say he’ll wind up with $1.5 billion to $2 billion of the value that is being set aside for management. In other words, if our guess is right, O’Callaghan will have increased his personal equity by a factor of six to eight in less than a year, while ending up with little or no personal debt.

The calculations assume, of course, that we accept O’Callaghan’s valuations at face value. Should we?

Whle Riverdeep doesn’t have to disclose numbers because it’s private, Irish newspapers report that Riverdeep had revenue of $330 million in the 12 months ended June 30. That means Riverdeep is assigning itself a valuation that is almost four times revenue‚ a steep valuation in any market that isn’t enjoying exceptional growth. The newspapers also report that Riverdeep earned $82 million in those same 12 months, which could easily justify a $1.2 billion valuation, or even higher, except that those earnings are EBITDA or, earnings before interest, taxes, depreciation, and amortization. While Riverdeep apparently wasn’t any more specific about net income, the newspapers said that for 2004, the company’s last year as a public entity, Riverdeep reported interest expense of $85 million and amortization costs of $67 million. Riverdeep remains heavily leveraged, so it seems likely that the company is losing money on a net basis, perhaps even quite a bit of money. In any case, earnings don’t seem to make the case for a valuation anywhere close to $1.2 billion.

As a result, it doesn’t seem possible that Riverdeep and Houghton Mifflin together would merit a valuation even approaching the claimed $5 billion.

Now, companies can sometimes push the envelope in their valuations of their businesses and yet grow their way out of any problems before they become apparent. Amazon comes to mind. Amazon used some accounting tricks to obfuscate certain costs early on, yet grew so rapidly that it could in a matter of years begin using more generally accepted accounting principles without losing too much of its stock-market following. But there are also plenty of companies that start down the path of financial engineering and find themselves so loaded with debt and with a structure so complicated that they can never straighten themselves out. Warnaco, for instance, cobbled together a series of brands‚ such as Calvin Klein and Speedo‚ through an involved series of transactions, then found itself so indebted that it had to file for bankruptcy protection in 2001. Holders of $2.5 billion of debt had to sit down with Warnaco and negotiate how much they would get back on each dollar.

So far, the new Houghton Mifflin Riverdeep Group is looking a lot more like Warnaco than like Amazon. The company is private, so it can assign itself any value it wants, for the moment. But the company now has to make the rounds of lenders and other potential investors to see if they’ll buy the numbers that O’Callaghan is selling. Our advice: If someone comes knocking on your door, hold onto your hats, your wallets, and anything else that matters to you.

A recent big example is Oshkosh Truck’s announcement in October that it would buy JLG Industries Inc. for $3 billion. The companies said they see a strategic fit, but look at their businesses. Oshkosh makes fire, military, concrete and garbage trucks. JLG makes equipment that lifts people and heavy materials several stories into the air. What do those businesses have in common?

The one example the companies cite is that Oshkosh’s fire trucks with ladders might be able to use JLG technology to lift firemen into the air faster and more safely. It’s hard to imagine that there are major improvements to be made there. We’re all for keeping firemen safe, but our bet is that the equipment already works quickly and safely. In any case, no other Oshkosh equipment needs to lift anything several stories into the air, so JLG’s core technology can’t help beyond the one type of fire truck. It’s possible the two companies can share some technology for transmissions, axles, etc., but that’s hardly enough to justify a major deal.

Oshkosh seems to be falling victim to one of the most common mistakes that can doom synergy strategies: Oshkosh is seeing synergies that don’t exist in the minds of customers. Japanese consumer electronics companies made this mistake in the late ‘80s and early ‘90s, when they decided that they would buy movie studios. The companies seized on a computer-industry analogy and decided they wanted to own “software” to run on their “hardware.” The analogy misunderstood the computer industry; while hardware and software are certainly both necessary, almost no company is a success in both parts of the industry. More importantly, the consumer electronics companies kidded themselves about how customers think. Sony, for instance, wasn’t going to be able to convince a customer to go to a movie made by Sony just because she owned a Sony TV. Nor would a customer rent a Sony video just because he owned a Sony VCR. Meanwhile, because Sony’s “hardware” people didn’t understand the peculiarities of movie business “software,” they lost their shirts. Sony bought Columbia Pictures in 1989 for $3.4 billion. In 1994, Sony took a $2.7 billion writeoff on the purchase and reported a $510 million operating loss at Columbia, meaning the value of its investment had almost entirely disappeared. 

Oshkosh also seems to be making another common mistake, overestimating the value of scale. Oshkosh said the purchase will mean that the combined companies will now buy roughly $1 billion of steel a year. That is surely a big increase for Oshkosh, but the figure means Oshkosh-JLG will account for less than half of one percent of the world’s steel consumption. How much pricing power does that give Oshkosh?

Without synergies or economies of scale to justify the acquisition, Oshkosh is basically just betting that JLG is worth more than shareholders thought it was–quite a bit more, in fact; Oshkosh agreed to pay 40% more than the price of JLG stock on the date the purchase was announced. Maybe that’s a good bet. But maybe it isn’t.

Oshkosh notes that JLG will be its 15th acquisition since 1996, and companies that make frequent acquisitions can sometimes get to be good at them. What Oshkosh doesn’t note is that its acquisitive decade began right after the company made a series of divestitures to clean up problems that followed a prior string of purchases. In addition, JLG is far larger than any prior purchase by Oshkosh, so the fact that others have worked out doesn’t necessarily say much about the prospects for the JLG deal. 

Sounds to us like Oshkosh may be headed for a crackup.

We still believe Disney-Pixar has the potential to be a horror film.
Disney made two of the three mistakes that can cause serious problems
when companies look for synergies. Those mistakes should manifest
themselves over the next year or two.

The first mistake is overpaying. This shows up all the time, apparently because companies that see synergies are willing to pay even more than they would be if they just thought they were buying a stand-alone business. Quaker Oats made this mistake when it bought Snapple for $1.7 billion in 1994. Some analysts said at the time that the price was $1 billion too high, but Quaker convinced itself that its distribution system for Gatorade would make Snapple available more widely and increase sales sharply. Didn’t happen. Quaker sold Snapple 27 months after buying it, for just $300 million.

Disney paid $8.24 billion, or about 60 times the earnings that Pixar was expected to generate in 2006. That ratio is about three times the price-earnings ratio for the average company. (The disparity in P-E ratios isn’t quite as large as it appears. For one thing, Pixar had about $1 billion in cash, reducing the effective price of the deal. For another, Pixar’s profits in 2007 and beyond stood to get a boost because a distribution deal with Disney was to expire this year. Pixar signed the deal when it was an unknown and had little bargaining power. Whatever new distribution deal it reached would have let Pixar keep a much higher share of the profit from distribution. Still, even after you adjust the value of the deal, it’s clear that Disney paid an enormous premium over the normal P-E ratio.)

For Disney to justify the premium, it needs, first of all, to have Pixar keep churning out an uninterrupted string of hits. But nobody does that. (That’s why many analysts said Pixar stock was overvalued before Disney came along and decided to pay an even higher price.) Disney, itself, once seemed to be on an untouchable winning streak, when it came out with The Little Mermaid in 1989 and followed that with Beauty and the Beast, Aladdin, The Lion King, etc. But competition developed, from Dreamworks and others, and Disney ran out of fresh ideas. In recent years, Disney has been releasing duds such as Atlantis and Treasure Planet. The same will likely happen to Pixar. The reports that there are a dozen computer-animated films set to come out by next summer show that Pixar will have plenty of competition, and the reaction to Cars, released this summer, suggests that Pixar’s winning streak could be ending. The film did well at the box office, based on the goodwill that Pixar generated with earlier films, but reviews were mediocre to negative. Another film or two like that, and Pixar films will no longer be must-sees. Treasure Planet, anyone?

Even a continued string of hits wouldn’t justify the price. Is a hit movie every year to year and a half really worth $8.24 billion? Disney also needs to have Pixar contribute in other ways. This is where Disney made its second mistake.

That second mistake—again a common one among those pursuing synergy strategies—was to assume that the two companies will mesh nicely when there is reason to believe they won’t. IBM, for instance, made this mistake in the 1980s even though all those involved desperately wanted to mesh nicely. IBM had made the personal-computer market explode with the introduction of its PC in 1981, creating an environment where start-ups such as Lotus were thriving. Yet IBM was nowhere in terms of a PC software business of its own. IBM decided on a synergy strategy. It bought pieces of numerous small software companies, then announced that it would sell the products through the IBM salesforce. The idea was that the companies’ stock would get a big boost from the IBM relationship, so IBM would immediately generate a large profit, at least on paper. Meanwhile, the entrepreneurial spirit from these smaller companies would transfer to IBM and let it finally get its own PC software business going. Instead, IBM smothered the small companies. IBM ran scores of sales people through the companies for training, meaning that these small outfits had to just about stop everything they were doing so they could deal with all the love IBM was pouring out on them. The companies soon began performing so badly that IBM’s $100 million-plus of investments were rendered almost worthless. For good measure, the entrepreneurial spirit didn’t transfer to IBM. It eventually took some $2 billion of losses on PC software before giving up on the business.

In buying Pixar, Disney is assuming that Pixar will be able to help make Disney’s animated films more successful. But if Pixar could generate two good ideas every year or so, instead of one, it would already have been making more films. And Disney’s animators are unlikely to want help from the upstarts at Pixar. Disney invented animated films and has a wonderfully rich tradition of such films, so Disney’s animators likely feel they can find their own way out of their recent slump. Just wait a bit, and you’ll start seeing stories about the culture clash between Disney and Pixar. Disney is also assuming that introducing Pixar’s characters to its theme parks will be a major attraction, which hardly seems likely. (Disney made a similar claim when it bought Cap Cities/ABC in 1996 for $19 billion, and ABC characters did nothing to enliven the theme parks.)

As often happens in failed synergy plans, the Disney-Pixar deal seems to have been driven more by emotion than economics. In this case, there’s a double dose of emotion. Disney had been beaten up about its animated-film failings and its inability to sign a new distribution deal with Pixar, so the company was desperate to find some way to take the heat off. In addition, Bob Iger, who became chief executive early this year, needed to deflect criticism that he was merely a puppet of his predecessor, Michael Eisner. For instance, an article in Fortune said in the headline that Iger was “unproven as a strategist” and in the text that “little in his past inspires confidence.” After saying the board interviewed only two candidates, Iger and eBay CEO Meg Whitman, Fortune quoted a former Disney director as saying, “Meg Whitman created one of the great companies in the world out of thin air. What has Bob done?” Good question. What better way to answer it than with a bold deal that let Iger articulate a new vision for the company?

If only the deal were a good one.