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Wednesday, November 18, 2015

The Rise of the Giants

The business landscape in Europe is on the verge of significant changes, which may affect the future of many industries and the long-term prospects of the EU economy.
It is well known that Europe did not manage to have the same number of successful start-ups as the United States or some countries in Asia do and the size of the EU behemoths, compared to competitors in other parts of the world, is actually shrinking, as well as the number of European giants in the world economy landscape..  There are several reasons for the situation, from red tape and bad public policies, to an ageing population in several countries and a failure to realize that the current welfare enjoyed by most Europeans in inherited from the previous generations, which, in their turn, have been more dynamic and better motivated than today.
Europe industries are mostly legacy business, designed and developed in a different economic context.  When the conditions change and getting profits becomes more difficult, these industries should seek to reinvent, up to making real revolutions in their respective businesses.
Instead they pursue another strategy, which belongs rather to the 19th century than to the present times: consolidation, by way of acquisitions and mergers.  Getting larger certainly brings short and medium term benefits, through increased economies of scale and larger portfolios of brands and customers (as customers use to follow the brands they like).
But this is no guarantee for more innovation; better products or services and the benefits to the markets and the consumers, on the short, medium and long run are highly questionable. The frenzy of consolidation by undertakings in industries which went well through the economic crisis but now seek to rule the market by sheer size is definitely driven mainly by the intention to maintain status quo (and, hence, to avoid radical changes in their business models) and by pressure coming from shareholders to keep revenues and profits up in markets where the purchasing power has been eroded drastically by the economic crisis.
In order to illustrate this trend, I would take two examples of mergers, agreed recently and which face the scrutiny of the European Commission, acting as a competition agency (the two merges also demonstrate why prior merger control is good).  Interestingly enough, the two mergers are proposed in industries, which are in a vertical relationship, which means that the European Commission should analyse their horizontal effects in correlation to the effects occurring at the other levels of the chain.  Due to the close market relationship of the participants, the European Commission should analyse the two mergers in conjunction with each other.
It is about the merger between Rexam and Ball and the announced deal between Anheuser-Busch InBev and SAB Miller.
In the first case, Ball, the world leader of the market for production of aluminium cans, used mainly for beer, soda and energy drinks, attempts to merge with the world no.2 producer and arch-rival, Rexam.  After years of being head to head and competing fiercely for customers, the two market leaders decided that they should put their swords at rest and shake hands.
It is difficult to guess what made Ball and Rexam decide to go this way, given that the market in which they operate is rather stable, their position is not yet challenged seriously by any other competitor and this is unlikely to happen any time soon. As mentioned in the press release of the European Commission, when the EU watchdog started the investigation in this matter in July 2015, entering the production of aluminium cans market is extremely difficult and no disruptive technology or similar event is in sight, which could change the situation. The financial crisis cannot be invoked now and the two companies announced healthy results in the previous years. It looks like two happy companies go together in order to be even happier.  
There are of course, challenges and the merger could improve the position of the new entity on its upstream and downstream markets. Negotiations with suppliers – mainly aluminium producers – and clients could be improved.  Regarding the suppliers, however, the market is not concentrated and clients such as Rexam and Ball had often the upper hand when it came to the prices paid for the aluminium.  It is also worth noting that aluminium costs remain always high, due to a variety of factors, from the difficulty to find aluminium in the Earth crust to the energy intensive process for extracting the aluminium and making the metal foil necessary for the cans.  This means that it is highly unlikely that Ball and Rexam will be able to obtain better prices than those of today.
In the downstream market, Ball and Rexam are the preferred suppliers of cans almost anywhere in the European Union – it is sufficient for anyone to just have a look on the side of the can, when buying a drink in such a packaging (cans producers always imprint their logo on the side). The beer market itself is already quite concentrated in most markets in EU and this concentration is likely to increase, if mergers such as that between AB InBev and SAB Miller shall be approved by the European Commission. Of course, Ball and Rexam may say that it is exactly this concentration what justify their merger, in order to be able to withstand increased bargaining power from their clients. The argument, however, does not hold ground : in this moment, the bear market has relatively low levels of concentration, lower anyway than those which will exist on the aluminium cans market, if the merger would be approved. In this context – and mergers are analysed primarily taking into account the situation in the market as it is at the time of the analysis – the new entity will be able to reap more benefits from the beer, soda and energy drinks producers. The concentration in the soft drinks markets is even lower than in the beer market and a giant Ball/Rexam will be able to raise the prices, to its benefit – the situation might be particularly difficult in the energy drinks market, where the aluminium can is an essential input – the only packaging used in this sector.
Looking from a subjective perspective (that of Ball, Rexam and their shareholders), the merger between Ball and Rexam is the right thing to do). Seen from a more objective perspective – the market – the merger does not even promise some benefits, let alone the risks that this market will become a giant ring in which the new giant will not be challenged by anyone.
Going to the AB InBev/SAB Miller proposed merger, things are not any brighter there.  Similarly to Ball and Rexam ”marriage” is difficult to see what benefits consumers might enjoy, as a result of these two giants creating an even larger giant. Certainly, it is about larger economies of scale and also economies of scope, in addition to access to new markets by each of the participants, but since one in three beers produced in the world will come from the new company, there is highly unlikely that consumers will get any benefit.  Even more interestingly, the combined brewer would be the happy beneficiary of half of the profits in this industry.
The effects of this merger will be different from a region to another and whilst African markets might benefit of the merger (with new brands entering these markets), the situation will be very different in Europe, where AB InBev and SAB Miller are competing fiercely.  The two giants justify that their merger will be able to counter an increase preference of consumers for crafted beer and for alternative drinks, such as wine.  It is however, unclear, how a larger company will be able to achieve this, given that the switch to locally produced beer and to wine happens even if often the prices for these products are higher.  In fact, the switch to alternative products is driven by fashion rather than by price and regards wealthy (thus, marginal) consumers rather than the typical consumers. If the raise of competing products would have been the concern, AB InBev and SAB Miller would seek rather to acquire smaller beer producers or wine producers, which they do not intend to do now.
We should not forget that AB InBev has been in a ”shopping” frenzy and has a previous attempt to acquire the Dutch producer Heineken, in 2014. Last but not least, the merger has an impressive price tag of approximately 106 billion USD (!), which will benefit the shareholders of SAB Miller but which will need to be then recovered from somewhere. AB InBev has a good reputation in cost cutting but even a genius will find very difficult to cut costs to this extent. 
I analysed the two important mergers in the aluminium cans and beer industry from a static perspective. But as Carles Esteva Mosso, the Director General for Mergers at the European Commission put it, on 12 November 2014, at the GCR Annual Conference:
The most harmful effects are of a dynamic nature. Indeed, productivity has to be the key driver of sustainable growth in the EU in the coming years. The beneficial effects of competition for productivity and innovation are widely recognised: competitive markets create incentives for firms to increase their internal productivity, that is to become more efficient in order to stay ahead of rivals; they force less efficient rivals out of the markets, thus improving the overall industry productivity; and finally, they also push firms to develop new products and to invest and innovate.
A concentration that reduces competition may, in the short term, make life easier for the operators in these markets by allowing them to raise prices. In the medium and long term, however, these operations will negatively affect the competitiveness of the whole industry by reducing incentives to increase efficiency and innovate.
There are plenty of examples of EU-players that have become world leaders precisely because they faced a very competitive market structure at home, which incentivised them to increase efficiency and innovate. The German top-end car manufacturers, BMW, Audi and Mercedes-Benz, with headquarters separated by only a few hundred kilometres, are one good example of this.”
Carles Esteva had two excellent points in his speech:
-       first, that mergers need to be considered in consideration of markets which are evolving and with particular attention to how the market may look in the future.  Merger analysis is not simple mathematics, it is about forecast, which means that optimism alone is not sufficient and a sceptical approach will help in analysing the relevant data. 
-       second, that  if the European Union needs giants, this should happen by keeping the competitive pressure at the highest possible levels. Giants should result from the competitive pressure, not from the shortcuts offered by the mergers. 
This is the context and these are the criteria based on which the EU competition authorities should take into account the raise of the giants.  Care must be given not to encumber the competition in the long run and make the consumers pay for the merger.
For instance, the today mathematics of the two mergers may look out-dated soon, if one of the smaller competitors of Ball/Rexam and AB InBev/SAB Miller will decide to leave the market or at least reduce their investments.  As long as the gap will widen, as a result of the mergers, the competitors, who will be the first to feel the heat of the new giants, might decide to tune down their market activity and refrain from further investment.  Investors in aluminium cans could switch to other industries where their technology would assist or to other geographical areas, outside the European Union. Smaller beer producers might increase their involvement in soft drinks or other alcoholic drinks, where most of them are already present, such as Carlsberg, which is now a major producer and bottler of soda drinks.  This would mean that the very high market shares resulting from the concentrations will be even higher in the future and the respective markets could be ”trapped” a la long in the hands of the giants, until a disruptive technology will allow for a change. 
Thus, Ball/Rexam and AB InBev/SAB Miller are a test for the European Commission.  It is not just about the number of market players getting from 4 to 3, as it happens in telecoms, where the equations are complicated by extensive regulation and spectrum scarcity.  It is about setting a benchmark, which will be later used by other industries, which may soon follow the same consolidation process.  In markets which already have high concentration ratios, when mergers are not pushed from the bottom up by new and dynamic entrants but from above, by the need to keep the level of the profits stable, they should not be allowed to go through.  The European Commission and other competition authorities should develop as clear as possible benchmarks, which should give parties early indication on whether or not the mergers should leave the boardrooms or not.  As indicated by Carles Esteva Mosso in 2014, the control of economic concentrations is far from being just a bureaucratic process, where the agencies try to foresee if the positive effects of the merger will surpass the reduction in competition, which is always a difficult endeavour (I am speaking as a former competition enforcer and I am aware that competition authorities have un unpleasant task in deciding, in advance, whether or not a merger would be detrimental to the competitive process and to the consumers).  In the end, merger control aims not just at preventing anticompetitive behaviours but it is also a policy instrument to a larger extent than the prohibition of anticompetitive agreements and practices (which has been used in the past for other objectives than the competition).   
There are several industries which are looking with interest what the Commission will do, the consumers are looking and we, as practitioners acting in the competition law area, are looking to see if the European Commission will stand to its reputation of a vigilant watchdog or will prefer to be just optimist and prefer not to put a stop to consolidation to mergers in industries where innovation is low and the barriers to entry are high.

Europe needs to experience a rise of the giants but this should come out of efforts and battles won over competitors, not from embracing them.

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