|The Kellogg Company and Keebler: The Critical Decisions That Make or Break the Deal
The top deal makers focus on four key imperatives that make or break the deal, and they are disciplined in their decision making. What does strong discipline look like in practice? The Kellogg Company's acquisition of Keebler provides a perfect illustration.
At the dawn of the 1990s Kellogg stood as one of the most venerable and successful brands in business history. Its products, like Kellogg's Corn Flakes, were staples of the family breakfast table. Its business was very profitable, with top-tier operating margins and leading share of the ready-to-eat cereal category. It was growing, and it enjoyed a remarkable ability to raise prices just enough to generate the profit surprises that stockholders love.
But by the middle of the decade, Kellogg's business had begun to grow soggy. Post, the No. 3 competitor, had initiated a fierce price war that called for an aggressive response from Kellogg. General Mills, the traditional No. 2 in the category, took the market-share lead. At the same time, leading retailers, tired of what they perceived as the company's high-handed ways, had begun to step up their offerings of store-brand products, calling on companies like Ralston Foods to supply the goods at cut-rate prices. And consumers were turning their backs on cereal as well: The once ubiquitous bowl of cereal was coming to seem like an unnecessary hassle to time-constrained families. As a result of these pressures, Kellogg's stock dropped by almost 20% during the late nineties, in what was otherwise a booming market.
That was the situation Carlos Gutierrez faced when the long-time Kellogg executive was named CEO in 1999. As he studied the company's challenges, three priorities became clear. First, he had to make Kellogg's traditional products more appealing. Second, he had to look beyond ready-to-eat breakfast cereals as the engine of future growth. Third, he would have to change the company's culture-the basic way it did business-if it was to respond to the times.
He saw some encouraging signs though. It was clear that people liked to snack on cereal-based products during the day, and Kellogg had such products, most notably its Nutri-Grain Bars and Rice Krispies Treats. And the snacking game was attractive: Between 1996 and 2001, the hand-held breakfast bar category grew 8% annually even as demand for ready-to-eat cereals declined 5% year after year. But making a big push into the snack market raised a fundamental problem for Kellogg: It lacked access to a direct distribution channel-the best way to deliver snacks. While the company had the internal capabilities to create new products and revamp culture, Gutierrez knew that it would be next to impossible to build a direct distribution channel from scratch. He would have to buy one.
That's where Keebler came in. The company was the No. 2 cookie-and-cracker maker in the United States behind Nabisco. But it wasn't Keebler's cookie-making prowess that excited Kellogg; it was Keebler's direct-store-delivery (DSD) system. Rather than ship products to a retailer's warehouse and have the retailer pull them and put them on the shelf, Keebler employees drove up to stores every day in panel trucks and stocked fresh snacks directly onto the shelves. The direct delivery system allowed the company to generate high product turnover and exert great control over merchandising. It provided it with an important advantage over most of its competitors, whose products had to go through the retailers' own logistics systems.
Kellogg saw gold in Keebler's DSD system, and its pursuit of the company provides a textbook case of deal-making discipline at each of the four crucial decision points:
How should you pick your targets? The deal fit tightly with Kellogg's overall growth plan, and the investment thesis was clear, focused, and compelling: Buying Keebler would add one to two points of top-line growth to the company by giving it a direct distribution channel that it could rapidly fill with an expanded snack-food product line. Some analysts nervously pointed out that the deal would likely dilute earnings per share. Brokerage reports estimated that Kellogg's EPS in the first year after the deal would fall from $1.75 to $1.30. Moreover, the merged company would add $4.6 billion in debt. But the stock market actually ended up applauding the deal. From the time the merger was announced to a year after it was complete, Kellogg's stock rose 26 percent, outperforming its peers by 11 percent. Although other things were certainly going on, it appears that the analysts and investment community bought into Kellogg's investment thesis. In other words, the upside of building on Kellogg's core in the cereal business offset the downside of dilution.
Which deals should you close? Kellogg focused its due diligence assessment on the few variables that would drive the deal's payoff. First, could Kellogg seamlessly move its snack products into the Keebler distribution system? Due diligence suggested that it could. Second, could Kellogg achieve significant cost savings through the deal-large enough to help offset the cost of the acquisition? Due diligence cautiously determined that the deal could deliver $170 million in cost synergies by year three. This justified the price Kellogg offered for Keebler ($42 a share). As it turned out, Kellogg was able to beat the synergy estimates by a wide margin, making the deal even more valuable than projected.
Where do you need to integrate? Kellogg did not get bogged down in a massive integration effort in the immediate wake of the deal. Rather, diligently following its investment thesis, it focused on getting its snack products into Keebler's DSD system as quickly as possible. Gutierrez and his team realized that, in many respects, this was a reverse merger: Kellogg was moving its snacking business into Keebler's operation, not the other way around. It was Keebler that had the proven expertise in snacks and direct distribution. Rather than rushing in to wrest control of the effort, therefore, Kellogg management stepped back and put strong Keebler managers in charge of expanding the snack business. In particular, Kellogg contracted with David Vermylen, then the president of Keebler Brands, to stay on board for three years after the deal closed and oversee much of the integration effort.
What should you do when the deal goes off track? Despite the decision to give Keebler executives control over the snack business, cultural conflicts began to emerge soon after the deal was completed. Keebler was entrepreneurial and cost focused, with a history of growing through acquisitions; Kellogg was none of those things. Keebler's CEO, Sam Reed, had been instrumental in the company's success and was an icon to its employees. His departure within a year after the merger dispirited many of Keebler's people, leading to an unexpected exodus of talent. This became a critical issue-directly affecting the investment thesis-when David Vermylen left the company with a year and a half still left on his contract.
Kellogg suddenly had to scramble to keep the deal on track. Gutierrez believed that the best way to do this was to focus on the key driver of his investment thesis: getting the benefits of DSD for Kellogg. Gutierrez acted decisively, putting John Bryant, the highly respected CFO of Kellogg USA, directly in charge of the integration effort. Bryant set aside his other duties in order to ensure that Kellogg's snacks would begin moving through Keebler's DSD system on schedule.
Once the key strategic imperative was fulfilled, Kellogg could address the broader integration issues, particularly the culture clash between the two companies. An effort was launched to create a new set of corporate values for the new company, and a program was established to regularly exchange managers between Kellogg and Keebler in order to share skills and perspectives. In the end, however, Kellogg found itself compelled to plow one culture-its culture-through the merged company in order to capture all the benefits. This outcome is consistent with the findings of studies that we have conducted at Bain, which suggest that scale deals like Kellogg-Keebler require the assimilation of the acquired companies-up to and including cultural assimilation.
After overcoming the initial disruptions, the new company soon began to gel.
Kellogg's acquisition of Keebler is a good example of solid deal management. Yes, there were decisions that Kellogg could have made better. But the decisions it got right included targeting a deal that fundamentally helped their core business; identifying how to get maximum value out of the resources acquired, from an operational point of view; planning a complex logistical move; and responding reasonably well when things went awry.