Corporate Finance

Shall We Dance?

Competitors are going cheek-to-cheek instead of toe-to-toe, as joint ventures turn rivals into partners.
Lee BertonJanuary 1, 1998
Shall We Dance?

Chemical companies do it. Engine makers do it. Even beer brewers and semiconductor manufacturers do it. They all form joint ventures or alliances with competitors. Who would have predicted that tough competition would foster so much cooperation among rivals? Although no one keeps tabs on joint ventures and alliances between companies that compete against one another, it appears that the practice, which used to seem almost unthinkable, is becoming commonplace.

That may come as a surprise to many finance executives who would find it anathema to shack up with a competitor. When news reached Bruce Hughes in early 1996 that his employer, GE Aircraft Engines, in Cincinnati, was talking with arch-competitor Pratt & Whitney, in East Hartford, Connecticut, about jointly designing jet engines for Boeing, he was stunned. “It was disbelief,” says Hughes, who subsequently became the venture’s co-general manager (along with a counterpart from Pratt & Whitney) and in December was named its president.

But in the year since it was launched, the alliance has survived the suspension of the Boeing program that spawned it in the first place, and has initiated discussions about the new engine with Airbus Industries, the European consortium that builds passenger aircraft.

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Truces between General Electric and Pratt & Whitney, Eastman Kodak and Sun Chemical, and Lyondell Petrochemical and Millennium Chemicals only exemplify the growing number of cases in which tough adversaries are exchanging swords for plowshares. The roster also includes linkups in recent years of Hewlett-Packard and Canon, Texas Instruments and Hitachi, and Canadian brewers Molson and Moosehead. Some of these arrangements are joint ventures in the sense of separate entities with their own financial structures; others are alliances, either formal or informal. Both categories, say experts, are proliferating.

“It’s a very important phenomenon that is growing by leaps and bounds,” says Washington, D.C., consultant Jordan Lewis, who helped arrange an alliance between rivals Bell Atlantic and AT&T to develop products and systems for the Bell network, and another between Merck and Pasteur-Mérieux to develop, produce, and market vaccines. “It is important not only to companies that have done it, but also to companies that are not doing it,” Lewis says, “because it’s going to hurt [the latter] badly.”

Despite fears that rivals might gain access to customers, markets, technologies, or patent secrets, powerful economic incentives trump long-standing rivalries. The incentives are not brand new, just heightened in degree amid intensifying global competition and the rising cost of doing almost any kind of business. “Competition is so tough that most companies realize there is no way they can be excellent at everything they have to do to compete,” says Lewis.

Early last year, Texas Instruments Inc. and Hitachi Ltd. increased their stakes in TwinStar Semiconductor Inc., a joint venture that grew out of longtime cooperation in the development of DRAM (dynamic random access memory) technology, a market sector in which the two companies compete. At the outset of the venture, in 1995, Texas Instruments and Hitachi had split a 52 percent interest in TwinStar and placed the rest of the equity with a consortium of banks that also supplied the venture’s credit facility. With the fresh investment, Texas Instruments and Hitachi increased their share of the equity to 76 percent.

Formalizing cooperation supplied two key advantages, explains Christopher Bettis, TwinStar’s chief financial officer. It provided a manufacturing forum to assemble the best design and engineering ideas of both companies. The financial structure, new to both, says Bettis, enabled them to put resources together in a critical but costly effort that has sustained development despite a punishing downturn in demand. “The technology and the engineering resources that you need to be successful in an industry like this are so critical and in such short supply that any time you can tap into a pool of resources, it’s the right thing to do,” he says. “The downsides, including having to protect information, are pretty minimal. In an industry that’s as competitive and fast-moving as this, the positives far outweigh the negatives.”

Deals of this sort highlight awareness in corporate suites that Pyrrhic victories advance no causes. “The profit motive can make for strange bedfellows,” says law professor John C. Coffee Jr., of Columbia University Law School, who specializes in corporate governance–always a lively topic when partners are competitors. Coffee attributes the surge in part to recent relaxation of legal and regulatory restrictions on cross-border joint ventures between U.S. companies and foreign rivals.

The expected costs of developing a new jet engine for a limited market–about $1 billion–is what drove GE Aircraft Engines to join forces with Pratt & Whitney. “A joint venture seems to be the only way out,” says a GE spokesman, “even if it’s with one of our most aggressive competitors.”

The alliance, as opposed to a more formal joint venture with a financial structure of its own, is based in Hartford. Its small operation consists chiefly of about 25 design-team members, who remain on the payrolls of their respective employers. Once an engine is designed, construction will be farmed out to both parent companies. Revenues from sales of the finished products will flow to the alliance, with GE and Pratt splitting what’s left after costs.

What’s Wrong with This Picture?

In recent months, Eastman Kodak Co., in Rochester, New York, joined with Sun Chemical Corp., in Fort Lee, New Jersey, to form a graphic-arts-products joint venture, even though they have gone head-to-head in selling film and offset-printing supplies to the same customers. According to a Kodak official, the venture is designed to compete worldwide against Agfa-Gevart Group, the world’s biggest supplier of graphic-arts materials. It was triggered, says the official, by Agfa’s August 1997 agreement to acquire DuPont Co.’s graphic-arts film and offset printing plate businesses, a transaction under investigation by the European Commission for possible monopolistic results.

“We at Eastman Kodak came to the conclusion that at this point it is better to join forces with another competitor [Sun Chemical] than to continue competing, with Agfa staring us in the face,” says a Kodak spokesman.

“The graphics field has been characterized in recent years by significant pricing pressures, and this obviously means that we need more efficiency and joining of forces in the field,” says the Kodak official. He adds that because the joint venture between Eastman Kodak and Sun is a 50/50 transaction, the results of the venture won’t be consolidated with the results of either of the participating parties. “We’ll get a dividend check from the joint venture, but we won’t have to disclose any results of the joint venture,” he says.

Wall Street analysts say that under current accounting, creating joint ventures in areas that are under great pricing pressure or technological competition is a good way to get rid of souring financial results (see sidebar, page 34). “Volume for Eastman Kodak in this graphic-arts-products field has been declining for the past two or three years,” says B. Alex Henderson, a financial analyst who covers Kodak for Prudential Securities in New York. “In a declining business, creating a joint venture is a great way of getting results off the income statement,” he adds.

Paul Allen, who works in Eastman Kodak’s public relations department, says that the company does not break out graphic-arts supplies from its $16 billion business. “We anticipate that sales of the joint venture will be more than $1 billion,” he says. But he declines to say whether the sales in this area have been growing or declining over the past few years. “We don’t break down sales and we don’t disclose results on that basis, because we don’t have to,” he says.

Davids Unite Against Goliaths

Joint ventures are helping groups of small rivals compete with much bigger rivals. For example, in mid-1997, a group of seven wireless-telephone companies in the United States and Canada announced a venture that would allow them to jointly market digital wireless-phone service to challenge such telecommunications giants as AT&T Corp. and Sprint Corp., which are rapidly rolling out their own national digital wireless services. And several Baby Bells have formed a limited partnership, PrimeCo Personal Communications LP, to provide such services.

The seven-company alliance consists of Pacific Bell Mobile Services, a unit of SBC Communications; Aerial Communications; Omnipoint; Western Wireless; Powertel; Microcell Telecommunications; and BellSouth Mobility, a unit of BellSouth.

One joint venture enabled two competitors to settle a lawsuit over royalties from a licensing agreement. In April 1996, Exxon Chemical Co., in Houston, and Union Carbide Corp., in Danbury, Connecticut, settled an escalating legal war over production of a new generation of plastics by agreeing to form a joint venture to develop, market, and license new polyethylene-production technology.

Union Carbide says that its production process, which reduces energy consumption, is extremely important to its bottom line and that it will take about two years for the venture with Exxon to help profits.

In the drug industry, increasing competition for supermarket shelf space for pain relievers has prompted some smaller producers, such as Bayer AG and Roche Holding Ltd., to form joint ventures to sell over-the-counter medicines in the United States. The moves are aimed at strengthening competitive clout against such industry powerhouses as Johnson & Johnson and Warner-Lambert Co., which have big and growing inventories of over-the-counter medicines. For example, the marketing partnership of Roche and Bayer is expected to boost sales of such drugs as Aleve. But it is still overshadowed by the dominance of Johnson & Johnson’s Tylenol brand, which has sales estimated at about $800 million annually.

The Question of Control

Lyondell Petrochemical Co., in Houston, and Millennium Chemicals Inc., in Iselin, New Jersey, announced a joint venture under the banner of Equistar Chemicals LP last June. Its operation encompasses 13 manufacturing plants making key plastic components that both companies have long offered to different markets. Cost advantages are significant, as is the advantage of rounding out the product lines. “While there is an advantage in that you don’t have to pay a premium for an acquisition or complete control, you don’t get to call the shots. Senior executives must manage their egos and be willing to share in the big decisions,” says Lyondell’s former CFO, Russell Young, who retired in December.

Neither partner in the transaction controls the joint venture under current accounting rules–even though Lyondell owns more than 50 percent of the venture. The financial results do not have to be disclosed unless they are material to either partner. Materiality usually means that the venture includes 5 percent or more of each partner’s assets or profits. Thus, $750 million of Lyondell’s long-term debt will be shifted to Equistar’s balance sheet–reducing Lyondell’s long-term debt to zero, says Kevin DeNicola, director of investor relations for Lyondell.

Young says that the joint venture with Millennium is material to Lyondell’s results. Thus, a full profit-and-loss statement, cash flow statement, and balance sheet will be included in the footnotes of Lyondell’s annual reports after the joint venture is formed, scheduled for early this year, he says.

Joint ventures and alliances spell opportunity for astute finance executives, says William Hickey, president and chief operating officer of Sealed Air Corp., a specialty-packaging company in Saddle Brook, New Jersey. “You can be the person who is objective,” he says. “Marketing and sales say they can’t get into bed with XYZ, no matter what the benefits are. The CFO can ask the question, ‘Do these things make business sense?’” Sealed Air operates a joint venture with Dow Chemical, for example, to reclaim used plastic wraps that both companies sell. He emphasizes that it’s not just environmentally sound, it’s also good business. “It hasn’t changed the competitive picture,” he says. “We still compete like hell.”

Maintaining the Chinese Wall

It’s not just a matter of pride that keeps competition intact; regulators are also concerned. “We have to be very careful about the Chinese wall, to make sure that the [GE/Pratt] engine alliance is, in effect, sealed off from the parent companies,” explains GE/Pratt’s Hughes. “We did have to apply with the [Federal Trade Commission] to make sure that they were okay with the joint venture. We also applied with the European Union. We do have controls in place such that we do not transfer business practices from Pratt to GE or GE to Pratt.”

To ensure that the message remains clear, engine alliance team members attend training classes with the legal staffs of their respective companies. The cardinal rules, says Hughes: Do not pass along any business practice. Do not pass along any information on marketing campaigns or sales campaigns. Do not talk about the two companies’ activities with their own products in the marketplace. “It adds a little complexity,” says Hughes, “but it has not impeded progress.”

Similar safeguards are necessary at New United Motor Inc. (NUMI), in Fremont, California, a joint venture between General Motors Corp., in Detroit, and Toyota Motor Corp., in Nagoya, Japan, that was launched in 1984 with a 12-year projected life, but was renewed by the participants with regulators’ blessings in 1993. The president of the joint venture, from Toyota, serves as the senior link to the Japanese carmaker, while comptroller Mark Matthews provides the main link to GM. “GM is informed of everything it should be informed of,” says Matthews. If GM needs an explanation or an interpretation of a NUMI forecast, for instance, Matthews will provide it.

As might be expected, the list of these joint ventures includes a number that stumble. “Alliances between competitors are always tricky. They are also more likely than most to lead to failure, disputes, breakups, or acquisition by one of the partners,” warns David Ernst, a partner at management consulting firm McKinsey & Co. and the author of Collaborating to Compete (John Wiley & Sons, 1993). “However, they are increasingly common.” If the reasons to link up with a rival are compelling, then the challenge, says Ernst, is fourfold. First, think through the scope carefully to make sure it doesn’t encroach on a core business area. Second, manage the balance of who is learning and who is teaching. Third, think through the bargaining power. Fourth, think through how to protect your competitive position in general.

One of the most visible failures was an ill-fated attempt by Apple Computer Inc. and IBM Corp. to find common cause. It was a five-part deal involving the development of a microprocessor, operating-system software, multimedia software, server software, and a common hardware platform.

“In retrospect, there was too much involved,” says Apple’s former CFO, Joe Graziano, who negotiated the deal. Ambitious goals were complicated by changes in top management at both partners and by cultural differences between Apple engineers, accustomed to cost-no-object design, and IBM engineers, who were more attuned to costs and markets. “The potential was there to do an enormous amount,” says Graziano, who now sits on boards of several Silicon Valley companies. “Unfortunately, it was not capitalized on.” That said, Graziano believes joint ventures between competitors certainly can have their place. “While they are very difficult to make work,” he says, “I believe they can work”–but not without explicit support at the highest levels of the parent companies. Without that, he warns, workers get confused and start scrambling to protect their own interests.

One of the boards Graziano sits on is doing it right, he believes. The company is IntelliCorp Inc., in Mountain View, California. It is engaged in an alliance with Germany-based SAP to co-design modeling tools used to install SAP programs, which both parent companies then sell to the marketplace.

Cooperating with competitors is no longer beyond the pale of good business practices. But there is an old adage that probably applies: No one ever forgets where they buried a hatchet.

Lee Berton is a New York-based financial writer.


———————————————————————— ————- While joint ventures between rivals change the competitive landscape, the accounting rules governing control remain muddy. For example, Lyondell Petrochemical Co. owns 57 percent of the equity

in its joint venture with Millennium Chemicals Inc. Nevertheless, Lyondell will not consolidate the joint venture on its books. “We do feel that full disclosure has been met when the venture’s results are included in the footnotes,” says Russell Young, who retired as CFO at the end of 1997.

Not everyone finds that level of disclosure satisfactory. Accounting analyst Pat McConnell of Bear, Stearns & Co. warns that relegating a joint venture to a single line on the income statement, Other Income and Expenses, could confuse investors. For this reason, joint ventures that foster cooperation between rivals can create rifts with shareholders.

Current accounting guidelines don’t help. And both companies can play the game, because when neither controls the joint venture in what is typically a 50/50 arrangement, neither consolidates. “A joint venture permits both sides to keep bad news off the profit-and-loss statement and the balance sheet,” says McConnell, a member of the International Accounting Standards Committee (IASC). “The [Financial Accounting Standards Board] says that determining which entity effectively controls the joint venture will fix the problem. But only management knows this fact, and it may not want to share this information with the outside auditor.”

FASB is trying to develop improved disclosure for joint ventures. The Board says that it has separated out consideration of joint ventures from its consolidations project and is trying to develop a paper on reporting problems relating to such ventures with standard-setters from Australia, Canada, and the United Kingdom, along with the IASC.

Behind the scenes, staff members at FASB concede that it may be a long time before the body can develop working accounting standards for joint ventures. Ronald Bossio, a FASB project manager, notes that “FASB is still in an early research phase,” and that “no one is working on it right now.”

Timothy Lucas, FASB’s research director, says that there is some disclosure now, but that he would be happier if there were “proportional disclosure” of financial results for each joint venture partner. “Unfortunately, this is not a big seller at FASB, and I suspect it would not be very popular with our constituency,” he adds. He notes that in Canada, companies have such disclosure in the natural-resources sector.

Dennis Beresford, former FASB chairman and currently executive professor of accounting at the J.M. Tull School of Accounting at the University of Georgia in Athens, isn’t very hopeful that FASB can improve joint venture disclosure in its current consolidation project.

The issue was added to FASB’s agenda in 1982, and it seems to be difficult, if not impossible, to improve the current accounting approach to joint ventures, asserts Beresford. “It’s 15 years later, and I’m not sure the Board is any closer to a better answer. And I wonder if it will ever be able to deal with this matter,” he says.–L.B.