Bank of America Acquires Merrill Lynch

Against the backdrop of the Lehman Brothers' Chapter 11 bankruptcy filing, Bank of America (BofA) CEO Kenneth Lewis announced on September 15, 2008, that the bank had reached agreement to acquire mega–retail broker and investment bank Merrill Lynch. Hammered out in a few days, investors expressed concern that the BofA's swift action on the all-stock $50 billion transaction would saddle the firm with billions of dollars in problem assets by pushing BofA's share price down by 21 percent.

BofA saw the takeover of Merrill as an important step toward achieving its long-held vision of becoming the number 1 provider of financial services in its domestic market. The firm's business strategy was to focus its efforts on the U.S. market by expanding its product offering and geographic coverage. The firm implemented its business strategy by acquiring selected financial services companies to fill gaps in its product offering and geographic coverage. The existence of a clear and measurable vision for the future enabled BofA to make acquisitions as the opportunity arose.

Since 2001, the firm completed a series of acquisitions valued at more than $150 billion. The firm acquired FleetBoston Financial, greatly expanding its network of branches on the East Coast, and LaSalle Bank to improve its coverage in the Midwest. The acquisitions of credit card–issuing powerhouse MBNA, U.S. Trust (a major private wealth manager), and Countrywide (the nation's largest residential mortgage loan company) were made to broaden the firm's financial services offering.

The acquisition of Merrill makes BofA the country's largest provider of wealth management services to go with its current status as the nation's largest branch banking network and the largest issuer of small business, home equity, credit card, and residential mortgage loans. The deal creates the largest domestic retail brokerage and puts the bank among the top five largest global investment banks. Merrill also owns 45 percent of the profitable asset manager BlackRock Inc., worth an estimated $10 billion. BofA expects its retail network to help sell Merrill and BlackRock's investment products to BofA customers.

The hurried takeover encouraged by the U.S. Treasury and Federal Reserve did not allow for proper due diligence. The extent of the troubled assets on Merrill's books was largely unknown. While the losses at Merrill proved to be stunning in the short run—$15 billion alone in the fourth quarter of 2008—the acquisition by Bank of America averted the possible demise of Merrill Lynch. By the end of the first quarter of 2009, the U.S. government had injected $45 billion in loans and capital into BofA in an effort to offset some of the asset write-offs associated with the acquisition. Later that year, Lewis announced his retirement from the bank.

Mortgage loan losses and foreclosures continued to mount throughout 2010, with a disproportionately large amount of such losses attributable to the acquisition of the Countrywide mortgage loan portfolio. While BofA's vision and strategy may still prove to be sound, the rushed execution of the Merrill acquisition, coupled with problems surfacing from other acquisitions, could hobble the financial performance of BofA for years to come.

When Companies Overpay—Mattel Acquires The Learning Company

Mattel, Inc. is the world’s largest designer, manufacturer, and marketer of a broad variety of children’s products selling directly to retailers and consumers. Most people recognize Mattel as the maker of the famous Barbie, the best-selling fashion doll in the world, generating sales of $1.7 billion annually. The company also manufactures a variety of other well-known toys and owns the primary toy license for the most popular kids’ educational program “Sesame Street.” In 1988, Mattel revived its previous association with The Walt Disney Company and signed a multiyear deal with them for the worldwide toy rights for all of Disney’s television and film properties

Business Plan

Mission Statement and Strategy

Mattel’s mission is to maintain its position in the toy market as the largest and most profitable family products marketer and manufacturer in the world. Mattel will continue to create new products and innovate in their existing toy lines to satisfy the constant changes of the family-products market. Its business strategy is to diversify Mattel beyond the market for traditional toys at a time when the toy industry is changing rapidly. This will be achieved by pursuing the high-growth and highly profitable children’s technology market, while continuing to enhance Mattel’s popular toys to gain market share and increase earnings in the toy market. Mattel believes that its current software division, Mattel Interactive, lacks the technical expertise and resources to penetrate the software market as quickly as the company desires. Consequently, Mattel seeks to acquire a software business that will be able to manufacture and market children’s software that Mattel will distribute through its existing channels and through its Website (Mattel.com).

Defining the Marketplace

The toy market is a major segment within the leisure time industry. Included in this segment are many diverse companies, ranging from amusement parks to yacht manufacturers. Mattel is one of the largest manufacturers within the toy segment of the leisure time industry. Other leading toy companies are Hasbro, Nintendo, and Lego. Annual toy industry sales in recent years have exceeded $21 billion. Approximately one-half of all sales are made in the fourth quarter, reflecting the Christmas holiday.

Customers. Mattel’s major customers are the large retail and e-commerce stores that distribute their products. These retailers and e-commerce stores in 1999 included Toys “R” Us Inc., Wal-Mart Stores Inc., Kmart Corp., Target, Consolidated Stores Corp., E-toys, ToyTime.com, Toysmart.com, and Toystore.com. The retailers are Mattel’s direct customers; however, the ultimate buyers are the parents, grandparents, and children who purchase the toys from these retailers.

Competitors. The two largest toy manufacturers are Mattel and Hasbro, which together account for almost one-half of industry sales. In the past few years, Hasbro has acquired several companies whose primary products include electronic or interactive toys and games. On December 8, 1999, Hasbro announced that it would shift its focus to software and other electronic toys. Traditional games, such as Monopoly, would be converted into software.

Potential Entrants. Potential entrants face substantial barriers to entry in the toy business. Current competitors, such as Mattel and Hasbro, already have secured distribution channels for their products based on longstanding relationships with key customers such as Wal-Mart and Toys “R” Us. It would be costly for new entrants to replicate these relationships. Moreover, brand recognition of such toys as Barbie, Nintendo, and Lego makes it difficult for new entrants to penetrate certain product segments within the toy market. Proprietary knowledge and patent protection provide additional barriers to entering these product lines. The large toymakers have licensing agreements that grant them the right to market toys based on the products of the major entertainment companies.

Product Substitutes. One of the major substitutes for traditional toys such as dolls and cars are video games and computer software. Other product substitutes include virtually all kinds of entertainment including books, athletic wear, tapes, and TV. However, these entertainment products are less of a concern for toy companies than the Internet or electronic games because they are not direct substitutes for traditional toys.

Suppliers. An estimated 80% of toy production is manufactured abroad. Both Mattel and Hasbro own factories in the Far East and Mexico to take advantage of low labor costs. Parts, such as software and microchips, often are outsourced to non-Mattel manufacturing plants in other countries and then imported for the assembly of such products as Barbie within Mattel-owned factories. Although outsourcing has resulted in labor cost savings, it also has resulted in inconsistent quality.

Opportunities and Threats

Opportunities

New Distribution Channels. Mattel.com represents 80 separate toy and software offerings. Mattel hopes to spin this operation off as a separate company when it becomes profitable. Mattel.com lost about $70 million in 1999. The other new channel for distributing toys is directly to consumers through catalogs. The so-called direct channels offered by the internet and catalog sales help Mattel reduce its dependence on a few mass retailers.

Aging Population. Grandparents accounted for 14% of U.S. toy purchases in 1999. The number of grandparents is expected to grow from 58 million in 1999 to 76 million in 2005.

Interactive Media. As children have increasing access to computers, the demand for interactive computer games is expected to accelerate. The “high-tech” toy market segment is growing 20% annually, compared with the modest 5% growth in the traditional toy business.

International Growth. In 1999, 44% of Mattel’s sales came from its international operations. Mattel already has redesigned its Barbie doll for the Asian and the South American market by changing Barbie’s face and clothes.

Threats

Decreasing Demand for Traditional Toys. Children’s tastes are changing. Popular items are now more likely to include athletic clothes and children’s software and video games rather than more traditional items such as dolls and stuffed animals.

Distributor Returns. Distributors may return toys found to be unsafe or unpopular. A quality problem with the Cabbage Patch Doll could cost Mattel more than $10 million in returns and in settling lawsuits.

Shrinking Target Market. Historically, the toy industry has considered their prime market to be children from birth to age 14. Today, the top toy-purchasing years for a child range from birth to age 10.

Just-In-Time Inventory Management. Changing customer inventory practices make it difficult to accurately forecast reorders, which has resulted in lost sales as unanticipated increases in orders could not be filled from current manufacturer inventories.

Internal Assessment

Strengths

Mattel’s key strengths lie in its relatively low manufacturing cost position, with 85% of its toys manufactured in low-labor-cost countries like China and Indonesia, and its established distribution channels. Moreover, licensing agreements with Disney enable Mattel to add popular new characters to its product lines.

Weaknesses

Mattel’s Barbie and Hot Wheels product lines are mature, but the company has been slow to reposition these core brands. The lack of technical expertise to create software-based products limits Mattel’s ability to exploit the shift away from traditional toys to video or interactive games.

Acquisition Plan

Objectives and Strategy

Mattel’s corporate strategy is to diversify Mattel beyond the mature traditional toys segment into high-growth segments. Mattel believed that it had to acquire a recognized brand identity in the children’s software and entertainment segment of the toy industry, sometimes called the “edutainment” segment, to participate in the rapid shift to interactive, software-based toys that are both entertaining and educational. Mattel believed that such an acquisition would remove some of the seasonality from sales and broaden their global revenue base. Key acquisition objectives included building a global brand strategy, doubling international sales, and creating a $1 billion software business by January 2001.

Defining the Target Industry

The “edutainment” segment has been experiencing strong growth predominantly in the entertainment segment. Parents are seeing the importance of technology in the workplace and want to familiarize their children with the technology as early as possible. In 1998, more than 40% of households had computers and, of those households with children, 70% had educational software. As the number of homes with PCs continues to increase worldwide and with the proliferation of video games, the demand for educational and entertainment software is expected to accelerate.

Management Preferences

Mattel was looking for an independent children’s software company with a strong brand identity and more than $400 million in annual sales. Mattel preferred not to acquire a business that was part of another competitor (e.g., Hasbro Interactive). Mattel’s management stated that the target must have brands that complement Mattel’s business strategy and the technology to support their existing brands, as well as to develop new brands. Mattel preferred to engage in a stock-for-stock exchange in any transaction to maintain manageable debt levels and to ensure that it preserved the rights to all software patents and licenses. Moreover, Mattel reasoned that such a transaction would be more attractive to potential targets because it would enable target shareholders to defer the payment of taxes.

Potential Targets

Game and edutainment development divisions are often part of software conglomerates, such as Cendant, Electronic Arts, and GT Interactive, which produce software for diverse markets including games, systems platforms, business management, home improvement, and pure educational applications. Other firms may be subsidiaries of large book, CD-ROM, or game publishers. The parent firms showed little inclination to sell these businesses at what Mattel believed were reasonable prices. Therefore, Mattel focused on five publicly traded firms: Acclaim Entertainment, Inc., Activision, Inc., Interplay Entertainment Corp, The Learning Company, Inc. (TLC), and Take-Two Interactive Software. Of these, only Acclaim, Activision, and The Learning Company had their own established brands in the games and edutainment sectors and the size sufficient to meet Mattel’s revenue criterion.

In 1999, TLC was the second largest consumer software company in the world, behind Microsoft. TLC was the leader in educational software, with a 42% market share, and in-home productivity software (i.e., home improvement software), with a 44% market share. The company has been following an aggressive expansion strategy, having completed 14 acquisitions since 1994. At 68%, TLC also had the highest gross profit margin of the target companies reviewed. TLC owned the most recognized titles and appeared to have the management and technical skills in place to handle the kind of volume that Mattel desired. Their sales were almost $1 billion, which would enable Mattel to achieve its objective in this “high-tech” market. Thus, TLC seemed the best suited to satisfy Mattel’s acquisition objectives.

Completing the Acquisition

Despite disturbing discoveries during due diligence, Mattel acquired TLC in a stock-for-stock transaction valued at $3.8 billion on May 13, 1999. Mattel had determined that TLC’s receivables were overstated because product returns from distributors were not deducted from receivables and its allowance for bad debt was inadequate. A $50 billion licensing deal also had been prematurely put on the balance sheet. Finally, TLC’s brands were becoming outdated. TLC had substantially exaggerated the amount of money put into research and development for new software products. Nevertheless, driven by the appeal of rapidly becoming a big player in the children’s software market, Mattel closed on the transaction aware that TLC’s cash flows were overstated.

Epilogue

For all of 1999, TLC represented a pretax loss of $206 million. After restructuring charges, Mattel’s consolidated 1999 net loss was $82.4 million on sales of $5.5 billion. TLC’s top executives left Mattel and sold their Mattel shares in August, just before the third quarter’s financial performance was released. Mattel’s stock fell by more than 35% during 1999 to end the year at about $14 per share. On February 3, 2000, Mattel announced that its chief executive officer (CEO), Jill Barrad, was leaving the company.

On September 30, 2000, Mattel virtually gave away The Learning Company to rid itself of what had become a seemingly intractable problem. This ended what had become a disastrous foray into software publishing that had cost the firm literally hundreds of millions of dollars. Mattel, which had paid $3.5 billion for the firm in 1999, sold the unit to an affiliate of Gores Technology Group for rights to a share of future profits. Essentially, the deal consisted of no cash upfront and only a share of potential future revenues. In lieu of cash, Gores agreed to give Mattel 50% of any profits and part of any future sale of TLC. In a matter of weeks, Gores was able to do what Mattel could not do in a year. Gores restructured TLC’s seven units into three, set strong controls on spending, sifted through 467 software titles to focus on the key brands, and repaired relationships with distributors. Gores also has sold the entertainment division and is seeking buyers for the remainder of TLC.
-What are the primary barriers to entering the toy industry?

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