Wharton SrLeadership2

8/9/2019 Wharton SrLeadership2

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STRATEGIC MANAGEMENT

VOL. 2

http://executiveeducation.wharton.upenn.edu http://knowledge.wharton.upenn.edu

WhARTONON

Senior Leadership


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WhartononSeniorLeadership Strategic Management, Vol.

When it comes to strategy, should companies focus on increasing market

share, improving shareholder value, diversification, or some other goal? And howshould the strategy be executed? Mergers and acquisitions are one option, but

they are fraught with risks that could outweigh the rewards. Even when they

pursue the latest strategy buzzwordinnovationfirms often fail to sustain

growth by finding the right balance between smaller, incremental improvements

and more rewarding, but riskier, major initiatives. In the following articles,

Wharton faculty and other experts offer their perspectives on managing strategy

in a global business environment.

Strategic Management


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Sustaining Corporate Growth Requires BIG I and small i Innovation 4

All companies, from major multinationals to startups, face a common challenge: how to keep growing.These firms find it difficult to sustain growth because they become risk averse, opting for safer incrementalproduct and service improvements instead of more rewarding, but riskier, major initiatives, according to astudy by Wharton Marketing Professor George S. Day. Companies, Day says, need to better understandthe risks inherent in different levels of innovation and achieve a balance between BIG I innovation andsmall i innovation.

Michael Porter Asks and Answers: Why Do Good Managers Set Bad Strategies? 8

Errors in corporate strategy are often self inflicted, and a singular focus on shareholder value is theBermuda Triangle of strategy, according to Michael E. Porter, director of Harvards Institute for Strategy andCompetitiveness. Porter, who recently spoke at Wharton as part of the Schools SEI Center Distinguished

Lecture Series, challenged managers to stop trying to be the best company in their industry and insteaddeliver a unique value to their customers.

Forging a Steel Giant: Mittals Bid for Arcelor 11

Alarm bells sounded in the global steel market on Friday, January 27, 2006, when Mittal Steel, the worldslargest manufacturer of steel, launched a whopper of an offer in that highly fragmented sectora hostile bidfor Arcelor, the European consortium that is its biggest competitor. A combined enterprise would have totalrevenues of $69 billion and a market share of about 10 percent. Lakshmi Mittal, owner of the Indian steelmaker, has forged his empire with his check book, but there was more at stake this time: Arcelors board ofdirectors said they would reject the offer because there would be no sharing of the corporate culture, and itwould put jobs and the productivity of its factories at risk.

Indian Companies Are on an Acquisition Spree: Their Target? U.S. Firms 14

Reliance Gateway Net, VSNL, Scandent, and GHCL arent exactly household names in the U.S., but they maybe signs of bigger things to come. These are only a few of the growing number of Indian businesses thathave acquired U.S. firms in the past few years. And the U.S. merger-and-acquisition activity is just part of abigger picture. Indian companiesusually quietly, but sometimes with media fanfarehave been on a buyingspree in continental Europe, Great Britain, and Asia in attempts to become key players in global markets.

Scrambling for Control of Hutch Essarand a Piece of Indias Mobile Phone Market 18

Its hard to say where valuation math ends and acquisitive ego begins with the current high bidding levels forcontrol of Hutch Essar, Indias second largest mobile phone services provider. In early 2007, active bidders

included Vodafone, Anil Ambanis Reliance Communications, and the Hinduja Group. Verizon Wireless of theU.S. is also said to be kicking the tires of a potential deal. In just 1 month, Hutch Essars valuation has doubledto $20 billion. India Knowledge@Wharton interviewed faculty members at Wharton and the Indian School ofBusiness and other experts for a closer look at the road ahead for Hutch Essars suitors.

Contents

007UniversityofPennsylvania WhartonExecutiveEducation Knowledge@Wharton


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all companies, from major multinationalsto startups, face a common challenge: how

to grow their businesses so they can boostearnings and enhance the value of their shares.Far too often, however, firms find it difficultto sustain growth because they become riskaverse and, as a result, opt for incrementalproduct and service improvements insteadof major initiatives, according to a study by aWharton marketing professor.

Professor George S. Day, who also servesas co-director of Whartons Mack Center forTechnological Innovation, says companies can

avoid lackluster growth by better understandingthe risks inherent in different levels of innovationand achieving a balance betweenusing twoterms he has coinedBIG I innovation and smalli innovation. In his study, Day discusses howexecutives can properly assess risks and thenseek creative ways to reduce risk exposure.

Day, a consultant to many Fortune 500companies, says his research is the outgrowthof years of thinking about the problems thatcompanies face in trying to set and achievegrowth targets. Growthparticularly organic

growth that comes from improving a companysperformance from within rather than relying onacquisitionsis so important that it is at the topof the agendas of some 80 percent of U.S. chiefexecutive officers, according to Day.

These executives know that the expectation ofsuperior organic growth is the most importantdriver of enterprise value in capital markets,Day writes in the paper entitled Closingthe Growth Gap: Balancing BIG I and small iInnovation. It is also a less expensive way to

grow because a firm typically pays a premiumto acquire another business. Yet studies haveshown that only 29 percent of managers ofmajor corporations are highly confident they canreach their organic growth targets.

A combination of factors can make organicgrowth hard to sustain. For one thing, firmsoften find themselves in saturated, price-competitive marketspressured by customers

who themselves are squeezedand are forcedto compete for incremental share gains with

rivals who follow similar strategies. One answerto this challenge is to explore new blue oceanmarkets with new business models and offera better customer experience. While this is anappealing growth path, the returns may notcompensate for the higher risk and long delaybefore any returns are realized. This approachalso does not account for the consistent growthrecords of Wal-Mart, Dell, and IKEA, which havebeen methodically leveraging their low-costbusiness models in closely adjacent markets.

In other cases, disappointing growth can stemfrom organizational impediments (such asshort-term incentives that subvert long-termobjectives), risk-averse cultures, and inferiorinnovation capabilities. Day says 80 percent ofCFOs of major corporations would reportedlyhold back on discretionary spending designedto fuel growth if they were likely to miss theirquarterly earnings target.

The combined effect of these external andinternal impediments to growth is thatincremental small i innovation displaces BIG Iinnovation growth initiatives. Small i projectsmake up 85 percent to 90 percent of theaverage corporate development portfolio.These projects are necessary for continuous

improvement but do not change the competitivebalance or contribute much to profitability. Bycontrast, 14 percent of a sample of businesslaunches that were substantial innovationsaccounted for 61 percent of profits, accordingto a study cited in Days paper.

This bias toward safer, incremental lineextensions and product improvements seems

Sustaining Corporate Growth Requires BIG I

and small i Innovation

Firms often find themselves in

saturated, price-competitive markets

and are forced to compete forincremental share gains with rivals

who follow similar strategies.


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to be intensifying. Between 1990 and 2004,the proportion of new-to-the-world, trueinnovations in development portfolios droppedfrom 20 percent to 11.5 percent, Day writes.Even the less ambitious development of productsnew to the company dropped by a third.

Crippling Consequences

There are any number of reasons whycompanies are placing a growing emphasison small i innovations. Long-established,incumbent firms may suffer from tunnel vision;that is, they miss early signals of marketopportunities that offer openings for rivals. Forinstance, by the time of its initial public offeringin 2004, Google was already a formidable rivalof Microsoft, Amazon, and Yahoo. Why didntthey see the same opportunity sooner?

In other cases, firms may opt for exploitationactivities over exploration activities. There is

a well-known organizational tradeoff betweenactivities that exploit existing capabilitiesand those that explore new market spacesand create breakthrough innovations thatstretch capabilities, Day writes. This uneasytradeoff is tilted toward exploitation by processmanagement methods that emphasize thereduction of variance in organization processes.When the mindset and methods of businessprocess reengineering, Six Sigma and ISO9000, are applied to innovation processes, theytend to displace the inherently divergent and

variance-increasing activities needed for creativeexploration. Slowlyand perhaps imperceptiblythe choices of research projects to select andproducts to develop are steered toward theincremental and more certain opportunities.

At other times, companies may succumb toshort-term thinking. Most financial yardsticksused to choose which development projects tofund are biased against the lengthy payoffs anduncertainty of BIG I innovations.

Finally, longer-term investments in innovation

may decrease when companies use up scarcedevelopment time and resources to react tourgent, short-term requests from customersand salespeople. These requests stem fromfragmenting markets, demanding channelpartners and new forms of competition thatrequire a proliferation of product offeringsand accelerated development cycles, Daywrites. Meanwhile, R&D budgets are being

held constant or tightened to meet short-termearnings targets. This leaves firms with moreprojects than they can handle, and pressingsmall i projects get priority.

Companies that avoid BIG I initiatives alsobelieve that the potential rewards will bereceived too far in the future at too high a risk.But this risk aversion imposes costs that needto be understood and contained. For example,while the actual rewards may be realized farin the future, the equity markets accountfor them in their expectations of earnings. Ifthe firm is viewed as mired in slow-growthmarkets, vulnerable to emerging technologies,and lacking a compelling story about its futuregrowth thrust, its stock price will suffer.

Indeed, risk aversion may have even morecrippling consequences. Certainly theprobability of failure goes up sharply when thebusiness ventures beyond incremental initiativesin familiar markets, according to Day. Butthis should not be an excuse for passivity. Itshealthier to properly assess the risks and thenseek creative ways to reduce the risk exposure.

McDonalds vs. GE

In his paper, Day includes a risk matrixdiagram that can help firms assess theprobability of failure of different growth pathsand calibrate the risks of unfamiliar markets andtechnologies. In essence, the matrix shows thatit is far less risky for a business to launch a newproduct or technology into a familiar servedmarket than to adapt the current product to anew end-use market.

Market risks are much greater than productrisks because there are more dimensions ofuncertainty, including competitors, channels,and consumers, writes Day. If the market isentirely unfamiliar, the firm doesnt even knowwhat it doesnt knowand the knowledgeis hard to acquire. Market risks are not onlyless controllable than technology risks, theytend to be confronted much later in the

Most financial yardsticks used to

choose which development projects

to fund are biased against the

lengthy payoffs and uncertainty ofBIG I innovations.


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product development process and are harderto resolve. A further complication is that anexisting brand name has no meaning in anew-to-the-company market. It is not simplya lack of awareness. Because the prospectivebuyers lack any experience, they view the newentrant as risky and have to be given specialinducements to try the new product.

For example, McDonalds abortive effort to offerpizza in its restaurants was initially viewed asa related product for the current market. Butpizza was actually a new-to-the-companyproduct because it didnt fit the basic servicedelivery model. No one could figure outhow to serve a pizza in 30 seconds or less,according to Day. This meant that service flowrates were disrupted, and pizzas couldnt beserved through the drive-in window. The post-mortem of the failure revealed that the brandname didnt give them permission to offer pizza.They lacked credibility.

Day says GE is an example of a firm that hasstruck the right balance in working to achieveorganic growth by growing on a number offronts. After he replaced Jack Welch, CEO JeffImmelt boosted the organic growth goal from 5percent to 8 percent per year, which translatesinto finding an additional $3.4 billion in organicgrowth annually. Many moves were made withinGE to encourage fresh thinking. These rangedfrom diversifying the top ranks with outsiders,in a break from the companys promote-from-

within history, to keeping executives in theirpositions longer so they become immersed intheir industries and then tying more of theircompensation to new ideas, improved customersatisfaction, and top-line growth.

The leaders of each GE business wererequired to submit at least three ImaginationBreakthrough proposals per year promisingat least $100 million in additional growth. Daynotes that such growth initiatives, which offertrue breakthrough potential, are awkward to

manage within the constraints of the existingorganization. There will inevitably be conflictsover resource allocation, with small i initiativesgaining the upper hand. Yet the fledgling BIG Iinitiatives may need to share resources, suchas brand presence, manufacturing expertise, ormarket access, with the established units.

An ambidextrous solution to the tensionbetween small i and BIG I initiatives is

to house the initiative in a structurallyindependent unit with its own processes,structures, and culture but still integrated withinthe exist ing senior management hierarchy,according to Days paper. The lead role for theImagination Breakthrough growth initiativewithin GE was given to the marketing teamwithin each of the 11 business units, whileholding the business leaders accountable

for results. This is a startling departure for acompany with a belief that superior productsand technology are what really count. Untilrecently, there were no marketers amongthe senior ranks and no coherent approachto marketing beyond building communicationprograms and designing product launches.

The Imagination Breakthrough effort aims toshift the balance toward BIG I growth initiativesby giving the organization permission to breakaway from the tyranny of past success and

take calculated risks with departures fromthe way the business has been run. By early2006, there were about 100 growth initiativesunderway within GE, ranging from business-model innovations and new ways to segmentand serve the global energy market, to productsfor new market spaces, such as bio-detectionof security threats and small super-efficientjet engines for the next generation of air taxis,according to Day.

Preliminary projections were for an extra $33billion to $35 billion of top-line growth from 3 to

5 years in the future. GEs 35 best projects aresubject to monthly CEO reviews, a strong signalof commitment. This procedure also encouragesthe sharing of best practices and the furthersearch for cross-division business opportunities.

The Praxair Case

Another company with a noteworthy approachto organic growth is Praxair, a Fortune 300global producer of industrial gases based inDanbury, CT.

In 2003, Praxair set out to find $2 billion inrevenue growth by 2008, Day says. One halfwas to come from acquisitions; the other halfrequired double-digit organic growth of $200million per year. This was far beyond the annualgrowth that could be realized from repackaginghelium, hydrogen, oxygen, and other gases. Sothe company broke down its organic growthinto actionable categories: The first 15 percent


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007UniversityofPennsylvania WhartonExecutiveEducation Knowledge@Wharton 7

would come from incremental growth in thebase business and new channels for servingcurrent markets; the rest would come from newservices, such as nitrogen injection of oil andgas wells, servicing the helium coolant usedin magnets in magnetic resonance imagingmachines, and developing new reactor coolingand nitrogen injection cooling methods for thebioscience industry.

These initiatives grew out of intimateknowledge of changing customer needsthat could be met with Praxairs existingcapabilit ies, writes Day. The lead role inexploring the market, articulating and screeningthe opportunities, and orchestrating thespecific projects was assigned to marketing,with sustained top management support andoversight. As a clear signal of commitment,the CEO of Praxair spent 1 day per quarterreviewing the growth prospects for eachbusiness. Day adds that the payoff wasimmediate: The $200 million growth target wasexceeded by $30 million in 2004.

Day says that the ideas presented in his paperbegan to come together several years agowhen he attended a CMO summit conferenceon innovation sponsored by Wharton, McKinsey,and the Marketing Science Institute. Therewas a persistent theme to the conversation:Our companies have scarce resources, and

were always pressured to think about the shortterm, Day notes. At the same t ime, I hadbeen reading about how process managementmethods, such as Six Sigma, tend to cut downon a companys willingness to take risks. Itthen occurred to me that maybe there was anincrease in the tendency for companies to relytoo heavily on what I call small i incrementalinnovations like product-line extensions, product

upgrades, and feature improvements.

If you have constrained budgets, theseincremental efforts tend to soak up a lot of thatbudget at the expense of BIG I projects, whichare risky and long termso long term, in fact,that senior managers may no longer be with thecompany once the project finally is completed.Then I read a great study by another researcher,who demonstrated persuasively that there wasa relative shrinking of innovations in corporatedevelopment portfolios. So the evidence wasmounting that there was a trend workingagainst BIG I innovation. Thats when I asked,How can companies fight that tendency?

The antidote described in the paper, Daysays, is a disciplined process for realisticallyassessing the growth gap to be filled, expandingthe search for opportunities, calibrating therisks, and using the latest thinking on screening,real option analysis, and partnering to containbut not avoid these risks.


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errors in corporate strategy are often selfinflicted, and a singular focus on shareholder value

is the Bermuda Triangle of strategy, accordingto Michael E. Porter, director of Harvards Institutefor Strategy and Competitiveness.

These were two of the takeaways from arecent talk by Porterentitled Why Do GoodManagers Set Bad Strategies?offered as partof Whartons SEI Center Distinguished LectureSeries. During his remarks, Porter stressed thatmanagers get into trouble when they attemptto compete head-on with other companies. Noone wins that kind of struggle, he said. Instead,

managers need to develop a clear strategy aroundtheir companys unique place in the market.

When Porter started out studying strategy, hebelieved most strategic errors were caused byexternal factors, such as consumer trends ortechnological change. But I have come to therealization after 25 to 30 years that many, if notmost, strategic errors come from within. Thecompany does it to itself.

Destructive Competition

Bad strategy often stems from the waymanagers think about competition, he noted.Many companies set out to be the best in theirindustry and then the best in every aspect ofbusiness, from marketing to supply chain toproduct development. The problem with that wayof thinking is there is no best company in anyindustry. What is the best car? he asked. Itdepends on who is using it. It depends on whatits being used for. It depends on the budget.

Managers who think there is one best companyand one best set of processes set themselvesup for destructive competition. The worsterror is to compete with your competition onthe same things, Porter said. That only leadsto escalation, which leads to lower prices orhigher costs, unless the competitor is inept.Companies should strive to be unique, he added.Managers should be asking, How can youdeliver a unique value to meet an important setof needs for an important set of customers?

Another mistake managers make is relyingon a flawed definition of strategy, said Porter.Strategy is a word that gets used in so manyways with so many meanings that it canend up being meaningless. Often corporateexecutives will confuse strategy with aspiration.For example, a company that proclaims itsstrategy is to become a technological leader orto consolidate the industry has not describeda strategy, but a goal. Strategy has to do withwhat will make you unique, Porter noted.Companies also make the mistake of confusingstrategy with an action, such as a merger oroutsourcing. Is that a strategy? No. It doesnttell what unique position you will occupy.

A companys definition of strategy isimportant, he said, because it predefineschoices that will shape decisions and actionsthe company takes. Vision statements andmission statements should not be confusedwith strategy. Companies may spend monthsnegotiating every word, and the results may bevaluable as a corporate statement of purpose,but they do not substitute for strategy.

Michael Porter Asks and Answers: Why Do

Good Managers Set Bad Strategies?

Managers who think there is one

best company and one best set of

processes set themselves up for

destructive competition.


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In the last 10 years or so, Porter added,companies have become increasingly confusedabout corporate goals. The only goal that makessense is for companies to earn a superior returnon invested capital because that is the only goalthat aligns with economic value.

Recently, companies have developed flakymetrics of profitability, he said, pointing to

amortization of good will as an example. Someof these measures began as a way for managersto stay a step ahead of the demands of WallStreet. What starts as a game for capitalmarkets then starts to confuse the managersthemselves. They [then] make decisions that arenot based on fundamental economics.

Porter said the Bermuda Triangle of strategyis confusion over economic performance andshareholder value. We have had this horrendousdecade where people thought the goal of acompany is shareholder value. Shareholdervalue is a result. Shareholder value comes fromcreating superior economic performance.

To think that stock price on any one day, orat any one minute, is an accurate reflectionof true economic value is dangerous, henoted. Research shows companies can beundervalued for years. Conversely, during theInternet bubble, managers whose motivationand compensation were tied to stock pricebegan to believe and act as if the shareprice determined the value of the company.Managers are now beginning to understand thegoal of their companies is to create superioreconomic performance that will be reflected infinancial results and eventually the stock price.We know theres a lag and its ugly. But itsimportant that a good manager understandswhat the real goal isnot spend time pleasingthe shareholders.

Corporate strategy cannot be done withoutstrong quantitative analysis, said Porter, addingthat each year students take his strategy course

thinking they will have at least one class inwhich they dont have to worry about numbers.Not true. Any good strategy choice makesthe connection between the income and thebalance sheet.

Right Time, Right Price

Companies hoping to build a successful

strategy need to define the right industry andthe right products and services. Bad strategyoften flows from a bad definition of thebusiness, said Porter.

He pointed to Sysco Corp., the number-onefoodservice supplier in North America. DefiningSysco simply as a food distribution firm wouldeventually lead to a failed strategy. The industryis actually two distinct sectors. One delivers foodto small restaurants and institutions that needhelp with finance and product selection. Theother has large, fast-food franchise customers,like McDonalds, that are not interested in anyadditional services. McDonalds just wantsindustrial-size containers delivered on time at thebest price. Sysco has developed two separatestrategies for its two customers.

Geographic focus is another type of businessdefinition that can trip up strategy. He gavethe example of a U.S. lawn care company thatdeveloped a plan to grow through internationalexpansion. The business, however, was notsuited to operating on a global scale. The

products were bulky and expensive to ship, andthe company had to deal with different retailchannels in different regions.

One more mistake managers make is confusingoperational effectiveness with strategy.Operational effectiveness is, in essence,extending best practices. Good operations candrive performance, Porter said, but added Thetrouble with that is its hard to sustain. If its abest practice, everybody will do it, too.

None of this is easy, he conceded. The realchallenge of management is you have to dothese things together at the same time. You haveto keep up with best practices while solidifying,clarifying, and enhancing your unique positions.

Managers often tend to let incrementalimprovements in operations crowd out thelarger strategy of building a unique businessthat will retain its competitive advantage,

Managers often tend to let

incremental improvements in

operations crowd out the larger

strategy of building a uniquebusiness that will retain its

competitive advantage.


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10 WhartononSeniorLeadership Strategic Management, Vol.

Porter noted. To bypass this problem, managersmust keep the competitive strategy in mindat all times. Every day, every meeting,every decision, has to be clear. Is this anoperational best practice or is this somethingthats improving on my strategic distinction?

He went on to describe key principles ofstrategic positioning, including a unique

value proposition, a tailored value chain, cleartradeoffs in choosing what not to do, andstrategic continuation or ongoing improvement.The underpinnings of strategy are activitiesthat fit together and reinvigorate each other.

Enterprise Rent-A-Car is an example of acompany that stumbled onto its strategy moreor less by luck, according to Porter. The companystarted as an auto-leasing firm, but customersfrequently asked if they could rent cars for shortperiods. The rental car industry was completelygeared toward travelers, with pickups at airports

and a price structure suited to expense accountsor vacationers willing to splurge.

It is difficult to sustain the kind of strategicadvantage Enterprise enjoys without a patent,Porter pointed out. Hertz has tried to connectwith this business but remains gearedtoward the traveler and cannot compete withEnterprise in its specific market.

Porter stressed that continuity is critical tosuccessful strategy. If you dont do it often, itsnot strategy, said Porter. If you dont pursuea direction for 2 or 3 years, its meaningless.Many companies start out with a goodstrategy, but then grow their way into failure,Porter continued. Research shows that amongcompanies that fade in 10 years, many enjoyedphenomenal growth in the beginning but thenput growth ahead of sticking to their strategy.

Dividends are one way to avoid the pressure toboost stock price with rapid growth, Porter said.Dividends also return capital to all investors,not just short-term investors who benefit from

trading on gains in share price.

Leadership and Strategy

Porter cited some capital market biases thatresult in barriers to strategy. First, Wall Streettends to create pressure for companies toemulate their peers. He said analysts oftenanoint a star performer in each industry, whichencourages others to follow that companys

game plan. Again, this leads to the no-winapproach of companies competing on the samedimensions, not on unique strategies.

Analysts also tend to choose metrics thatare not necessarily aligned with true value ormeaningful for all strategies, said Porter, notingthat analysts apply pressure to grow fast andhave a strong bias toward deals, which lead to a

quick bump in the stock early on. Managers aremade to feel like Neanderthals if they resistmergers and acquisitions or other financialmarket tactics, he added. What happenedin a lot of companies was that the equitycompensation was [tied to share price], andpeople became crazed and very attentive tothese biases. All the corporate scandals camefrom pressure to do things that were stupid.

Other barriers to strategy include industryconventional wisdom, labor agreements orregulations that constrain choice, inappropriate

cost allocation to products or services, andrapid turnover of leadership. Increasingly, heis struck by how important leadership is tostrategy. Strategy is not something that isdone in a bottom-up consensus process. Thecompanies with really good strategy almostuniversally have a very strong CEO, somebodywho is not afraid to lead, to make choices, tomake decisions. Strategy is challenged everyday, and only a strong leader can remain oncourse when confronted with well-intentionedideas that would deviate from the companys

strategy. You need a leader with a lot ofconfidence, a lot of conviction, and a leaderwho is really good at communication.

Years ago, corporate strategy was considereda secret known only by top executives for fearcompetitors might use the information to theiradvantage, said Porter. Now it is important foreveryone in the organization to understand thestrategy and align everything they do with thatstrategy every day. Openness and clarity evenhelp when coping with competition. Its goodfor a competitor to know what the strategy is.The chances are better that the competitor willfind something else to be unique at, instead ofcreating a zero-sum competition.


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alarm bells sounded in the global steelmarket on Friday, January 27, 2006, when

Mittal Steel, the worlds largest manufacturerof steel, launched a whopper of an offer inthat highly fragmented sector. Mittal made ahostile bid worth 18.6 billion for Arcelor, itsmain competitor.

The offer by Mittalwhich is run by LakshmiMittal, the third-richest man in the worldisthe highest in the history of the steel industry.It calls for exchanging four Mittal shares plus35.25 in cash for every five shares of Arcelor.The offer values shares of Arcelor at 28.21

each, which means that it involves a premiumof 27 percent over the closing price on thestock market the day before.

Arcelors senior executives saw the offer ashostile from the very first moment. Its boardof directors called an urgent meeting on theafternoon of Sunday, January 29, where itunanimously rejected the offer. In addition,Arcelorwhich is itself the product of a mergerin 2002 between Luxembourgs Arbed, FrancesUsinor, and Spains Aceraliarecommended

that its shareholders reject the Mittal offer. Oneof the arguments given by Arcelors board tojustify a rejection is that Arcelor and Mittal donot share the same strategic vision, the samemodel for development, or the same values.Arcelor is not going to share its future withMittal, Guy Doll, president of Arcelor, told apress conference.

Coordination of the Sector

The deal left experts in shock because althoughMittal is quite accustomed to expanding its base

through acquisitions, it is now daring to confronta company that ranks second in the steel sectorin terms of production and first in terms ofrevenues. In addition, notes Esteban GarcaCanal, professor of business administration atthe University of Oviedo (Spain), What makesthis deal unique is that this is the steel sector.Until very recently, this business was protectedby the governments, and no one thought that

companies could make hostile takeover offerson this scale, despite the fact that the sector

was in the process of consolidation.

According to Wharton Professor Mauro Guilln,Mittal wants to grow, to strengthen itself,and to eliminate competitors in a maturesector where costs are a fundamental factor.For his part, Jos Mario lvarez de Novales,a professor of strategy at the Instituto deEmpresa in Madrid, explains that Mittalsinterest in Arcelor is based on the type ofproduction each company is involved in. Mittalproduces low-cost steel, so it has factories

in countries where labor costs are low, andits mills are located near mines and close tomarkets where there is a lot of demand. Incontrast, Arcelor produces steel for industriesthat demand higher quality products, such asthe auto sector. As a result, Mittals offer isan attempt to enter the higher range of thesteel industry as well as new markets wherethe company does not have any productionfacilities, he adds.

What would happen if the deal succeeded? Itwould create an enterprise with total revenuesof some $69 billion, a market capitalization ofsome $40 billion, and a global market share

of about 10 percent. The new Mittal wouldbecome the first steel company to producemore than 100 million tons of production ayear, three times the production volume of itsclosest rival, Japans Nippon Steel.

According to Victor Pou, a professor ofmanagement at IESE, the Spanish businessschool, The deal is an attempt to make

Forging a Steel Giant: Mittals Bid for Arcelor

Although Mittal is quite accustomed

to expanding its base throughacquisitions, it is daring to confront

a company that ranks second in the

steel sector in terms of production

and first in terms of revenues.


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the two companies complementary. If itwere approved, he adds, Arcelor wouldbring innovation and technology, and Mittalwould achieve greater geographic reach andhave access to more raw materials. Fromthe strategic point of view, there are manysynergies between the two companies.

Beyond the fact that Arcelor is an obvious

opportunity for Mittal to gain size and acquireaccess to new markets, The Europeansteelmaker [Arcelor] is Mittals main rival, notonly in the market but when it comes to makingother deals for acquiring other competitors,adds Garca Canal.

European Politicians to the Rescue

In principle, there is no reason to believe thatthe deal could fail because of any problemsinvolving its impact on competitiveness. Thisdeal does not mean any limitations in termsof competitiveness for other companies in thesector, notes Pou. We are talking about thesteel market, which has a very low level ofintegration and where there is a lot of roomfor this type of deal. If you add up the marketshares of the two companies, you barelyexceed 30 percent, so this would not have anyimpact on competitiveness in the market or onthe activities of other companies. The presidentof Arcelor himself has also acknowledged thatthere are no problems regarding competition,especially if Mittal were to sell CanadasDofasco, which Arcelor recently purchased, toGermanys ThyssenKrupp.

Nevertheless, Doll has pointed out a seriouschallenge for the merger: The contrastingbusiness cultures of the two companiescould make it hard for the deal to succeed.Doll believes that Mittal Steels idea of goodgovernance practices are not the norm inEurope. The Indian family itself controls 97percent of the companys capital, and theson of the companys president is also its

director of finance and its managing director.In addition, Lakshmi Mittal owns shares thathave two votes each, which would guaranteehim control of the resulting group. He wouldhave more than 50 percent of the ownershiprights and 64 percent of the voting rights.Moreover, in Luxembourg, where Arcelor has itsheadquarters, it is not permitted to issue sharesthat have double voting power.

Arcelor has also said that it is worried aboutthe consequences this deal would have forits shareholders, employees, and customers.As a result, Arcelor has mobilized Europeanpoliticians in an attempt to prevent the dealfrom moving forward. The three countriesinvolved in the dealLuxembourg, France, andSpainhave already rejected the acquisitionoffer. It is the first time that I have seen a

deal that seems to be so poorly prepared, saidThierry Breton, Frances minister of economics.Breton also insisted that Arcelor should have aEuropean character.

Luc Frieden, Luxembourgs treasury and budgetminister, and Jeannot Kreck, the countrysminister of economics and trade, declaredthat the social and cultural model of Arcelorhas our firm support. Luxembourg is not onlythe headquarters of Arcelor, but it is the chiefshareholder of Arcelor, owning 5.6 percent ofits shares. The government of Spain, the thirdplayer in the deal, said that it would studythe impact of the move on employment andactivity in the 18 plants Arcelor operates inSpain. We will act in consonance with the restof the European countries that are involvedin this operation, especially with France andLuxembourg, declared Pedro Solbes, secondvice-president of the Spanish government.

The three European governments seemto have forgotten that Mittal Steel has itsheadquarters in Holland and that Lakshmi

Mittal owns important businesses in the UnitedKingdom. His main residence is in London.In addition, they have been overlooking thefact that Germanys largest steel producer,ThyssenKrupp, would benefit from this deal,since it would be able take over Dofasco.

Although Luxembourg is the largest shareholderin Arcelor, Guilln believes that it is a countrythat is very small when it comes to playing animportant role. In addition, the Luxembourggovernments 5.6 percent [ownership stake] may

not carry enough weight to prevent the takeoveroffer, notes Garca Canal. For his part, Alvarezde Novales believes France can make a lot oftrouble, given its tendency to rescue Frenchcompanies, as it has shown on other occasions.

Garca Canal notes that beyond the defensivemaneuvers that the management of Arcelorcan carry out with the backing of [European]politicians, the success of the deal depends


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on two other groups: shareholders [of Arcelor]and officials at the agency that enforces[European] competition laws. From theviewpoint of shareholders, Arcelors high freefloat of 80 percent makes it feasible that Mittalcould achieve the 50-percent level [of shares]necessary for taking control. Nevertheless, headds, The Indian steel manufacturer shouldconvince institutional investors by making

credible commitments to improve its [Mittals]corporate governance, since the deal wouldtake place largely through an exchange ofshares. If the deal involved cash, it would bemore attractive for shareholders.

A Company Formed by Writing Checks

Mittal Steel is the result of a long line ofacquisitions based on a simple strategy: acquiremoney-losing companies owned by formerlypublic enterprises, make investments toreduce their production costs, and expand their

capacity. This strategy has always worked wellfor it, and shareholders have never punishedthe company on the stock exchange whenit announced another acquisition, explainslvarez de Novales.

This path to growth, notes Garca Canal, is acommon way to do things in sectors that arehighly cyclical, since it means not adding newcapacity to the industry during periods whendemand contracts, and it enables a company torapidly take advantage of growth opportunities.

Lakshmi Mittal has spent his entire life in steel.At the age of 21, he began working in the steel

plant his father owned in India. Years later, hefounded his own steel company in Indonesia.Over time, he added new factories in formerSoviet republics and other emerging markets,creating his own empire of steel. Now the Mittalfamily owns 88 percent of the worlds largeststeel company. Its most recent purchase, lastyear, was International Steel, the U.S. company,at a cost of $4.5 billion. Mittal Steel is nowusing the same strategy to challenge the sectorby presenting an offer for its closest rival. Mittalmay already be the leader in the United Statesand Asia, but it could soon reach the top spot inthe European rankings.


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reliance gateWay net, Vsnl, scandent,and GHCL arent exactly household names

in the U.S., but they may be signs of biggerthings to come.

These are only a few of the growing number ofIndian businesses that have acquired U.S. firmsin the past few years. And the U.S. merger-and-acquisition activity is just part of a biggerpicture. Indian companiesusually quietly, butsometimes with media fanfarehave been ona buying spree in continental Europe, GreatBritain, and Asia in attempts to become keyplayers in global markets.

What accounts for all the M&A activity?Faculty members at Wharton and a New Yorkinvestment banker who is advising an Indianfirm on the acquisition of a chain of U.S. jewelrystores point to a combination of factorsmeans, motive, confidence, and opportunity.

Over the last decade, Indian firms in variousindustriesmost visibly in informationtechnology but also in areas like autocomponents, the energy sector, and [foodproducts]have been slowly building up

to become emerging multinationals , saysWharton Management Professor SaikatChaudhuri. The outsourcing phenomenon,in which Western firms have hired Indiancompanies for call center work and othertasks, has reaped benefits for Indian managers,exposing them to Western companies andmanagement practices and, at the same time,demonstrating to non-Indian firms that India isa reliable source of low-cost, yet high-quality,products and services.

Moreover, Indian firms are becomingmore profitablethe result, in part, of anever-booming economyand can accesssignificantly more capital than in the past.Incomes have grown phenomenally in somecompanies in some sectors, says Anil Kumar,managing partner at Virtus Global Partners, aninvestment and advisory firm with offices in theU. S. and India. But the biggest factor [in thegrowth of acquisition activity] is that suddenly,

theres a lot more cash available in the Indianmarket than earlier on. Many companies are

underleveraged; they dont have much debt.Their capacity to borrow from others is a lotbetter. They can borrow sizeable amounts ofcash, which can be deployed for acquisitions.

A number of Indian firms see global markets,not the domestic market, as their chief pathwayto growth. If you are a large company, youhave to have a good presence in the U.S,Kumar notes. Another factor: India is muchmore confident now. Companies are taking a lotmore risk than earlier on. Astute managers, headds, are realizing that taking on risk [can be]a good thing.

In addition, regulatory changes in India havemade it easier for firms to acquire overseascompanies. For example, World Trade

Organization rules governing quotas on theimportation of textiles into developed countrieswere lifted in 2005, sparking an increase in theability of Indian firms to produce apparel fornon-Indian markets, according to Kumar.

There is also an element of pride in Indian firmsbeing able to make acquisitions in America,Kumar notes. It means [Indian companies]have come of age and are better managedthan they were 10 years ago. To acquire U.S.companies, you need tohave a good capital

base and fundamentals in place. This is a signthat India companies can truly compete on aglobal basis.

Jagmohan S. Raju, a Wharton marketingprofessor, says that restrictions imposed byNew Delhi on the amount of foreign exchangethat was allowed to enter India have also beenrelaxed. Now the country is flush with foreignexchange. Indian companies [that have acquired

Indian Companies Are on an Acquisition Spree:

Their Target? U.S. Firms

A combination of factors

means, motive, confidence, and

opportunityaccount for the recent

Indian M&A activity.


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overseas firms] sell products in dollars and takepart of that money to India, some of which endsup in government coffers.

Yet another factor spurring the acquisitionspree: Indian companies have greater powerto raise money in U.S. capital markets becauseinvestors have grown more familiar withbusinesses in India, says Raju, adding that in

general, the increase in acquisition activityhas less to do with the Indian governmentproactively encouraging it than with thegovernment removing barriers to M&A deals.The roadblocks are gone, he says.

An Array of Acquisitions

The increased interest in U.S. acquisitions byIndian firms comes against a broader backdropof accelerated acquisitions by Corporate Indiaof companies in many places. In the first 9months of 2006, for example, Indian companiesannounced 115 foreign acquisitions with a valuetotaling $7.4 billion, according to The Economist.That is roughly a seven-fold increase from 2000.

A report by Grant Thornton India shows thatthe largest proportion of outbound deals (Indiancompanies acquiring international companies)in 2005 occurred in Europe (50 percent of dealvalue), followed by North America (24 percentof deal value). The report says that the ITsector saw the lions share of outbound M&Adeals in 2005, with 23 percent of the totalnumber of international acquisitions, followedby pharmaceuticals/health care/biotech (14percent). As for deal value, telecommunicationsled the way with a 33.6-percent share of dealvalue, followed by energy (14 percent), IT (8percent), and steel (6.5 percent).

The Grant Thornton India report notes threesignificant trends in cross-border M&A activityby Indian firms in 2005. First, more than halfthe deals were cross-border: 58 percent ofdeal value, amounting to $9.5 billion, and 56

percent of deal volume at 192 deals. Second,there were more outbound deals than inbounddeals both in value and volume terms. Third,while Indian companies have acquired severalbusinesses overseas to get an internationalfootprint, most of these outbound dealshave been lower-volume deals, showing thatIndian businesses are treading carefully andminimizing their risks through value buys.

One major U.S. acquisition took place inFebruary 2006 when GHCL, based in the stateof Gujarat, India, acquired Dan River, a Danville,VA-based maker of home textiles for $93 million($17 million in cash and the assumption of $76million in debt).

Kumar calls the Dan River deal precedent-setting in that it may inspire other Indian

companies to look for turnaround situations intheir quest for U.S. acquisition targets. Manycompanies have robust management and greatoperations, but their industry is not doing wellfor example, the textile industry, Kumar notes,adding that Dan River had many mills inside theU.S. but was facing significant challenges andwas competing with low-cost providers outsidethe country. GHCL bought Dan River for morethan $90 million, shut factories, and startedsourcing [its raw materials] from India. A yearlater, Dan River is doing a lot better. It turned a

profit in October.Also making major moves in 2006 weremembers of the Tata Group, a major Mumbai-based conglomerate with interests in, amongother things, steel production, transportation,software, and hotels. In June, Tata Coffee paid$220 million to buy Eight OClock Coffee, avenerable U.S. brand. In August, Tata Tea paid$677 million for a 30-percent stake in Glaceau, amaker of vitamin water in Whitestone, NY.

According to statistics compiled by the Mape

Advisory Group, there were a number ofnoteworthy acquisitions by Indian companies ofU.S. firms from January 2000 to March 2006.They include Reliance Gateway Nets acquisitionof Flag Telecom in 2003 for $191.2 million;the purchase by Mumbai-based VSNL of TycoGlobal Network, a submarine cable network,from Tyco International, based in New Jersey,for $130 million in 2004; and the acquisitionby Bangalore-based Scandent of CambridgeServices Holding, a global outsourcing firmheadquartered in Greenwich, CT, in 2005 for

$120 million.

Diamonds: A Dealmakers Best Friend

Many of Corporate Indias cross-borderacquisitions have involved such stalwarts aschemicals, IT, steel, and pharmaceuticals. Butsometimes action in the M&A space can takea glamorous turn: Kumar is currently advisingan Indian company in its negotiations to buy


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a chain of 100 U.S. jewelry stores. Kumardeclined to identify the firms involved butagreed to discuss the reasons for the Indiancompanys interest in making a U.S. acquisition.

India has long been known as a center forthe cutting, polishing, and manufacturing ofquality diamond jewelry, which is sold to retailstores worldwide. Today, Indian companies are

increasingly moving into the area of jewelrydesign. But Indias diamond experts haveworked largely behind the scenes, away fromthe eye of consumers. The acquirer Kumaris advising, however, would be able to placeits name front and center before U.S. jewelrycustomers. The U.S. jewelry market is dividedroughly into thirds among retailers. Departmentstores hold about 38 percent of the market,while mall chains like Zales have 35-percentmarket share and independent stores theremainder, Kumar says.

Competition in the diamond business isintensifying, and branding is one way todifferentiate oneself. China is becoming bigcompetition for Indian companies, accord ingto Kumar. So Indian companies are saying,

How do we go up the value chain? Brandingis one way to do that for customers who buyfrom Tiffanys and Zales as opposed to anoutlet store.

Kumars client also is looking to increase itsprofit margins and improve its pricing powerover what it sells. You do this by selling[directly] to customers, he says. This is thequestion our company has been facing. Itshard for them to compete with up-and-comingvalue-diamond suppliers. So they said, Maybe[it would be better] if we were right in front ofa customer by buying a chain that will help usincrease margins in our business. Kumar saysthe chain being acquired is a well-known brand,which allows them to charge higher prices thansellers of value-diamonds.

The goal of the acquiring firm is to keep themanagement of the acquired chain intact. Theywill not try to shake the tree, says Kumar. U.S.

companies tend to shake the tree right away.Many times thats why mergers fail in the U.S.

Post-Merger Integration

Indeed, Indian companies may be excitedabout their cross-border shopping spree, butWharton Management Professor Raphael (Raffi)Amit says enthusiasm is no guarantee of a

successful merger.Whenever companies in India, Korea, Israel,or anywhere [do cross-border acquisitions],the problems they encounter are a differentculture, different managerial norms, differentcompensation, and a different regulatoryenvironment, Amit says. Unfortunately, theliterature shows companies dont pay sufficientattention before the merger to the post-merger integration (PMI) issues that need tobe addressed. PMI is a major barrier that firmsface as they try to operate as one entity.

Amits advice to Indian companies consideringcross-border mergers would be to pay closeattention to the issues associated with PMIbefore agreeing to buy a company. That relatesto understanding the strategic considerationsand the merits of such an acquisition; marketconsiderations that relate to the process bywhich companies agree on the terms of theacquisition; and post-acquisition issues that dealwith the degree and scope of the integration,compensation for executives, and managerial-

norm issues.

Looking ahead, Kumar of Virtus GlobalPartners sees cross-border deals by Indianfirms increasing in number and changing innature. Only the big deals get mentioned inthe newspapers, but there are a lot of small-and mid-sized opportunities going on [in the$20 million to $60 million range], he says.We see a lot of those happening in the next4 or 5 years. Kumar predicts more M&Aactivity in industrial products, packaging, auto

components, and textiles.

Whartons Chaudhuri says that, like the diamondcompany being advised by Kumar, Indiancompanies in many sectors will, in years tocome, seek out acquisitions that help themmove up the value chain.

Look at pharmaceuticals, Chaudhuri explains.Everybodys doing so much research and

According to studies, companies dont

pay sufcient attention before the

merger to the post-merger integration

issues that need to be addressed.


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development in India you can imagine theyretrying to come up with their own independent,research-driven drugs that could be blockbustersworldwide. You can make the same point abouthigh-quality, skilled people [in the diamondbusiness]. In the IT sector, the future will alsosee firms moving up the value chain by doingmore consulting work.

Chaudhuri adds that Indias confidencein pursuing such deals will continue tostrengthen. The success that has beenenjoyed so far has been due to self-confidence.That will only increase over time. In fact, wenow see a reverse brain drain taking place.People who left are going back to India tostart up firms or head the Indian operations ofmultinational corporations.

Corporate India, as it accelerates its cross-border acquisitions in years to come, willresemble China Inc. Says Chaudhuri: Look atthe amount of capital going into India and howthe accounting and governance practices ofthe West are being adopted in India, like theyare in China, and how Indian investors perceiveopportunities in foreign markets. Theres ananalogy between Indian and Chinese companies.

My prediction is 15 to 20 years from now, Indianand Chinese firms will compete with Westernfirms in all sectors around the world. Its goodfor everybody. Its part of the integration of theglobal economy, and its important for India toparticipate in that.


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its hard to say where valuation math endsand acquisitive ego begins with the current

high bidding levels for Hutch Essar, Indiassecond largest mobile phone services provider,which currently has 22.3 million subscribersand Rs. 5,800 crore in revenues ($1.3 billion).[As of January 2007], active bidders includethe worlds largest mobile telecommunicationscompany Vodafone, the Anil Ambani-ledReliance Communications, and the HindujaGroup. Verizon Wireless of the U.S. is also saidto be kicking the tires of a potential deal.

Others in the fray are Japans NTT DoComo,

Egyptian telecom operator Orascom, and otherbig-name investment banks, including GoldmanSachs, Blackstone, and Texas Pacific. Over thelast month, Hutch Essars valuation has doubledto $20 billionthe enterprise value that HongKong parent Hutchison Whampoa likes for its67-percent stake with partners. The other 33percent is owned by the Ruias of the Mumbai-based Essar group, who seem open to eitherrunning the entire company themselves or inpartnership with others.

At first sight, it seems obvious why HutchEssars valuations climbed so rapidly to suchhigh levels. Indias current high economicgrowth makes it an attractive market forforeign investors. Also, it is not every day thatone gets to control a big player in a tightlyregulated policy environment where entrybarriers are high. Whats more, the countrysmobile phone subscriber base is adding 6million new subscribers each month and isfast approaching 200 million, or a tenth of theworlds subscribers. India Knowledge@Whartoninterviewed faculty members at Whartonand the Indian School of Business and otherexperts to get closer to the valuation metricsand see what is in store for a new owner atHutch Essar.

At least two theories are floating around as towhy Hutchison Whampoa wants to sell its stakein Hutch Essar. One is that the company badlyneeds the cash since it has committed up to

$30 billion in investments across Europe. Theother is that Li Ka-Shing, the Hong Kong-basedshipping and real estate baron who controlsHutchison, wants to cash out. He is a fairlyastute entrepreneur and, in the past, he hasbeen known to sell when he thinks valuationshave maxed out, says Saurine Doshi, partner atconsulting firm A.T. Kearney in Mumbai. IndiasFDI regime prevents Hutch from buying out theRuias of Essar and gaining complete ownership.Hutchison, however, would have to settle adispute with Essar that recently arose and nowseems headed for the courts. Essar claims thatunder its partnership agreement with Hutchison,it has the right of first refusal in case the lattersells its stake in Hutch Essar. Hutchison saysthat right of refusal is not a blanket agreementand is good only in specific circumstances.

Of the several possible configurations underconsideration, the two most popular are first,a Vodafone-Ruia partnership and second,Reliance Communications buying out bothHutchison and the Ruias and merging it with

Scrambling for Control of Hutch Essarand a

Piece of Indias Mobile Phone Market

It is not every day that one gets

to control a big player in a tightly

regulated policy environment where

entry barriers are high.


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existing operations. Indias policy regimedoesnt allow much elbow room in thosescenarios: FDI rules require Vodafone or anyforeign player to have a local partner holdingat least 26 percent; and Reliance or any othercompany cannot own more than a 10-percentstake in two different operators.

GSM and 3G

The quicker tempo being set in the race forHutch Essar is a testimony to the appealof the Indian opportunity, says Ravi Bapna,professor and executive director of the Centerfor Information Technology and the NetworkedEconomy at the Indian School of Businessin Hyderabad. This is as strong a signal asyou can getfor the valuation to double in6 months [to more than $20 billion] is totallyunprecedented; it was $10 billion in June[2006]. Part of what people are responding to isthe growth rate of mobile phone subscribers inthe market as a whole. No country in the planetis adding 6 million customers a month, and thecost of handsets is going down.

Those higher valuations could be justified onlywith a couple of significant assumptions, saysBapna. The key for the underlying valuationis the hypothesis that the Internet is going tobe played on the mobile phone in India. Thisimplies higher average revenue per user (ARPU)for the mobile operators, which, coupled withthe explosive growth and potential in the

subscriber base, is a deadly combination. Hesays Hutch Essars new owner will expect thesubscriber base to double in 2 to 3 years andalso a doubling of the ARPU from current levelsof between $10 and $20 a month.

Two other big attractions for internationalplayers in Hutch Essar are the opportunityto gain a significant presence on the GSMtechnology platform and a 3G opportunity thatis coming up soon, says Doshi. GSM is thefastest-growing and most popular wirelessstandard, with penetration in more than 200countries, according to the GSM Association, atrade group based in London. Third-generation(3G) services on the GSM platform would bemade possible when those licenses are issuedby the Indian government next year. Part ofthe reason the [Hutch Essar] valuation is high isyou are [getting] an option to buy 3G licensesin 2007-08 when preference will be given tothe existing operators, says Doshi, adding that

while the 3G market has been slow to take offin Europe, this technology is the way to go inthe future, especially with the convergence ofvoice, data, and video.

A Skeptical View

Wharton Marketing Professor Peter Fadersenses serious disconnects between whathe calls the base behavior of our speciesand the valuation assumptions made by bothbidders and sellers of companies such asHutch Essar. The revenue promise held out byHutch Essars existing and projected subscriberbase is often seen as crucially linked to howthe service is priced and the functionalitiesit offers. Here is where the deal makers maybe off-key, says Fader. When it comes to,Should I keep this contract or not? often itsthe silly little things that make you stick aroundor leave. They are not necessarily big, major,obvious factors like the pricing policy. He saysit is precisely because the swings could takeplace due to seemingly small issues in a mobilephone servicelike a goofy design aspectthat it is difficult to pinpoint specific drivers.

When you boil it all down to individual behavior,whatever the device is that they are holdingin their hand, their tendency to stick with it orswitch to a new oneand other kinds of verybasic behavioral patternswill still be largelythe same in 10 and 20 years as it is today,even though the functionality being delivered is

different, says Fader. Thats a point Im willingto stand by, and its a fairly radical point.

Fader and Bruce Hardie, a marketing professorat the London Business School, did capturesome of those behavioral patterns in aJune 2006 study entitled, Customer-BaseValuation in a Contractual Setting: The Perilsof Ignoring Heterogeneity. They say in theirpaper that M&A deal makers have, in recentyears, relied increasingly on extending theconcept of customer lifetime value (CLV) tovalue a customer base. The application ofstandard textbook discussions of CLV sees usperforming such calculations using a singleaggregate retention rate, the researcherswrite. But these retention rates typicallyincrease over time due in large part to asorting effect in a heterogeneous population.Failure to recognize these dynamics yields adownward-biased estimate of the value of thecustomer base, they suggest.


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In making such flawed assumptions, Faderfeels sellers are just being nave; theyreonly hurting themselves and they are leavingso much money on the table when they dothese valuations. Mobile phone customers areno different in their behavioral patterns thanpurchasers of other consumer products likemagazine subscriptions, he adds. There isenormous heterogeneity among customers in

every contractual database Ive ever seen. Inother words, for every person whos going tochurn the instant he is able to do so, theresanother person whos completely, blindly loyaland foolishly will keep his contract forever. Andso the real key here is to capture the variabilityacross customers. Too often, what these firmsare doing when they make their calculationsis they are assuming an average customer.In doing so, and in ignoring the variabilityacross customers, they end up systematicallyundervaluing the future value of the customer

base, which is really what it is all about.

Wharton Marketing Professor RaghuramIyengar has closely studied the impact ofpricing strategies in the U.S. mobile phoneservices market. He says the concept of CLV,which combines profits per customer and theretention rate, gained currency as a valuationtool during the tech boom of the late 1990s.At that time, a lot of companies in this spacewere not making profits, but they had bigcustomer bases.

The key factors in analyzing the enterprise valueof a mobile phone services provider includethe ARPU, the retention rate of customers,the cost of capital, and the costs of customeracquisition. With a natural limit on the numberof minutes each customer could conceivablyuse each month, the best opportunity toincrease revenue per subscriber is in providingvalue-added services that command a premium.Having said that, it is the retention rate thathas the maximum impact on the companysvaluation, says Iyengar.

Pointing to a November 2006 report fromVerizon for its latest quarter, Iyengar says thecompany is extremely happy about the factthat its churn rate is 1.3 percent per monthone of the best in the industrybecause itensures that their customer lifetime valuewill be high. Verizon had posted the fourthconsecutive quarterly drop in its churn rate,

which measures defecting customers. Thechurn rate in the U.S. wireless phone servicesmarket is between 1.5 percent and 2 percentper month. Cingular Wireless last quarterreported a churn rate of 1.8 percent, up slightlyfrom 1.7 percent in the prior quarter; T-Mobileschurn rate also edged up, from 2.2 percent to2.3 percent, over the past two quarters.

Keeping Customer Churn LowA. T. Kearneys Doshi says that, as with otherglobal majors, customer retention will be thetop challenge Hutch Essars new owners willface. Customer churn is high across the worldfor mobile users, but higher in India, saysDoshi. The only way [mobile phone servicescompanies] do it globally is by strengtheningcustomer relationships; price becomes a factor,in addition to service levels and dropped calls.Once you have parity on those dimensionswith all others, you need to adopt an end-to-

end customer touch model. Doshi says at thatstage, the key issues include convenience inthe billing and payment cycle, the resolution ofcustomer problems, and customer reachhow companies proactively reach out tocustomers on an ongoing basis with new optionsand offers. In sum, the big challenges facingHutch Essar will be how to reverse the ARPUdecline and how to put in place a leading end-to-end customer relationship model, says Doshi.

He tempers an optimistic outlook with other,more sobering considerations. In the short term,he says, the challenges a new owner faces will

be in customer retention and ARPUs. Whileeverything started with a bang [a few yearsago], most operators have seen a decline in theirARPUs, he says. Hutch Essars ARPUs of Rs.375 a month ($8.50) compares with industryaverages of Rs. 325 ($7.30), according to Doshi,who adds that Hutch Essars current ARPU levelshave actually fallen from levels of Rs. 450 about18 months ago and that they have declined

With a natural limit on the numberof minutes each customer could

conceivably use each month, the best

opportunity to increase revenue per

subscriber is in providing value-added

services that command a premium.


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at a faster rate than those of others. Initially,customers were thrilled with the mobile phone,but now they have started optimizing their use,says Doshi. That is one thing that [any potentialbuyer] will have to deal with.

If trends in the U.S. mobile phone servicesindustry could point to things to come in theIndian market, a simple expression that Iyengar

employs to arrive at customer lifetime value isuseful: M multiplied by R, divided by 1+I-R,where M stands for the margin per customer,R for the retention rate and I for the cost ofcapital. The ARPU in the U.S. market is currentlyaround $50 a month, Iyengar says. Assuminga margin of 45 percent and the churn rate at1.5 percent a month (or 18 percent annually,meaning a retention rate of 82 percent), Iyengararrives at $790 as the customer lifetime value.

If one applies those ARPU numbers, profitmargins and retention rates to Hutch Essars

22.27 million existing customer base, thetotal value works out to $17.6 billion. That,incidentally, is close to the $17.4 billion thatGoldman Sachs believes is the appropriatebreak-even price its client Vodafone shouldkeep in mind. Goldman Sachs further said thatVodafone would be overpaying if it valued HutchEssar at more than $20 billion. Hypothetically,if one assumed a higher customer retentionrate of 90 percent (instead of 82 percent), theenterprise value shoots up to $26.75 billion. Incontrast, with other things being equal, a lower

capital cost of say, 7 percent, pushes up theenterprise value to $19.5 billion.

Doshi feels Hutch Essars price tag is onthe high side: At $20 billion, thats almost$1,000 a user, he says. He points to ChinaMobiles failed bid last July to acquire MillicomInternational Cellular SA of Luxembourg, aprovider with then about 10 million subscribersacross Latin America, Africa, and South Asia.(Its current subscriber base is closer to 13million; and like Hutch Essar, it, too, is addingabout a million subscribers a month.) By the

time the deal talks failed, China Mobile hadoffered $5.3 billion for Millicom, or about$500 a customer. The company had the addedattraction of licenses in 16 countries, includingChad, Bolivia, El Salvador, and Cambodia, with acombined market of 400 million people.

Hutch, Hunch, IRR, or Instinct

Fader suspects the valuation math in dealslike Hutch-Essar is far from scientific, basinghis assessment on statements in corporatefinancial documents. Ive never seen a casewhere a company has estimated customerretentionor at least admitted to doing itina manner that their shareholders should insistupon, he says. They are using very crudeestimates of retention; they are assuming thatthey are constant across customers or overtime rather than capturing the huge dynamicsthat take place there.

Indias mobile phone services market is quitedifferent from that in the U.S., says Bapna,and he points to Indias higher growth indata traffic as one example. Voice usagelevels arent likely to increase dramatically;you can make more money from data andmultimedia applications and from residentialmiddle-class and enterprise users, he says.Startup businesses are developing softwarefor seamless video conferencing and otherapplications for the mobile phone. Its liketaking a salesforce.com application and pushing

it on the mobile phone.

Fader agrees that the mobile phone industryis in a time of unique change but is equallyskeptical about the long-term projectionsfloating around. People who sit around and saywhat the landscape will look like, say, 10 yearsfrom now are fooling themselves, he suggests.I think a lot of people have placed the wrongbets, if you look at the U.S. side. People talkingabout the nature and speed of convergencehave been way off. Its really, really hard to sayhow its going to play out.

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