Any company attempting an acquisition in the forestry products sector risks launching its share price into a free fall, or so it would seem from stock market reactions to recent bids. When UPM-Kymmene (Finland) announced a bid for Champion International (United States) in February 2000, for example, the share price of the would-be acquirer fell by more than 8 percent within a day and its market capitalization fell by $1.2 billion within a week—enough to permit International Paper to challenge the deal. The bids of Stora Enso (Finland) for Consolidated Papers (United States) and of Abitibi-Consolidated (Canada) for Donohue (Canada) met with similar responses (Exhibit 1). Nonetheless, equity analysts and investment bankers continue to recommend consolidation and companies continue to plan acquisitions.

Now, however, the leaders of forestry products companies must rethink their approach to consolidation. Merged companies that use innovative approaches to transform themselves will still be able to unlock substantial value. But companies without such skills might find that the best way to create shareholder value is not to buy assets but to sell them: the take-the-money-and-run approach. And all companies in the industry, whether they buy or sell, must be aware of the predatory moves of new entrants, such as private equity firms, that are attracted by the sector’s latent potential for creating value.

Consolidation is sound in theory . . .

Many corporate combinations do make sense. Companies usually justify them with four arguments:

1. Synergies yield value. Combining head office activities or sales forces, for example, can create substantial and immediate benefits.
2. Big companies have greater control over their own destiny. They can invest in more new ventures because they amortize development over a larger cost base. In addition, the higher equity value of a big company can protect it from unwelcome bids.
3. A smaller number of players can mean more stable prices. The fewer decision makers an industry segment may have, and the more revenue each of them has at risk from price movements, the less likely it is that any of them will invest in new capacity that would bring down prices in the segment as a whole.
4. There is more demand for the shares of big companies. A major acquisition attracts attention, setting in train a virtuous cycle: more coverage by analysts, more awareness among investors, and more demand for that company’s shares—which would be particularly welcome in a thinly traded sector. As a result, the cost of capital of a company may fall, permitting it to use more of its own shares to pay for future acquisitions.

When the forestry products sector found itself in a downward spiral of value destruction in the mid-1990s, arguments such as these persuaded its decision makers that consolidation was the way forward. Capital spending had failed to pay its way, and the overcapacity caused by aggressive expansion had eroded price levels and increased price volatility. Management teams, under pressure from institutional fund managers in the United States and Europe to improve the performance of their companies, thought consolidation would help them curb unsustainable capital spending, save costs, and stabilize prices. Analysts and investment bankers supported this view, believing that mergers would unlock hidden value in struggling companies, raise their profile, and increase trading in their shares.

A string of high-profile deals duly followed. In 1996, International Paper (United States) acquired Federal Paper Board (United States); SCA (Sweden) bought PWA (Germany); and Kimberly-Clark (United States) combined with Scott Paper (United States). Deal fever took hold, and neutrality wasn’t an option: industry executives had either to buy or to sell. The scramble for assets persuaded normally conservative directors to accept huge acquisitions. Fears of hostile takeovers prompted several "mergers between equals" in which management teams aimed to achieve unassailable scale and to preserve regional independence—all on the companies’ own terms. The trend accelerated. During the first quarter of 2000, transactions worth $14 billion were completed, as against $17.3 billion for the whole of 1999—itself a 20 percent increase over the annual average from 1992 to 1996.

. . . but tough in practice

To the consolidators, the arguments for these mergers seemed ironclad. Although the capital markets thought otherwise, investors can quickly change their minds once they are persuaded of the merits of a deal—as they were in the case of Abitibi-Consolidated, which almost regained its pre-announcement share price (Exhibit 2). But on the whole, investors do not believe that the benefits of combining two companies in this sector outweigh the costs. Investors have three concerns in particular.

1. Too much trapped value

Most of the plants in the forestry products business already operate at optimum economic scale

The problem for forestry products companies trying to make acquisitions succeed is that most plants already operate at optimum economic scale; few network benefits, and thus few additional savings, can be had by combining them. If a company pays, for example, a 40 percent premium to buy a company with a market capitalization of $5 billion, the acquirer will have to improve annual earnings by more than $300 million to get back to where it started. Even the elimination of an entire head office saves far less than is needed. Our analyses show that if two companies with directly overlapping products and markets merge, they can achieve savings on this scale—but little more. Most of the value to be created by the acquisition thus goes "in advance" to the shareholders of the target company. A quick comparison between the synergies announced in recent deals and their respective acquisition premiums shows the scale of the challenge (Exhibit 3).

Acquisitions abroad tend to offer even fewer synergies than do those closer to home, and the foreign acquirer must outbid local competitors. Such acquisitions represent an almost certain transfer of value from buyer to target.

2. Weaker strategic positions

Size alone doesn’t strengthen a company’s strategic position. Of course, the new entity could try to play the role of the industry’s capacity valve by reducing output to strengthen prices. Returns to the industry as a whole might then improve, but the real beneficiaries could be smaller companies that stubbornly produced flat out. More important, competitors that used to feel some degree of responsibility for pricing levels might decide that the arrival of a bigger company released them from this obligation.

3. Diseconomies of scale and eroding performance

Consolidators find economies of scale fiendishly difficult to realize; indeed, these companies may put so much energy into capturing synergies and maintaining current performance that none is left for making the merged business grow. Apart from the usual merger problems—culture clashes and the need to manage a larger, more complicated organization—levels of debt may rise to cover the deal’s cash component. The outcome, to the dismay of investors, is less freedom for management to put money into new ventures.

If these are the realities of consolidation, why do equity analysts persist in recommending it? Part of the answer is that many investors straddle both sides of a deal and stand to benefit from the premium paid for a target company—premiums that have ranged from 20 to 90 percent (Exhibit 4). In addition, the momentum of consolidation has actually boosted the fortunes of all companies in segments such as containerboard and publication papers. So despite the decline of the market value of buyers in recent months, financial advisers are not likely to turn against consolidation in the foreseeable future.

Buy or sell?

One conclusion to be drawn from the erosion of the acquirers’ shareholder value is that unless a board of directors has a highly sophisticated approach to acquisitions, it should aim to sell rather than buy. A smart seller would ramp up outgoing assets to top performance and then negotiate an acquisition premium that crystallized a large chunk of the value likely to result from synergies with the buyer’s assets. Fletcher Challenge (New Zealand) took this approach when it realized, under new management, that operational improvements were failing to create sufficient value. Another company, MacMillan Bloedel (Canada), restructured its asset portfolio and improved its operations substantially before Weyerhaeuser (United States) bought it. To pursue the sell strategy aggressively, a company—incumbent or new entrant—could assemble a portfolio of assets expressly for the purpose of making itself a more appealing target for acquisition. Small, diversified companies would be obvious targets: their unrelated assets could be unbundled and reaggregated with other holdings in a package large enough to attract buyers.

However, the low market-to-book ratio of the industry renders it open to any company that can capture value in unusual ways. By leveraging intangible assets such as distinctive skills, brands, and talent and by restructuring asset portfolios, a buyer can justify the premium it must pay. Can old-timers make this kind of deal, or will new entrants seize all of the best opportunities? Although pioneering approaches are available to incumbents and attackers alike, the focus of the attackers on growth, and their imaginative ways of achieving it, could give them an advantage. They will spread their risk by maintaining a full pipeline of opportunities to cover the low conversion rate of prospects into deals, and they will know which distinctive capability—deal structuring, risk management, or even operating excellence—to draw upon to extract value from each deal. Their goal will be to change the nature of the game in their segments, not to win through scale alone.

Papier Masson, a Canadian newsprint maker formed when a private company (partly financed by Enron) bought the newsprint assets of Nexfor, provides a prototype of what one class of attacker could look like. The new owners decapitalized the business by applying sophisticated hedging instruments to stabilize its cash flows, thus bringing its debt-to-equity ratio close to 4:1 and greatly increasing returns on equity. Another type of attacker is represented by the European private equity firm CVC Capital Partners, which has bought several fine-paper mills in Europe over the past two years and is now moving into pulp. In order to create value, CVC has combined its financial-restructuring skills with an intense performance discipline. For both Papier Masson and CVC, the amount of value extracted had nothing to do with scale.

Nonetheless, incumbents that adopt the ambitions and techniques of attackers may yet outperform them. Successful incumbents have huge advantages: a strong knowledge of the industry, established sales and marketing channels, and products to sell. New entrants must acquire (or do without) all of these things.

After the deal: Transformation tools

Making the right deals is only part one of a successful acquisition strategy. Going on to create value is perhaps the harder challenge, requiring the effective application of a range of tools.

Reinvigorating management

A well-designed integration plan will pitch improvement targets high to realize expected synergies

The combination of two companies sometimes provides an opportunity to boost performance far beyond past levels. With this in mind, a well-designed integration plan should pitch improvement targets high to realize expected synergies, and it should challenge every accepted practice in both companies. Integration provides a unique chance to refresh management teams, to break down dysfunctional legacy management structures, and to upgrade the quality of senior leaders. Improving a company’s leadership capacity (which often involves increasing the skills rather than the number of leaders) will help a company progress swiftly from integration to the development of new ventures.

Restructuring the portfolio

Companies that merge can focus their portfolios by divesting noncore businesses that might previously have been needed to maintain reasonable scale. Such companies can also profit from selling strategically stranded assets to their "natural" owners, who could manage them better: a specialist can operate power-generation and water-treatment facilities, for example, more efficiently than can a paper company.

The merged company should consider abandoning vertical integration as an organizing principle: it could find other owners for assets that produce inputs such as fiber or pulp, thereby releasing the capital shut away in those assets. Kimberly-Clark, when it bought Scott Paper, knew that most of its acquisition’s value lay in the tissue business—and above all in the brand—yet huge amounts of capital were locked up in pulp mills. Kimberly-Clark sold them.

Recent European asset swaps show that other incumbents too recognize the value of restructuring portfolios. In August 2000, Metsä-Serla (Finland) acquired the newly formed company Modo Paper (Sweden) from its Swedish joint owners, SCA and Holmen. In return, SCA received Metsä-Serla’s corrugated-packaging and tissue units. The deal lets Metsä-Serla focus on fine paper, SCA on hygiene and packaging products, and Holmen on newsprint, magazine paper, and paperboard.

Shaping competitors’ conduct

Concentrating forestry products assets among fewer owners is not going to change the industry’s pricing behavior all by itself

Raising revenues by raising prices is a natural source of value for any company, but concentrating assets among fewer owners will not of itself change pricing behavior. To improve the regional balance of supply and demand, newly expanded companies should withdraw excess capacity. They should also redefine contract structures to reinforce good behavior and discipline free riders.

Market dominance in microsegments can yield worthwhile returns. By purchasing MacMillan Bloedel and TrusJoist MacMillan (United States), for example, Weyerhaeuser has achieved a leading position in the production and distribution of engineered wood products in North America. This success should help the company maintain high margins on what might otherwise have become commodities.

Developing and exploiting intangible assets

In today’s integrated global economy, companies have new opportunities to exploit valuable intangible assets, such as distinctive skills, talent, intellectual property, brands, and business networks. Newly combined companies should nurture their unique stock of complementary intangible capital, which competitors can’t match. The electric power sector provides an example in the form of the generating company Calpine (United States), which since its launch five years ago has become a stock market favorite through a focus on originating, financing, and operating independent power plants. Calpine has been able to dominate this fast-growing niche in the power industry because of the company’s unique skills in these three areas.

Think like an attacker

If obvious synergies and increased scale do not deliver enough value to make a merger pay off, incumbents must ask themselves tough questions about what to do next. Should they sell the company to harness large acquisition premiums with little downside risk? Or do they have the desire and the courage to play the attackers’ game?

There is little doubt that attackers, already visible on the periphery, will capture the best unconventional growth opportunities unless incumbents themselves pursue unconventional approaches. Yet many incumbents may not feel ready to change their game: they like their old assets and don’t recognize that their traditional sales channels and contract terms, for example, make them inflexible. But the stock market’s suspicion of companies that announce old-style megamergers or fail to consolidate at all may force such incumbents to change their minds. Those eager to think and act like attackers will have an important advantage over competitors chasing scale alone—indeed, even over the attackers.