Diversification By A.V. Vedpuriswar

Understanding Diversification Few firms are single businesses. Rumelt classified firms into four business groups: - Single business firm > 95% of revenues from one business - Dominant business firm 70 – 95% of revenues from principal activity - Related business firm < 70% of revenues from principal activity but other lines of business are related - Conglomerate firm < 70% + other unrelated businesses.

Ways of diversification - Internal development - Joint ventures - Mergers

Benefits of Diversification Economies of scale and scope -Operational synergies Spreading the firm's unutilised organizational resources to other areas -Managers may develop skills that can be applied across businesses. Transaction costs - The multi product firm can be an efficient choice when transaction costs complicate coordination among independent firms Internal capital market - Cash from some businesses can be used to make profitable investments - External finance may be more costly due to transaction costs, monitoring costs, etc. - Good explanation for unrelated diversification

Diversifying shareholders’ portfolios -Individual shareholders may benefit from investing in a diversified portfolio -But shareholders can diversify their own personal portfolios. -Corporate managers are not really needed to do this. Identifying undervalued firms Shareholders may benefit from diversification if its managers are able to identify firms that are undervalued by the stock market. But this may not really hold good in practice

Costs of diversification Combining two businesses in a single firm is likely to result in substantial influence costs. Resource allocation can be influenced by lobbying. - Costly control systems may be needed that reward managers based on division profits and discipline managers by tying their careers to business unit objectives. - Internal capital markets may not work well in practice.

From the 1950s onwards, the development of management principles and the professional education of managers led to the belief that general management skills provided the justification for diversification. Diversified companies and conglomerates were seen to add value through the skills of their professional top managers, who applied modern management techniques and generalized approaches to a wide variety of businesses across different industries. During the late 1960s, however, the performance of many conglomerates weakened, and a new approach to corporate management of diversity was sought.

Portfolio planning techniques helped many companies improve capital allocation across businesses with different strategic positions, and led to the idea of balanced portfolio management. But such analytical approaches overlooked the problem of manageability. Many companies found it difficult to manage businesses facing different strategic issues. During the 1980s poor corporate performance again became a critical issue. Raiders, executives, and academics realized that many diversified corporations were not creating shareholder value, and there was a wave of takeovers, corporate break-ups, and restructuring. The main themes of corporate strategy during the 1980s became restructuring back to core businesses and a resolve to stick to the knitting.

In the 1990s, it became increasingly clear that there was no consensus on what sticking to the knitting in practice implies. Among the currently popular themes, the search for synergy and the building of core competences each have significant followings. But both views need to be complemented with some account of how the corporation allocates capital across businesses. Here the concept of understanding the dominant strategic logic of a portfolio, and its compatibility with the approaches of top management, seems promising.

Ultimately, diversity can only be worthwhile if corporate management adds value in some way. The test of a corporate strategy must be that the businesses in the portfolio are worth more under the management of the company in question than they would be under any other ownership. To achieve this goal with a diverse group of businesses, it may be necessary to restructure portfolios to allow more uniformity in dominant logic and management style, more effective means of realizing synergies and more sharing of core competences.

Performance of diversified firms - The relationship between performance and corporate diversity is not clear. - Profits are more likely to be determined by industry profitability, coupled with how the firm relates new businesses to old ones rather than by diversification per se. One problem affecting research studies is the assumption that different types of relatedness have an equal impact on firm performance. Valuation studies show that shares of diversified firms trade at a discount relative to those of their undiversified counterparts. At least part of the diversification discount can be explained by the fact that firms that elect to combine appear to be those whose shares traded at discounts even before the combination.

Diversified firms with shares trading at large discounts are more likely to be taken over. From the event study literature on diversifying acquisitions, it would seem that returns to acquirers are negative on average while target companies seem to benefit. There is some evidence that the increase in the market value of the target is greater than the reduction in market value of the acquirer. There is evidence that acquirers generate greater returns when they target related firms.

Firms with highly specialised resources engage in more related diversification strategies and achieve superior results compared to firms that use unspecialised resources, such as cash, to diversify. The merger wave of the 1980s which was characterised by more related acquisitions and by corporate refocusing can be viewed as a broad correction to the conglomerate mergers of the 1960. Firms that diversify according to a core set of resources and and focus on integrating old and new businesses, tend to outperform firms that do not work towards building interrelationships among their units. Defensible diversification involves exploiting economies of scope and transaction economics that make it efficient to organize diverse businesses within a single firm, relative to joint ventures, contracts, alliances or other governance mechanisms.

Adjacencies According to Chris Zook, the most sustained, profitable growth comes when a company pushes out the boundaries of its core business into an adjacent space. The average company succeeds only 25% of the time in launching new initiatives. Companies that have hit upon a repeatable formula have much higher success rates of twice that, and some drive their rates up to 80% or higher. Repeatability allows the company to systematize the growth and, by doing so, take advantage of learning-curve effects.

Different ways to pursue adjacencies Some companies make repeated geographic moves, as Vodafone has done in expanding from one geographic market to another over the past 13 years, building revenues from $1 billion in 1990 to $48 billion in 2003. Others apply a superior business model to new segments. Dell, for example, has repeatedly adapted its direct-to-customer model to new customer segments and new product categories. In other cases, companies develop hybrid approaches. Nike, has expanded into adjacent customer segments, introduced new products, developed new distribution channels, and then moved into adjacent geographic markets.

Two characteristics The successful repeaters seem to have two common characteristics. First, they apply rigorous screens before they made an adjacency move. This discipline pays off in the form of learning-curve benefits, increased speed, and lower complexity. And second, they develop their repeatable formulas by studying their customers and their customers' economics carefully.

Moving into adjacencies Expand along the value chain Develop new products and services. Use new distribution channels Enter new geographic regions. Serve new customer segments by modifying existing product or technology Enter a new business leveraging a strong capability

Identifying the new core Company after company prematurely abandons its core in the pursuit of some hot market or new idea, only to falter. But no core endures forever. Companies misjudge the point their core business has reached in its life cycle and whether it is time to stay focused, expand, or move on. How does a company know when the core needs to change in some fundamental way? And how does the company determine what the new core should be?

Developing a new core A new core may make sense for three reasons. The first has to do with profit pools – the places along the total value chain of an industry where attractive profits are earned. If the company is targeting a shrinking or shifting profit pool, improving the ability to execute can accomplish only so much. Consider the position of Apple, whose share of the market for personal computers plummeted from 9% in 1995 to less than 3% in 2005. The entire profit pool in PCs steadily contracted during those years. So Apple moved its business toward digital music.

The second reason is inherently inferior economics. These become obvious when a new competitor enters the field unburdened by structures and costs that an older company cannot readily shake off. General Motors saw this in competition with Toyota, just as Compaq did with Dell. Other well-known examples include Kmart (vis-à-vis Wal-Mart) and Xerox (vis-à-vis Canon). Occasionally a company sees the clouds gathering and is able to respond effectively. The Port of Singapore Authority for example, fought off threats from Malaysia and other upstart competitors by slashing costs and identifying new ways to add value for customers. But sometimes the economics are driven by laws or entrenched arrangements that a company cannot change.

The third reason to rethink a core strategy is an unsustainable growth formula . A manufacturer of a specialized consumer product might find its growth stalling as the market reaches saturation or competitors replicate its once unique source of differentiation. Or growth might slow as competitors catch up. A company that has prospered by simply reproducing its business model may run out of new territory to conquer. The core business of a mining company might expire as its mines become depleted. In all such circumstances, finding a new formula for growth depends on finding a new core.

Developing a new core Management teams react in different ways when they reach the conclusion that a core business is under severe threat. Some decide to defend the status quo. Others want to transform their companies all at once through a big merger. Some leap into a hot new market. Such strategies are inordinately risky. The odds of success are less than one in ten for the first two strategies, and only about one in seven for the third. The most successful companies proceed in a way that leaves less to chance.

Case studies Dometic American Can

Dometic Consider the Swedish company Dometic. Dometic's roots go back to 1922, when two engineering students named Carl Munters and Baltzar von Platen applied what was known as absorption technology to refrigeration. Whereas most household refrigerators used compressors driven by electric motors to generate cold, their refrigerator had no moving parts and no need for electricity; only a source of heat, was required. So the absorption refrigerator was particularly useful in places like boats and recreational vehicles (RV), where electric current was hard to come by.

In 1925 AB Electrolux acquired the patent rights In 1925 AB Electrolux acquired the patent rights. The division responsible for absorption refrigerators later became the independent Dometic Group. By 1973 Dometic was still a small company, with revenues of just 80 million kronor (about U.S. $16.9 million) and losing money. Then Sven Stork, an executive charged with fixing the ailing Electrolux product line, moved aggressively into the hotel minibar market, where the absorption refrigerator's silent operation had a real advantage over conventional technology.

Dometic grew rapidly and was able to acquire some of its competitors. The real breakthrough came when Stork's team focused more closely on the RV market, which was just then beginning to explode. The point wasn't to sell more refrigerators to the RV segment; the company's market share within that segment was already nearly 100%. Rather, it was to add other products to the Dometic line, such as air-conditioning, generators, and systems for cooking, lighting, sanitation, and water purification. As Stork explained, "We decided to make the RV into something that you could really live in. The idea was obvious to people who knew the customers, yet it took a while to convince the manufacturers and especially the rest of our own organization."

These moves fundamentally shifted the company's core. Dometic was no longer about absorption refrigeration: It was about RV interior systems and the formidable channel power gained by selling all its products through the same dealers and installers. That channel power allowed Dometic to enhance its cost structure dramatically. The company streamlined its go-to-market approach in the United States by skipping a distribution layer that had always existed and approaching RV dealers directly. By 2005 Dometic had grown to KR 7.3 billion, or roughly U.S. $1.2 billion. No longer part of Electrolux (the private equity firm EQT bought it in 2001 and sold it to the investment firm BC Partners a few years later), the company was highly profitable and commanded 75% of the world market share for RV interior systems.

Dometic's story of growth and redefinition features all the elements of the successful core-redefining companies . (1) gradualism during transformation, (2) the discovery and use of hidden assets, (3) underlying leadership economics central to the strategy, and (4) a move from one repeatable formula that is unique to the company to another. Dometic never made anything like a reckless "bet the company" move . Dometic redefined its core business by shifting its center of gravity along an existing vector of growth. To do this, it relied on hidden assets–resources or capabilities that it had not yet capitalized on. In Dometic's case, the treasure was its understanding of and access to customers in the RV market.

Leadership economics is crucial to success. Most industries have more than six competitors, but usually more than 75% of the profit pool is captured by the top two. Of those two, the one with the greatest market power typically captures 70% of total profits and 75% of profits above the cost of capital. When Dometic focused on a defined market where it could stake out a leadership position, enormous financial benefits followed. Its new growth formula offered the same kind of repeatability the old one did. Dometic's first focus was on applications for absorption refrigeration, which it pursued product by product, one of which was for RVs. The new formula angled off into a sequence of interior components for the RV customer base. Recently, as RV sales have slowed, Dometic has moved into interior systems for "live-in" vehicles in general, including boats and long-haul trucks.

From American Can to Primerica Sometimes businesses have to reinvent themselves to cope with threats in the environment and limited growth opportunities in existing businesses. American Can manufactured cans/constrainers for the beverage industry. Competition increased as technology was simple. Forward integration by aluminum producers and backward integration by food companies eroded the ability to raise prices. Plastics emerged as an important substitute American Can diversified into paper, musical records retailing and direct mail marketing. In 1980, it started to refocus and entered the financial services business in a big way through acquisitions.

From American can to Primerica (cont..) The can business was sold off In 1987, the company changed its name to Primerica And also acquired Salomon for $9.2 billion In 1998, it merged with Citicorp

Podcast by Chris Zook on developing adjacencies and new cores