prophets and profits

8/8/2019 Prophets and Profits

1/24

McKinsey onFinance

Trading the corporate portfolio 1

A systematic approach to buying and selling assets can deliver supershareholder returns.

Do carve-outs make sense? 6

Yes, but not for the reasons you might think.

Prophets and profits 11

Executives should be wary of bending strategy to suit the wayward

long-term earnings forecasts of equity analysts.

Shopping in the Internet bargain basement 15

Beleaguered dot-coms can represent real bargains for savvy acquirerand real lemons for buyers who dont scope out the territory.

Viewpoint: Whither globalization? 18

The war on terrorism may change the shape and pace of economicintegration. But the fundamental human forces that drive it will notbe dislodged.

Perspectives on

Corporate Finance

and Strategy

Number 2, Autumn

2001


2/24

McKinsey & Company is an international management consulting firm ser ving corporate and government

institutions from 84 offices in 43 countries.

Editorial Board: Marc Goedhart, Bill Javetski, Timothy Koller, Michelle Soudier, Dennis Swinford

Editorial Contact: [email protected]

Editor: Dennis Swinford

Managing Editor: Michelle Soudier

Design and Layout: Kim Bartko

2001 McKinsey & Company. All rights reserved.

Cover images, left to right: Eyewire; Steve Cole/PhotoDisc; Barton Stabler/Stock Illustration

Source; PhotoLink/PhotoDisc; Kevin Mayes/Stock Illustration Source

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undertaking any other complex or s ignificant financial transaction without consulting with appropriate

professional advisers.

No part of this publication may be copied or redistributed in any form without the prior written consent of

McKinsey & Company.

McKinsey on Financeis a quarterly publication written by experts and practitioners in McKinsey & Companys

Corporate Finance & Strategy Practice. It offers readers insights into value-creating strategies and the

translation of those strategies into stock market performance.


3/24

Trading the corporate por tfolio |

Trading the corporate portfolio

A systematic approach to buying and selling assets can

deliver superior shareholder returns.

Jay P. Brandimarte, William C. Fallon, and Robert S. McNish

Corporate strategy planners have neverhad it tougher. Companies are bracing forthe worst economic year in more than a

decade. Disruptive technologies and new

competitors continue to proliferate. Capital

markets are a storm of discontinuity,

allocating capital among winners and losers,

encouraging the creation of corporations, and

removing them when they no longer perform.

In this environment large companies are

particularly vulnerable.1 Even as some

corporate icons have relied on their sheer

size and momentum to survive, they have

not created superior shareholder value. One

approach to countering such turbulence, our

research shows, is to emulate the dynamism

of capital markets within individual

companies. Companies that trade theircorporate portfoliodeveloping a balanced

M&A program that actively allocates capital

to acquire new businesses, encourages their

growth, and then sloughs them off in a

timely fashioncan create superior

shareholder returns.

Active, balanced M&A

programs outperform

We identified 200 of the largest companies in

1990 that were still trading independently

in 2000 and examined all their acquisitions

and divestitures during that period that were

more than $100 million.2 We ranked and then

compared the performance of the most active

one-third of the group, based on total numbe

of completed acquisitions and divestitures, to

the least active, or passive, one-third. We

further differentiated among active companies

that primarily acquired,3 primarily divested,4

or acquired and divested assets in relative

balance.5

Our findings indicate that companies withactive, balanced programs of acquisitions and

divestitures create more shareholder value tha

those that transact few deals. Over the ten-

year period we examined, these companies

had 30 percent higher total return to

shareholders (TRS) than did companies with

passive M&A strategies. Furthermore, among

active companies, those that pursued a

balanced strategy had 17 percent higher TRS

than did those that primarily acquired and a32 percent higher TRS than those that

primarily divested (Exhibit 1).

Consider Texas Instruments. From 1990 to

1994, TI made only two significant

acquisitionsone in information engineering

and another in travel productsand divested

an industrial controls company. In 1995,

however, the company began aggressively

managing its portfolio, completing ninesignificant acquisitions over the next five year

and becoming a segment-leading player in cor

analog, DSP (Digital Signal Processing), and

wireless components businesses. It also shed

three successful but noncore businesses in

custom manufacturing and defense electronics


4/24

2 | McKinsey on Finance Autumn 2001

Suddenly, TIs profile changed. Its market cap

increased from $7 billion in the fourth quarter

of 1994 to $60 billion in the second quarter

of 2001. Between 1995 and 2000, its average

annual TRS was 48 percent, compared to

approximately 22 percent for the S&P 500 in

the same period.

Or consider the experiences of J. P. Morganand Primerica, now Citigroup. In 1990,

J. P. Morgan was one of the most valuable

and well-respected financial institutions in

the United States. Its $8 billion market cap

ranked it second among U.S. financial

institutions and it boasted long-standing

relationships with some of the worlds most

respected companies. By contrast, Primerica,

with revenues of $5.2 billion and a market

cap of $2.5 billion, was smaller and focusedon lower-middle-class consumer finance.

By 2000, however, Primerica had made 11

significant acquisitions, including major

brokerage and investment banking businesses

like Salomon Brothers and the brokerage unit

of Shearson Lehman. Its ten major divestitures

included both less profitable businesses and

noncore assets like health insurance, mortgage

banking, and long-term care. For its part, J. P.

Morgan spent the decade attempting to grow

organically, making no significant acquisitions

or divestitures.

Where are they now? Citigroup increased its

revenues to more than $82 billion by the end

of the decade, with a market cap of nearly

$265 billion. J. P. Morgan, on the other hand,

was unable to turn its strength in commercial

lending into a top-tier spot in lucrative

investment banking. Morgan underperformed

its peers and the S&P 500, and its market cap

ranking tumbled. In 2000, Chase Manhattan

Bank took it over.

Managing a balanced portfolio

These anecdotes illustrate a modern-day fact

of corporate life: nearly every large

corporation is actually a portfolio containing

multiple, potentially independent business

units. In a world of increasingly efficient

capital markets, multibusiness companies no

longer add value simply by providing access tocapital. They must add value by applying their

unique set of corporate skills or competencies

to each business unit in their portfolio.

These core competencies include those that

drive the performance of existing businesses,

such as financial performance management,

operations planning and management, or

marketing. They also include those that

identify new sources of growth, such asmergers, acquisitions, alliances, product/

customer strategy, or new product

development.

Naturally, the skills needed to create value in

any single business unit change as the unit

Exhibit 1. Among active strategies, a balanced

approach creates the most value

Value of $100 invested 1/9012/991

1 Risk adjusted for beta.2 Active portfolios split into those that primarily divest,

primarily acquire or pursue a balanced approach.Source: McKinsey analysis

$353

Passive

Active vs.

passive

approaches

Average

number of

transactions

Breakdown

of active

approaches2

Acquirer

$459

152

$392

DivestorActive

$442

Balanced

$519


5/24


down frequent, small bets. Often, alliances

and joint ventures are of equal importance to

acquisitions. Proprietary deal flow is critical,

as is high-volume deal screening and creative

deal structuring. The imperative of market

forces means that the many small bets that

have been made must be reviewed frequently

and divested quickly.

This is what Cisco achieved via its M&A as

R&D approach. Cisco acquired gap-filling

technology to assemble a broad line of

network-solution products, investing $24

billion to acquire 71 companies from 1993 to

2001. During this period, Ciscos sales

increased from $650 million to $22 billion,

and its market cap increased from $6 billion

to $120 billion. Nearly 40 percent of Ciscoscurrent annual revenue comes directly from

companies it acquired since 1993. Even with

the recent market downturn, Ciscos

annualized TRS from 1991 to the first quarter

of 2001 was 57 percent, contrasted with 16

percent for the S&P 500 for the same period.

evolves. A new, growing business unit needs

help in marketing, product development, and

fund-raising, while a mature business unit in a

highly competitive industry needs help cutting

costs, slimming capital, and restructuring

operations. Our research points to value-

creation levers and critical skills required at

four key stages of a businesss life cycle:

building a business, expanding it, operating it,

and reshaping it (Exhibit 2).

Because a companys core competencies are

relatively static and the skills it needs at each

stage of the life cycle unique and dynamic, few

companies excel at managing business units

across all stages. Therefore, as a business

units value-creation needs evolve, its parentcompany typically faces three strategic

choices. First, it can allow the needs of the

business unit to drift away from the

companys competencies, obviously leaving

value on the table. Or it can try to transform

its competencies to suit the future needs of the

businessan option that is difficult and, our

research suggests, justified only when the

majority of business units in the portfolio

simultaneously require the same skills to bechanged. Finally, it can sell the business, which

is often the right option.

Winning M&A strategies

Just as each phase of the business life cycle has

a winning operating strategy, each phase also

has a winning M&A strategy (Exhibit 3). The

challenge for executives is to adopt an M&A

strategy consistent with the life cycle focus ofbusiness units in each of the four phases.

Build

In the build phase, companies need to be able

to quickly assemble the business model, laying

ReshOperateExpandBuild

Objective

Value-

creation

levers

Critical

skills

Establisha viablebusiness

Grow thetop line

Driveefficiency

Rationaindustrstructu

Innovation,pioneering

Replicationandextension

Cost andcapitalreduction

Consvalueinflue

R&D Business

development

Marketing Financing

Operations Control

Re-engin

Creation

Source:McKinsey analysis

Exhibit 2. Four-phase business life cycle


6/24

ReshapeOperateExpandBuild

M&A

objective

Acquisition

strategy

Divestiturestrategy

Assemblethe businessmodel

Replicateacrossproductsandmarkets

Stay focussedon efficiency/cost sweetspot

Improveindustrystructure

Many smallbets

Generationof owndeal flow

Specialization

Numerousmidsizebolt-ons tocross-fertilizeproducts/markets

Poorlyoperatedproductsand brands

Roll-ups Dis-

integrationand re-integrationof the valuechain

Frequentreview ofbets

Divestiture ofcompletedbusinessmodels

Divestiturewhenefficiencytrumpsgrowth

Divestiturewhen costadvantagenotsustainable

Divestitureto operatorif structurerestored

Else,divestitureto LBO forharvest

Critical

M&A

skills

Deal flowscreening

Creativestructuring

Dealstructureandmanagerialintegrationto capturesynergies

Operationalintegration

Insight tospot trends

Dealstructuring

Creation

Source:McKinsey Analysis

Exhibit 3. Winning M&A strategies across

life cycle phases

Expand

In the expand phase, the name of the game is

to rapidly replicate the successful business

model across as many markets, geographies,

and products as possible. Often, this means

bolting on midsize firms to cross-fertilize,

especially when deal structuring and

integration can capture revenue synergies. Assoon as the business reaches the point of

inflection where cost and capital efficiency

trump top-line growth, the expander should be

looking to divest. For example, Johnson &

Johnson created value for shareholders through

the 1990s by developing many small


acquisitions into significant product lines, even

as it weeded out businesses that no longer fit.

Its annualized TRS from 1991 to the first

quarter of 2001 was a strong 19 percent.

OperateIn the operate phase, companies must remain

focused on their cost/efficiency ratio, scouring

the deal flow for opportunities to acquire

poorly operated businesses with solid market

presence. Successfully integrating operations is

often critical to driving cost and capital

reductions. The operator should divest when

its cost advantage is not sustainable or the

industry requires restructuring.

Industrial products and hand tool

manufacturer Danaher, for example, has

aligned its M&A strategy with its skill at

operations. The company acquires niche

industrial brands with undermanaged

operations and applies its operating know-how

to make substantial improvements. Since

1985, Danaher has made more than 30

acquisitions in the process and environmental

controls segment and seven acquisitions in thehand tools segment. These segments now

account for 58 percent and 42 percent of

sales, respectively. Danahers annualized TRS

from 1991 to the first quarter of 2001 was 28

percent.

Reshape

Reshaping a mature industry suffering from

overcapacity typically calls for a roll-upconsolidation strategy, acquiring a major

competitor, or reinventing the business by

disintegrating and reintegrating the value

chain. If growth and profitability can be

improved (i.e., returned to the operate phase

of the business life cycle), the company may


7/24


once again emerge as the natural owner of the

business. Otherwise, the restructured business

may be suitable for harvest in a leveraged

buyout. Superior insight into industry trends

and distinctive deal-structuring skills are a

must to thrive in this game.

In 1994, for example, San Antoniobased

Clear Channel had 35 radio stations, nine TV

stations, and no billboard or concert venue

assets. When the Federal Communications

Commission in 1996 lifted restrictions on

radio ownership, however, the company began

an acquisition spree. With 1,200 stations Clear

Channel is today the largest owner of radio

stations in the United States, as well as the

largest billboard owner with 770,000 outdoorad displays, and is both concert promoter and

venue operator. By consolidating the moribund

radio industry, Clear Channel improved scale

and focus. It achieves cost savings by

delivering common content (e.g., national

radio shows) across geographic boundaries

and spreading advertising across radio and

billboards nationwide. Clear Channels

annualized TRS from 1991 to the first quarter

of 2001 was 54 percent.

The right mix of acquiring and divesting also

varies across the four stages. Our analysis

suggests that successful builders and

expanders pursue M&A strategies that are

weighted toward acquisitions. By contrast, the

best strategy for operators and reshapers is a

relatively balanced program of acquisitions

and divestitures. In fact, in the build and

expand phases, companies with acquisition-focused strategies had shareholder returns

almost five times greater than companies

following a balanced M&A approach.

However, in the operate and reshape phases,

companies following a balanced strategy had

shareholder returns almost six times greater

than companies following an acquisition-base

strategy. This stands to reason, since builders

and expanders are assembling small businesse

into larger businesses. Once a business unit

has reached a relatively stable size, the

successful operator and reshaper are more

likely to pursue a balanced diet in terms of

deal quantity.

Matching the dynamism of markets in a

corporate setting is not easy. But companies

that pursue active, balanced M&A strategies

matched to their core skills and the life cycle

stage of their business units have the bestchance to thrive in an ever more tempestuous

market.

Jay Brandimarte([email protected])

is a consultant andBill Fallon(Bill_Fallon@McKinsey

.com) is a principal in McKinseys New York office.

Rob McNish([email protected]) is a

principal in the Washington, DC, office. Copyright


The authors wish to thank Michael Patsalos-Foxfor

his contribution to this article.

1 Richard Foster and Sarah Kaplan, Creative Destruction, New

York Doubleday, 2001.

2 Size of company determined by market capitalization.

Independent companies defined as those that had not

themselves been acquired. Acquisitions and divestitures

included straight sales, carve-outs, spin-offs, and leveraged

buyouts.

3 Companies with a ratio of acquisitions to divestitures

greater than 3:1 (active M&A strategy).

4 Companies with a ratio of acquisitions to divestitures less

than 1:1 (passive M&A strategy).

5 Companies with a ratio of acquisitions to divestitures

between 1:1 and 3:1 (balanced M&A strategy).

MoF


8/24

Exhibit 1. Definitions

Many CEOs consider equity carve-outs(Exhibit 1) too good to miss: a financialinstrument that increases company stock price

without sacrificing control of a valuable

business unit. However, analysis we conducted

of 200 major carve-outs across the world over

the past ten years1 shows that this perception

is not entirely accurate. We found that the vast

majority of carve-outs ultimately lead tochanges in corporate control, and very few

produce significant share price increases for

the parent. Most actually do not create

shareholder value unless the parent company

follows a plan to subsequently fully separate

the carved-out subsidiary.

This is not to say that carve-outs, executed

wisely, are not useful tools in an executives

restructuring toolbox. They are certainlypopular, with average yearly volumes of more

than $20 billion between 1995 and 2000. It

also cannot be denied that some high-profile

carve-outs have imbued this financial device

with a kind of star quality. When Kmart

announced its 52 percent carve-out of

Borders, Kmart stock went up 13.2 percent

during the week around the announcement,

generating $803 million in value for its

shareholders. The same effect was evident in3Coms 20 percent carve-out of Palm, which

increased stock prices by 17.6 percent and

generated $2.7 billion for shareholders.

The fact is that carve-outs can be valuable

but for reasons other than those that many

have believed. Executives evaluating a carve-

out for one of their business units must think

beyond the question of a simple boost for

their stock price. Rather, to achieve the value

that carve-outs can deliver, executives must be

prepared over time to give the carved-out

business full independence.

Ready or not, here comes

independence

The idea of maintaining indefinite corporate

control over carve-outs is nearly always a

fallacy. Our findings indicate that only 8

percent of carve-outs continue to exist as

Do carve-outs make sense?

Yes, but not for the reasons you might think.

Andr Annema, William C. Fallon, and Marc H. Goedhart


Carve-out: The flotation of a minority stake of usually

less than 20 percent (in the United States) of a

subsidiarys shares through an IPO for cash

Spin-off: Full flotation of a subsidiary by distributing

subsidiary shares in the form of dividends to existing

parent shareholders

Split-off: Full flotation of a subsidiary by offering

subsidiary shares to existing parent shareholders in

exchange for parent shares

Tracking stock: Special class of parent stock forwhich the dividends track a specific subsidiarys

economic performance, either through an IPO for

cash (tracking stock carve-out) or through a

distribution to parent shareholders as dividends

(tracking stock spin-off)


9/24


10/24

exposing it to the full brunt of market forces

and susceptibility to takeover.

However, parent companies that obstruct

carve-outs on their way to independence and

use their majority stake to exercise managerial

control in the long run risk eliminating the

very benefits the carve-out was intended to

deliver. They also risk precipitating further

conflict as subsidiary executives formallypursue the best interest of their own company

and shareholders. Consider US oil exploration

and production (E&P) company Vastar, which

was carved out by ARCO in 1994. At one

point, Vastar found itself bidding against

ARCO for the same E&P projects. ARCO

resolved this potential conflict not by

preventing Vastar from bidding but rather by

shifting its own focus to international projects

and leaving the US market for its subsidiary.2

Such conflicts can easily intensify over time as

the distance increases between parent and

carve-outs, especially since carve-outs often

operate in different, higher-growth industries

than their parents do. In our sample, revenues

for carve-outs grew at an average annual rate

of about 13 percent for the first two years

after the IPO, compared with around 5

percent for their parents.

When carve-outs make sense

Another chimera associated with carve-outs is

that they routinely deliver big boosts in share

price. Our research shows that in the short

term only 10 percent of carve-outs resulted in

a share price increase of more than 12 percent

for the parent. Over the long term, most

carve-outs actually destroy shareholder value,

as shown by negative, risk-adjusted

performance measures (Exhibit 3).

Shareholder value typically increases only

when both parent and subsidiary perform

better as independent companies, and only

when parent companies aim for full separation

of the subsidiarythrough a subsequent spin-

off or full public offering of subsidiary shares.

Carve-outs can create value for shareholders

from enhanced strategic freedom and access to

independent funding. As part of a parent

group, subsidiaries are often restricted inchoosing customers, suppliers, funding, and

transaction opportunities. For example, prior

to its carve-out and subsequent spin-off, one

telecom equipment provider had virtually no

access to customers for its hardware products

that were competitors of its parent. Similarly,

Palm was in a better position to close strategic

alliances with AOL, Nokia, and Motorola

after its carve-out from 3Com. These strategic

and funding benefits can be fully capturedonly when parent companies are prepared to

reduce control over time.

Furthermore, carve-outs can create value

through better alignment of managerial

incentives and more streamlined decision


1 Benchmark index is S&P 500 for U.S. companies andDatastream's European Market index for European companies.

2 Benchmark index is median estimated S&P 500 index for allcompanies.


Average return

Parents

Average

index adjusted1

Median

index adjusted2

Subsidiaries

26.7%

24.9%

10%

15.8%

21.5%

8.5%

Exhibit 3. Cumulative two-year post-transaction TRS

Percent


11/24

Do carve-outs make sense? |

making within the carved-out business. As

management is freed from the parents

decision process, decision making in the

subsidiary can become less complex and more

effective. Moreover, listing equity publiclyenables management to provide high-powered

incentives in the subsidiary through stock and

stock option plans, which make up a

significant part of total compensation to

carve-out executives.3

In the best cases, parent company executives

anticipate and plan full independence for

carve-outs. In the United States, a carve-out

followed by a spin-off usually also enables aparent company to divest a subsidiary without

incurring the capital gains taxes that it would

typically face in a trade sale or full IPO. For

example, the carve-outs Guidant, Palm, and

Lucent were subsequently spun off by parents

Eli Lilly, 3Com, and AT&T, respectively, in

tax-free distributions to the parents

shareholders. Indeed, carve-outs that

eventually become independent from their

parents as a result of a subsequent full spin-of

or public offering of the parents remainingstake have significantly outperformed the

stock market as a whole in the first two years

after their flotation (Exhibit 4).

You cant go home again

A carve-out is not likely to be a good option i

there are still operating or strategic synergies

with the parent group. Most synergies

between parent and subsidiary will be lostafter a carve-out as the two entities operate at

the requisite arms length. Legal protections

for the public minority shareholders typically

demand that all transactions with the parent

company take place at fair market terms and

conditions as if it were between two

Exhibit 4. Long-term TRS of carve-outs varies by trajectory

Transactions announced before 1/1/98; median TRS index

0 2 4 6 8 10 12 14 16 18 20 22 2460.0

70.0

80.0

90.0

100.0

110.0

120.0

130.0

140.0

150.0

160.0

Totalreturn

index

Months after IPO

Median

excess return

over S&P 500

Percent

Independent(Free float> 75%)

Acquired

Buy-back/delisted

Parentcontrolled(Free float


12/24

independent entities. This greatly reduces the

flexibility and ease with which parent andcarve-out can cooperate to capture any

synergies.

Although many parent executives anticipate

that they still have a strategic option to buy

back the public minority stake if the carved-

out business is successful, the facts show quite

the opposite. Carve-outs that were bought

back by their parent companies show very low

long-term stock market performance. Buyingback a minority stake to recover significant

synergies between parent and subsidiary, or to

compensate for lagging subsidiary share

prices, can also prove expensive for the parent.

In one example, after US biotech company

Genzyme carved out its testing division, IG

Laboratories, Genzyme realized that it was

still very dependent on IG Laboratories to test

its products. When it found IG to be less and

less willing to accommodate its needs,Genzyme ultimately had to buy back the

public stake in IG from the capital market.4 In

another example, following its 1997 carve-out

of Hertz, Ford revised its corporate strategy to

focus on becoming the global leading

consumer company for both automotive


Shareholder value typically increases

only when both parent and subsidiary

perform better as independent

companies, and only when parent

companies aim for full separation of

the subsidiarythrough a

subsequent spin-off or full public

offering of subsidiary shares.

products and services.5 Under the revised

strategy, Ford considered Hertz to be one of

the worlds strongest automotive service

brands and an integral part of this strategy. To

enhance the operating flexibility between itself

and Hertz, Ford bought back the public stake

in Hertz at a 46 percent premium over the

$24.25 September 20, 2000, share price,

reflecting a $224 million acquisition premium

over Hertzs stand-alone value.

Carve-outs remain a useful financial tool. But

corporate executives need to avoid illusions

about what carve-outs can deliver. Carving

out even small stakes of subsidiaries is likelyto lead to complete and practically irreversible

separation. Companies that do not plan for

such complete independence for their carved-

out subsidiary or even try to reverse the carve-

out are likely to end up destroying shareholder

value.

Andr Annema([email protected]) is a

consultant andMarc Goedhart(Marc_Goedhart@

McKinsey.com) is an associate principal inMcKinseys Amsterdam office;Bill Fallon

([email protected]) is a principal in the New

York office. Copyright 2001 McKinsey & Company.

All rights reserved.

1 Source: Securities Data Corporation global database.

Transactions analyzed were those exceeding $50 million

between January 1990 and May 2000.

2 Patricia Anslinger, Sheila Bonini, and Michael Patsalos-Fox,

Doing the spin-out, The McKinsey Quarterly, 2000 Number

1, pp. 98105.3 Patricia Anslinger, Sheila Bonini, and Michael Patsalos-Fox,


1, pp. 98105.

4 Patricia Anslinger, Sheila Bonini, and Michael Patsalos-Fox,


1, pp. 98105.

5 Ford Chief Financial Officer Henry Wallace, December 2000.

MoF


13/24

Prophets and profits | 1

Equity analysts make their livingpredicting the future of corporateearnings. Yet while capital markets consider

the accuracy of analyst forecasts variable at

best, many corporate executives feel pressure

to reach or even beat these projections. They

often go to great lengths to satisfy Wall Street

expectations in their financial reporting andeven in long-term strategic moves. Academics

call this motivation earnings management,

and it has drawn increasing attention from

regulators and other market observers. Arthur

Levitt, former chairman of the Securities and

Exchange Commission, expressed concern that

the practice may be overriding long-

established precepts of financial reporting and

ethical restraint.1

So how good are the analysts at predicting

earnings and setting forecasts that, whatever

their flaws, serve as an important benchmark

of the current and future health of companies?

To answer this question, and to explore

whether there are patterns in analyst forecasts

that might enable us to better interpret their

projections, we examined aggregate corporate

earnings forecasts for companies on the

Standard & Poors 500 index between 1985and 2001.2 Our research shows that analyst

forecasts are most often notably

overoptimistic, particularly in periods of

declining economic growth. The longer the

term of the forecast, the greater the degree of

overestimation one usually finds. Moreover,

our analysis shows that capital markets see

through these overoptimistic analysts

projections, making them even more

questionable as earnings per share (EPS)

targets for corporate executives.

Optimism on Wall StreetNo question, forecasting earnings with any

degree of accuracy one, two, or even three

years into the future is difficult. But if the

unpredictable nature of companies fortunes

and the fallibility of human foresight were the

only factors in play, one might expect that any

inaccuracies in broker forecasts would be

fairly randomly spread, canceling one another

out over time.

This is not what the record shows, however.

In fact, our examination of the forecasts

revealed three clear patterns (Exhibit 1). First

at the aggregate level, analysts almost always

overestimate corporate profits. The gap

between forecast and reported earnings can b

wide. On average during the period 1985 to

2000 the aggregate earnings forecast

overestimated corporate profits by more than

13 percent. Forecasts exceeded actual EPS by22 percent at three years out, 18 percent at

two years, and 10 percent at twelve months

ahead of the fiscal year end.3 Second, the

degree of overestimation is generally higher

the further out the forecast is made. Typically

forecasts are then revised downward until the

Prophets and profits

Executives should be wary of bending strategy to suit the wayward long-term

earnings forecasts of equity analysts.

Marc H. Goedhar t, Brendan Russell, and Zane D. Williams


14/24


forecast is roughly in line with the eventual

reported earnings, probably as a result of

guidance by corporate executives. Finally,forecast errors are typically larger in periods

of declining economic growth, suggesting that

analysts are lagging in revising their forecasts

to reflect new economic conditions.

Since aggregate earnings growth over time

must approximate growth in the real economy

overall, we looked at the relationship between

earnings, earnings forecasts, and US economic

growth. Obviously, as economic growth cyclesup and down, the actual earnings reported by

S&P 500 companies will occasionally coincide

with analyst forecasts, for example, for 1988

and 19941997. More frequently, though,

forecasts are too high; between 1985 and

2000, earnings for the S&P 500 grew by an

average of 11 percent a year while the average

analyst forecast showed 22 percent. Over

time, a reasonably consistent pattern emerges:when economic growth accelerates, the size of

the forecasting error declines, but when

economic growth slows, the error increases.4

Overshooting occurs in all sectors

The phenomenon is not limited to companies

or industries that are rapidly growing and thus

more prone to excessive optimism on the part

of analysts. We examined a sample of 14specialty chemical companies that have grown

very slowly over the past decadewith sales

increasing less than 3 percent per year. Even

with this slow growth, analysts were prone to

overestimate earnings and then reduce their

forecasts in the last months prior to

Exhibit 1. Aggregate EPS forecasts for S&P 500 companies

60.00

70.00

80.00

50.00

40.00

30.00

20.00

10.00

Jan85

Jan86

Jan87

Jan88

Jan89

Jan90

Jan91

Jan92

Jan93

Jan94

Jan95

Jan96

Jan97

Jan98

Jan99

Jan00

Jan01

1985 19861987

1988 1989

1991

1992

1993

1994

1995

1997 1998

1999

20002001

2002

2003

1990

1996

EPS

(US

cents)

Date of forecast


Lines illustrate analystforecast EPS over timefor each year

Squares indicate realizedEPS for each year


15/24

Prophets and profits | 1

announcement. As Exhibit 2 shows, analyst

estimates declined in 9 of the 12 fiscal

years for which data was available and fell

by an average of 7 percent over even the

last 12 months prior to the end of the

fiscal year.

Analysts also forecast five-year EPS growth

rates for these specialty chemical companies,

with a median forecast consistently

approaching 12 percent per year. Just as

consistently, these companies delivered growth

significantly below analyst estimates. In fact,

they never exceeded the five-year growth fore-

casts (Exhibit 3). And although actual growth

in the sector continues to decline dramatically,

analysts are still forecasting future growthrates near 12 percent until 2005.

What to expect in

the current downturn

We are currently in that phase of an economic

cycle where economic growth, at best, has

slowed and where, for many companies,

earnings are in decline. The forecast for 2001

fiscal year as of September predicts EPS forthe S&P 500 of $0.53, a decline of about 8

percent from the level achieved in the previous

year. However, the earnings forecasts for the

next two years still include growth in excess

of 15 percent.

Are these analyst forecasts reasonable?

Forecasts for nominal US gross domestic

product (GDP) growth for 2002 and 2003

were around 5 percent in September.5

Since1985, S&P 500 earnings growth has been on

average only 3 percent above GDP growth. A

difference between S&P 500 earnings and

GDP growth of more than 10 percent for the

next two years therefore seems quite

exceptional, if not unreasonable.

What earnings expectations do the capital

markets really take into account? The pre

September 11 level of the S&P 500 seems to

have reflected market expectations of growth

well below analyst forecasts. As of August 31the median price-to-earnings ratio of the S&P

500 was 17, which we calculate to be

consistent with long-term EPS growth betwee

5 and 7 percent. A market-implied long-term

EPS growth in this range is also more

reasonable, considering historical experience.

As prior McKinsey research has indicated,6

long-term growth in earnings for the market

as a whole is unlikely to be significantly

different from growth in GDP. Real GDPgrowth has averaged 3.5 percent over the past

70 years, which would indeed be consistent

with nominal growth of around 6 percent

given current inflation rates of 2 to 3 percent

Analysts, too, will ultimately lower their

forecasts as they pick up on the lower

2.5

19901991

1992 1993

1994

1995 1997

1998

1999

20002

1.5

1

Jan 91 Jan 92 Jan 93

0.5

0

Jan 94 Jan 95 Jan 96 Jan 97 Jan 98 J an 99 Jan 00 JJan 90

Source:Zacks Investment Research, Inc.

1996

Exhibit 2. 12 month EPS forecasts for specialty

chemicals companies

Forecast EPS, last 12 months of fiscal year


16/24


attention from efficiently running existing

businesses to chase transactions designed to

boost EPS. For the same reasons, managers

should not invest time developing accounting

and funding method solutions just to stay on

track for analyst EPS forecasts.

It is important to note that analyst forecasts

are more reliable in the months immediately

preceding earnings announcements. At

that point they are typically considered by

investors and corporate executives alike to

be actual targets and incorporated in market

pricing. Indeed, historical evidence suggests

that markets are right in taking this view:

forecasts three months prior to EPS

statements have an average error rate lowerthan 5 percent. Not unexpectedly, earnings

announcements that do not meet short term

forecasts are likely to surprise the markets

and impact share price.

Marc Goedhart([email protected]) is

an associate principal in McKinseys Amsterdam

office, Brendan Russell(Brendan_Russell@McKinsey

.com) is a consultant in the London office, andZaneWilliams([email protected]) is a

consultant in the Washington, DC, office. Copyright


1 Remarks at the Economic Club of Washington, April 6, 2000.

2 We examined the market-weighted aggregates of earnings

forecasts, compiled monthly by Institutional Brokers

Estimates System.

3 Forecast errors are measured as actual earnings minus

forecast earnings divided by actual earnings.

4 The correlation between the absolute size of the error in

forecast earnings growth and the 12-month trailing industrial

production data is a negative 0.56.

5 Source: The Economist Intelligence Unit, September 2001.

6 Tim Koller and Zane Williams, What happened to the bull

market? McKinsey on FinanceNumber 1, p. 6.

MoF

economic outlook that is already reflected in

market pricing.

Implications for

corporate executives

Managers should not necessarily feel pressured

to deliver against longer-term analyst growth

forecasts, as these typically reflect a significant

upward bias. Nor should they consider these

forecasts to be capital market targets.

Indeed, the market most likely does not expect

them to do so; capital markets have typically

already incorporated future forecast revisions

into the current share price.

In fact, if managers pursue unrealistic EPS

growth to meet longer-term analyst

projections, there is a real risk they will

actually destroy value if they engage in high-

risk, high-growth projects or shift their

14.00%

ForecastEPS growth

Actual

EPS growth

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%

19901995

19911996

19921997

2.00%

4.00%

19931998

19941999

19952000

19962001

19972002

19982003

19992004

20002005

19891994

Source:Zacks Investment Research, Inc.

Exhibit 3. Five-year EPS forecasts for specialty

chemicals companies

Median EPS growth over 5-year periods


17/24

Shopping in the Internet bargain basement | 1

Buy cheap, the saying goes, and you getcheap. In what is shaping up as a dismalyear for the Internet sector, at least 450

Internet companies closed their doors during

the first nine months of 2001, nearly twice as

many failures as in all of 2000.1 As valuations

plunged, failing dot-coms have become

acquisition targets for better-positionedcompanies eager to take advantage of bargain-

bin prices. Investors, many of them

traditional, off-line companies, have poured

billions into acquiring almost 1,000 different

Internet assets and properties so far this year.

In comparison to the same nine-month period

last year, the average dollar value of each

transaction has dropped, but the total number

of transactions has actually increased by about

40 percentand the figures are projected togrow by years end.2

But acquirers rummaging through the

Internets bargain basement should temper

their enthusiasm with caution. The spectrum

of options to choose from is much broader

than typical M&A, and there is much less

data to help sort it out. Think about how

many start-ups there were in each major

e-tail category alone, for example. How does apotential acquirer know it is picking the one

deal that has real assets? Unfortunately, these

acquisitions are relatively small and can

easily fall below the radar of established

M&A departments. Most targets do not have

I-banks, either, to shop their assets in this fire

sale. More than in typical M&A, it is critical

that potential buyers thoroughly understand

the complexities of an opportunity before

completing a deal, both in valuing intangible

assets and in capturing potential synergies.

Shop carefully, even whentime is short

Companies looking to take advantage of the

bargains must guard against allowing a feeling

of urgency to lead them into a bad investmen

With sources of funding disappearing and

companies on the brink of insolvency, Interne

companies hurrying to liquidate may not be

entirely candid about their financial status.

Acquirers should be on the lookout for hidden

liabilities that would destroy the value of anacquisition. For example, close examination o

one dot-com found that more than half of its

accounts receivable were to other cash-

strapped dot-coms, and it had hidden

liabilities in ongoing service contracts,

equipment leases, and software licenses.

Combined, the company would need 60

percent more cash than it had estimated to

return to profitability.

Moving fast may make sense in some cases,

for example to reach an agreement before a

potential acquisition heads into insolvency, bu

companies must not give short shrift to

standard M&A best practices. This is

especially true when it comes to evaluating

Shopping in the Internet bargain basemen

Beleaguered dot-coms can represent real bargains for savvy acquirers

and real lemons for buyers who dont scope out the territory.

David H. Dorton, C. Brent Hastie, and Patrick Q. Moore


18/24

tangible and intangible assets. The few

tangible assets an Internet company may have,

such as customized e-commerce hardware and

software, are often too difficult and expensive

to integrate with existing systems. Key

personnel may leave before an acquirer can

convince them to stay, taking with them

crucial knowledge of software codes.

Intangible assets are even more difficult to

value and may be worth little or nothing to an

acquirer. Brands, customer relationships, and

talent have been among many Internet

companies core assets. But how can an

acquirer evaluate an Internet brand, for

example, when so many are suddenly available

and so few have been around long enough tobuild up solid brand equity?

Similarly, while acquiring existing customer

relationships may be tempting, the usefulness

of customer lists is questionable. Privacy

groups fighting to prevent companies from

selling customer information are not the only

concern. Factors such as nontransferable

customer contracts, poor customer quality, or

low visitor-to-buyer conversion rates are alsoobstacles. For example, one on-line health

player purchased a major competitor

expecting to broaden its customer base.

However, postmerger analysis revealed

significant customer overlap, dramatically

decreasing the value acquired.

Thoroughly understand where

value will come from

In order to understand clearly the value of a

potential merger, companies must incorporate

postmerger management planning from the

beginning, just as in more traditional mergers

and acquisitions, including critical input from

the teams that would be responsible for

integrating assets. They must also structure

each deal to minimize the potential risks that

often accompany bankruptcy, such as talent

flight, deterioration of customer relationships,

or lawsuits by creditors or other parties.

Particularly in the Internet sector, success

hinges on the acquirers ability to be creative

in considering the full slate of deal options.

For example, one travel start-up headed to

insolvency seemed at first glance to have little

to offer. But a closer look by an opportunistic

incumbent uncovered favorable terms for

reservation processing that the start-up had

been granted by an established player. Since

the contract was transferable, it was worth

$10 to $20 million to the establishedacquirerwell above the actual purchase price

for the company.

Plan an Internet strategy

Established incumbents that carefully identify

and pursue specific assets to support a strong

existing Internet strategy are the most

successful acquirers. Targeting specific assets

rather than buying an entire companyincreases the chance of success by minimizing

risks associated with costs, complexity,

personnel, vendor relationships, and other

potential liabilities. Many successful deals

have not only reduced time-to-market or

development costs but have also generated a

unique and proprietary advantage that

increased entry barriers for competitors.

Electronic commerceone of the first sectorsto collapsehas yielded several successful

transactions. For example, one major retailer

acquired specific key assets of its bankrupt on-

line competitor in a series of separate

transactions, improving both its off-line and

online operations. More than $40 million of



19/24

inventory was purchased for $5 million; the

trademarks, logos, URLs, and other intellect-

ual property were purchased for $3 million,

and several months later the distribution and

fulfillment operations were purchased for a

fraction of the original investment.

The acquirer was able to leverage these

bargain assets almost immediately into

incremental sales and profit. And by focusing

on complementary assets rather than on trying

to acquire and fix the failed company as a

whole, the retailer was able to improve its

chances for success and increase its return on

investment. In fact, the company felt the brand

name of the defunct e-tailer to be so valuable

that it relaunched the brand less than a yearlater. The relaunched site already represents

40 percent of the retailers total on-line sales,

and the retailer expects to break even on the

investment in less than a year.

Another successful strategy has been to

acquire all the specific assets necessary to

create a complete, market-leading offer. For

example, Homestore.com, a leader in the on-

line real estate market, carried out a systema-tic acquisition program or roll up, targeting

weaker players to build economies of scale

and expanding the companys service offering

and revenue sources. Homestore identified real

estate listings as a critical, scarce resource in

its industrys value chain. Its control of

listings, bolstered by key acquisitions of

languishing dot-coms, provided improved

control over an expanded range of listings to

close future deals on attractive terms.

The results have been impressive.

Homestore.com has grown into one of the

Webs top 25 most-visited destinations, leading

its industry segment in visitors for more than

two years.3 This market leadership has

translated into significant sales growth

expected to grow over 100 percent in 2001

and positive operating cash flows.4

Unfortunately, Homestore has not been

immune to the events of recent months, and

its market valuation has declined significantly.

Distressed assets are usually cheap for good

reason. Finding companies that retain value in

the midst of the Internet stock collapse is not

easy, but it is possible. The key to finding the

best values is a rigorous application of M&A

fundamentals combined with a thorough

understanding of the Internets distinctive

characteristics.

Dave Dorton([email protected]) and

Brent Hastie([email protected]) are

associate principals in McKinseys Atlanta office,

wherePatrick Moore([email protected]

is a consultant.

The authors wish to thank David Ernstfor his

contribution to this article.

Copyright 2001 McKinsey & Company. All rights

reserved.

1 Webmergers.com; Q3 report: M&A down 38 percent

shutdowns hit 12-month low.

2 Webmergers.com; Q3 report: M&A down 38 percent

shutdowns hit 12-month low.

3 Tim Haran, Homestore.com raises projections, CBS

Marketwatch, July 25, 2001.

4 Homestore press release, October 15, 2001.

MoF

Shopping in the Internet bargain basement | 1

By focusing on complementary asse

rather than on trying to acquire and

fix the failed company as a whole, t

retailer was able to improve its

chances for success.


20/24


Whither globalization?

The war on terrorism may change the shape and pace of economic integration.

But the fundamental human forces that drive it will not be dislodged.

Martin N. Baily

Is globalization still inevitable? For morethan a generation the worlds economy hasbeen on a seemingly inexorable march toward

tighter economic, political, and social

alignment as people, goods, and capitalbecame ever more mobile. Yet even before the

September 11 terror attacks on the United

States, a backlash was brewing against

globalizations dislocating effects, even among

some who understand the benefits of trade

and investment. The terror attacks and their

aftermath, replete with the specter of a long-

running conflict between Islamic

fundamentalism and the modern economy,

quickly sparked a rethinking of convictionsabout globalizations forward momentum.

Executives plotting their companies strategies

on this unforeseen landscape may well have to

recalculate the speed and direction of trade

and economic liberalization. And they will

certainly have to factor in new costs, barriers,

and uncertainties. But they should also take

reassurance from the fact that the fundamental

forces that helped globalization take firm rootand grow will secure its progress, through this

crisis and beyond.

Globalization sounds clinical, yet in the final

analysis it is about the impulses of institutions

and people. It is about the desire of companies

to earn profits. The choices savers seek to earn

a high return on their assets. The decision a

consumer makes to buy a Mercedes rather

than a Cadillac. Or to buy a Big Mac. Unless

people live in North Korea or Cuba (and evenin such isolated corners of the global economy

the question is not really about whether

change will come, but rather when), consumers

and business leaders will continue to be

exposed to new products and best practices

from other countries and cultures. The

pressure of demand from consumers and the

pressure of unexploited profit opportunities

will always wear away at barriers to

globalization and the spread of new ideas.

Mutually assured growth

During the 1990s, after the Cold Wars bipolar

ideological conflict gave way to broad

economic competition, increasingly low-cost

technology created enormous profit potential

for companies entering new markets. So did

the practice of applying successful business

systems outside their home markets.McDonalds, for example, began the decade

with about 3,000 overseas restaurants but

ended it with nearly 15,000surpassing even

its count of domestic US restaurants. No

company, it seemed, could resist tapping the

opportunities from global expansion.

Viewpoint


21/24

Whither globalization? | 1

Companies with a strong competitive

advantage will continue to benefit by

exploiting their advantage worldwide.

International comparisons carried out by the

McKinsey Global Institute have suggested that

an important contributor to higher levels of

productivity is global competition against best

practice companies, which increases the

intensity of competition and forces companies

to innovate or be driven out rather than

hunker down in protected local markets. In

turn, technology development depends on

finding global markets to justify the risky

investments required.

Globalization has also contributed to

economic growth more broadly asrelationships among economies grew. Key to

the US economys extraordinary economic

performance in the 1990s were openness,

mobility, and the benefits of globalization,

factors that were to some degree adopted by

regional economies everywhere. Most

economists believe that the US economy, now

in a period of cyclical weakness, will make a

strong recovery, and the same dynamism that

accelerated globalization in the 1990s will stillbe strong in the next decade. Technology will

continue to pierce borders, support trade

among people, and offer economic choices

that keep globalization advancing.

Bumps in the road

This isnt the first time globalizations

momentum has been challenged. Financial

crises in Asia, Latin America, and the formerSoviet bloc during the late 1990s, for example,

exposed structural weaknesses that shook

world markets, exposed vast instabilities, and

called into question beliefs about the

durability of globalization approaches like

Asias forced march industrialization.

Of course, the imponderables are quite

different in a conflict where cruise missiles,

commercial airliners, and postal envelopes can

assume a horrifying lethal equivalence. In the

short run, at least, the conflict will slow the

pace of globalization and influence the tactics

that companies will implement to cope.

For one, consider that a major thrust of US

and Western foreign policy has been to

encourage economic liberalization, pushing

globalization forward. With the focus now on

fighting terrorism, it will simply be harder for

institutions such as the International Monetar

Fund and the World Trade Organization to

pressure governments to liberalize. Many of

those governments will now be in position touse their role as a political and military

coalition partner with the United States to

bow to local protectionist interests and resist.

Obstacles to globalization will break down

more slowly, even in the United States and

Europe.

The very nature of globalization will also

change. Various financial crises had already

altered the growth prospects and relativeattractiveness of different regions, but

selecting the right markets for expansion has

become even more important. Having a strong

global brand, especially a strong American

brand, is suddenly less attractive. As brands,

Coke and Big Mac are still massively valuable

but the future may involve more alliances and

increased effort to preserve local brand

identities. Understanding and managing

political constraints always was important; itis now even more so.

The terrorist attacks will have more concrete

effects as well, the most significant being an

increase in uncertainty and risk. Insurance

premiums have never reflected the possibility,


22/24


for example, that airlines and skyscrapers

might be destroyed by terrorists. Now they

do. One of the problems in getting the

economy running smoothly again is that

insurance premiums have soared, particularly

for airlines. And the insurance against terrorist

attacks will not go away for a while, if ever,

so it will be a bit more costly to fly and run

airports. Even with government help in

disaster insurance coverage, it will be less

attractive to invest in tall towers or visible

attractions easily identifiable as American.

The probability of default on high-yield debt

has also sharply increased in many industries.

The beleaguered telecom industry aside, the

trend is notable in aerospace, services, andnondurable consumer goods. Blue-chip

corporations also now face higher premiums

on borrowing costs, paying 2.5 percentage

points above Treasury rates, compared to 2.15

percentage points prior to the attacks and

1.25 percentage points in 1999. While most of

the rise in the risk premium was in the market

prior to September 11, the attacks have made

things a bit worse. This rise in the risk

premium affects all borrowing but at themargin is likely to have its largest impact on

funding for global investments.

Then there is the certainty of a higher

security tax. It was known for some time

that security at US airports was dreadful, but

no one really believed it would matter, at least

not on the scale of September 11, and no one

wanted to pay the bill for a better system.

Now we know better. Yet the issue of securityextends well beyond the airline sector. Private

companies will have to strengthen security.

Executives may wait longer for visas, and their

travel may be otherwise impeded. Manu-

facturers will have to hold larger inventories

as trucks endure longer waits to enter the

United States from Canada and Mexico.

Yet these new barriers can be overcome. Most

of the increase in borrowing costs was the

result of the economic downturn, not directly

related to the attacks. A strong economic

recovery should bring borrowing costs back to

normal or close to it. On the security side,

innovation and the benefits of widespread use

will bring costs down as well. As with air

bags, introduced with a high cost per bag,

many people will complain about paying a

safety tax. Today mass production has

sharply lowered the cost, and people buy cars

with multiple air bags. Best practiceapproaches to security will emerge and

address many of todays issues, with only a

slight cost to productivity.

Most important, the future of globalization

will depend more heavily than before upon

the willingness of populations and policy

makers around the world to embrace it. The

impulse to turn inward will have greater

appeal, threatening to restrict the flow ofcapital and people and slowing not only the

pace of globalization but also the pace of

economic growth. But the countervailing

force of consumers and companies lined up

behind the inherent freedom of choice it offers

will prove too powerful to resist, ensuring that

the vital opening of the global economy

continues.

Martin Baily, a McKinsey alumnus, is senior fellow atthe Institute for International Economics and former

chairman of the White House Council of Economic

Advisers. Copyright 2001 McKinsey & Company. All

rights reserved.

MoF


23/24

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prophets and profits

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