Do Pepsi and Oatmeal Mix?

Commentary by Peter Cappelli and Harbir Singh / Wall Street Journal 5dec00

Messrs. Cappelli and Singh are professors of management at the Wharton School of the University of Pennsylvania.

The news yesterday that PepsiCo Inc. agreed to buy Quaker Oats represents another major development in a busy year of mergers and acquisitions, another company with a household name that will be submerged into a giant acquirer along with Chrysler, Honeywell and J.P. Morgan. Acquisitions are running at record levels this year and have increased at a frenetic pace the past five years. The globalizing of markets has driven the trend as has the pressure on companies from financial markets to grow, particularly important in this case.

Much attention has been given recently to M&A excesses, with some studies suggesting that as many as two-thirds or more of these deals end up not working -- i.e., they never deliver value to shareholders. Often, the acquiring company pays too much. In this case, Pepsi made an offer for Quaker in early November at about $13 billion, then stepped aside as Coca-Cola approached Quaker with an offer that would have been worth more than $15 billion. But when Coke backed away, Pepsi returned and purchased the company for slightly more than its earlier offer.

Why did Pepsi back out last month but come back at a higher price now? It is important to remember that despite all the sophisticated financial analyses that accompany deals like these, they probably have more in common with buying a car from your next-door neighbor than most participants would like to admit. Part of the story surely is the simple psychology that Quaker became more attractive once other companies were bidding for it. The fact that Pepsi and Coke have a deep and enduring rivalry no doubt helped make Quaker more attractive to Coke when Pepsi couldn't buy it and then, in turn, made it more attractive to Pepsi when Coke couldn't close the deal. Quaker may have been willing to accept a deal that was marginally better than the one it spurned earlier -- and significantly worse than the one in process with Coke -- for the same reason: Having first Pepsi, then Coke, and then the French company Danone SA walk away from potential deals with Quaker is like having three potential buyers walk away from the car you're trying to sell. Once an owner is committed to sell, he feels some pressure to complete the deal.

Part of the story too is that seeing a competitor try to make a move like an acquisition, even if it doesn't come off, helps signal some new direction in the industry. The proposal by United Airlines to acquire USAirways, for example, immediately set off a flurry of merger discussions by competitors. If the motivation for both Pepsi and Coke to acquire Quaker was primarily to get its Gatorade operation, don't be surprised if the market for acquiring other, noncarbonated beverages and juices heats up as Coke and other soft-drink companies try to grab those markets. The deal that looked too rich for Coke may seem more of a bargain now that its chief rival has done it.

About 55% of acquisitions fail to create value for the acquirer. The main reason why they do not lies in failures to integrate two companies after a merger. Intellectual capital often walks out the door when acquisitions aren't handled carefully. But in Quaker's case, the main assets are brands and products. Traditionally, acquisitions deliver value when they allow for scale economies or market power, better products and services in the market, or learning from the new firms.

In this case, however, whether the merger delivers value seems to hinge on whether Pepsi as a beverage company can substantially improve Gatorade's already dominant position in the sports-drink market. In addition, Pepsi will have to manage the cereal lines and other Quaker brands better than in the past. Besides beverages, Pepsi has the best chance of improving performance in Quaker's snack food line of business given the Pepsi expertise with Frito-Lay.

The post-integration efforts of any acquiring company have to be planned carefully and well-coordinated because there are many points of contact between the two companies and many things that can therefore go wrong -- coordinating distribution channels, combining product lines and merging administrative systems, to name a few. Research suggests that the first few months are crucial and that, beyond that time, the window of opportunity for achieving synergies closes quickly. Management has to act decisively early on to avoid missing these opportunities.

If a company does not know for sure how it can add value with parts of an acquisition, perhaps in this case the nonbeverage operations, it should not wait around to figure it out. For Pepsi, it may be better to simply sell those operations than to risk making costly mistakes. An acquirer should focus instead on where its executives understand how to add value.

While most of the attention has been focused on the Gatorade aspect of the transaction, the answer to the oft-asked question -- will this deal work? -- may come from how Pepsi handles the other aspects of the Quaker integration.