What Works: Innocents Abroad

Texan Erle Nye seemed like a sharpshooter when his firm, Texas Utilities, won a bidding war for assets of the British power company the Energy Group in 1998. A respected veteran energy executive, CEO Nye anted up $7.6 billion to win the deal. Soon after, a cartoon in the British press depicted a Texas Utilities meter reader ringing a doorbell–dressed as a cowboy.

Nye would have done better to stay home on the range. He announced last month that Dallas-based TXU (as the company was renamed) would sell the U.K. business to German energy giant E.On for just $2.1 billion and book a write-off that might hit $4.2 billion. In a soft drawl he explains, “We were on the ropes.”

Nye has plenty of company. Using cheap debt and inflated equity as currency, scores of firms expanded internationally during the go-go 1990s–not just through exporting, but by making direct foreign investments–and lost big. From tech (Gateway Computer) to financial services (Merrill Lynch) to media (Vivendi Universal) to energy (TXU and others), many firms are scrambling to restore their balance sheets after disastrous foreign campaigns. Partly as a consequence, U.S. foreign direct investment was down 55% in the first half of this year compared with the same period in 1999, when it peaked at $175 billion for the year.

At the same time, other firms, far fewer in number, have succeeded grandly on foreign soil. Now, with a little distance, it’s possible to evaluate some of what separated the winners from the losers and formulate a few 21st century lessons.

James Root, a global strategist with Bain Consulting in New York City, surveyed the 1996-2000 financial results of 7,500 publicly traded companies and shared his findings exclusively with TIME. Root analyzed firms from Australia, France, Germany, Italy, Japan, the U.K. and the U.S. that had revenue of more than $500 million. First, he weeded out those that didn’t grow total revenue and profit at least 8% annually (slightly above an average combined rate of inflation and economic growth). Then he eliminated firms that didn’t report the same 8% growth in foreign revenue and operating profit (which includes exports sold through foreign entities). Conclusion: only about 1 company in 6 grew its foreign sales and operating profits at least as rapidly as its domestic ones. “For many companies,” says Root, “expanding abroad was not very profitable.”

Root’s message is not that foreign investment isn’t worth trying. His survey focused on reported foreign operating profits, a figure that doesn’t account for the potential cost saving and intangible benefits (like R.-and-D. expertise) that multinationals can derive from global sourcing and manufacturing. In fact, companies that increase foreign sales and profit at a sustained and healthy clip (at least 8% annually) yielded superior shareholder rewards. From 1995 to 2000, their stocks delivered compound annual growth of 36%, vs. 21% for the Standard & Poor’s 500 index.

Among the firms Root surveyed, the usual U.S. suspects–such as Dell Computer, GE, Pfizer, Microsoft and Wal-Mart–beat the index and passed all his tests. But so did some less predictable, smaller multinationals such as footwear and apparel maker Timberland and home builder KB Home. Says Root: “Profitable foreign growers come from all walks of life.”

So what do the winners have in common? For starters, a strong business at home. Timberland’s U.S. sales grew about 30% annually for seven years before the company ramped up its foreign business around 1997, adding stores and improving its overseas product mix. Since then, through subsidiaries and retail outlets in 16 European countries and Japan, its foreign operating profits have grown an average of 40% a year. “A strong domestic business gave us the critical mass to support stronger international growth,” says Carden Welsh, a Timberland senior vice president.

In overseas markets, Timberland hired local executives who knew their customers well, and the company tailored products to local tastes. To make this feasible, Timberland uses a homegrown design-and-manufacturing system that lets it make, say, just 1,500 pairs of slim-cut pants for Scandinavia or a run of boots with extra metal hardware for Germans. Explains CEO Jeff Swartz: “Your customers don’t care if you have a centralized warehouse. They care about how you face them with a locally relevant brand.”

Many U.S. companies, Root found, underestimated how tough it can be to compete against entrenched overseas rivals if you lack a unique product or service. Merrill Lynch might have benefited from a more rigorous “asset test”–analyzing economic and competitive conditions to see how an investment might yield the greatest profit–before spending about $300 million in 1998 to buy the accounts of the failed Japanese brokerage Yamaichi Securities. Merrill wanted to be ready for Japan’s “Big Bang” financial reforms, which were supposed to entice Japanese households to remove their retirement money from safe savings accounts and start buying mutual funds and stocks–in other words, the U.S. retail-business model.

Despite regulatory reform, that buying binge never occurred. Meanwhile, Merrill’s local rivals, with ample name recognition and deep pockets, snapped up many of the risk takers who did materialize. “When it came to retail, everyone thought the U.S. financial-services model was a global one, and it wasn’t,” says a Merrill executive who asked not to be named. “Local institutions had a better image, and competing with them was difficult.” After a $600 million loss on the retail side, Merrill radically scaled back the business and is now earning slim profits, though it took a $2.2 billion charge largely related to operations in Japan.

Perhaps most important, says Root, a company needs to identify its competitive advantage and expand with a commitment to exploiting it. For Microsoft, that means developing and selling unique software; for Dell, it means selling low-cost computers and other tech gear direct.

For a company such as KB Home, being successful overseas meant appreciating that all housing markets are profoundly local. Since the mid-1980s, the American home builder has earned healthy profits in France, where it forecasts that revenues will jump 13%, to $650 million, this year. The firm made marketing decisions that “were considered crazy by local gurus,” CEO Bruce Karatz says. KB chose not to build homes with basements–a staple of French houses–and instead offered amenities such as walk-in closets, garages and kitchens replete with appliances, cabinets and fixtures. French builders, in contrast, tend to add those features at the customer’s request, which yields a more customized home at greater expense.

Would the same strategies succeed in other foreign markets? Alas, no. After forays into Belgium, Canada, Germany and England, KB decided that it is finished with new foreign adventures. In England, KB concluded that entrenched home builders were too powerful to beat. In Germany, labor was too expensive, and generations-old inheritance practices resulted in a quagmire of negotiations with families and local officials over developing parcels of land.

Even where KB made some profit–in Mexico, for instance–the company determined that the market was simply more trouble than it was worth. According to Karatz, KB entered Mexico in the mid-’90s on the premise that a secondary-mortgage market would develop and spark a home-buying boom. That market never bloomed. Meanwhile, profit from a successful development near Mexico City shrank because of currency movement. “Our failure to hedge the peso proved costly,” says Karatz.

To consultant Root, such global misadventures suggest that firms are better off not investing abroad just because it’s possible or popular–the build-it-and-they-will-come school–but only when rigorous analysis shows a strong potential for profits. “It’s so popular for CEOs to talk about globalization,” he says, “you’d think it was a golden path to success.” But while globalization as a macro trend may be unstoppable, the reality for most companies, he argues, is that local conditions are even more powerful.

Think back to the Texans at TXU: while they suffered from a slump in wholesale U.K. energy prices, the firm also appears to have miscalculated some of the specific risks of expanding into Britain. TXU underestimated the threat from European multinationals and couldn’t compete effectively after a shift in British public policy that wound up favoring its rivals. “The market just did not materialize as we expected,” concedes a frank Erle Nye. “But we learned a lot of lessons that we can apply going forward.”