The Department of Justice’s battle with Microsoft Corp. over the way it markets its Internet browser has dominated the antitrust headlines. But another fight between federal trustbusters and corporations is occurring on the mergers and acquisitions front, and it could have far more immediate consequences for CFOs.
Granted, a victory by Microsoft could help it dominate the Internet, which would have huge implications for customers, competitors, and investors. But the conflict, over a 1995 agreement with Justice on how Microsoft would integrate new applications into its operating system, may drag on for some time. The company has asked a federal judge to give it two months just to examine evidence. And if the parties eventually settle the dispute, the outcome’s significance may not be as great as the headlines suggest it will be. Or so, at least, the situation looked at press time.
Meanwhile, there’s been a sea change in how antitrust officials at the Federal Trade Commission (FTC) are evaluating M&As, and that change could undo more than a few high-profile deals in the offing. In fact, its effects are already being felt.
The biggest so far hit last June, with the FTC’s successful court challenge of the proposed $4 billion union of office-supply chains Staples Inc., in Delray Beach, Florida, and Office Depot Inc., in Westboro, Massachusetts. The FTC’s opposition to the deal–unalloyed by Staples’s offer to sell 63 stores to Office Max–wasn’t predicated on the fear that the resulting 1,000-store chain would monopolize the U.S. market for three- ring binders and laser-printing paper. After all, in most cities, outlets ranging from KMart to neighborhood stationers sell such supplies. Rather, by relying on data collected from point-of-sale scanners and by using sophisticated econometric tools, the FTC concluded that the merged entity would possess too much unilateral market power–that is, the new company could raise prices dramatically despite apparently ample competition.
“The argument that office supplies are office supplies and everybody competes with everybody, was belied by documents that showed these firms could raise prices if they were competing against only one other superstore,” says William J. Baer, director of the FTC’s Bureau of Competition.
FOUR BUCKS FOR A FILE FOLDER?
Indeed, data showed that file folders cost $1.95 in an Office Depot in Orlando, where it competed with Staples and Office Max, but sold for a hefty $4.17 in nearby Leesburg, Florida, which lacked a competing superstore. “Several studies indicated that the difference in price between one-chain cities and three-chain cities was about 13 percent–an extremely large price difference in retailing, where profits and profit margins are usually narrow and volume is great,” FTC chairman Robert Pitofsky said in a speech last September.
The Staples/Office Depot decision was just one of many cases the FTC and its colleagues at Justice have taken on as the merger frenzy continues unabated. Right now, the trustbusters are scrutinizing the proposed unions of behemoths like Price Waterhouse and Coopers & Ly-brand, Ernst & Young and KPMG Peat Marwick, and Travelers and Salomon Brothers. Antitrust officials will also have their hands full if the bids of either WorldCom or GTE win over MCI shareholders.
The reasoning and tools employed by the FTC in the Staples/Office Depot case represent the emergence of a new information-intensive approach, which, if nothing else, will mean more work for CFOs pursuing deals.
“We provided huge amounts of information, truckloads of data that we had collected electronically,” says Barry Goldstein, executive vice president and CFO of Office Depot, and the point person for collecting and disseminating the information during the merger effort. Indeed, CFOs often find themselves overworked during the prolonged negotiations between the FTC and the merging companies. “It puts tremendous pressure on the organization, just to accumulate all the data and respond to all the document requests,” says Goldstein.
Many economists and antitrust lawyers link the shift epitomized by the Staples/Office Depot ruling with the arrival of a new skipper at the FTC’s helm. The FTC shares antitrust oversight duties with the Department of Justice’s antitrust division, whose high- profile leader, Anne Bingaman, returned to the private sector in the summer of 1996. She was replaced by Joel Klein, who, though less of a Beltway big shot is no less aggressive on antitrust, and is leading the charge against Microsoft (see “The New Trustbusters,” CFO, November 1994). Installed in April 1995, Pitofsky, a well-respected veteran of the FTC and academia, brought with him a crew of number-savvy economists and lawyers, and their approach is bound to influence the Justice Department, as well.
While not willing to engage in the highly interventionist merger enforcement of the 1960s, today’s FTC regards the hands-off policy of the “Chicago School,” prevalent in the 1980s and early ’90s, as overly permissive. The Chicago School–so-called because of its identification with conservative University of Chicago economists– put great store in the invisible hand of competition, and assumed that firms acted primarily to reduce costs and increase efficiency rather than gain market power. So it used market share as the primary criterion for evaluating M&As.
Today’s postChicago School sees no less virtue in competition, but is far less willing to assume that it will arise. So it seeks to use sophisticated game-theory models to gain insight into just how extensive the effects of competition are likely to be in any situation. “Since the rise of the Chicago School, there have been developments in theoretical economics and in the empirical tools that have helped us see where the Chicago School arguments are still the best and where they might be qualified,” says Jonathan Baker, director of the FTC’s Bureau of Economics.
WATCH THAT CROSS-ELASTICITY
These tools enable the FTC’s economists to examine “unilateral” effects–that is, the ability of a merged entity to exercise market power and raise prices on its own. Although this yardstick was included in 1992 merger antitrust enforcement guidelines issued by the Bush Administration, the FTC did not look closely at unilateral effects until Staples/ Office Depot. But more powerful computers, better software, and the scads of data collected by firms via scanner at the point-of- sale have enabled FTC economists to apply the measure in rigorous fashion.
“Increasingly, where we have good data on what consumers of the products are doing in the marketplace, we can build a model that allows us to estimate the cross-elasticities of demand between the products made by the merging firms and other products in the marketplace,” says the FTC’s Baer. In other words, Pitofsky’s people think they can make the heretofore invisible hand of competition quite visible.
For those on the losing end of this argument, the shift represents a return to the bad old days of overstrict merger enforcement. “Post- Chicago is really pre-Chicago. It’s just old wine in new bottles,” says Donald Kempf, a partner at Kirkland & Ellis, in Chicago, who worked on the Staples/Office Depot case. “The staff attorneys assigned to the case were against it from the outset, and that never changed.”
Maybe. But the team of Pitofsky’s predecessor at the Clinton FTC might not have been as effective in court.
The shift in thinking hasn’t slowed down the pace of mergers and acquisitions–so far. But the small minority of actions that draw formal scrutiny may not be a predictable lot. That’s because the FTC isn’t just evaluating the products that merger candidates offer, but also the type of service and business environment for which they are known. Indeed, the FTC warns senior executives that they can no longer assume that products or services that are similar to those of merger partners offer sufficient competition. “If I’m a CFO, I want my lawyers to take a close look at how closely we compete with the merging assets and how many real substitutes there are out there,” says Baer.
With that in mind, companies are increasingly drawing on the expertise of econometric consultants like National Economic Research Associates Inc., Charles River Associates Inc., and Economists Inc., all based in Washington, D.C., and Chicago-based Lexecon Inc. Staples and Office Depot enlisted Massachusetts Institute of Technology economist Jerry Hausman to testify on their behalf. “Not all mergers lend themselves to their own unilateral effects analysis. But there’s good reason to do it, because the FTC may well do it,” says Robert Schlossberg, a partner at Morgan, Lewis & Bockius LLP, in Washington, D.C.
In this age of rapid technological advances, the FTC has also been forced to consider potential competition in products that don’t yet exist. When Ciba-Geigy Ltd. and Sandoz Ltd., the two massive Swiss pharmaceutical firms, applied for approval of their $63 billion merger (which formed Novartis AG), the FTC expressed concern that their combined research on gene therapy products would render that sector uncompetitive, even though neither firm marketed significant products based on that research. So aside from making the merged entity divest Sandoz’s U.S. and Canadian corn herbicide and flea control businesses, the FTC required the firms to license gene therapy technology and patent rights to Rhône-Poulenc Rorer Inc.
More often that not, divestitures will be demanded by the antitrust police–and subject to strict conditions. “They’ve tightened up on divestitures, insisting that any asset sale be real; and they’ve shortened the period of time within which firms must divest,” says Schlossberg.
Consequently, it’s imperative for CFOs and their colleagues to think ahead about which assets–stores, mines, units–they’re willing to live without and about potential buyers. “It’s never fun to sell an asset when you’ve got a gun at your head. People know you have a given time period to sell the asset, and you lose a lot of your bargaining power in the process,” says Jim Mandel, senior vice president and general counsel of Vail Resorts Inc., in Vail, Colorado, which sold off a resort for a scant $4 million to get a recent acquisition past Justice.
Of course, for every Staples/Office Depot merger that it opposes, the FTC lets a dozen larger mergers pass. Indeed, despite the Staples/Office Depot action, the FTC has shown a reluctance to stand in the way of corporate moves that help companies become more efficient and competitive in world markets. Still, for CFOs who have tangled with the FTC, the agency has proved anything but permissive. Says an exhausted Goldstein of Office Depot: “I have no desire to talk about or deal with this anymore.”
And while the current spate of rulings doesn’t seem to have a partisan bent, that won’t necessarily make life easier for CFOs. “It makes the prediction process more difficult,” says William E. Kovacic, a law professor at George Mason University School of Law, in Arlington, Virginia, and an antitrust expert. “To some extent, every firm has some market power. And the hard issue is how much it really matters. That’s an extremely subjective judgment.”
And now back to Microsoft.