Companies buy companies for many reasons, but the most common is to acquire customers. Consider the ten biggest deals ever (as of spring 2003), all of which happened in the past few years: AOL and Time Warner, Pfizer and Warner-Lambert, Exxon and Mobil, Comcast and AT&T Broadband, Verizon and GTE, Travelers and Citicorp, SBC and Ameritech, Pfizer and Pharmacia, NationsBank and Bank of America, and Vodafone and AirTouch. It's clear that most of these acquisitions were acquisitions of customers. SBC bought Ameritech, for example, mainly to reach a huge new group of customers to whom it could sell telecommunications services.
Of course, there are other reasons to buy a company: to get real estate or other facilities; to get brands, trademarks, patents, or technology; sometimes even to get employees. But ultimately, it's still about the customers. The acquirer buys those capabilities to help it serve existing customers better or to help it acquire new ones. For example, when IBM buys a small, specialized software company, it's probably not buying new customers; most likely, the target company's customers are IBM customers already. But IBM is buying new ways to serve them.
Once the managers of an acquiring company understand that they're really buying customers, they can take the next, far more revealing step in the analysis: understanding that some customers are more profitable than others. At most companies, this is an unfamiliar perspective. Companies are generally organized around products, territories, or functions, so that's how they measure and manage profitability. They can tell you to the penny how much they made or lost in the brake shoe division or the home mortgage division or in Latin America—but how much they made or lost on a particular customer? Most managers have no idea.
The extent of corporate ignorance and misinformation on this crucial topic is staggering. A surprisingly large percentage of executives we've talked to believe their companies have no unprofitable customers, which is virtually never true. When asked to name their most profitable and least profitable customers, most executives name the wrong ones or simply have no clue. Sometimes they guess that their biggest customers are also the most profitable; other times they guess the largest ones are the least profitable because of discounting and excessive service demands, adding, "But they're still profitable." When managers analyze customer profitability for the first time, their biggest "Aha!" is that the range of customer profitability is much wider than they imagined. Our study shows that it is far from rare for the most profitable 20 percent of a company's customers to contribute more than 100 percent of its profits, sometimes more than 200 percent, and for its least profitable 20 percent of customers to generate losses of an equal amount, with the middle 60 percent accounting for any net profits the company may earn.
Knowing that customer profitability varies widely, and combining that fact with the realization that most acquisitions are done for the customers, it becomes possible to analyze deals in a new way. Recall the deal we imagined above (not shown here —Ed.), this time supposing that the target company's customers are classified into four profitability quartiles. From most profitable quartile to least, we'll call them the Darlings, the Dependables, the Duds, and the Disasters. (See the exhibit "Salvaging the Deal.") For simplicity, the company's capital is divided equally among the four quartiles. We've assigned each customer quartile an after-tax operating profit; we won't take you through the spreadsheet behind the numbers, but with this data we've calculated the shareowner value created by each customer segment. For example, the Darlings have an intrinsic value of $3 billion, while $125 million of capital has been invested in them, so the segment's shareholder value creation is $2.875 billion. The total share-owner value creation of the target company is $1.5 billion.
| A surprisingly large percentage of executives we've talked to believe their companies have no unprofitable customers... |
| — Larry Selden and Geoffrey Colvin |
We observe that just one quartile of customers, the Darlings, generate 200 percent of the economic profit and 192 percent of the share-owner value creation, while the Disasters are almost symmetrically abysmal. The Disasters' negative intrinsic value is the amount by which their continuing failure to earn the cost of capital actually reduces the total value of the company—or, to put it another way, it's how much you should be willing to pay to make them go away. Again, this wide distribution of customer profitability is far from unusual.
Let's assume this company is acquired on the same terms described previously. A great deal of new capital is added to the business; we've already seen how the buyer loses from this investment. Now we can see exactly how this value destruction is divided among the company's customer quartiles. (We assume that, like most companies, this firm does not know the economic profit of the quartiles; we also assume it allocates capital among them equally.)
It's clear that the acquirer's overpayment for the Disasters, the quartile comprising the company's least profitable customers, is wrecking the whole deal. 1 Suppose it were possible to pay the Disasters to go away in effect, by shutting down and writing off some of the assets being used for them and redeploying other assets to the other quartiles. The quartile's value destruction would be reduced (due to the write-down), while the other quartiles would increase in value (through the use of new assets). All the other numbers remain the same, but the totals change dramatically. (See again the exhibit "Salvaging the Deal.")
Just by shutting down some of the target company's worst customers and redeploying assets to other customer segments where they can be better utilized, the acquirer changes this deal from a big loser to a big winner. Share-owner value creation increases from negative $1 billion to $4.075 billion. And it is possible for some companies to shut down customers, though the move is drastic and most would rather avoid it. A financial services company, for example, could stop offering certain services, or it could increase fees to levels that cause unprofitable customers to leave. A local phone company, on the other hand, might be prohibited by law from doing this. A retailer can't stop people from walking into its stores, but it can change its inventory, layout, marketing, and customer service in ways that discourage unprofitable customer behavior. At the very least, it could stop pursuing and encouraging unprofitable customers, which many companies unwittingly do. And of course a retailer can close stores that attract disproportionate numbers of unprofitable customers.
While jettisoning customers produces dramatic results in this example, in practice there would probably be better alternatives. Most companies can find ways to make unprofitable customers profitable. For example, Fidelity Investments found that many of its unprofitable customers were unprofitable because of the time they spent on the phone with company call centers. So the company routed calls from these customers into slightly longer queues, then trained the phone reps to educate these callers about use of the Fidelity Web site (a much lower-cost channel) and made the Web site far more helpful. The result was a shift in channel usage by these customers, many of whom became profitable, and an increase in Fidelity's economic profit. If an innovative acquirer could create new ways to make some of the Disasters profitable, the resulting increase in share-owner value would be even greater than that shown in the exhibit.
It's worth mentioning that the customer-focused acquirer in our example turned a bad deal into a good one—but a customer-centered target company could have been an even bigger winner without a deal. If, before the deal, the target company had eliminated the Disasters and made small additional investments in the Darlings and Dependables on its own, share-owner value creation would have increased from $1.5 billion to nearly $6 billion (the new market value, $6.575 billion, minus the original invested capital of $500 million and the small additional investments). Indeed, performance like that would probably have earned the company an even higher market value, because investors would have given this stellar outfit a P/E multiple higher than twenty, the one we gave it. In all probability, the company would never have become an acquisition target in the first place.
