John connelly crown cork and seal

Chapter11:GrowthMainContent CHAPTER ELEVEN

GROWTH

In 1989, John Connelly, in poor health, stepped down from active management at Crown Cork & Seal, appointing his longtime protégé, William Avery, as CEO. One year later, Connelly died at age eighty-!ve.

Upon taking over the leadership of Crown, Avery immediately began a program of growth through acquisition. Interviewed four years later, he recalled, “When I became president in 1989, I had to light a !re and get the company going again. The company’s growth had slowed down in the 1980s.”1 The !re Avery lit was fueled by people with expertise in deals and acquisitions. The new team he assembled

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was led by acquisition specialist Alan Rutherford, who moved from the Brussels o"ce to become Crown’s chief !nancial o"cer. In addition, Craig Calle moved from investment bank Salomon Brothers to become Crown’s treasurer, and Torsten Kreider left investment bank Lehman Brothers to run planning and analysis.

During 1990 and 1991, Avery doubled Crown’s size with the acquisition of Continental Can’s domestic and foreign businesses. In 1992 and 1993, Crown spent $615 million to buy Constar, a leading maker of plastic containers for the soft drink and bottled water industries, and another $180 million on Van Dorn, a maker of plastic, metal, and composite containers. It paid $62 million for Tri-Valley Growers, a traditional maker of metal food cans.

In 1995, Crown began an eighteen-month e#ort to acquire CarnaudMetalBox S.A., the largest maker of plastic and metal containers in Europe. CarnaudMetalBox

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was the outcome of a di"cult merger between two-hundred-year-old Metal Box of the United Kingdom and Carnaud of France. It was a leading can maker in both countries, with much of its production being traditional metal food cans.

Commenting on the purpose of the combination, Avery said, “We want to grow bigger and get a better use of our resources. As the global leader in the metal and plastic segments of the packaging industry … we will have a worldwide foundation for continued international growth.”2 Few executives have been so clear in stating that they want to grow in order to have a platform for further growth.

By 1997, Avery’s team had completed twenty acquisitions and Crown had become the largest container manufacturer in the world. Avery had predicted that its size would allow it to get better prices from suppliers and that Crown’s traditional skill at cost control would let it trim excess

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overhead and capacity from French-run CarnaudMetalBox. No one mentioned the awkward fact that Crown’s traditional competence had been $exibility and short runs, not cost control.

In 1998, troubles appeared. Crown’s foray into plastic containers had paralleled the rapid growth in this business. The new blow-molded polyethylene terephthalate (PET) containers were taking signi!cant business away from traditional glass and metal containers in soft drinks and certain foods categories (for example, ketchup and salad dressing). But this growth was not powered by a basic increase in the demand for containers. Rather, it came from replacing metal and glass with plastic. Growth based upon substitution has a clear ceiling and, once the conversion to the substitute has taken place, the growth grinds to a sudden halt. This happened to Crown’s PET business just as Crown became the world’s largest producer. And not only

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were conversions from metal to plastic pretty much complete, but unit sales of PET containers actually started to shrink as large two-quart plastic soda bottles replaced several single-drink containers.

To add insult to injury, whereas management and analysts had hoped for !rmer prices from the more consolidated industry of metal cans, prices began to fall instead of rise, cutting pro!ts dramatically. Several factors were to blame. No competitor seemed willing to close European plants, each facing labor problems if a plant closed and each wanting to increase its market share. In addition, competition from cheaper PET containers was spilling over to virtually eliminate the already razor-thin margins in traditional metal cans. All of this—the slowdown of growth, the industry overcapacity, and the spillover of price competition from plastic back to metal cans—is basic industry analysis and could have been easily

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predicted by the use of the popular Five Forces framework developed by Michael Porter.3

Between 1998 and 2001, Crown’s stock price dropped catastrophically, falling from $55 to $5 (see the chart). In mid-2001, Avery retired, replaced by John Conway, a longtime Crown employee with training in economics and law. The era of rapid expansion by acquisition was over, and it was up to Conway to !nd some way to

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make the now gigantic Crown pro!table again. Whereas Avery’s mantra had been grow, Conway stressed cost, quality, and technology. From 2001 through the end of 2006, sales and pro!ts were essentially $at, about $1 billion in debt was repaid, and the value of a share of common stock climbed gradually from $5 to $20, about $5 higher than it had been seventeen years earlier when the program of expansion began.

As quoted earlier, when Avery took over

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at Crown he complained that “the company’s growth had slowed down.” It had. During the ten years (1980–89) before Avery become CEO at Crown, revenues grew at only 3.1 percent per year. However, it had nevertheless generated an annual average return to shareholders of 18.5 percent, enormously more than the 8.6 percent achieved by the S&P 500 during the same period. During the seventeen years after Connelly stepped down, from 1990 to 2006, the company grew rapidly, becoming the “leading” container maker in the world. But an owner of Crown’s common stock received a return of only 2.4 percent per year, much lower than the 9 percent provided by the S&P 500 Index. The chart below shows how Crown’s rapid run-up in sales revenue was accompanied by a dramatic fall in return on capital—the ratio of pro!t to investments.4 That ratio was a respectable 15.3 percent when Avery took over, but it fell almost immediately to

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below 10 percent, then to below 5 percent after the acquisition of CarnaudMetalBox.

Crown’s long record of superior performance under Connelly’s leadership had rested upon its carefully designed strategy that, through a coordinated set of policies, focused the company on products and buyers where the customer’s bargaining power was lessened. When Avery took over leadership of Crown, he found that the new PET bottles were making big inroads into the market for soft drink containers. Product changeover costs in plastics were much lower than in metal containers, so the basis of Crown’s traditional advantage was eroding. What to do?

Avery chose to grow the corporation by acquisition with an emphasis on the PET business, attracted by the growth in that industry. The problem was that he left the company’s traditional competitive advantage behind without replacing it.

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Asked about a loss of focus, CFO Calle showed no concern, interpreting focus as merely a restriction on the product line: “It’s currently fashionable to focus, but we’ve always been there. We operate in a $300 billion industry and serve only the metal and plastic portion, which amounts to $150–200 billion.”5 He did not choose to understand the deeper meaning of focus—a concentration and coordination of action and resources that creates an advantage. Instead, he and CEO Avery were mesmerized by the prospects of expansion.

The problem with diving into the growing PET industry was that growth in a commodity—such as cement or aluminum or PET containers—is an industry phenomenon, driven by an increase in overall demand. The growing demand pulls up pro!t, which, in turn, induces !rms to invest in new capacity. But most of the pro!ts of the growing competitors are an illusion because they are plowed back into

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new plant and equipment as the business grows. If high pro!ts on these investments can be earned after growth slows, then all is well. But in a commodity industry, as soon as the growth in demand slows down, the pro!ts vanish for !rms without competitive advantages. Like some sort of economic black hole, the growing commodity industry absorbs more cash from the ordinary competitor than it ever disgorges.

The proposition that growth itself creates value is so deeply entrenched in the rhetoric of business that it has become an article of almost unquestioned faith that growth is a good thing. CEO Avery’s description of his problem (“The company’s growth had slowed down in the 1980s”) and his goals (“We want to grow bigger … a worldwide foundation for continued international growth”) are little more than the repetition of the word “growth”—magical invocations of the name

Carmen Stenson
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of the object of desire.

The problem with engineering growth by acquisition is that when you buy a company, especially a public company, you usually pay too much. You pay a premium over its ordinary market value—usually about 25 percent—plus fees. If you have friendly investment bankers and lenders, you can grow as fast as you like by acquisition. But unless you can buy companies for less than they are worth, or unless you are specially positioned to add more value to the target than anyone else can, no value is created by such expansion.

Corporate leaders seek growth for many reasons. They may (erroneously) believe that administrative costs will fall with size. A poor, but common, reason for acquisitions is to move key executives to the periphery rather than let them go. The leaders of larger !rms tend to be paid more. And, in a decentralized company,

Carmen Stenson
Carmen Stenson
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making acquisitions is a lot more fun than reading reports on divisional performance. In addition to all these reasons, key corporate advisers—investment bankers, consultants, mergers and acquisitions law !rms, and anyone who can claim a “!nder’s fee”—can earn a king’s ransom by being “helpful” in a major deal.

In 1998, I was retained by Telecom Italia as a special consultant on strategy. Telecom Italia was then the !fth largest !xed-line telecommunications operator and Europe’s largest and most innovative mobile operator. It had been privatized in a series of steps beginning in 1994 and ending in the sale of public shares in 1997.

At that moment the strategic problems facing traditional !xed-line European operators were considerable. Many still earned the juicy gross margins typical of monopoly national carriers, but the future held the possibility of dramatically increased competition and technological

Carmen Stenson
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change. Deregulation was allowing foreign entry into national markets, and the Internet was blossoming. Companies such as Telecom Italia had large cash $ows based on past investments, and a critical issue was where to invest those cash $ows. More !xed lines seemed unwise. Optical !ber rings around cities looked promising, but three foreign !rms already had plans for regional centers like Milan. Competing against them would simply cannibalize existing business revenue. The Internet was growing rapidly, but income was small—its growth was based on very low prices, much lower than those charged for voice or traditional data tra"c.

The chairman and CEO, Gianmario Rossignolo, had been talking about an alliance with Cable & Wireless, a company begun in the nineteenth century as a provider of undersea telegraph links across the British Empire. Nationalized in 1947, it had been reprivatized in 1981 by Margaret

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Thatcher. Cable & Wireless CEO Richard Brown was an American, brought in to break an internal political logjam that had kept the company operating like a set of independent !efdoms. Brown had been seeking a major alliance, !rst $irting with British Telecom, then AT&T, then Sprint. The ($u#y) argument was that telecommunications was globalizing and that there would be value in a global brand.

Brown and Rossignolo had begun their alliance discussions with talk of a series of cross holdings in France, the Caribbean, and other locations. By late summer, their informal proposal had escalated into what would e#ectively be a merger of the two companies, with Richard Brown emerging as chairman.

Rossignolo had been slotted into his position as Telecom Italia’s chief by the in$uential Agnelli family, which led the small group of “core” shareholders. By early October 1998, however, some board

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members, including Agnelli agents, had become disenchanted with him. They were particularly concerned about the proposed merger with Cable & Wireless. In this context, I was asked to meet with Joseph Silver (not his real name), a managing director of Morgan Stanley Dean Witter, which was the lead investment banker involved in the deal. A board member told me, “Wall Street has the global view of the industry.” My assignment was to !nd out Morgan Stanley’s rationale for the merger.

Joseph Silver and I met in a plain conference room in Milan. I started the discussion with a straightforward question. In his view, what was the rationale for the proposed deal?

“Economies of scale,” he replied. “But these companies operate in totally

di#erent regions,” I responded. “Where are the economies of scale in combining a Caribbean operator with one in Italy, or Brazil?”

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“Telecom Italia,” he replied, “needs to move tra"c from South America to Europe. Cable & Wireless has cables that can handle that tra"c.”

This response surprised me. It was a $unking response to a standard question in an MBA course midterm exam. You don’t need to own a cattle ranch to get fertilizer for your rose garden and you don’t need a $50 billion merger to move communications tra"c. A contract will su"ce.

“It seems to me,” I said, “that we could simply write a contract, right now as we sit here, to move some Telecom Italia tra"c on certain Cable & Wireless cables. We don’t need a major merger to do it.”

“Well, professor,” he said, “the issue is larger than tra"c. The fundamental rationale for the merger is really … economies of mass.”

“I am not familiar with that term.” “What I mean by ‘economies of mass’ is

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that the two companies will, together, be larger. The combined company will have much greater cash $ow.”

Again, I was surprised at his argument. Combining any two companies sums their cash $ows—that’s arithmetic. It is not an argument for why a speci!c deal is worth the price.

“Telecom Italia,” I said, “already has substantial cash $ow. In fact, the major reason its stock price is not higher is because analysts and investors doubt that the company has good uses for all that cash. For example, Telecom Italia just overbid for an important license in South America. There was over $1 billion between its o#er and the next highest bid. Cable & Wireless is in about the same position, generating more cash than it can wisely invest. I just don’t see any ‘economies of mass’ in combining these cash $ows.”

Joseph Silver closed his slim briefcase.

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He was clearly uninterested in further discussion. He looked at me as if I were a child, someone who just didn’t understand the big leagues. He said, “With more cash $ow you can do a bigger deal.” Then he left the room.

Pressed to explain why the deal made sense, Silver could only suggest that it was a gateway to an even bigger deal. Morgan Stanley, of course, stood ready to collect a healthy fee, skimmed from the billions that would $ow in this deal and any larger deals to follow. Two days after our meeting, the board rejected the proposed merger and, in a stormy session, accepted Gianmario Rossignolo’s resignation.

Healthy growth is not engineered. It is the outcome of growing demand for special capabilities or of expanded or extended capabilities. It is the outcome of a !rm having superior products and skills. It is the reward for successful innovation,

Carmen Stenson
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cleverness, e"ciency, and creativity. This kind of growth is not just an industry phenomenon. It normally shows up as a gain in market share that is simultaneous with a superior rate of pro!t.

Carmen Stenson