(FORTUNE Magazine) – AS A FRIEND said of W. C. Fields, anyone who hates children and dogs can't be all bad. These days Uncle Claude might find some like-minded folks over at % Quaker Oats Co. Kids and pooches have not been kind to the Chicagoans recently, a situation directly attributable to two management decisions that turned fiscal 1990 into one of Quaker's worst years in a decade. Each decision had a compelling logic to it, and each decision created a calamitous result from which Quaker is just now recovering. The experience has literally reshaped Quaker and is giving the company's executives a new perspective on merger strategy, brand management, and the supposed value of economies of scale. Quaker's nightmare began with an acquisition. In late 1986 the company bought Anderson Clayton & Co. to get its Gaines Foods division, a leading pet food maker. Quaker bought Gaines to achieve ''critical mass'' -- one of the grails of marketing types -- and made it a critical mess instead. Although the big food company perceived correctly that it needed to enlarge its position or get out of the business, Quaker's management couldn't foresee the harsh, almost irrational way the competition would react (see box). Nor did Quaker help its cause with its handling of the merger. In the end the company's sales of pet food declined 14.5% in the year ended last June, to about $520 million. The second decision reshaped an operation Quaker already owned, toymaker Fisher-Price. For years, Fisher-Price avoided the go-for-broke bent of the toy industry by sticking to basic preschool toys whose appeal lasted forever. But then Fisher was flushed from its niche by a pack of competitors who went after the preschool market. Deciding that the best defense was a good offense, Quaker expanded into high-end electronic toys to compete with the Nintendo crowd. In short order, Fisher-Price's P&L was as red as Santa's nose for the Christmas quarter. For the fiscal year its sales were off 17%, to $702 million, and it posted a $60 million operating loss, including special charges. A division that two years ago contributed 20% of Quaker's operating profits and 15% of its sales suffered a more than $100 million reverse in operating profit between 1988 and 1990, prompting Quaker to decide to spin it off to shareholders. Quaker is paying inordinately for its missteps. In pet foods, its largest business, with sales of $1 billion worldwide, Quaker has lost the No. 2 market position in the U.S. that the company bought in 1986. Wall Street analysts who loved Fisher-Price when it was making money howled for divestment when the wheels came off. In preparation for the launch of Fisher-Price as a free- * standing business, Quaker recently shut down two plants and began pruning staff. Excluding Fisher-Price, Quaker's total sales increased just 3% to $5.03 billion in the year that ended in June, a year when critics even questioned the health value of oat bran. Profits decreased 17% to $169 million. The stock plummeted from a 52-week high of $63.38 a share to $42.63 recently. And so, too, has the reputation of William Smithburg, 52. Since becoming CEO in 1981, Smithburg has won plaudits by sorting out Quaker's grab bag portfolio of businesses and putting up some consistent numbers. But with the year he's had, including his unsuccessful effort to buy out the troubled Campbell Soup Co., he increasingly hears the words ''takeover target'' from the baying pack on the Street. HAD YOU BEEN in Bill Smithburg's shoes, looking to build on your existing brand-name businesses, chances are you would have come to the same conclusion he did in September 1986, when he outbid Ralston Purina Co. to buy Anderson Clayton for $801 million. The real target was Gaines, which Anderson bought from General Foods in 1984. With sales of more than $400 million, Gaines was good for a 6% to 7% share of the U.S. pet food market. The operation was particularly strong in the small but highly profitable segment known as semimoist, those ersatz burgers that come wrapped in plastic. Quaker, which owns Ken-L-Ration, was a major presence in semimoist already. In combination, the Gaines and Quaker brands represented 75% of the semimoist market. After a four-month battle, Smithburg snatched Anderson Clayton away from Ralston Purina with some nifty last-minute maneuvering. Ralston CEO William Stiritz had amassed Anderson Clayton shares and even had management's blessing. But Smithburg negotiated to buy the 33% of the company controlled by the Clayton family for $66 a share, $2 more than Ralston's last bid. Strangely, Ralston didn't make a counteroffer, even though it had already purchased some shares for as much as $70 each. When the dust cleared, Quaker had 56% of the stock, and Ralston was looking at a loss on its higher-priced holdings. In one stroke Smithburg almost doubled the size of Quaker's pet food business -- achieving the vaunted critical mass. The company now had about a 15% market share of total pet food and bolted from fifth in the industry to second behind Ralston, which had 28%. By quickly selling off all the other pieces of Anderson Clayton -- Seven Seas salad dressing, Chiffon margarine, and Igloo coolers -- Quaker got Gaines at a net cost of $225 million, cheap for a packaged goods business with sales of almost twice that, but $37 million more than Clayton had paid General Foods two years earlier. ''On paper the Gaines acquisition made all the sense in the world,'' says Bruce Bramen, a former executive vice president with Gaines, who left soon after the acquisition. Quaker's strategy was unexceptionable: The company had enjoyed a good but not great position in pet food. Each of its major competitors -- Ralston, Mars Inc. -- was much bigger. Gaines was a solid brand that could add some real market power to Quaker's lineup. Consolidating the two businesses would lower production and marketing costs. Thus, the increase in market share -- and this is a sacrosanct principle in brand management -- would translate into higher profitability. Says Smithburg: ''We consolidated to get more profitable. I still think in time that will occur, and in fact in some of the operations synergies do exist.'' The gang from Chicago committed the most common mistake an acquirer makes: overestimating the benefits it would derive from putting two businesses together. Gaines had three distinct brand names: Gainesburgers, Cycle, and Gravy Train. Quaker had two: Ken-L-Ration and Kibbles'n Bits. Merely assembling all these brands under one corporate umbrella did not make any of them stronger. Remarks a manager at Kal Kan, the pet food division of Mars Inc.: ''This is the critical-mass issue. They thought they were buying market share. But Quaker has too many brands to play with.'' There are synergies in owning a collection of brands -- in buying media, for instance, or in distribution. But Quaker then had to present five different brand messages to consumers, while so-called megabrands such as Purina present only one name with every message. Quaker had every reason to believe in its ability to manage an acquisition. In 1983 the company acquired Stokely-Van Camp Inc. in a merger that now seems seamless. Quaker took a modestly successful Van Camp product called Gatorade and built it from $87 million in annual sales to more than $600 million last year without breaking a sweat. With the confidence born of such success, Quaker let go most of Gaines's management. But in the process, the Gaines brands lost their champions in the councils of the corporation. Says Bramen, the former Gaines exec: ''In hindsight, they probably tried to bring the ! products together with too few people. And quite frankly they did not have enough background in the Gaines brands.'' What Quaker didn't predict is that in becoming No. 2 in pet food it also became the No. 1 target in the industry. ''The competitive arena has been more intense than anyone could have imagined,'' Smithburg admits. As ruler of the pet food roost, Ralston had a lot to lose from a suddenly powerful No. 2. So, soon after Quaker acquired Gaines, Ralston bought a small pet food company in Zanesville, Ohio, that makes a semimoist offering called Moist & Meaty. There was really no reason for Ralston to get into a game where total sales are $200 million and shrinking; none except that Quaker had 75% of the market and could use the business as a cash cow. Says a source close to Ralston: ''What Stiritz did is say, 'I'm not going to let those guys manage for profit. I'm going to make them spend against the acquisition.' '' Ralston quickly ramped up Moist & Meaty into a national brand and slashed prices. Forced to defend its share, Quaker had to forgo the extra profits. In fact, Ralston began tearing up the semimoist market, wolfing down a 33% share, whacking nine points from Quaker's market share in a year. Ralston's enthusiasm for attack may be spiced by a zesty rivalry between top dogs. One story has it that Smithburg let it be known that he intended to thrash the hayseeds from St. Louis with the Gaines acquisition. Bad move. Ralston next took aim at Quaker's dry dog food business. ''Dry dog,'' as it is called, accounts for half the market and is Ralston's biggest seller. By spending heavily to promote its products and to blunt pricing attacks, the gang from St. Louis has continued to block any and every line extension Quaker puts forth. Last year Ralston increased its pet food ad spending more than 40%. In the process it hindered Quaker's effort to develop a total dry dog line, a puppy-to-mature-dog strategy that at retail stores means more space and higher visibility with consumers. WHILE RALSTON pounded away on the dry side, Mars Inc., longtime owner of Kal Kan, went to work on the canned, or ''wet,'' business. Over the past three years Kal Kan has spent vast sums of money changing the brand name of its product to Pedigree, a move that leaves most marketers dumbfounded by both its daring and its expense. To do this Mars advertised so much and made the price of canned dog food so cheap that consumers noticed: This year Pedigree picked . up three share points while Quaker's wet brands lost four points, dropping to about a 15% market share. Even consumer buying habits began to change, to Quaker's detriment. A new kind of ''scientific'' pet food began to grab consumers' attention and money. These brands, such as Iams, Eukanuba, and Hills, owned by Colgate-Palmolive, are sold only in pet shops or by veterinarians. They compete directly with Quaker's most profitable lines. To stay competitive, Quaker had to reformulate its premier product, Cycle, which may end up costing the company as much as launching a new product. In response to the moves by its competitors, Quaker also began to change the formulas on some of its other products and to reposition its brands in the minds of consumers. Says Smithburg: ''We had to make a number of changes -- product changes, basic marketing changes.'' The new Quaker strategy is not to chase the volume it lost but to concentrate on the higher-profit premium side of the business. In dry dog food this means focusing on items such as Cycle, which Quaker is trying to sell from spiffy new store racks. Not until last November, when retailers canceled orders en masse, did Quaker begin to realize that its toy company, Fisher-Price, was also in big trouble. Being a manager in the toy business is to be a poker player forever attempting to draw an inside straight. Grown men and women wager millions in the hope that they have figured out what 8-year-olds will kill for two years down the road. And you think you've got planning problems. Fisher-Price, acquired by Quaker in 1969, never was much of a gambler. It carved out a terrific position by concentrating on the preschool and infant market and ignoring the gotta-have-a-hit strategy that dominates other sectors. Executives at Fisher-Price watched Atari and Coleco blaze cometlike through the toy firmament and explode, just as the brass at Quaker saw their rivals at General Mills struggle with its Kenner and Parker Brothers toys group before finally spinning it off in 1985. INFANT AND PRESCHOOL toys such as Little People and Chatter Telephone account for about 60% of Fisher-Price's sales and contributed heavily to its compound sales and operating profit growth of 17% a year between fiscal 1984 and 1989. Annual sales zoomed from $383 million to $845 million. But by 1988, Fisher-Price found its cushy niche being invaded by others looking for market share and safety. Since then the toy market has weakened, with the notable exception of Nintendo, the Japanese electronic game. Mattel, a former member of the comet club, put on its earth shoes and reorganized the company with an emphasis on preschool toys. Mattel brought an ace to this game, in the form of a licensing agreement with Walt Disney Co. By the 1989 season Mattel had 65 items in the Disney line, on the way to ringing up $190 million in sales over two years, much of it at Fisher's expense. Hasbro, too, whose GI Joe doll was showing his age, invested lots in its Playskool line. And Little Tikes, bought by Rubbermaid in 1984, set about its own expansion campaign. To break out of the closing pack, Fisher-Price introduced a 1989 line that was the broadest and most sophisticated in its history. There were many new products aimed at the over-5 crowd, including a record number of so-called promotional toys. These items -- think of the Cabbage Patch Kids -- are advertised early and often to send kids running to their parents, pleading for the product. Fisher-Price was not new to promotional toys or to breaking into new markets.''We even moved down in the age category to newborns,'' notes Smithburg. The company had entered the stroller and car-seat business and virtually taken it over. Why then the 1989 crash? Says former Fisher-Price President R. Bruce Sampsell, who departed for the banking business in January: ''Fisher-Price had the longest run of any major toy company. It was inevitable that they were going to get dealt a cold hand. And it really is that simple.'' Not quite. Never in the 21 years Quaker owned the business did it suffer from such volatility. Says Smithburg: ''The belief was that we would have moderate success and handle the downside when it came.'' Even before the November disaster, Fisher-Price executives had run through a couple of stop signs. The company's inventory carryover from 1988 was higher than in the previous two years, indicating a slowing market. Says Smithburg: ''It was clear by late summer we weren't going to meet our goals. The only issue was how much.'' Many of the order cancellations weren't for lack of sales: They were for lack of product. In February 1989, for instance, only 20% of the toymaker's new items were in production, compared with 70% this year. Fisher-Price gambled on being able to produce complex products late in the cycle and ran into production difficulties. The toughest product in the line turned out to & be a battery-powered $299 Sport Car that kids could drive around. Motor problems stretched Fisher's technical capability, and the price taxed shoppers' desire to pay. On the Friday after Thanksgiving, Fisher cut the price to $199. But nothing happened. In attempting to market toys to a more mature audience -- like 7-year-olds -- the toymaker also ran into an image problem. ''Fisher-Price is the preeminent preschool and infant brand,'' says Smithburg. ''What it is not is a brand for older children.'' In selling preschool products, the company's advertising efforts are aimed at parents, with whom the Fisher-Price name is gold. ''Kids have less preference or even awareness of the Fisher-Price name than parents do, and for some kids, the name is too closely associated with babies,'' argues Sean McGowan, a toy analyst at Gerard Klauer Mattison & Co. Last year, too, Fisher-Price harvested the crop of ill will it had sown earlier among segments of the retail trade. As the operation became more successful over the years, it became more arrogant. Manufacturers obviously want to get as much shelf space as possible -- it keeps competitors out -- but Fisher-Price had pushed retailers to the edge. In 1988 the company began spewing out large numbers of new products. By the next year its total number of items, or stock-keeping units (SKUs), had ballooned. Yet as a company in the basics business, Fisher-Price didn't have much new to offer other than variations on a theme -- for instance, variations on its Fun With Food line. The company nevertheless pushed the goods on retailers to the point where they began to resent it. Now a downsized Fisher-Price is going back to preschool, to fight it out with Little Tikes and Playskool for the under-5 set. The soon-to-be- independent outfit still retains the No. 1 share in preschool toys. But any gains it makes on the rebound won't accrue to Quaker's benefit. THE WORST is probably over for the crew from Chicago. With a pantry full of solid brand franchises such as Quaker Oats and Aunt Jemima, the company seems a good bet for a turnaround. Pet food sales increased in June, and the Gatorade franchise has benefited from a hot summer. Analysts have begun to add the company to their buy lists because they believe it has bottomed out. The Fisher-Price spinoff also appears to be a winner: Shareholders will now own two pure plays, one in food and one in toys. Perhaps ironically, once it is rid of Fisher-Price, Quaker will be in a position to grow through acquisition again. With management having learned an expensive lesson, the choice should be an interesting one, although don't be surprised if the critical-mass rationale is the same. Smithburg still argues that the Gaines merger will pay off down the road. Says he: ''I'm not happy with the numbers. I don't think it was good; I don't think the merger has accomplished what we wanted. But I still think it was the right thing to do.'' It's just that the next time, he just might handle it just a little differently.

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