Last week I appeared on Xinhua’s CNC World Report discussing the Kodak bankruptcy.

The discussion centered on Kodak’s history and its response to industry change. As I mentioned in the interview, Kodak was unable to change its internal culture so as to benefit from the shift to digital photography – technological change that, paradoxically, it helped usher in. Kodak did not realize the potential of digital photography early enough and it reacted late, by which time it was far too late to play catch up.

A little snippet:

As film began its path to obsolescence, Kodak missed the opportunity on several occasions to jump into the digital world. It first underestimated the impact that digital would have on its business and then it ignored what it might mean…Once it tried to jump in it was far too late.

You can watch the full clip below (or by clicking on this link):

A recent issue of Columbia Perspectives on FDI asks whether foreign direct investment subsidies are good or bad for the countries that offer them (see Investment incentives and the global competition for capital).

Investment incentives (subsidies designed to affect the location of investment) are a pervasive feature of global competition for foreign direct investment (FDI). They are used by the vast majority of countries, at multiple levels of government, in a broad range of industries. They take a variety of forms, including tax holidays, grants and free land.

In general, I am opposed to such government incentives, as I believe it results in distortionary outcomes.

Like all subsidies, investment incentives tend to be economically inefficient and make income distributions more unequal (by transferring funds from average taxpayers to owners of capital).

The result is not just the transfer of funds from average taxpayers to the owners of capital, but also the transfer of funds from domestic taxpayers to foreigners.

Not only that, but the foreign entrants often magnify the distortionary outcomes by aggressively negotiating for incentives – effectively pitting country against country (locale against locale) in a horse race. The article acknowledges this as well:

Bargaining over incentives is characterized by major information asymmetries, leading to the likelihood of a government paying more than needed to attract an investment. Companies often conduct an incentives auction even when they have already made their location decision, a clear sign of rent-seeking behavior.

All of this, and we haven’t even broached the topic of whether the foreign entrant’s presence truly benefits the local economy. The answer to that question, so far, is inconclusive. Although some academic studies demonstrate that foreign entrants can stimulate the local economy through increased employment, the development of upstream and downstream support industries, and knowledge spillovers to local firms; others (including some of my own research) are beginning to demonstrate that foreign fims can have deleterious consequences for the local economy as well. For example, foreign firms may dampen local innovation and hinder the long-term economic growth prospects of the host economy.

It’s for all these reasons that I am skeptical of the efficacy of subsidies for FDI. It even reminds me a bit of Bastiat’s satire of protectionism in The Candlemakers’ Petition (see the Candlemaker’s Petition), but in perverse reverse. Instead of subsidizing domestic owners of capital at the expense of ordinary taxpayers, local lawmakers end up subsidizing foreign owners of capital at the expense of local taxpayers.

I wish lawmakers, and other interested parties, would take the high road and adopt policies of abstention when it comes to FDI subsidies. Unfortunately, local officials often engage in these kinds of practices for their own near-term political gain, using them to tout their own records on job creation. We, however, need to start asking more questions about the long-term implications of such practices…

Coca-Cola announced in October that it was looking to further expand into the Middle East. Towards that end, Coca-Cola and Aujan Industries signed an agreement that marks one of the largest multinational investments in the consumer-goods industry in the region (see Aujan Industries and The Coca-Cola Company Announce Signing of $980 Million Agreement).

Under the terms of the agreement, The Coca-Cola Company will acquire 50 percent of the Aujan entity that holds the rights to Aujan-owned brands, and 49 percent of Aujan’s bottling and distribution company…

As many of you know, I am generally skeptical of acquisitions (see Great Shareholder Ripoff and Why M&A Deals Go Bad). I am even more skeptical of international deals, especially those in developing markets (see So You Want to Do Business In a Developing Country?). But this one might just be different…

“As one of the region’s leading beverage companies, this partnership will allow us to unlock new and substantial opportunities,” said Sheikh Adel Aujan, Chairman of Aujan Industries. “Drawing upon Aujan’s deep regional insights and the international capabilities of The Coca-Cola Company, Aujan will continue to leverage the strength of its leadership team and is now positioned for even greater success in the region and internationally.

I think that analysis is pretty spot on. This agreement allows a combination of Aujan’s local expertise with Coca Cola’s branding and distributional capabilities. If they are able to successfully avoid the kind of partner conflict that often scuttles alliances of this sort, Coca-Cola and Aujan will be able to work together to enhance the sales of Aujan’s products by leveraging Coca-Cola’s 80+ years of international experience and existing distribution network throughout the Middle East. In fact, it is similar to the Pepsi Wimm-Bill-Dann deal – another deal that I liked (see Pepsistroika).

So taking stock, I believe that the Coca Cola deal might just have a shot at increasing shareholder value.

I’ve always found the notion of private enterprise in China somewhat confusing. This is not because private enterprises do not exist in China, but because it’s incredibly difficult to determine whether, or to what extent, “private” companies are really State-owned enterprises (SOEs) in disguise. This is especially true for large corporations.

With that in mind, I found a recent Economist article on the subject especially timely (see Capitalism Confined). The article details how Chinese companies fall into 4 general categories: large state-controlled enterprises (SOEs), joint ventures between private (often foreign) companies and SOEs, companies with minority state ownership but state influence, and companies backed by government-owned investment funds. The main take-away is that the Chinese government is still involved at almost every level of economic organization.

According to the Economist:

The first category [state-controlled enterprises] comprises the vast banks and transport, energy and telecoms providers that were, and to some extent still are, government ministries…they account for perhaps 1% of privatised companies… Most of these huge companies have been turned into vaguely conventional-looking businesses. They have been restructured, recapitalised and rebranded. A minority of their equity has been sold to the public and is traded on the stockmarket.

The second category of firms, joint ventures, is also small in number…Often the private partner is a Western company hoping to gain access to a huge and growing economy. In return the Chinese gain [access to] Western know-how. For the Westerners, this involves obvious risks beyond the usual differences of opinion in a joint venture: that they will be pushed aside once the Chinese have acquired their knowledge.

The third group, largely in private hands, contains the most successful privatised companies: …[those] that ended up in the hands of their managers…In only 1% of these firms did the state have a shareholding of more than 20%…[The state] does, however, continue to exert influence, notably through party representatives.

The success of this third group of companies has encouraged the development of the fourth. Officials in cities and provinces have created hundreds of municipally backed funds to invest in promising ventures.

Taken collectively, these iterations of state engagement reflect how China’s government has not only held on to its economic control but found subtle ways to extend it. At the very least, these iterations constitute an important series of large-scale economic experiments with implications for China’s economy and, effectively, the world’s too.

Given China’s increasing role in the global economy, I agree with the author’s inference about the implications of this kind of experimentation with economic organization. I also think it calls for further research into the costs and benefits of structuring economic activity in this way. One point the article details is how, as a consequence of state influence, Chinese companies have struggled to compete abroad. Although they benefit from cheap financing capital and political favor domestically, large Chinese companies struggle to compete with their more organizationally (and technologically) efficient foreign counterparts abroad.

Nevertheless, truly interesting stuff! I encourage you to read the article in its entirety.

Early last week, India’s government looked set to change its retail laws, freeing up restrictions on foreign direct investment (see Let Walmart In, Wholesale Reform, Fury erupts as India opens door to Wal-Marts, IKEA set to announce retail plans for India). Foreign retailers that sell multiple brands (Walmart, Tesco, Carrefour, etc.) will now be allowed to own 51% of retail operations in India; single brand retailers (Ikea, Nike, Apple, etc.) will be allowed to own 100% of retail operations.

India’s hope? The hope is that foreign entry can help modernize infrastructure, distribution, and supply chains, and ultimately, reduce prices paid by end consumers. In this way, India views foreign investment as a way to stimulate the local economy.

For some foreign companies, this legal change is the green light they’ve been waiting for. IKEA, for example, which previously refused to enter the market, is now in India considering a retail foray. However, the change in law comes with a catch:

Foreign retailers will be obliged to invest $100m over five years. And at least half has to be spent to develop rural infrastructure and to establish a cold-chain system. Firms will also have to commit to sourcing 30% of their wares from small and medium-sized suppliers. Finally, foreign retailers will only be allowed to set up shop in cities with a population of over a million.

Political and public reaction has been split. Parliament and the opposition BJP (Bharatiya Janata Party) are outraged, some even going so far as threatening to burn down foreign-owned stores opened in the country.

…half of India’s states say they will refuse to implement the reform…Trade unions have promised strikes. Parliament has been shouted to a standstill. Already there is talk that the government might back down.

Many small business owners fear the effects of foreign entry.

Experts predict that stepped-up competition will sharply reduce the number of small retailers — the nation’s second-largest employer after farming, with 35 million workers.

I am generally pro-trade, in favor of open economic exchange. So I believe that this would be a welcome change. Nevertheless, it will be interesting to watch how things play out politically.

There was word last week that, in the face of significant domestic pressure, the Indian government was actually reconsidering its decision. However, even if the Indian government decides to go ahead with the proposed law change, I’m not so sure that it will bring about a flood of foreign entry.

India, with its underdeveloped political and economic institutions, remains an exceptionally difficult place for foreign firms to conduct business, …even with the legal change. Moreover, the mandates built into the legislation (minimum $100m investment, mandated infrastructure development, etc.) are particularly onerous. It will make entry more costly, and potentially, unattractive. So although the law makes it theoretically more feasible for multinational retailers to conduct business in India, in practice, I’m not convinced it will have a great effect.

UPDATE: Bowing to public pressure, the Indian government decided to hold off on implementing the controversial retail law (allowing multibrand retailers to own 51% of their operations in India) until a broader consensus can be reached (see India retail reform unravels after backlash). It is interesting to note that the government has only suspended one of the two retail law changes; single brand retailers will still be able to own 100% of their retail operations.

Although I did not anticipate that the multibrand retail law change (had it taken effect) would result in mass foreign entry, I generally view any step closer to free trade and lower foreign entry barriers as a step in the right direction. For this reason, I think the Indian government is bowing to pressure from a powerful minority that runs counter to the greater national good.

The Economist recently summarized Joseph Lampel’s (Professor at the Cass School of Business) reaction to Ryanair’s planned expansion. Professor Lampel believes the expansion represents a poor decision on the part of Ryanair CEO Michael O’Leary (see Michael O’Leary’s lessons from Napoleon and Ryanair Eyes Fresh Growth).

Joseph Lampel’s opinion (as quoted by the Economist):

One of history’s enduring mysteries is why Napoleon invaded Russia. He had an empire…and the all round title of military genius. And yet he could not resist the lure of complete domination of the European continent…he wanted…total victory.

One gets the same feeling reading the news release about Michael O’Leary’s ambition to acquire 300 aircraft…The goal is to grow Ryanair to 130 million passengers, which would make the airline the largest in Europe…

What is clear is that he sees the current economic crisis as an opportunity to push aggressively forward where other airlines fear to tread. The risk he runs is that an extraordinary success story will come apart…this expansion will stress Ryanair’s organizational capacity…

Perhaps he should take a lesson from Napoleon. When told by his advisers that the winters in Russia were exceptionally long and cold he insisted that they were misinformed…He lived to find out that reality can bite.

While Ryanair sees the acquisition of 300 additional aircraft as an opportunity to steal share in an economic downturn, I tend to side with Professor Lampel on this one. I think the planned expansion might reflect a bit of Napoleonic hubris. Not only will the expansion stretch the organization thin, but this is an incredible risk to take while Europe is in the midst of a crisis that threatens to turn into a nasty, and protracted, recession (see OECD warns of Euro Recession). A deep recession on the European continent would not bode well for travel in general, and air travel in particular.

OK, spoiler alert: I’m going to disappoint by not providing the “secret” to doing good deals. I just wanted to take the opportunity to highlight a typical popular press article offering such snake oil.

Exhibit A: A recent Forbes article suggests that mergers and acquisitions (M&A) create shareholder value when they are done at the right price, with the right vision, and with proper planning (see Do Mergers and Acquisitions Enhance or Destroy Shareholder Value).

[Does M&A] enhance or destroy shareholder value? It depends on how the M&A is planned and executed. M&A that begin with the right vision and executed at the right price enhance shareholder value.

Awesome! That’s really insightful. Now can you please tell me what you mean by right price, right vision, and proper planning?? Oh wait, never mind, that information is in there too, …and with specific examples:

Oracle’s and IBM’s string of software acquisitions that have allowed the two companies to ride the rising demand for enterprise software is a case in point—both Oracle and IBM have [sic] rewarded handsomely their stockholders.

By contrast, M&A that begin with the wrong vision and executed at the wrong price destroy shareholder value. Cisco Systems wave of acquisitions in the late 1990s is a case in point.  Over the period 1993-2000, Cisco acquired seventy companies, including Cresendo Communications (1993), Newport Systems Solutions (1994), Network Translation (1995), Netsys Technologies (1996), Net Speed (1998), and Growth Networks (1999), etc. The problem with this strategy, however, is that Cisco [sic] end up paying top prices for Net Speed and Growth Networks acquired at the peak of the high-tech bubble.

Get it? Got it? Good.

Wait. Come again??? It seems to me that the author arbitrarily picks cases that match his thesis. This is a scientific no-no. It’s called “sampling on the dependent variable” – choosing among outcomes that are consistent with a particular viewpoint without identifying potentially disconfirming counterfactuals. Not only that, but he doesn’t, at any point, mention execution prices, premiums paid, synergies identified, and/or anything about the due diligence processes. So in addition to sampling on the dependent variable, none of the data presented can speak to whether these deals were planned, executed, and/or priced well.

But wait, there’s a really profound take-away:

“The bottom line: M&A do not always deliver what they promise to stockholders, especially if they are pursued without a clear vision [sic] at a too high price.”

Again, not much useful there. All I really learned is that the article is in significant need of editing.

That aside, what we do know from research is that most deals fail – an overwhelming number of deals fail to create value for shareholders (see Great Shareholder Ripoff, Why M&A Deals Go Bad, The Deal that Worked). If doing M&A deals were as simple as the author makes it seem, everyone would get it right. And in the end, these kinds of articles bum me out because they are based on conjecture, not science.

It’s been over two years since Fiat acquired a 35% stake in Chrysler, and 3 months since it acquired its 51% controlling stake. As you may recall from my earlier posts, I was (and remain) skeptical that this deal would succeed due to the challenges associated with deriving value from Chrysler, and integrating it into Fiat’s global operations (see Appearance on Cavuto, Now Introducing Fiat/Chrysler, Can Fiat Pull it Off, Is Fiat Nuts?).

Given the recent downgrades of Fiat’s debt by Fitch and Moody’s, the ratings agencies increasingly seem to agree with my opinion. Here’s a recent article from The Detroit News that discusses some of the reasons why Fitch downgraded Fiat to BB from BB+, outlook negative, earlier this month (see Fitch Downgrades Fiat Over Chrysler).

While the agency acknowledged the marriage of the two companies should ultimately lead to increased sales and greater economies of scale, it expressed concern about the challenge of integrating a still-struggling Chrysler with Fiat when both companies remain under tremendous pressure.

“The current ratings are based on Fiat’s standalone credit profile, but incorporate heightened short-term risks for Fiat from its combination with Chrysler LLC in an increasingly challenging environment for the group,” said Fitch analyst Emmanuel Bulle, citing continuing softness in the European and American car markets. “Chrysler has a weaker credit profile than Fiat, and sustained benefits to Fiat from this deal should only accrue in the medium to long term.”

As I recognized in my earlier posts, there are some strategic reasons this acquisition makes sense, including, as the article states:

“Chrysler’s technology, product range and geographic diversification have become central to Fiat’s strategy…”

But it is important to remember that, even in the best of circumstances, acquisition integration is difficult. Lingering weakness in the automotive sector and broader macroeconomic environment make it even more challenging.

The Economist recently published a Special Report focusing on developing country growth (see The World Economy – A Game of Catch-up for the entire special report). The report focuses on the shift in economic power from developed to emerging economies. As much of the developed world continues to grapple with the aftermath of the financial crisis, the special report argues that the emerging world is catching up. The articles address various topics including the East catching up with the West, changes in the global labor market, trends in global M&A, and the U.S. dollar’s status as the world’s reserve currency.

Within this Special Report, I’d highlight two articles:

1. A Game of Catch-up: Many are beginning to predict that China, India and other emerging markets will catch up with the West at a faster pace than previously assumed.

A “great convergence” in living standards is under way as poorer countries speedily adopt the technology, know-how and policies that made the West rich. China and India are the biggest and fastest-growing of the catch-up countries, but the emerging-market boom has spread to embrace Latin America and Africa, too.

If emerging markets keep on growing three percentage points a year faster than America (a conservative estimate), they will account for two-thirds of the world’s output by 2030. Today’s four most populous emerging markets—China, India, Indonesia and Brazil—will make up two-fifths of global GDP, measured at PPP. The combined weight in the world economy of America and the European Union will shrink from more than a third to less than a quarter.

No country, or group of countries, stays on top forever. History and economic theory suggest that sooner or later others will catch up. But this special report will caution against relying on linear extrapolation from recent growth rates. Instead, it will suggest that the transfer of economic power from rich countries to emerging markets is likely to take longer than generally expected. Rich countries will be cursed indeed if they cannot put on an occasional growth spurt. China, for its part, will be lucky to avoid a bad stumble in the next decade or two. Emerging-market crises have been too quickly forgotten, which only makes them more likely to recur.

The force of economic convergence depends on the income gap between developing and developed countries. Going from poor to less poor is the easy part. The trickier bit is making the jump from middle-income to reasonably rich.

MY COMMENT: I agree that growth in many developing countries has been nothing short of remarkable; however I can’t help but side with the more cautious points in the article. Emerging markets have a long way to go, and their development path are fraught with serious downside institutional (cultural, political, and economic) risks. It therefore remains to be seen if the recent explosive growth in the emerging world is sustainable.

2. South-North FDI: Role Reversal: As I noted in my post India Buys Global, emerging market firm are increasingly buying developed market firms. The motivations include access to markets, basic resources, and advanced technology.

Their (emerging market firms) share of cross-border mergers and acquisitions (M&A) rose to 17% in the seven years to 2010, up from just 4% in the previous seven years, according to a recent report by the World Bank. They are the source of more than a third of foreign direct investment (FDI) in other emerging markets. Typically this sort of FDI is “organic”, which involves setting up a local factory or branch office. By contrast, direct investment by emerging-market firms in rich countries (so-called south-north FDI) tends to be “acquisitive”, which means one company buying another.

The bulk of the emerging-markets’ M&A in rich countries comes from five countries, led by China but also including India. America is the rich world’s main recipient, with Britain not far behind, even though its economy is only around one-sixth America’s size. Other big targets are commodity-rich Canada and Australia.

An acquisition is often the quickest (and sometimes the only) way to gain a foothold in a country.

Emerging-market firms may also want to limit their exposure to their lively but often brittle home market. Growth in the rich world may be slow but the investment climate is often warmer. There are better regulations; the tax laws are easier to live with; the courts are less capricious.

Brands are a consideration too. Building a brand can take years and pots of money; buying an established one is often cheaper. Acquiring a rich-world company can also be a quick way to get hold of technology as well as the tacit know-how that comes with operating a firm in mature markets.

Moreover, a corporate presence in the rich world offers access to cheaper and more reliable financing. Corporate bond markets in places like China and India are still underdeveloped, so a big, globally financed M&A deal paves the way for future capital-raising.

MY COMMENT: As I stated last week, I’m not convinced these investments will succeed, as these kinds of acquisitions are especially difficult. Given that they’ve been fueled by an abundance of foreign exchange reserves, in addition to the typical acquisition integration problems that these firms will face, questions could (and should) be raised about the prices at which they have been executed. Nevertheless, as I mentioned last week, the trend is not only interesting, but also worth monitoring.

Although I’ve highlighted only two of the articles in the Special Report, I’d encourage you to take a look at the entire set. They’re worth the read!

A recent NY Times article highlights how U.S. financial firms have been expanding into emerging markets in an effort to boost profits in the face of weaker U.S. earnings and rising regulatory costs (see Emerging Markets Offer Banks Profits, but Headaches Too).

Banks like Citigroup, Goldman Sachs and Morgan Stanley are chasing the potential payoff abroad. The economies of countries like China, India and Brazil are growing faster than that of the United States. Such places also represent an untapped client base, with a growing middle class and a large number of wealthy individuals.

As profits wane on the home front, Wall Street firms are increasingly dependent on the emerging markets to bolster their bottom lines…But the perils can be plentiful, with economic, political and regulatory challenges.

…it can [often] take years if not decades to build up local relationships and understand the country’s customs.

Looking to emerging markets for growth is nothing new. And as I’ve mentioned before, although emerging markets hold tremendous promise, they also bring incredible risk. In addition to the economic, political and regulatory risks companies face in emerging markets, there are also cultural risks (see So You Want to Do Business in a Developing Market).

As I wrote several years ago:

There are many compelling reasons that companies look to developing countries for growth. Less-developed countries hold the promise of large, fast-growing consumer markets (e.g., the BRICs); an abundance of cheap labor; and access to otherwise unavailable natural resources. Managers are often lured by this unbridled potential.

But there is a reason these countries are considered “developing” – largely because of the under-developed state of their institutional environments…

Although developing markets hold jaw-dropping potential, it often remains just that. Realizing potential from developing markets is incredibly challenging. Companies often find that the institutional (cultural, political, and economic) environments in the developing markets they enter…are so vastly different from anything that they encounter in their own domestic market (or even in other developed markets) that the costs involved in navigating them exceed even their most conservative estimates.

The bottom line: Decisions to enter emerging markets should not be taken lightly…