The New Economy
In an age of consolidation, are sleek entrepreneurial companies being overtaken by gas-guzzling corporate Cadillacs? Hardly
You want to talk about merger mania? After reaching a record high of more than $1 trillion in 1996, the value of announced company mergers worldwide topped $1.6 trillion in 1997. More than half of that activity--$919 billion in 1997--was in the United States, where there were 10,700 mergers in 1997 and 10,340 in 1996. What's more, from 1988 to 1995, while the average number of companies grew by 10%--from 6 million to 6.6 million--the number of companies with more than 1,000 employees grew by 20%, from 5,000 to 6,000, faster than groups of any other size.
Behind those striking figures are the daily headlines you've certainly read, describing how already-large companies are combining to form truly mammoth ones, many of which seemingly dominate entire sectors. Raytheon's absorption of Hughes Electronics resulted in a single U.S. air-to-air missile maker. Columbia/HCA Healthcare Corp.'s acquisition of Value Health Inc., and Aetna Life & Casualty's marriage with U.S. Healthcare Inc., drastically reduced market competition among health-maintenance organizations.
Add to all that the consolidation from below--the so-called "roll-up" or "poof" companies that combine small operations in areas like printing, waste hauling, and video rentals into bigger, publicly traded enterprises. "Poof!" says one consolidator with a successful record of marketing roll-ups to investment-hungry Wall Street, "you have a company." While recent accounting-rule changes may dampen roll-up activity, efforts to consolidate many traditional types of small businesses, such as drugstores and veterinarians, contribute to the sense that the days of the "little guy" are numbered.
So if industry after industry is being rolled up into just a handful of mammoth companies, and Wall Street is pouring billions into "big-cap" stocks and ignoring the rest, shouldn't the 1990s be thought of as the Age of Big?
Recent consolidations in sectors like tire businesses and railroads have been, at least at first, disastrous. There have been cases in which new train companies couldn't even keep track of where their engines were. And even the well-publicized struggles of small businesses like mom-and-pop druggists may sometimes have been overstated. In 1980, 13 chain-drugstore companies operated 200 or more stores; today there are only 10 chains. In the same period, the number of drugstore chains with more than $75 million in revenues fell from 43 to 33. From 1988 to 1995, the total number of drugstores did fall, but only by 12%, from 50,000 to 44,000. From 1993 to 1995, a period in which small companies really felt competitive heat, payrolls for the smallest drugstores, with just one to four employees, actually increased by 8%, more than the industry average. Consolidation is happening, to be sure, but it hardly heralds the death of independents.
Let's face it: "big" just isn't what it used to be. The U.S. economy is no longer an atomistic, libertarian free-for-all in which the biggest player is likely to be the strongest. Even the largest and smallest businesses must form enduring links--strategic alliances, supply chains, project-specific work teams--to survive in constantly changing markets. Modern production networks comprise truly gargantuan organizations that dwarf even the largest merger, but what makes them tick is collaboration, constant learning, and unique compensation and authority structures, not size. Still, it's easy to understand why some might think otherwise.
Big Investors Build Big Illusions
So what accounts for our current merger mania and Wall Street's big-company infatuation? The answer is that mutual-fund money and huge institutional investors have profoundly changed the investment criteria that motivate highly public financial markets. In the past, company performance and skill were the primary factors guiding where money was spent. Today the things that matter are liquidity and name recognition.
When money flooded into mutual funds through retirement, pension, and other savings accounts, fund managers had to find ways of investing huge sums without driving up the price of the stocks they wanted to buy. "You just can't buy small-cap stocks as efficiently as big-caps," explains David Shulman, formerly the chief equity strategist for Salomon Brothers and now a general partner at Ulysses Management. The managers also wanted to be able to sell their holdings as easily as possible if they needed to raise cash.
Over the past five years, billions of dollars shifted into the biggest companies' stocks because they had the largest number of shares on the market, as well as brand-name recognition. Since 1994 the proportion of cash invested in "big-cap" index funds--those consisting of only large-company stocks--has risen from just 3% of total mutual-fund investments to 20%. "The market is willing to pay a premium for liquidity and so-called quality," explained one fund manager, John Bogle Jr. of Numeric Investors, to the Wall Street Journal. "And that's going to benefit the larger companies."
Merger mania was largely a direct result of Wall Street's preference for liquidity. Companies saw they would be rewarded for meeting the new criteria, and fund money provided the cash to do big deals. As companies' stock prices rose, moreover, they could use their own equity as currency to do their own mergers and acquisitions, trading stock for businesses.
Consolidation and stock-price appreciation began to feed on each other. Through layoffs, recapitalizations, and growing industry market shares, newly merged companies could often dramatically improve earnings and balance-sheet ratios. In the quarter-by-quarter time frame that governs public equity markets, those achievements seemed to justify even greater stock-price appreciation.
Indeed, the prices of holdings favored by most fund managers spiked to stratospheric levels. And in the mid-1990s large-company corporate earnings generally met expected targets. But often, smaller companies offered much better economic fundamentals, and in those cases, Wall Street had to scramble to explain why only big-cap investments made sense. More than anything else, it was the need for a story the Street could use to make pricey big-cap investments plausible--coupled with the fact that the media tend to focus on Wall Street but don't always understand it all that well--that launched the "Big Is Back" campaign.
Apart from simple investment liquidity, Shulman points to three other arguments Wall Street promulgated in support of big-cap stocks:
Near-monopoly positions. Large companies like Intel and Microsoft so dominated their markets that they could effectively set prices and ignore pathetically weak competitors.
Globalization. Only the biggest companies could afford to be in several markets at once, an advantage in hedging against a recession in any one country.
Procurement power. Big brand-name companies--such as Boeing, Ford, and Disney--can squeeze suppliers for price concessions and insulate themselves from profit pressures.
All of those attributes were supposed to protect big-cap company earnings and justify stratospheric stock prices, particularly when compared with the attributes of more vulnerable little companies. But in retrospect, there was much to doubt about that story.
For one thing, bigness has little to do with access to foreign markets. Fully 96% of exporters are small businesses. Far from suffering under intolerable wage and price pressures, those small companies pay wages comparable with those paid by the biggest companies. And while cornering the market on stock microprocessors or operating systems might well be profitable, increasingly, such products are commodities around which higher-end, more lucrative components and innovations are assembled. That's why the small companies are doing so well, even if Wall Street doesn't recognize it.
So no one should have been surprised when last October, Boeing--the very model of a monopoly, a globalized, oppressive big-cap company--predicted it would lose a record $2.6 billion over the ensuing 15 months. Early in the decade, the company had done exactly what Wall Street said it should do: ruthlessly cut back by 50% the number of suppliers it used, to "streamline" and cut costs. Boeing discovered that that strategy also gutted the skills and production capabilities of its crucial supply chain to the point where it could not meet demand.
"Ten years ago, if we bought rubber hoses, we might have bought them from 10 suppliers, and today we'd buy them from 3," explained Ron Woodard, president of Boeing Commercial Airplane Group, to the Seattle Times last October. "There are cost advantages and all that, but there's a downside. If one supplier doesn't come through, you've lost a third of your supply source." Even mighty Boeing had become dependent on small companies throughout its supply chain.
At the same time, despite their supposed advantages, much-hyped companies like Gillette and Coca-Cola failed to meet earnings projections. "The markets began to realize the big guys aren't perfect," recounts Shulman, "and maybe they were overvalued."
Wall Street's "Big Is Beautiful" story further crumbled with the collapse of Asian currency markets last summer, an event that undermined one of the key advantages largeness purportedly conferred: global reach. For three years big-cap stocks had been hyped on the theory that large companies could open offices overseas and take advantage of foreign opportunities more quickly than small companies could. Now, with an Asian meltdown in progress, that same attribute was seen as exposing big companies to a far greater risk, the caprices of overseas markets. "The allure of globalism has been tarnished," wrote Shulman in an October investment report.
Seemingly overnight, Wall Street shifted billions out of once-favored big-cap stocks into smaller domestic stocks, triggering rallies in the Russell 2000 and other small-cap stock indexes. For the first time in three years, small stocks outperformed large ones.
The moral of the story is that the fables Wall Street tells itself, no matter how widely they're publicized, don't necessarily reflect the rest of the economy. "Just about 7,000 companies are publicly traded," says small-business expert David Birch, and those amount to perhaps 15% of the nation's net growth. "Wall Street is a tiny part of what's really going on."
It's Not the Size; It's the Coordination
At a deeper level, while big companies are unquestionably part of the economic landscape, and supply chains are generating even larger production networks, those who study company organization are concluding that 1950s-style "big" can't possibly make a comeback. Size, in fact, seems increasingly irrelevant to business success.
One sign of that new awareness is that the old theory of why companies become big in the first place is in total disarray. In the past, economists claimed that bigness reduced transaction costs. If each person in a production team--a welder and a painter; a graphic artist and a secretary--was an independent company, the time and effort of bargaining over prices, delivery, or quality would overwhelm the whole operation. Worse still, people with special skills no one else could match might threaten to hold up everyone else for more compensation. Big companies, it was thought, solved those problems by bringing everyone under one set of rules that dictated how everyone interacted.
Even when that approach was plausible, it had its limitations. If vertical integration reduces transaction costs and increases efficiency, why shouldn't a single company control the whole economy? And when should a particular skill be brought in-house to avoid production holdups, while other skills are purchased on the open market? No one could answer those questions, and no one could convincingly explain why certain companies got big and others didn't.
Today, with the advent of E-mail and high-speed computer networks, it seems absurd to claim that corporate expansion is still driven by companies' fear of holdups and efforts to avoid transaction costs. As industry observers Peter Huber and Jessica Korn wrote in Forbes magazine, old-style "corporations grew for negative reasons--to eliminate friction and to compensate for poor communication and the prohibitive cost of negotiating with too many outsiders. Andy Grove and Bill Gates grow their companies to exploit economies of scale and scope and to capture the fecundity and elusive value of teamwork culture. The new corporation isn't an assembly line. It's a human beehive, at its best."
Similarly, the idea of bigness as an antidote to "knowledge blackmail" is inconsistent with how large companies actually decide to "make" or "buy" products and services. Older, 1970s-era studies of auto suppliers, for example, suggested that companies like Ford and GM would be more likely to make something in-house--become vertically integrated--when the product involved demanded a greater level of design and engineering skill. That was consistent with the view that companies got bigger to avoid holdups when sophisticated activities are involved.
But now, two decades later, companies still tend to outsource even those projects demanding greater skills, instead of handling them in-house. "Vertically integrated establishments," a team of Columbia University researchers recently concluded, "are no more likely to be engaged in design work...on technically demanding parts than independent firms." Something other than mistrust of other groups' intentions, or friction caused by transaction costs, must explain how companies are organized.
Like Huber and Korn, Columbia University law professor Charles Sabel believes there's a new logic at work that challenges our understanding of how entire industries, not just individual companies, operate. "When you fully articulate any supply chain," he says, "the resulting unit is quite large. And it's completely confusing to many what's going on--it's decentralized but still coordinated."
In contrast to the thinking behind Wall Street's "Big Is Back" campaign, which focuses on the 1950s notion that economies of scale drive corporate earnings, Sabel believes the best modern companies and production networks instead seek "economies of scope": the more they do, the easier it is for them to do something new that builds on past experience. By pooling information and monitoring one another's performance over time, work groups within companies, and even vast production networks, continually increase their ability to understand and solve market problems.
What counts is not size but the ability to learn, apply knowledge to problems other companies face, and convince other prospective team members that a company can hold up its part of the production chain. "In the past," Sabel notes, "the game was being the first in the door with prospective customers or vendors. Now getting a foot in the door is just the first step; not only do you have to qualify, you have to continually show you can solve problems better than others."
The implications Wall Street and others want to draw about a company's prospects on the basis of its capitalization or how many employees it has are particularly misguided. If "big" means having a hierarchy and being efficient when it comes to repetitive tasks, and, on the darker side, engaging in wage, price, and consumer-market exploitation, then being big doesn't guarantee much in today's economy. Solving the riddles of autonomy to stimulate creativity and collaboration so that joint solutions to complex problems can be found is the real key. Size is no indicator of whether a company or an entire supply chain is performing well.
That's the ultimate reason the "Big Is Back" claim is so wrongheaded: it implies that the crude 1950s-era business model is somehow back in vogue. The companies that try to duplicate such practices, no matter how dominant they may appear, will suffer if they disrupt the ongoing development of modern collaboration and coordination approaches. Think of companies like Boeing, which elected to cut back the number of its suppliers and then turned up the heat on product prices for those it continued to do business with.
Aspiring and existing business owners who fear that their dreams will be dashed by a newly merged corporate giant should remember that this is still the age of the entrepreneur. The path to success may be more complicated for a start-up or a growing company than ever before, but bigness has little to do with getting there.