8
September 1991: The Acquisition of NCR Corporation by AT&T Corporation
AT&T: COLLECT CALL
After a bruising hostile takeover fight, Robert Allen, CEO of American Telephone & Telegraph (AT&T) Corporation, and Charles Exley, CEO of National Cash Register (NCR) Corporation, announced in May 1991 an agreement for AT&T to acquire NCR for $7.48 billion.1 This represented a 132 percent premium over NCR’s market value prevailing at the end of October 1990, shortly before AT&T commenced a hostile tender offer for NCR. By May, the two men were buoyant.Then and earlier, Allen had said that the merger would “create an enduring American institution with the technological, financial and marketing strength to succeed against foreign competition in the emerging global information market,”2 and “will be uniquely equipped to meet what customers will need in the future.”3 “I am absolutely confident that together AT&T and NCR will achieve a level of growth and success that we could not achieve separately. Ours will be a future of promises fulfilled.”4
Five years later, in May 1995, AT&T announced that it would spin off NCR leaving an entity with a market capitalization of $3.4 billion, about a fourth of the value of AT&T’s total investment in the computer segment. The press was remorseless: “Fiasco . . . a lesson in just about everything that can go wrong . . . one of the biggest flops in the computer industry,”5 and an “unmitigated disaster for all concerned.”6 Reflecting on the experience, Robert Allen said that AT&T’s entry into computers “was made with no experience and a belief that technology would drive the industry.”7 He also said, “The complexity of trying to manage these different businesses began to overwhelm the advantages of integration. The world has changed. Markets have changed.”8
ORIGINS OF THE ACQUISITION
In 1919, after a bitterly-fought consolidation effort, AT&T was tacitly sanctioned as the national telephone monopoly in the United States. Monopolies have never rested quietly with the body politic in the United States; AT&T was subject to regulation at the federal, state, and local levels, and to periodic antimonopoly lawsuits and legislation. In 1974, MCI Communications Corporation sued AT&T on antitrust grounds; the lawsuit was subsequently joined by the U.S. Department of Justice (DOJ). A jury awarded MCI $1.8 billion in damages in 1980; and the DOJ pressed its suit to break up the monopoly. Surprisingly, the directors of AT&T agreed to do just that, and in 1982, settled the government antitrust suit by signing a consent decree that separated the long-distance and local telephone operations. AT&T kept the long-distance business, the Western Electric equipment manufacturing business, and Bell Labs, a research organization. Seven independent regional phone companies (Baby Bells) emerged.
The breakup occurred in 1984, upon which AT&T entered the computer equipment manufacturing business. Thereafter, the firm sought to develop a computer systems business that would compete on world markets with the likes of IBM. Management of the new AT&T committed itself to a bet on convergence between computing technology and telecommunications, providing customers with integrated computing and communications systems. In 1991, Richard Bodman, senior vice president of AT&T described the strategy as follows:
AT&T’s mission is broad and deep: to be the world leader in information technology—a technology that inescapably involves the best of both computer and communications technology. AT&T has a well-defined strategy for establishing leadership in this field:
1. Maintaining leadership in its core business like network services.
2. Establishing world leadership in networked computing, which is the technology driving the growth of electronic transactions.
3. To firmly establish AT&T as a truly global company.9
On the face of it, the marriage of computing and communications seemed like a plausible strategy. AT&T had the largest captive market in long-distance telecom. It had some manufacturing expertise in Western Electric. And its Bell Labs was the incubator of UNIX, the computer language that was the basis for open-source system architecture.
Unfortunately, the entry into computing was unsuccessful. AT&T accumulated $2 billion to $3 billion10 of losses over its initial internal development effort. Its systems were neither leaders, nor likely to be competitive. For instance, AT&T’s joint venture with Ing. C. Olivetti & Company, made computers for AT&T since 1983 that were viewed as overpriced and poor performers. And generally it seems that AT&T picked its fights poorly.
Part of AT&T’s problem has been that, despite its technological strength, it has not brought much new to the computer business. The company already had more than $30 billion in revenues from its long-distance business, and it wanted its computer business to generate several billion dollars in revenue, at least. As a result, it has tended to enter larger, established markets, which have entrenched competition, rather than pioneer new, smaller markets where the growth is. AT&T entered the computer business with large minicomputers just as the industry was shifting to smaller desktop models. Worse, the AT&T 3B minicomputers, having been designed primarily for use in telephone switches, were not well received.11
Computer segment revenues had risen from $900 million in 1986 to $1.5 billion in 1990. Further, a pretax loss of nearly $1 billion had been reduced to about $300 million in 1990.These numbers were enough for AT&T to conclude that it needed an acquisition to stay competitive in the computer business. Moreover, the adverse impact of AT&T’s divestiture was beginning to emerge: AT&T reported net income of $2.5 billion, while the Baby Bells had a combined net income of $8.5 billion. The cumulative market-adjusted returns on AT&T shares from the breakup in 1984 to 1990 (see Figure 8.1) were erratic; AT&T was holding its own relative to the market, but not creating value on a relative basis. And the firm’s return on total capital sagged below its cost of capital following the breakup (see Figure 8.2). The computer business was not the path to new value. One critic wrote:
It says it must be in the computer business to pursue its strategy in computer networking. But this is as logical as claiming that one must manufacture ovens to be in the restaurant business. These problems make me wonder whether AT&T has lost its way, whether it has any overall realistic strategy. Is the ship rudderless in the high seas of competition, while the captain searches for the New World of computers?12
Figure 8.1 Cumulative Market-Adjusted Return on Shares of AT&T and NCR, 1980 to 2000
Source of data: Datastream.
Figure 8.2 Returns Spread on AT&T and NCR Common Stock
Source of data: Company annual reports and Bloomberg Financial Services. Computations are author’s estimates.
Charles Exley of NCR called it a “failed strategy.”13 And a third critic said, “It would be cheaper shutting it down. But that would be admitting failure.”14
AT&T was at a crossroads: It needed to fix the unit or to exit the business. Exit would require a major redirection of the firm’s strategy. Aside from the ambiguity about what the firm would do instead, there would be sizable writeoffs, recriminations, and loss of face. Given how rapidly computing technology was changing, Robert Allen, the CEO of AT&T, chose to raise the bet rather than to fold and leave the game. Analysts believe that AT&T ultimately decided that the potential benefits of being able to provide integrated communication and computing systems outweighed the business risks. Charles Ferguson of MIT said, “Everything AT&T has done to stay in the computer business has been kind of irrational.”15
NCR: FROM CASH REGISTERS TO COMPUTING
“We have reinvented ourselves several times,” said Charles Exley.16 Founded in 1884, National Cash Register became a national icon selling registers and other business machines. But it hastily adapted to the advent of electronic cash registers in the 1970s, and entered the manufacture of minicomputers, mainframes, and PCs. Charles Exley became CEO in the mid-1980s when yet another change was required: One analyst said,“They were on the verge of collapse. They had mainframes that nobody wanted anymore. The minicomputer business was dying. They had no software to speak of.”17 Thus, NCR reinvented itself again, to a line of computing equipment configured by open systems architecture that was based on networks of PCs, rather than on a mainframe computer hub. Success required a broad line of equipment to meet the diverse computing requirements of clients. The first computers (Series 3000) under this new line were produced in September 1990.
At that moment, the process of reinvention meant that NCR was vulnerable. Its recent share price performance was evident in Figure 8.1: The cumulative market-adjusted returns show a declining trend from March of 1987 to the takeover announcement. And the firm’s spread over cost of funds turned sharply negative in 1990, reflecting heavy capital spending to bring on the Series 3000 product line (see Figure 8.2).
NCR offered a number of attractive attributes to AT&T including profitability of operation, larger competitive scale (NCR was the fifth-largest computer company in the United States), global reach, a strong position in commercial transaction processing with its ATMs and sophisticated cash registers, and above all, complementarity. The equipment of NCR and AT&T used the UNIX operating system; NCR had special competencies in computing, AT&T in telecommunications; NCR was strongly positioned among business customers in retailing, financial services, and state and local governments; AT&T was strongly positioned among customers in telecommunications, transportation, manufacturing, and the federal government. NCR had a strong revenue base outside the United States; AT&T was focused domestically.18 Finally, several observers thought that both firms had a “Midwestern ethos” in their corporate cultures.19
Unfortunately, by the winter of 1990/1991, NCR’s big bet on Series 3000 was weakening.The early stages of recession did not favor corporate capital spending on new computer gear. As all producers tried to move inventory, pricing turned cutthroat. NCR was finding it difficult to keep up with the rapid pace of innovation required for survival. And it discovered that its costs were too high.20 In September 1991, NCR revised downward its forecasts in filings with the SEC.
THE TAKEOVER
In 1988, Robert Allen met with Charles Exley to explore the possibility of a friendly combination between the two firms. Exley demurred, but indicated that if NCR were ever the subject of a hostile raid, he would consider calling upon AT&T to act as a “white knight.” A year later, the two men met on the same subject, and with the same result.
On November 15, 1990, AT&T extended an offer of $85 per share to NCR, by a confidential message from Robert Allen to Charles Exley. In response to the secret bid, NCR chairman Charles Exley replied that he would not sacrifice a successful computer company to save AT&T’s failing computer group and that AT&T’s bid was just an attempt to salvage its failure in computing. Exley also threatened to quit if AT&T acquired his company. Analysts believed that NCR’s response was aimed at getting AT&T to raise its offer. Indeed, NCR was prepared to negotiate at a price of $125 per share ($8.5 billion) but AT&T viewed that price as “outrageous and totally unjustified.” At the same time, NCR took steps to boost its antitakeover measures.
Following the rejection by NCR’s board, AT&T commenced a public tender offer for NCR at $90 per share, on December 2, 1990. The cash-for-stock bid was valued at about $6.1 billion. The hostile bid was seen as being highly unusual for AT&T, “which generally uses its dominant position in the telephone industry and the reputation of its research staff to find willing partners.”21 AT&T sought to portray the offer as friendly, but NCR reacted negatively to the offer. Dennis Block, an NCR lawyer, said, “A marriage of the companies makes no business sense.” Exley told a reporter, “There’s not only no synergy, there’s a direct contradiction.”22
On December 14, 1990 NCR’s board rejected AT&T’s takeover offer, describing the $90 per share bid as “grossly inadequate and unfair.” Two days later, AT&T announced that it would mount a proxy fight to unseat NCR’s board. A special meeting of the shareholders could be called by 25 percent of NCR’s shares, but 80 percent of the shareholders would be needed to vote out the board of directors. Institutional investors owned about 60 percent of NCR’s stock. For the next month, AT&T and NCR jousted with lawsuits in various courts either aimed at stopping or delaying AT&T, or limiting the ability of NCR to delay the takeover process. These lawsuits included claims about violations of federal securities laws, antitrust laws, bank holding company laws, and federal communications rules.
On January 16, 1991 AT&T reported that it had received tenders for about 70 percent of NCR’s common stock. With proxies in hand, AT&T called for a special meeting of shareholders to elect directors; the meeting was scheduled for March 28. The growing feeling among analysts and investors was that Exley should negotiate an acquisition for a suitably high price, rather than let AT&T win NCR at the existing $90 per share bid. But Exley continued to defend the independence of NCR.
In late February NCR tried to create a $500 million employee stock ownership plan (ESOP) that could control eight percent of the company’s stock (the purchase of 5.5 million shares for the program would not require outside financing). A court subsequently threw out the ESOP defense. NCR also approved a special $1 billion dividend payment as well as an increase in its regular quarterly dividend from 35 cents to 37 cents.
These defenses notwithstanding, it became apparent to all including Exley, that AT&T would gain four seats on the board after the special shareholders meeting on March 28, and gain control of the board one year later. On March 10, AT&T indicated that it would be willing to raise its offer to $100 a share ($6.77 billion) if NCR’s board dropped its objections to the deal. Once again Exley reacted negatively to the offer saying, “If AT&T wants to proceed in a professional and responsible manner, they should deal directly with us and submit a serious proposal in writing—rather than posturing in the media.”23 Nine days later, AT&T announced that it would definitely raise its offer for NCR to $100 per share if shareholders voted to remove the board at NCR’s special stockholders meeting.
Then, just four days before the special shareholders’ meeting, Exley announced, “The board authorized management to initiate a process that will help AT&T understand the basis for the board’s conclusion that [NCR’s] value is substantially above $100 per share. Accordingly, I have advised AT&T that we are prepared to meet with them and make appropriate information available.” NCR and AT&T negotiators met for two days, and then parted bitterly over the valuation of NCR. AT&T vowed to press on with its takeover efforts in the absence of talks.
At the special meeting, AT&T fell short of gaining the necessary 80 percent shareholder support to replace NCR’s entire board. However, AT&T did win 4 of 12 seats on the board. On April 8, 1991 Exley announced that NCR would be willing to restart merger talks with AT&T—but not at a price below $110 per share ($7.48 billion).
Two weeks later, AT&T raised its bid to $110 share, provided it could pay for the transaction with its own stock and account for the transaction under the pooling-of-interests method. The offer was also conditional on an agreement with Exley to stay on for the transition period, as well as on reaching a new employment arrangement with seven other top executives to retain their leadership in the new company. NCR indicated that it would approve the new bid if shareholders were assured of getting $110 when the deal was completed. Therefore, AT&T offered to include a collar, which would guarantee the $110 per share price as long as AT&T stock stayed within a targeted price range.
NCR finally agreed on May 6 to AT&T’s takeover bid in a deal for $7.4 billion of AT&T shares. NCR was to retain its corporate identity, as well as its headquarters in Dayton, Ohio. Exley said that his company would move swiftly to combine operations with AT&T, with six to eight managers from each company working solely toward this effort.Transition teams were chartered to explore how the two firms could best combine their manufacturing, products, finances, marketing, and personnel.
A month later AT&T announced that it would divest its 19 percent stake in Sun Microsystems, the fast growing leader in computer workstations. AT&T’s 19.1 million shares in Sun were worth about $692 million. The partnership had led to the development of a unified version of UNIX, but did not have any further strategic significance. This sale was ironic: Sun remained profitable, continued to grow rapidly, and went on to create the hugely popular Java software that would enable computers to run other software applications off the Internet. Every Internet provider (including Microsoft) ultimately embraced Java.
At the time of its bid, AT&T announced its intent to hand over its computer business to NCR to be run by NCR’s management at its existing headquarters in Dayton, Ohio. Layoffs and other cost reductions were to come from the AT&T side. In July, AT&T announced better-than-expected earnings for the second quarter at $828 million (up 26 percent), but said it would take a write-off of as much as $4 billion ($2.5 billion after taxes) by the end of the year in charges24 related to its takeover of NCR as well as a number of cost cutting programs. Jack Grubman, a research analyst, concluded that this amounted to a total write-off of AT&T‘s computer operations:“You can finally say, eight years after they started to break up the old AT&T, that the ship has turned and is headed in the right direction.” 25 Earlier he had said, “You can consider this a reverse acquisition. AT&T is getting out of the computer business by a $6 billion acquisition of NCR.”26 But another analyst asked, “Can you execute a vision that isn’t yours? This is AT&T’s vision for what the future should hold, not NCR’s.”27 Ultimately, the 7,500 employees of AT&T’s computer segment were laid off, though 2,000 were re-hired by NCR.
On September 13, 1991, NCR’s shareholders overwhelmingly approved the takeover by AT&T. The merger was consummated on September 19.
AFTERMATH
Following the acquisition in September 1991, AT&T was silent for several quarters regarding the performance of its new business unit. The firm announced some costs related to the acquisition, and various restructuring charges totaling $2.65 billion. But in general the presentation to the public was upbeat. In June 1992, NCR chairman Gilbert Williamson said his company was growing and was profitable across all divisions. This was re-confirmed in September 1992, and January and May 1993.
In March 1993, NCR chairman Gilbert Williamson announced his retirement effective May 1. He was to be replaced by Jerre Stead, an AT&T executive who had successfully turned around AT&T’s office phone systems business. Williamson said that he was not being forced to retire; the decision was his own choice. He simply wanted to spend more time with his family.
The management transition in 1993 proved to be the equivalent of a belated postmerger integration. AT&T installed one of its own senior managers to run NCR. As John Keller reported:
[AT&T] let many top NCR executives exit, then rankled an embittered and balky work force and hostile management by imposing its own culture on the new property. . . . AT&T waited through a voluntary two-year hands-off period to take full management control of NCR.Then it appointed its own executives to run the unit—even though AT&T managers had flopped in steering the parent company into computers. The AT&T team tried to put in a financial-reporting system that made it tougher to gauge profitability as products moved from production to market. They reorganized sales, confusing customers. And they ultimately dumped the NCR name . . . in favor of the sterile [Global Information Solutions].”28
Roughly coincident with Stead’s arrival, the financial performance of NCR deteriorated sharply. Figure 8.3 gives the operating income for NCR and its ratio of EBIT to invested capital. Plainly, the business turned sharply for the worse after Gil Williamson left. Though NCR recovered profitability in 1996, never again was it as prosperous as earlier. What changed? AT&T paid $500 million in restructuring costs associated with closing the old AT&T computer segment. But the firm also noted that “we faced fierce competitive pricing, particularly for lower-end computer products, and weak economic and market conditions in Europe and Japan.”29 Later, the firm noted:
All parts of our business face substantial and intensifying competition. Product pricing and technology are under continual competitive pressure, and business and market conditions are changing rapidly. . . . Price competition for personal computers was severe. Most personal computers from different manufacturers use the same or comparable microprocessors and software, leading customers to focus increasingly on price. We plan to make NCR a stand-alone business focused on transaction-intensive computing. The new strategy centers around more profitable products such as massively parallel computer processors, automated teller machines and retail scanning equipment. This 
direction also enhances the company’s primary strategy which is to help businesses use new technology to collect and use information to enhance customer service. Although NCR is ceasing the manufacture of personal computers, it will continue to offer personal computers manufactured by others as part of its total solutions approach. NCR, as a result of continuing operating losses, has taken decisive action in 1995 to create a smaller, more focused business, concentrating on the three industries in which it has a leading position—retailing, financial and communications. This resulted in restructuring and other charges in the third quarter of 1995, of approximately $1.6 billion before taxes ($1.2 billion after taxes). The pretax charges reflect $698 million for employee separations and other related costs, $564 million for asset write-downs, $196 million for closing, selling and consolidating facilities and $191 million for other items .30
Figure 8.3 NCR Operating Profit and EBIT/Investment
Sources of data: Company annual report and author’s computations.
One analyst wrote:
The problem, in a nutshell, is that business is horrible and the cost structure is too bloated. NCR’s domestic business actually saw a double-digit revenue increase, but international was down as weak overseas orders from last year carried over into weak revenues in the first quarter. In addition, the product mix at NCR was skewed to the areas with the most pricing pressure, hence, the worsening of losses despite the top-line pickup.31
Another analyst said:
NCR wasn’t a bad asset; it’s just that AT&T merged it into its own money-losing computer operations and tried to do too much with it too soon. In addition, NCR’s customer segments fell into a global swoon, and some of its product lines were too early or inefficiently targeted (we think the in-house PC business has always been a disaster, while first-generation massively parallel systems lacked generic software).32
On November 24, 1993, NCR announced a plan to reduce its workforce by as much as 15 percent in order to cut costs and regain its competitiveness. The company had been suffering all year from intense price competition and tight markets, and NCR had announced a $49 million operating loss for the third quarter (versus a $50 million profit the year before). NCR hoped to eliminate 7,500 jobs through voluntary measures, rather than layoffs.
A year later, Jerre Stead announced that the business unit’s losses had narrowed, and that he would resign to become chairman and CEO of Legent Corporation. In March 1995, AT&T announced that Lars Nyberg, an executive from Phillips Electronics with a reputation as a cost-cutter, would take over as chairman and CEO of AT&T Global Information Solutions. Nyberg had been brought in to cut jobs and costs. In May the business unit was losing money at the rate of $2 million per day. Results for the first nine months of 1994 included an operating loss of $501 million, compared with earnings of $63 million in the first nine months of the merger year. Analysts saw a need for the computer unit to gain market share “in whatever part of the business they are competing in or get out.”33 In short, by the summer of 1995, AT&T found itself facing the decision it had faced in 1990: Raise the bet or exit the industry.
On July 28, 1995, AT&T announced that it would shrink its computer unit and focus on its core strengths in the financial, retail, and communications industries. Then on September 21, 1995, AT&T announced a three-way breakup into units focused on telecommunications (the new AT&T), equipment manufacturing (Lucent Corporation), and computer equipment manufacturing (NCR). AT&T’s stock rose 11 percent on the announcement. Analysts attributed the increase to the elimination of a diversification discount. AT&T Chairman Robert Allen said, “The market value of AT&T was being buried. Investors will clearly understand now.” Employees of NCR celebrated with balloons and champagne. After the announcement of the NCR spin-off, John Myers, an NCR programmer candidly said, “I think it’s great to get rid of the ball and chain around us. They’ve been slowing us down for five years now. We can really focus more now in the areas we know about.”34
The spinoff of NCR occurred on January 2, 1997, yielding a market value of NCR of $3.4 billion, less than half of what AT&T had paid five years earlier. AT&T sold its remaining stake in NCR by year-end 1997. A rough estimate of AT&T’s internal rate of return on investment would be -40 percent.35 Considering that from September 1991 to January 1996 the S&P 500 index grew by an average annual rate in excess of 15 percent, the return to AT&T shareholders adjusted for the lost opportunity of investing in the market was -50 percent. Possibly foreshadowing this loss was the dramatic movement in AT&T’s share prices during the takeover fight. Thomas Lys and Linda Vincent (1995) studied these movements, and concluded that the takeover fight reduced AT&T shareholder wealth by about $3 billion.
Journalists and securities analysts viewed the acquisition of NCR by AT&T as a disaster. “Part of the problem, according to analysts, was that AT&T bought NCR right at the time it was making the transition from traditional mainframe computers to so-called massively parallel computers powered by collections of smaller, cheaper processors running in tandem. The unit has also been hit by a decline in its traditional cash register business as low-margin personal computers have made up a rising proportion of such sales. And on the hardware side, it has found it difficult to compete with efficient producers such as Compaq Computer.”36 The Economist suggested that the failure was due to the absence of a useful marketing fit, a clash of cultures (unionized at AT&T, nonunion at NCR; conservative at NCR and “politically correct” at AT&T), and the huge cost in terms of capital and people.
A COMPLEMENTARY DEAL FROM HELL: MERCK AND MEDCO
For a comparative example to the case of AT&T and NCR, consider another unhappy case, Merck’s acquisition of Medco. The latter differs from the former in one important dimension: Medco was prospering greatly under Merck’s ownership at the time that Merck decided to spin it off to shareholders. As such, it offers a lesson about the forces necessary to overcome cognitive biases favoring retaining a unit. As AT&T and NCR showed, sunk cost mentality and the escalation of commitments are powerful contributors to M&A failure. But are they inevitable in M&A?
The facts of the acquisition are as follows. On July 12, 1993, Roy Vagelos, CEO of Merck, announced that he was holding talks to acquire Medco Containment Services, Inc., in a deal that would total $6 billion and that would be consummated on November 18. Ten years later, Merck spun off Medco to its shareholders in a deal that valued Medco at about $6 billion, a virtual giveaway in light of Medco’s sixfold growth and strong profitability over the decade of ownership by Merck. The large question is not why Merck exited from this sound business, but rather, why it took so long.
Merck was a leading producer of prescription pharmaceuticals and had been recognized by Fortune magazine as the most-admired company in the United States. Medco was a pharmaceutical benefits manager (PBM), a mail-order supply house that provided prescription fulfillment services under contract to corporate clients and HMOs. Through its bulk purchasing and other management efforts, Medco reduced prescription drug costs for its clients.
Vagelos saw that the explosive growth in health care costs would intensify cost-containment pressures on patients and health care providers. Merck’s annuity drugs were drawing close scrutiny by lawmakers and regulators. Figure 8.4 shows the sagging share prices of pharmaceuticals companies as the reality of the expected price pressure hit investors. Accordingly,Vagelos focused on means of offsetting the price cuts through volume increases. Medco offered a solution: As manager of pharmacy fulfillment for 33 million people, Medco could push Merck-brand products over its competitors’ and give Merck insights into prescription trends. Furthermore, Medco’s selling and administrative efforts were done by telephone, which was much cheaper than Merck’s 5,500 direct field sales people. Medco’s revenues were growing at 35 percent annually. Vagelos said, “I’ve always thought there would be a better way.This is it.This is eureka.” 37 Other big pharmaceutical companies followed suit with purchases of other PBMs.
The only problem was that Medco shifted from a neutral cost-cutter to a partisan product-promoter. For example, Medco used aggressive telemarketing tactics to steer physicians toward Merck products. One physi-cianwrote, “By acquiring Medco, Merck will be in a position through the large mail-order drug dispenser to sway physicians to prescribe Merck products. Consumers and health reformers both have a stake in the outcome. To the degree that individual Merck drugs are the best on the market, this will be beneficial. To the degree that other drugs are better, the public interest will not be served. And in either event, companies attempting to bring forth competing products will be at a disadvantage.”38 “It’s putting the fox in charge of the henhouse,” he later added.39
Figure 8.4 Price Trends of the S&P 500 Index and S&P Drugs Index
Source of data: Datastream.
Economically, Merck’s strategy of dominating the channel of distribution made sense. Ethically the implementation of this strategy did not. Prescription-switching was conducted by Medco’s telephone pharmacists without disclosing to physicians that they ultimately represented Merck and had a potential conflict of interest between the welfare of the patient and the welfare of Merck.Whether this practice crossed the line of illegality was the focus of lawsuits and government investigations for the next several years.
Just two years after the deal, beginning in 1995, the legal challenges gained traction. In February, Merck settled a lawsuit by agreeing to offer other manufacturers’ drugs in the Medco formulary (a list of recommended drugs for treating diseases) and to limit the exchange of certain information about drug prices quoted by other manufacturers. In October, Merck settled with 17 states in litigation that Merck had violated consumer-protection laws. Merck agreed to disclose to physicians that the Medco pharmacists were calling on behalf of Medco, owned by Merck, and to disclose the manufacturers of recommended drugs. In November, the Government Accounting Office (GAO) reported on practices adopted by PBMs after their acquisition by pharmaceutical firms—Merck/Medco, SmithKline Beecham’s Diversified Pharmaceutical Services, and Lilly’s PCS Health Systems. The GAO found that Medco had dropped from its formulary some drugs that competed with Merck.40
The U.S. Federal Trade Commission (FTC) was concurrently investigating these competitive practices, and found that those at Merck/Medco raised “the most difficult issues.”41 In 1998, Merck signed a settlement with the FTC finding that “Medco has given favorable treatment to Merck drugs. As a result, in some cases, consumers have been denied access to the drugs of competing manufacturers.”42 Merck agreed to adopt practices diminishing preferential treatment for Merck’s drugs. Also in 1998, the U.S. Food and Drug Administration began a study of possibly regulating the PBMs. Later, the FDA relented after intense resistance from PBMs and drug companies.
Medco succeeded in building Merck’s share of market, despite these interventions. Table 8.1 shows substantial disparities in sales of Merck products through Medco, as compared with the open market. Merck defended the share of market gains by noting that simply focusing on share ignored rebates and discounts that Medco won for its clients.
In 2002 the U.S. Attorney’s office in Philadelphia launched an investigation into Medco’s practices. And separately, the State of West Virginia sued Merck, alleging that Medco had steered state employees to more expensive drugs and had kept rebates that should have been passed along to the state. Medco countersued, alleging that it had saved West Virginia more money than expected, and that some of the savings should be shared with Medco. Merck settled a similar five-year lawsuit with clients, who charged that Medco kept rebates due to them. Merck agreed to pay $42.5 million and change its disclosure practices. Merck also noted that plaintiffs’ attorneys would garner 30 percent of the settlement.
The settlement sparked the interest of more state attorneys general. In January 2003, 25 of them joined West Virginia in opening inquiries into Medco’s PBM practices. Medco denied favoring one manufacturer over another. In March, a large union and a consumer group sued the four largest PBMs for failing to pass savings onto health plans and consumers. “In the early 1990s, they told us PBMs were the key to controlling drug costs. . . . But now its clear that PBMs have not only failed to deliver any savings, but they have built all kinds of new profit-shaving into the system,” said a spokesperson for the consumer group.43 In June, the U.S. Attorney in Philadelphia finally moved: The Department of Justice joined a whistleblower lawsuit that claimed Medco put profits before patients. Later that year, the DOJ charged Medco with fraud. Medco contests the charge; the litigation is ongoing.
TABLE 8.1 SELECTED MARKET SHARES OF MERCK DRUGS WITHIN MEDCO AND IN OPEN MARKET
Source of data: Court documents, reported in B. Martinez, “Merck’s Ties with Medco Detailed,” Wall Street Journal, January 8, 2003, D6. Copyright © 2003 by Dow Jones & Co. Inc. Reproduced with permission of Dow Jones & Co. Inc. in the Format Trade Book via Copyright Clearance Center.
As if the litigation weren’t sufficient to motivate an exit, Merck encountered fierce challenges to its leading drug lines. Studies found that Vioxx and Celebrex were no more effective as pain cures than older and cheaper drugs. In 1997, Zocor was suddenly displaced as the leading anticholesterol drug by Lipitor, produced by Warner-Lambert. And the patents on five important Merck drugs accounting for one-third of Merck’s medicine sales would expire in 1999. Though Merck introduced 17 new drugs to the market between 1995 and 2002, the financial impact of the sudden reverses was sharp. Merck informed investors that earnings would be lower than forecasted. Merck’s market value fell nine percent on June 22, 2001, the date of announcement. In 2001, Merck lost one-third of its market capitalization.
Meanwhile, the other large pharmaceutical companies that had acquired PBMs were bailing out of the industry. Eli Lilly sold PCS Health Systems for a $2.4 billion loss in 1997; SmithKline Beecham sold Diversified Pharmaceutical Services for a $1.9 billion loss in 1999.
In response to these difficulties, Merck decided to exit from the PBM business, announcing on January 29, 2002, a prospective carve-out of Medco. Merck aimed to sell 20 percent of Medco in an initial public offering (IPO) in mid-year. Later, Merck would distribute the balance of the shares to its shareholders.The prospectus for the deal disclosed that Medco would be obligated to continue to promote the sale of Merck drugs for five years. Then the IPO was cancelled when Merck disclosed that from 1998 to 2001, it had recognized $12.4 billion in drug co-payments (collected through Medco) as revenue. Professor Charles Mulford said, “While it doesn’t alter net income, clearly they’re taking an aggressive stance relative to other companies in the industry. It overstates total economic activity at the company.”44 In contrast, Robert Willens of Lehman Brothers opined that “the accounting was appropriate because Medco served as the obligor of the payments.”45 But in July, Merck and the underwriters decided to cancel the offering.
Nine months later, Merck announced that it would spin off Medco, distributing shares in Medco directly to Merck shareholders. The spin-off would be accompanied by two features. First, as with the carve-out, Medco would be required to push Merck drugs for a period of time. Second, Medco would borrow and pay a $2 billion dividend to Merck. Under the earlier carve-out plan, Merck had anticipated receipts of $2.5 billion. The spin-off occurred on August 19, 2003.
As with AT&T and NCR, one wonders why it took so long for Merck to decide to exit. In both cases, the companies were awash in bad news long before the spin-offs. But in Merck’s case, the story is more complicated than just sunk cost mentality. Medco was just too profitable to let go. Figure 8.5 shows that Medco’s operating profit was rising rapidly, during the time of difficulty for Merck. Given that Merck was facing a worsening position in its leading drugs, and then a worsening economic climate starting in 2000, the prospect of lost earnings must have been par-ticularlyunappealing. Offsetting this, of course, would be the sizable payment to Merck, to help fund its R&D efforts.
Figure 8.5 Medco Operating Profit
Sources of data: Company annual reports and author’s computations.
CONCLUSION
The M&A failure framework highlights the many dimensions of the disastrous deal between AT&T and NCR. Business was not as usual given the rapid shift toward open-architecture computing, rapid technological innovation, price competition, and the onset of a recession in 1991. AT&T was smarting from a six-year failed attempt to establish a viable foothold in the industry. Unknown to all was NCR’s impending distress. Both AT&T and NCR were in the midst of reinventing themselves and would discover only in 1993 that their reinvention was too late.
On the surface, it would seem that this deal offered little complexity: AT&T simply erased its existing computer group and brought its existing client base to NCR. But complexity appears in NCR’s own corporate transformation to open-architecture computing as of 1991. Such transformations require the migration of employees, customers, and suppliers to new products and processes in virtually every dimension of the business. And they require high coordination. This, plus the high purchase price sapped flexibility from the situation: NCR’s fortunes were tightly coupled to its shift to open-architecture computing.
The fundamental management choice that predetermined its difficulties was the strategic decision to enter the computer industry in 1984. Cognitive biases, particularly overoptimism, sunk cost mentality, and escalation of commitments spurred Robert Allen onward through the operational losses and major investment in NCR. Finally, cultural differences dragged on team effectiveness, particularly after the departure of Gil Williamson and the arrival of Jerre Stead in 1993.
The cognitive biases in this case received special attention. A careful study of the AT&T/NCR case by Thomas Lys and Linda Vincent led them to reflect that the acquisition was a manifestation of the escalation of commitments. Decision-makers can become “bound” to an earlier decision when it is difficult to reverse, is clear and public, is freely taken, and has large personal implications for the decision-maker.46 To become “bound” to a decision means to follow through with it even in the face of information, opinion, or outcomes to the contrary. Escalation occurs when decision-makers who feel bound to a course of action “raise the ante” in an effort to make their gambles pay. AT&T’s managers had freely consented to the court decree dividing the firm, and then committed themselves to a strategy that would marry computing and telecommunications. Management wanted to prove the value of the strategy they had adopted after agreeing to the court decree. AT&T’s initial efforts in computers failed, motivating AT&T to acquire NCR. Even though the assessment of the equity market was sharp and adverse, AT&T’s management slogged ahead. Lys and Vincent estimated that the cumulative wealth loss to AT&T shareholders because of the acquisition was $6.5 billion. Even after acquiring NCR, AT&T’s management raised the bet further by absorbing ongoing losses.
The complementary deal, Merck’s acquisition of Medco, would qualify as another deal from hell in the damage it wrought to Merck’s reputation. Though it was moderately successful in economic terms, the deal created enormous conflicts of interest, the evidence of which will occupy trial lawyers for years to come. Merck was the first pharmaceutical company to enter the PBM field and the last to leave. Its delay is easily explained by the economic success of Medco, in contrast to AT&T, which delayed the exit in disbelief that the losses were chronic.
NOTES
1 This chapter was prepared with research assistance from Sean Carr, David Eichler, Chad Rynbrandt, and Sanjay Vakharia.
2 Quotation of Robert Allen in Nikhil Deogun and Steven Lipin, “Deals & Deal Makers: Cautionary Tales,” Wall Street Journal, December 8, 1999, C1.
3 Quotation of Robert Allen in Cindy Skrzycki, “NCR Corp. Agrees to AT&T Merger,” Washington Post, May 7, 1991, C1.
4 Quotation of Robert Allen in “Deals and Deal Makers: Cautionary Tales: When Big Deals Turn Bad,” Wall Street Journal, December 8, 1999, C1. Copyright © 1999 by Dow Jones & Co. Inc. Reproduced with permission of Dow Jones & Co. Inc. in the Format Trade Book via Copyright Clearance Center.
5 Raju Narisetti, “History Holds Some Hard Lessons for Compaq,” Wall Street Journal, January 28, 1998, B1.
6 Nicholas Booth, “NCR Rejoins the Road to Success,” The Times of London , June 25, 1997, Interface 12.
7 Quotation of Robert Allen in “Fatal Attraction,” Economist, March 23, 1996, 74.
8 Quotation of Robert Allen in “Deals and Deal Makers: Cautionary Tales: When Big Deals Turn Bad,” Wall Street Journal, December 8, 1999, C1.
9 Letter to the Editor from Richard Bodman, New York Times, April 14, 1991, Section 3, 11. Copyright © 1991 by the New York Times Co. Reprinted with permission.
10 The extent of losses by AT&T before the NCR deal is not known for certain.Three billion dollars is the figure most commonly cited.Three billion dollars is an upper-bound given in Andrew Pollack, “Big Deal That Poses Little Threat,” New York Times, May 7, 1991, D6.
11 Andrew Pollack, “Coming to the Rescue of a Computer Venture,” New York Times, December 4, 1990, D1. Copyright © 1990 by the New York Times Co. Reprinted with permission.
12 Figures given in Michael Noll, “The Failures of AT&T Strategies,” New York Times, March 31, 1991, Section 3, 9. Copyright © 1991 by the New York Times Co. Reprinted with permission.
13 Quoted in Eben Shapiro, “Cash Offer by AT&T after Rebuff,” New York Times, December 6, 1990, D1.
14 Keith Bradsher,“NCR and AT&T: Would the Combination Work?” New York Times, December 9, 1990, Section 3, 12.
15 Quotation of Charles Ferguson in L. J. Davis, “When AT&T Plays Hardball,” New York Times, June 9, 1991, Section 6, Part 2, 14.
16 Quotation of Charles Exley in L. J. Davis,“When AT&T Plays Hardball,” New York Times, June 9, 1991, Section 6, Part 2, 14.
17 Quotation of Judith Hurwitz at Patricia Seybold’s Office Computing Group in L. J. Davis, “When AT&T Plays Hardball,” New York Times, June 9, 1991, Section 6, Part 2, 14.
18 The points of complementarity are paraphrased from Rick Whiting, “NCR/AT&T: One Era Ends . . .Another Begins,” Electronic Business, May 1993, 34.
19 Eben Shapiro, “AT&T Is Offering $6 Billion to Buy a Computer Maker,” New York Times, December 3, 1990, A1.
20 Points of downturn are abstracted from Edmund Andres, “AT&T Acquisition, Soon to Be Spun Off, Regains NCR Name,” New York Times, January 11, 1996, D5.
21 Eben Shapiro, “AT&T Is Offering $6 Billion to Buy a Computer Maker,” New York Times, December 3, 1990, A1.
22 Keith Bradsher,“NCR and AT&T: Would the Combination Work?” New York Times, December 9, 1990, Section 3, 12.
23 Eben Shapiro, “AT&T Pressures NCR Board,” New York Times, March 11, 1991, D1.
24 From advising in the AT&T-NCR deal, Dillon Read (NCR’s advisor) received fees of $18.5 million; Morgan Stanley (AT&T’s advisor) was paid $13.3 million.
25 Barnaby Feder, “AT&T Expects Big Write-Off,” New York Times, July 19, 1991, D1.
26 Andrew Pollack, “Coming to the Rescue of a Computer Venture,” New York Times, December 4, 1990, D1.
27 Carla Lazzareschi, “Will This Marriage Succeed?” Los Angeles Times, May 7, 1991, D1.
28 Keller (1995).
29 Quoted from AT&T Form 10-K, 1994, filed with the Securities and Exchange Commission.
30 Quoted from AT&T Form 10-K, 1996, filed with the Securities and Exchange Commission.
31 Salomon Brothers, U.S. Equity Research, Telecommunications, “AT&T—The Clear Winner in Telecom,” May 3, 1994.
32 AT&T Corporation Company Report, Prudential Securities, M. Elling, R. Walsh, C. Larsen, October 12, 1995, 11. “GIS Free to Find a New Home.”
33 New York Times, May 5, 1995.
34 Quotation of John Myers, NCR programmer, in James Hannah, “NCR Celebrates Independence from AT&T,” Associated Press Newswires, January 2, 1997.
35 This estimate is based on the following assumptions. AT&T’s initial outlay was the sum of $7.48 billion for NCR’s common stock, plus the equity value of its own computer business, which for simplicity I assume was nil. From 1990 to 1995, the computer business lost an accumulated $3.85 billion. It is not possible to obtain a clear pattern of these losses over time from AT&T’s annual reports. But news reports suggest that the losses began after Gilbert Williamson’s departure in March 1993. For simplicity, I assume that the computer business operated at breakeven from 1991 to 1992, and that the losses were spread evenly across 1993, 1994, and 1995. Also for simplicity, I assume that ongoing outlays for working capital or fixed assets are zero. The exit value for this calculation was the market value of NCR at the date of spin-off, $3.4 billion. The simplifying assumptions bias the negative return toward zero, suggesting that a more accurate estimate is probably worse by a wide margin. However, the refinements would add little to the qualitative conclusion that the investment in NCR was sharply value-destroying.
36 New York Times, July 29, 1995.
37 Brian O’Reilly, “Why Merck Married the Enemy,” Fortune, September 20, 1993, 60.
38 Philip R. Alper,“Health Care: Report from the Trenches—High-Pressure Tactics Raise Doctor’s Pressure,” Wall Street Journal, November 17, 1993, A22.
39 Quotation of Philip R. Alper in Elyse Tanouye,“Changing Minds: Owning Medco, Merck Takes Drug Marketing the Next Logical Step,” Wall Street Journal , May 31, 1994, A1.
40 The GAO finding is summarized in “Merck Settles Arm-Twisting Charges,” Business & Health, December, 1995, at www.findarticles.com/p/articles/mi_m0903/is_n12_v13/ai_178575492.
41 Elyse Tanouye and Laurie McGinley, “GAO Report Says Merck-Medco Merger Raises Issues That Warrant Scrutiny,” Wall Street Journal, November 13, 1995, B12.
42 Barbara Martinez, “Merck’s Ties with Medco Details—Drug Maker Used Unit to Increase Market Share, Court Documents Show,” Wall Street Journal, January 8, 2003.
43 Quoted in Barbara Martinez, “Pharmacy-Benefit Managers Are Stiffing Consumers, Suit Says,” Wall Street Journal, March 19, 2003, D3.
44 Quotation of Charles Mulford in Barbara Martinez, “Merck Included Co-payments among Revenue,” Wall Street Journal, June 21, 2002, C1.
45 Paraphrase of Robert Willens in Martin Sikora, “Merck to Get a Cash Payment in Spinning Off Medco,” Mergers and Acquisitions, June 2003, 16.
46 See, for instance, Salancik (1977) and Keisler (1971).
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