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Innovation through acquisition
Technology and Innovation~
II_novation through
Acquisition While the acquisition of small companies by big companies is nothing new, innovation by acquisition can become a company's primary strategy. by Bradford T. Hudson THE DEVELOPMENT OF new products, services, and concepts is critical to a company's growth and livelihood. Innovation has a tremendous impact on the ability to capture and defend m a r k e t share, m a i n t a i n a price premium, differentiate from the competition, and m a i n t a i n competitive advantage in operating efficiencies. According to the Journal of Product Innovation Management, companies t h a t lead their industries in financial performance © 1994, Cornell University
receive 49 percent of their revenues from new products or services. By comparison, the least successful companies in a given i n d u s t r y receive only about 11 percent of revenues from new products or services. 1 Innovation is a difficult, risky, and expensive undertaking. A recent study by Kuczmarski and Associates, a Chicago-based m a n a g e m e n t consulting firm, followed the life cycle of 11,000 new products launched by 72 firms. 2 After five years only 56 Christopher Power et al., "Flops," Business Week, August 16, 1993, p. 76. 2Ibid.
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percent of those products were still on the market. According to a Booz Allen and Hamilton study, 46 percent of all new research and development costs go toward products or services t h a t eventually fail. One need only t h i n k of RCA's $500-million loss on the videodisc to u n d e r s t a n d the stakes involved. The r e s t a u r a n t i n d u s t r y is no different. Morgan Keenan and Company, a Memphis-based stock-brokerage firm, B r a d H u d s o n is a senior consultant with The TQM Group, a Boston-based management consulting firm.
THE CORNELL H.R.A. QUARTERLY
studied 42 growing r e s t a u r a n t chains t h a t went public between 1980 and 1984. By 1992, onethird of those companies were in liquidation or bankruptcy. D'Lites and Fresher Cooker are but two examples2 The question, then, is how to lower the financial risk of innovation and increase the likelihood of success. Within the r e s t a u r a n t industry, we see innovation in three basic areas. The first is new equipment, such as food preparation equipment or information systems, which is introduced to increase productivity or reduce costs. With a few notable exceptions, this type of innovation is driven by the equipment manufacturers r a t h e r t h a n by the r e s t a u r a n t industry itself. The second is new products, such as Wendy's grilled-chicken sandwich, which are introduced for marketing impact, production convenience, or capacity utilization. The third is new concepts, such as California Pizza Kitchen, which are introduced to increase m a r k e t share and to fuel growth. While this article will touch on equipment and product innovation issues, the main subject is concept innovation.
Strategies for Innovation Despite the importance of innovation, corporate America seems to have a limited repertoire when it comes to developing new products, services, and concepts. Four innovation strategies appear most often. The first is a strategy of "innovation through research and development," used most notably in high-technology industries.
Research and development. Companies invest huge sums of money in deliberate and wellplanned research efforts aimed at Tom Petruno, "Boom in R e s t a u r a n t Stocks Starts Getting Stale," Los Angeles Times, A u g u s t 16, 1992, p. 5.
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finding a product t h a t is so extraordinary t h a t it provides sustainable competitive advantage for years to come. The problem with this strategy is t h a t companies sometimes risk everything with no certainty of result. Furthermore, this strategy works best when the resulting product can be patented or copyrighted, thereby protecting the future income stream needed to recover the initial investment. Within the r e s t a u r a n t industry, the strategy of innovation through R&D is used by some of the larger r e s t a u r a n t corporations. McDonald's, for example, has made large investments in the development of new products (such as the McLean Deluxe) and equipment (such as the two-sided grill) with a reasonable degree of success. Taco Bell has been widely recognized for its achievements in reengineering food processing and preparation systems. 4 An R&D approach has also been used for restaurant-concept development, but with less consistent results. McDonald's has developed a variety of test concepts--for example, Golden Arch Cafe and McDonald's Express--but has not been successful in bringing them to market. Whether by circumstance or by choice, the concepts developed by McDonald's R&D efforts have not been widely introduced. General Mills is one of the few t h a t has been successful in developing new r e s t a u r a n t concepts internally and bringing them to market, as evidenced by Olive Garden and the China Coast. But even General Mills 4 See: Leonard A. Schlesinger a n d J a m e s L. Heskett, "The Service-Driven Service Company," Harvard Business Review, September-October 1991; a n d Bradford T. Hudson, "Industrial Cuisine," The Cornell Hotel and Restaurant Administration Quarterly, Vol. 34, No. 6 (December 1993), pp. 73-79.
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has had some concept failures, such as Betty Crocker Pie Shops. Inspiration. The second strategy is one of "innovation through inspiration," common in the software and financialservices industries. Companies fill their ranks with bright people and provide working environments conducive to creativity, hoping t h a t innovative products or services will result. Compensation levels are usually high, while corporate cultures stress independence and empowerment. In some cases the creative team is isolated from the m a i n s t r e a m in a "skunk works." The problem with the inspiration approach is t h a t results are hit-or-miss, long-term planning is difficult, and innovation efforts are vulnerable to chance. This strategy lacks the deliberate, managed approach used in R&D. Within the r e s t a u r a n t industry, inspiration is a common approach to concept development. In theme r e s t a u r a n t s or fine dining, for example, artistic and intuitive approaches seem predominant. Entrepreneurs such as Wolfgang Puck rely more on their experience, intuition, personal style, and even their celebrity t h a n on m a r k e t research and beta tests. Even large, multiunit corporations have been known to use this approach. Brinker International has established a strategic alliance with Phil Romano, the creative talent behind Fuddrucker's. Romano creates new concepts with the whim of an entrepreneur, but because of the financial and professional support provided by Brinker, he is isolated from the problems t h a t drain the energy of m a n y entrepreneurs. The concepts t h a t succeed in the marketplace, such as Romano's Macaroni Grill, are then purchased outright by Brinker.
A true innovation-by-trial approach would involve the development and launch of perhaps 50 concepts per year per company.
S u r v i v a l o f t h e f i t t e s t . The third strategy frequently seen in corporate America is "innovation by trial," also called design-forresponse, which is used extensively in the consumer-products industry. Companies produce a multitude of different products, sometimes with relatively little m a r k e t research, and flood the m a r k e t with a wide variety of offerings. Products or services t h a t are successful are continued and the rest are abandoned. The advantage of such an approach is t h a t it measures consumers' actual buying behavior, r a t h e r t h a n their attitudes toward products, and thus reduces vulnerability to poor m a r k e t research. The problem with an innovation-by-trial strategy is that, although it m a y be more efficient overall, it is much less directed and focused t h a n R&D. It also requires a relatively low product cost and rapid developm e n t cycle-time, and is most appropriate for industries where unit costs and inventory expenses are low. Within the r e s t a u r a n t industry, innovation by trial is seen frequently in special product promotions. Many of the s t a n d a r d items on McDonald's m e n u were originally offered as special promotional items, as were KFC's popcorn bites. Taco Bell seems to have a revolving set of special products aimed at m a i n t a i n i n g the interest levels of jaded consumers, and some of those will undoubtedly end up on the p e r m a n e n t menu. For the most part, innovation by trial is not used as a strategy for concept development. While it is true t h a t new r e s t a u r a n t concepts are tested in the marketplace with actual consumers, this usually occurs after extensive and costly
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development efforts. Furthermore, even the largest r e s t a u r a n t operators test only a few concepts at a time. A true innovation-bytrial approach would involve the development and launch of perhaps 50 concepts per year per company. S t a t u s q u o . The fourth strategy is simply to m a i n t a i n the status quo (although some might argue this is not really a strategy). Some companies are in a state of denial, avoiding the need for change or innovation, and, while they may have an R&D d e p a r t m e n t and limited introductions of new products, they have not made reinvention a strategic imperative. They favor the steadiness of operating income from existing operations over the turmoil and risk of organizational change. Public utilities, the telecommunications i n d u s t r y before deregulation, and the automobile i n d u s t r y during the 1960s immediately come to mind in this category. The problem is t h a t while avoidance reduces a company's R&D investment and innovation risk in stable markets, it also leaves their products vulnerable to competitive obsolescence. Some segments of the marketplace are approaching saturation, consumers are more valueconscious, and diners' expectations are increasing. Yet m a n y of the largest chains offer tired concepts, outdated decor, unpopular m e n u offerings, slow production systems, and unsatisfactory service operations. In this environment, up-and-coming local entrepreneurs are giving established operators a run for their money. The companies t h a t fail to change will find their competitive position undermined. Remember Howard Johnson's? The company,
THE CORNELL H.R.A. QUARTERLY
which dominated the chainr e s t a u r a n t industry 40 years ago, failed to change with the times and has been a marginal player since the 1970s. The four predominant approaches to innovation are less than optimal. Innovation through R&D involves large capital investments with an uncertain payoff. Innovation through inspiration is a hit-or-miss proposition that makes long-term planning difficult. Innovation by trial can be effective in industries where unit costs are low, but is not really appropriate for restaurant-concept development. Maintaining the status quo leaves a company vulnerable to competitive obsolescence. There must be a better w a y and, in fact, there is.
Innovation by Acquisition Within the r e s t a u r a n t industry a growing number of r e s t a u r a n t corporations are using a strategy of"innovation through acquisition." Companies scan the environment for viable concepts, especially growing chains that have already penetrated regional markets, and then buy the concept by purchasing the restaurant chain. In doing so, they immediately gain a marketproven concept and established points of distribution. Instead of relying on internally driven concept development, these companies are externally focused. They wait for the marketplace to select winning concepts and then they buy future growth. That is exactly the strategy used by one of the nation's leading r e s t a u r a n t companies, PepsiCo. In the past 15 years, PepsiCo has created a r e s t a u r a n t empire by purchasing KFC, Pizza Hut, Taco Bell, Hot 'n Now, Chevy's, California Pizza
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Kitchen, and D'Angelo Sandwich Shops2 Although PepsiCo also develops concepts in-house, that is not where they are investing the majority of their capital. Given the fact that Fastino's has not been rolled out, and that tests with Pizza H u t Cafe and Salsa Rio have been scaled back, it seems clear that acquisition has been their primary approach. Why is acquisition an appropriate innovation strategy for PepsiCo? Let's look at a competitor for a moment. Boston Chicken is a concept that never would have been created by a corporate R&D organization--it lacks technological sophistication, proprietary technology, and brand defensibility. Yet the chain, which in 1990 had only two outlets, now has more than 175, is publicly owned, and at one point was trading at 150 times earnings. Boston Chicken succeeded through ready access to financial capital, concept integrity, and strength of will. In an industry where m a r k e t presence and brand awareness are more important than proprietary technology, Boston Chicken simply built enough units to attain critical mass. And this gets at the central issue. PepsiCo doesn't rely on R&D, because it isn't needed and it doesn't always work. The r e s t a u r a n t industry is structured in such a way that formal, directed R&D efforts will usually not pay off. Proprietary technology is rare, and service systems generally cannot be patented. 5The long-term viability and success of Hot 'n Now was unclear at the time this article was being prepared for publication. PepsiCo, which originally purchased the concept simply to exploit its speedy production and service technology, later decided to expand the concept intact. Recently, expansion plans have been on hold. It is my opinion, however, t ha t PepsiCo's potential problems with Hot 'n Now do not undermine the innovation-through-acquisition theory.
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The restaurant industry is structured in such a way that formal, directed R&D efforts usually do not pay off.
The companies that benefit most from innovation by acquisition are those that make restaurants their core business.
While there have been some attempts to define the legal defensibility of trade dress--for example, in the Taco Cabana case--concepts are easily copied2 Furthermore, the r e s t a u r a n t i n d u s t r y has so m a n y entrepreneurs and such low barriers to entry t h a t concepts n a t u r a l l y proliferate. The marketplace is complex and chaotic, such t h a t any a t t e m p t by a major player to control the situation is futile. In an environment of n a t u r a l selection, expensive R&D operations a m o u n t to an unacceptable risk. Risk avoidance is a big part of the innovation-by-acquisition strategy. PepsiCo might pay more to buy existing chains t h a n it would to develop and build its chains from scratch, but it also increases the chance of success because those concepts are fully developed and market-tested. In the language of finance, PepsiCo is paying a risk premium. The company pays a higher a m o u n t for the same potential income stream over time, but in doing so they reduce the risk t h a t the income stream will fail. The need to grow is the other big part of the innovation-byacquisition strategy. Executives of publicly owned companies frequently feel pressure from stockholders to achieve constant and rapid growth. This reflects the stockholders' interest in having their investment appreciate at more t h a n an incremental rate. PepsiCo has achieved an average 15-percent earnings growth rate for the past 27 years. Last year, the r e s t a u r a n t divisions posted a sales growth of
16 percent and a profit growth of 19 percent. 7 To continue achieving such growth, PepsiCo m u s t be aggressive in expanding m a r k e t share and m u s t look for opportunities t h a t are certain to deliver desired returns. Traditional R&D operations presume a long time between the intial idea and the introduction of an actual product, require large investments of capital, and have uncertain results. Unless PepsiCo radically redesigns its approach, in-house R&D simply cannot keep up with the company's demand for successful new concepts. While the success of PepsiCo's acquisition strategy seems clear, other major corporations have experienced problems with r e s t a u r a n t acquisitions in the past 20 years. These include W.R. Grace (El Torito), General Foods (Burger King), Ralston Purina (Jack-in-the-Box), Quaker Oats (Magic Pan), R.J. Reynolds (KFC), Campbell Soup (Pietro's Pizza), and Hershey Foods (Friendly's). In every case, the acquiring company eventually gave up and sold the r e s t a u r a n t chain. Does this invalidate the acquisition theory? Not really. Each of these examples involves a large corporation t h a t did not have a core competency in restaur a n t management. In most cases, those companies were conglomerates following a financial portfolio-diversification strategy. The companies t h a t can and do gain the greatest advantage from innovation through acquisition, on the other hand, are those t h a t make r e s t a u r a n t s their core business.
(~See: J e A n n a A b b o t t a n d J o s e p h L a n z a , " T r a d e Dress: Legal I n t e r p r e t a t i o n s of W h a t Constit u t e s Distinctive A p p e a r a n c e , " The Cornell Hotel and Restaurant Administration Quarterly, Vol. 35, No. I ( F e b r u a r y 1994L pp. 5 3 - 5 8 . 7PepsiCo Anuual Report, 1993.
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Exciting Times Ahead The development of new products and concepts is critical to the growth and profitability of leading companies, especially those t h a t are publicly traded. However, the structure of the restaur a n t industry suggests t h a t a sophisticated R&D effort is a risky strategy for concept innovation. Innovation by acquisition, meaning the outright purchase of small growing chains, is a preferable strategy for the r e s t a u r a n t industry, especially if the right conditions apply (see the accompanying sidebar). In a corporation using a strategy of innovation by acquisition, the role of the planning staff is to monitor carefully the growth of local and regional players as potential acquisition targets. It is important, however, t h a t senior m a n a g e m e n t not be overly distracted by the glamour associated with mergers and acquisitions. An acquisition strategy clearly does not excuse executives from paying attention to basic operating responsibilities or from the need to be creative and flexible. As corporate America continues to dominate the r e s t a u r a n t industry, we can expect to see more acquisitions of regional chains by international corporations. This is a competitive t h r e a t to independent r e s t a u r a t e u r s and small chains. It is also a tremendous opportunity for savvy, ambitious entrepreneurs to grow regional, high-concept chains specifically for subsequent acquisition. Given the trend in buyouts, we can also expect to see increasing interest by venturecapital firms in new r e s t a u r a n t start-ups. There are exciting times ahead in the r e s t a u r a n t minor leagues, co J U N E 1994
When to Innovate by Acquisition Innovation by acquisition involves the purchase of small growing companies by large corporations as an altemative to developing new concepts internally. For the company that chooses to innovate by acquisition, the strategy is most appropriate when the following corporate environment and market conditions exist: • The company generates lots of cash, or at least has a regular and dependable income from operations. This is necessary either to purchase companies outright or to provide evidence of credit worthiness to capital markets. • The company has a low tolerance for risk and for the potential losses that could be incurred from investing in a failed concept or product. This may be especially applicable to publicly held corporations, whose stockholders are likely to be risk-averse. • The company has made a strategic decision to assemble a portfolio of complementary brands or products. Just as different investment options provide balance and diversify risk in a securities portfolio, different concepts can diversify the dsk of product failure. ° The company has a low investment in formal R&D. Innovation by acquisition can either replace R&D efforts or supplement them. • The company has the organizational and management sophistication to handle a portfolio of multiple concepts and to assimilate new operating units and cultures. The ability to operate new divisions effectively is critical to the return on investment. • The company is operating in an industry in which market presence and brand awareness are more important than proprietary technology or in which innovative approaches and methods are not legally protected through patents or copyrights. In those cases, large R&D expenditures will result in products or services that cannot be defended from imitation. ° The company is operating in an industry in which there are low barriers to entry and there are a large number of entrepreneurs. In those instances, the number of successful concepts produced by market forces will far exceed the number that can be produced through a single company's R&D efforts.--B. T.H.
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II_novation through
Acquisition While the acquisition of small companies by big companies is nothing new, innovation by acquisition can become a company's primary strategy. by Bradford T. Hudson THE DEVELOPMENT OF new products, services, and concepts is critical to a company's growth and livelihood. Innovation has a tremendous impact on the ability to capture and defend m a r k e t share, m a i n t a i n a price premium, differentiate from the competition, and m a i n t a i n competitive advantage in operating efficiencies. According to the Journal of Product Innovation Management, companies t h a t lead their industries in financial performance © 1994, Cornell University
receive 49 percent of their revenues from new products or services. By comparison, the least successful companies in a given i n d u s t r y receive only about 11 percent of revenues from new products or services. 1 Innovation is a difficult, risky, and expensive undertaking. A recent study by Kuczmarski and Associates, a Chicago-based m a n a g e m e n t consulting firm, followed the life cycle of 11,000 new products launched by 72 firms. 2 After five years only 56 Christopher Power et al., "Flops," Business Week, August 16, 1993, p. 76. 2Ibid.
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percent of those products were still on the market. According to a Booz Allen and Hamilton study, 46 percent of all new research and development costs go toward products or services t h a t eventually fail. One need only t h i n k of RCA's $500-million loss on the videodisc to u n d e r s t a n d the stakes involved. The r e s t a u r a n t i n d u s t r y is no different. Morgan Keenan and Company, a Memphis-based stock-brokerage firm, B r a d H u d s o n is a senior consultant with The TQM Group, a Boston-based management consulting firm.
THE CORNELL H.R.A. QUARTERLY
studied 42 growing r e s t a u r a n t chains t h a t went public between 1980 and 1984. By 1992, onethird of those companies were in liquidation or bankruptcy. D'Lites and Fresher Cooker are but two examples2 The question, then, is how to lower the financial risk of innovation and increase the likelihood of success. Within the r e s t a u r a n t industry, we see innovation in three basic areas. The first is new equipment, such as food preparation equipment or information systems, which is introduced to increase productivity or reduce costs. With a few notable exceptions, this type of innovation is driven by the equipment manufacturers r a t h e r t h a n by the r e s t a u r a n t industry itself. The second is new products, such as Wendy's grilled-chicken sandwich, which are introduced for marketing impact, production convenience, or capacity utilization. The third is new concepts, such as California Pizza Kitchen, which are introduced to increase m a r k e t share and to fuel growth. While this article will touch on equipment and product innovation issues, the main subject is concept innovation.
Strategies for Innovation Despite the importance of innovation, corporate America seems to have a limited repertoire when it comes to developing new products, services, and concepts. Four innovation strategies appear most often. The first is a strategy of "innovation through research and development," used most notably in high-technology industries.
Research and development. Companies invest huge sums of money in deliberate and wellplanned research efforts aimed at Tom Petruno, "Boom in R e s t a u r a n t Stocks Starts Getting Stale," Los Angeles Times, A u g u s t 16, 1992, p. 5.
JUNE 1994
finding a product t h a t is so extraordinary t h a t it provides sustainable competitive advantage for years to come. The problem with this strategy is t h a t companies sometimes risk everything with no certainty of result. Furthermore, this strategy works best when the resulting product can be patented or copyrighted, thereby protecting the future income stream needed to recover the initial investment. Within the r e s t a u r a n t industry, the strategy of innovation through R&D is used by some of the larger r e s t a u r a n t corporations. McDonald's, for example, has made large investments in the development of new products (such as the McLean Deluxe) and equipment (such as the two-sided grill) with a reasonable degree of success. Taco Bell has been widely recognized for its achievements in reengineering food processing and preparation systems. 4 An R&D approach has also been used for restaurant-concept development, but with less consistent results. McDonald's has developed a variety of test concepts--for example, Golden Arch Cafe and McDonald's Express--but has not been successful in bringing them to market. Whether by circumstance or by choice, the concepts developed by McDonald's R&D efforts have not been widely introduced. General Mills is one of the few t h a t has been successful in developing new r e s t a u r a n t concepts internally and bringing them to market, as evidenced by Olive Garden and the China Coast. But even General Mills 4 See: Leonard A. Schlesinger a n d J a m e s L. Heskett, "The Service-Driven Service Company," Harvard Business Review, September-October 1991; a n d Bradford T. Hudson, "Industrial Cuisine," The Cornell Hotel and Restaurant Administration Quarterly, Vol. 34, No. 6 (December 1993), pp. 73-79.
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has had some concept failures, such as Betty Crocker Pie Shops. Inspiration. The second strategy is one of "innovation through inspiration," common in the software and financialservices industries. Companies fill their ranks with bright people and provide working environments conducive to creativity, hoping t h a t innovative products or services will result. Compensation levels are usually high, while corporate cultures stress independence and empowerment. In some cases the creative team is isolated from the m a i n s t r e a m in a "skunk works." The problem with the inspiration approach is t h a t results are hit-or-miss, long-term planning is difficult, and innovation efforts are vulnerable to chance. This strategy lacks the deliberate, managed approach used in R&D. Within the r e s t a u r a n t industry, inspiration is a common approach to concept development. In theme r e s t a u r a n t s or fine dining, for example, artistic and intuitive approaches seem predominant. Entrepreneurs such as Wolfgang Puck rely more on their experience, intuition, personal style, and even their celebrity t h a n on m a r k e t research and beta tests. Even large, multiunit corporations have been known to use this approach. Brinker International has established a strategic alliance with Phil Romano, the creative talent behind Fuddrucker's. Romano creates new concepts with the whim of an entrepreneur, but because of the financial and professional support provided by Brinker, he is isolated from the problems t h a t drain the energy of m a n y entrepreneurs. The concepts t h a t succeed in the marketplace, such as Romano's Macaroni Grill, are then purchased outright by Brinker.
A true innovation-by-trial approach would involve the development and launch of perhaps 50 concepts per year per company.
S u r v i v a l o f t h e f i t t e s t . The third strategy frequently seen in corporate America is "innovation by trial," also called design-forresponse, which is used extensively in the consumer-products industry. Companies produce a multitude of different products, sometimes with relatively little m a r k e t research, and flood the m a r k e t with a wide variety of offerings. Products or services t h a t are successful are continued and the rest are abandoned. The advantage of such an approach is t h a t it measures consumers' actual buying behavior, r a t h e r t h a n their attitudes toward products, and thus reduces vulnerability to poor m a r k e t research. The problem with an innovation-by-trial strategy is that, although it m a y be more efficient overall, it is much less directed and focused t h a n R&D. It also requires a relatively low product cost and rapid developm e n t cycle-time, and is most appropriate for industries where unit costs and inventory expenses are low. Within the r e s t a u r a n t industry, innovation by trial is seen frequently in special product promotions. Many of the s t a n d a r d items on McDonald's m e n u were originally offered as special promotional items, as were KFC's popcorn bites. Taco Bell seems to have a revolving set of special products aimed at m a i n t a i n i n g the interest levels of jaded consumers, and some of those will undoubtedly end up on the p e r m a n e n t menu. For the most part, innovation by trial is not used as a strategy for concept development. While it is true t h a t new r e s t a u r a n t concepts are tested in the marketplace with actual consumers, this usually occurs after extensive and costly
84
development efforts. Furthermore, even the largest r e s t a u r a n t operators test only a few concepts at a time. A true innovation-bytrial approach would involve the development and launch of perhaps 50 concepts per year per company. S t a t u s q u o . The fourth strategy is simply to m a i n t a i n the status quo (although some might argue this is not really a strategy). Some companies are in a state of denial, avoiding the need for change or innovation, and, while they may have an R&D d e p a r t m e n t and limited introductions of new products, they have not made reinvention a strategic imperative. They favor the steadiness of operating income from existing operations over the turmoil and risk of organizational change. Public utilities, the telecommunications i n d u s t r y before deregulation, and the automobile i n d u s t r y during the 1960s immediately come to mind in this category. The problem is t h a t while avoidance reduces a company's R&D investment and innovation risk in stable markets, it also leaves their products vulnerable to competitive obsolescence. Some segments of the marketplace are approaching saturation, consumers are more valueconscious, and diners' expectations are increasing. Yet m a n y of the largest chains offer tired concepts, outdated decor, unpopular m e n u offerings, slow production systems, and unsatisfactory service operations. In this environment, up-and-coming local entrepreneurs are giving established operators a run for their money. The companies t h a t fail to change will find their competitive position undermined. Remember Howard Johnson's? The company,
THE CORNELL H.R.A. QUARTERLY
which dominated the chainr e s t a u r a n t industry 40 years ago, failed to change with the times and has been a marginal player since the 1970s. The four predominant approaches to innovation are less than optimal. Innovation through R&D involves large capital investments with an uncertain payoff. Innovation through inspiration is a hit-or-miss proposition that makes long-term planning difficult. Innovation by trial can be effective in industries where unit costs are low, but is not really appropriate for restaurant-concept development. Maintaining the status quo leaves a company vulnerable to competitive obsolescence. There must be a better w a y and, in fact, there is.
Innovation by Acquisition Within the r e s t a u r a n t industry a growing number of r e s t a u r a n t corporations are using a strategy of"innovation through acquisition." Companies scan the environment for viable concepts, especially growing chains that have already penetrated regional markets, and then buy the concept by purchasing the restaurant chain. In doing so, they immediately gain a marketproven concept and established points of distribution. Instead of relying on internally driven concept development, these companies are externally focused. They wait for the marketplace to select winning concepts and then they buy future growth. That is exactly the strategy used by one of the nation's leading r e s t a u r a n t companies, PepsiCo. In the past 15 years, PepsiCo has created a r e s t a u r a n t empire by purchasing KFC, Pizza Hut, Taco Bell, Hot 'n Now, Chevy's, California Pizza
JUNE 1994
Kitchen, and D'Angelo Sandwich Shops2 Although PepsiCo also develops concepts in-house, that is not where they are investing the majority of their capital. Given the fact that Fastino's has not been rolled out, and that tests with Pizza H u t Cafe and Salsa Rio have been scaled back, it seems clear that acquisition has been their primary approach. Why is acquisition an appropriate innovation strategy for PepsiCo? Let's look at a competitor for a moment. Boston Chicken is a concept that never would have been created by a corporate R&D organization--it lacks technological sophistication, proprietary technology, and brand defensibility. Yet the chain, which in 1990 had only two outlets, now has more than 175, is publicly owned, and at one point was trading at 150 times earnings. Boston Chicken succeeded through ready access to financial capital, concept integrity, and strength of will. In an industry where m a r k e t presence and brand awareness are more important than proprietary technology, Boston Chicken simply built enough units to attain critical mass. And this gets at the central issue. PepsiCo doesn't rely on R&D, because it isn't needed and it doesn't always work. The r e s t a u r a n t industry is structured in such a way that formal, directed R&D efforts will usually not pay off. Proprietary technology is rare, and service systems generally cannot be patented. 5The long-term viability and success of Hot 'n Now was unclear at the time this article was being prepared for publication. PepsiCo, which originally purchased the concept simply to exploit its speedy production and service technology, later decided to expand the concept intact. Recently, expansion plans have been on hold. It is my opinion, however, t ha t PepsiCo's potential problems with Hot 'n Now do not undermine the innovation-through-acquisition theory.
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The restaurant industry is structured in such a way that formal, directed R&D efforts usually do not pay off.
The companies that benefit most from innovation by acquisition are those that make restaurants their core business.
While there have been some attempts to define the legal defensibility of trade dress--for example, in the Taco Cabana case--concepts are easily copied2 Furthermore, the r e s t a u r a n t i n d u s t r y has so m a n y entrepreneurs and such low barriers to entry t h a t concepts n a t u r a l l y proliferate. The marketplace is complex and chaotic, such t h a t any a t t e m p t by a major player to control the situation is futile. In an environment of n a t u r a l selection, expensive R&D operations a m o u n t to an unacceptable risk. Risk avoidance is a big part of the innovation-by-acquisition strategy. PepsiCo might pay more to buy existing chains t h a n it would to develop and build its chains from scratch, but it also increases the chance of success because those concepts are fully developed and market-tested. In the language of finance, PepsiCo is paying a risk premium. The company pays a higher a m o u n t for the same potential income stream over time, but in doing so they reduce the risk t h a t the income stream will fail. The need to grow is the other big part of the innovation-byacquisition strategy. Executives of publicly owned companies frequently feel pressure from stockholders to achieve constant and rapid growth. This reflects the stockholders' interest in having their investment appreciate at more t h a n an incremental rate. PepsiCo has achieved an average 15-percent earnings growth rate for the past 27 years. Last year, the r e s t a u r a n t divisions posted a sales growth of
16 percent and a profit growth of 19 percent. 7 To continue achieving such growth, PepsiCo m u s t be aggressive in expanding m a r k e t share and m u s t look for opportunities t h a t are certain to deliver desired returns. Traditional R&D operations presume a long time between the intial idea and the introduction of an actual product, require large investments of capital, and have uncertain results. Unless PepsiCo radically redesigns its approach, in-house R&D simply cannot keep up with the company's demand for successful new concepts. While the success of PepsiCo's acquisition strategy seems clear, other major corporations have experienced problems with r e s t a u r a n t acquisitions in the past 20 years. These include W.R. Grace (El Torito), General Foods (Burger King), Ralston Purina (Jack-in-the-Box), Quaker Oats (Magic Pan), R.J. Reynolds (KFC), Campbell Soup (Pietro's Pizza), and Hershey Foods (Friendly's). In every case, the acquiring company eventually gave up and sold the r e s t a u r a n t chain. Does this invalidate the acquisition theory? Not really. Each of these examples involves a large corporation t h a t did not have a core competency in restaur a n t management. In most cases, those companies were conglomerates following a financial portfolio-diversification strategy. The companies t h a t can and do gain the greatest advantage from innovation through acquisition, on the other hand, are those t h a t make r e s t a u r a n t s their core business.
(~See: J e A n n a A b b o t t a n d J o s e p h L a n z a , " T r a d e Dress: Legal I n t e r p r e t a t i o n s of W h a t Constit u t e s Distinctive A p p e a r a n c e , " The Cornell Hotel and Restaurant Administration Quarterly, Vol. 35, No. I ( F e b r u a r y 1994L pp. 5 3 - 5 8 . 7PepsiCo Anuual Report, 1993.
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THE CORNELL H.R.A. QUARTERLY
Exciting Times Ahead The development of new products and concepts is critical to the growth and profitability of leading companies, especially those t h a t are publicly traded. However, the structure of the restaur a n t industry suggests t h a t a sophisticated R&D effort is a risky strategy for concept innovation. Innovation by acquisition, meaning the outright purchase of small growing chains, is a preferable strategy for the r e s t a u r a n t industry, especially if the right conditions apply (see the accompanying sidebar). In a corporation using a strategy of innovation by acquisition, the role of the planning staff is to monitor carefully the growth of local and regional players as potential acquisition targets. It is important, however, t h a t senior m a n a g e m e n t not be overly distracted by the glamour associated with mergers and acquisitions. An acquisition strategy clearly does not excuse executives from paying attention to basic operating responsibilities or from the need to be creative and flexible. As corporate America continues to dominate the r e s t a u r a n t industry, we can expect to see more acquisitions of regional chains by international corporations. This is a competitive t h r e a t to independent r e s t a u r a t e u r s and small chains. It is also a tremendous opportunity for savvy, ambitious entrepreneurs to grow regional, high-concept chains specifically for subsequent acquisition. Given the trend in buyouts, we can also expect to see increasing interest by venturecapital firms in new r e s t a u r a n t start-ups. There are exciting times ahead in the r e s t a u r a n t minor leagues, co J U N E 1994
When to Innovate by Acquisition Innovation by acquisition involves the purchase of small growing companies by large corporations as an altemative to developing new concepts internally. For the company that chooses to innovate by acquisition, the strategy is most appropriate when the following corporate environment and market conditions exist: • The company generates lots of cash, or at least has a regular and dependable income from operations. This is necessary either to purchase companies outright or to provide evidence of credit worthiness to capital markets. • The company has a low tolerance for risk and for the potential losses that could be incurred from investing in a failed concept or product. This may be especially applicable to publicly held corporations, whose stockholders are likely to be risk-averse. • The company has made a strategic decision to assemble a portfolio of complementary brands or products. Just as different investment options provide balance and diversify risk in a securities portfolio, different concepts can diversify the dsk of product failure. ° The company has a low investment in formal R&D. Innovation by acquisition can either replace R&D efforts or supplement them. • The company has the organizational and management sophistication to handle a portfolio of multiple concepts and to assimilate new operating units and cultures. The ability to operate new divisions effectively is critical to the return on investment. • The company is operating in an industry in which market presence and brand awareness are more important than proprietary technology or in which innovative approaches and methods are not legally protected through patents or copyrights. In those cases, large R&D expenditures will result in products or services that cannot be defended from imitation. ° The company is operating in an industry in which there are low barriers to entry and there are a large number of entrepreneurs. In those instances, the number of successful concepts produced by market forces will far exceed the number that can be produced through a single company's R&D efforts.--B. T.H.
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