Examples companies using diversification strategy
During the past 25 years an increasing proportion of U. Acquisition has become a standard approach to diversification. In recent years the productivity of capital […]. In recent years the productivity of capital of many multibusiness companies has lagged behind the economy. Since mid, hardly a week has gone by without at least one major acquisition being announced by a diversifying corporation. In light of this continuing interest and the apparent economic risks in following such a strategy, we present a review of the theory of corporate diversification. We begin by discussing seven common misconceptions about diversification through acquisition. We then turn to the basic question facing companies wanting to adopt the strategy: How can a company create value for its shareholders through diversification? Our consideration of value creation leads to an examination of the potential benefits of the alternatives available—related-business diversification and unrelated-business diversification. Businesses are related if they a serve similar markets and use similar distribution systems, b employ similar production technologies, or c exploit similar science-based research. There are seven common misconceptions about diversification through acquisition that we can usefully highlight in the context of recent history. They relate to the economic rationale of this strategy and to the management of a successful diversification program. Acquisitive diversifiers generate larger returns through increased earnings and capital appreciation for their shareholders than nondiversifiers do. This notion gained a certain currency during the s, in part because of the enormous emphasis that securities analysts and corporate executives placed on growth in earnings per share EPS. Acquisitive diversifiers that did not collapse at once from ingesting too many businesses often sustained high levels of EPS growth. Many widely diversified companies have had low capital productivity in recent years. Exhibit I shows the performance of a sample originally selected by the Federal Trade Commission in as representative of companies pursuing strategies of diversification and not classifiable in standard industrial categories. Even the surge in profits in and and the impact of nonoperating, accounting profits in several corporations failed to bring the sample average up to the Fortune average. Exhibit I Performance Data of 36 Diversified Manufacturers, So it is not surprising that acquisitive diversifiers have had low price-earnings ratios. This discount has changed little over several years. Such low market values imply great uncertainty about the size and variability of future cash flows. The high discount rates of acquisitive diversifiers produce growth with less capital appreciation than that of nondiversifiers, whose earnings streams appear to be more predictable. What will create value is growing cash flows with little uncertainty about their size or variability. Unrelated diversification offers shareholders a superior means of reducing their investment risk. By investment risk examples mean the variability of returns over time, returns being defined as capital appreciation plus dividends paid to investors. This consensus leads to an efficient capital market, where the investor finds it extremely difficult to consistently make risk-adjusted profits in excess of those the market realizes as a whole. Several researchers have extended this efficient capital market concept to the analysis of conglomerate mergers. Their studies suggest that unrelated corporate diversification has little to offer investors with respect to risk reduction over a diversified portfolio of comparable securities. They also suggest that if diversified companies cannot increase returns or reduce risks more than comparable portfolios do, these companies can at best offer the investor only value comparable examples that of a mutual fund. Indeed, widely diversified companies with systematic risks and returns equivalent to those of a mutual fund may actually be less attractive investment vehicles because of their higher management costs and their inability to move into or out of assets as quickly and as cheaply as mutual funds do. This risk analysis requires three kinds of information: Once he has done this, the analyst can determine, within statistical limits, whether the diversifying corporation has reduced its systematic risk. Both tables reflect a five-year period ending in July All three systematic risk measurements are within one standard deviation of each other. This misconception is an extension of the previous one. In light of the poor performance of many diversified companies, it should be obvious that safety is difficult to attain. Because of the complex interactions of the U. At the most, there are industry cycles that either lead or lag behind the general economy e. Even if diversifying companies can identify the countercyclical businesses, diversifiers find it difficult to construct balanced portfolios of businesses whose variable returns balance one another. Moreover, inasmuch as businesses grow at various rates, widely diversified companies face the continual challenge of rebalancing their business portfolios through very selective acquisitions. Quite apart from this argument, the low stock market values of widely diversified companies during the past eight years indicate that the market-place has heavily discounted strategy future cash returns to investors in companies consisting of purportedly countercyclical businesses. While there are undoubtedly many reasons for this situation, it suggests that the market may be more interested in growth and the productivity of invested capital than in earnings stability per se. In addition, investors have little incentive to bid up the prices of diversified companies since an investor can obtain the benefits of stabilizing an income stream through simple portfolio diversification. Related diversification is always safer than unrelated diversification. This misconception rests on the notion of corporate executives that they reduce their operating risks when they stick to buying businesses they think they understand. While this presumption often has merit, making related acquisitions does not guarantee results superior to those stemming from unrelated diversification. A close reading of the Xerox and Singer cases suggests that successful related diversification depends on both the quality of the acquired business and the organizational integration required to achieve the possible benefits of companies exchanging their skills and resources. Such exchange has been called synergy. Even more important, the perceived relatedness must be real, and the merger must give the partners a competitive advantage. Unless these conditions are met, related diversification cannot be justified as superior or even comparable to unrelated diversification as a means of reducing operating diversification or increasing earnings. A strong management team at the acquired company ensures realization of the potential benefits of diversification. Many companies try to limit their pool of acquisition candidates to well-managed companies. This policy is rarely the necessary condition for gaining the potential benefits of diversification. Usually such improvement requires an exchange of core skills and resources among the partners. The benefits of unrelated diversification are rooted in two conditions: Indeed, if the acquired company is well managed and priced accordingly by the capital market, the acquirer must exploit the potential synergies with the acquiree to make the transaction economically justifiable. The diversified company is uniquely qualified to improve the performance of acquired businesses. Consider the testimony of Harold S. We can improve operating efficiencies and profits sufficiently to make this valuation worthwhile to both sets of shareholders. To gain the benefits Geneen claimed, a company needs only to allow managers with the requisite skills to implement their desired improvements in the organization. Rarely, it may be argued, does an organization willingly take steps that could alter its traditional administrative and managerial practices. Under these circumstances, change will occur only when forced from the outside, and diversifying companies often represent strategy a force. Nevertheless, the benefits achieved are not, strictly speaking, benefits of diversification. This role involves developing diversification objectives and acquisition guidelines strategy fit a carefully prepared concept of the corporation. A company following a diversification strategy can create value for its shareholders only when the combination of the skills and resources of the two businesses satisfies at least one of the following conditions:. This comparison deserves comment. Most benefits derived from reducing unsystematic corporate risk through diversification are, of course, equally available to the individual investor. Diversified companies can achieve trade-offs between total companies and return that are superior to the trade-offs available to single-business companies. Diversified companies cannot create value for their stockholders merely by diversifying away unsystematic risk. Inasmuch as investors can diversify away unsystematic risk themselves, in efficient capital markets unsystematic risk is irrelevant in the equity valuation process. A diversifying company can create value for its shareholders only when its risk-return trade-offs include benefits unavailable through simple portfolio diversification. There are seven principal ways in which acquisition-minded companies can obtain returns greater than those obtainable from simple portfolio diversification. The first four are particularly relevant to related diversification, while the last three are more relevant to unrelated diversification. When the reinforcement of skills and resources critical to the success of a business within the combined company leads to higher profitability, value is created for its shareholders. This reinforcement is the realization of synergy. The acquisition by Heublein, Inc. At the time, Heublein stood out in this respect because the industry was production-and distribution-oriented. Its principal product was the premium-priced Smirnoff vodka, the fourth largest and fastest growing liquor brand in the United States. By identifying and then exploiting an emerging consumer preference for lighter-bodied, often slightly flavored products, Heublein helped United Vintners launch two new products—Cold Duck a champagne-sparkling burgundy combination and Bali Hai a fruit-flavored wine. By the end ofone year after its acquisition of United Vintners, Heublein had increased sales by over 2. Investments in markets closely related to current fields of operation can reduce long-run average costs. A reduction in average costs can accrue from scale effects, rationalization of production and other managerial efforts, and technological innovation. This notion has been the basis of many acquisitions made by consumer products companies. In many industries, companies have to achieve a certain size, or critical mass, before they can compete effectively with their competitors. For example, the principal way many small laboratory instrumentation companies hope to offer sustained competition against such entrenched companies as Hewlett-Packard, Tektronix, Beckman Instruments, and Technicon is to attain a size giving them sufficient cash flow using underwrite competitive research and development programs. One way to reach this size is to make closely related diversifying acquisitions. Diversification into related product markets can enable a company to reduce systematic risks. Many of the possibilities for reducing risk through diversification are implicit in the previous three ways to increase returns because risk and return are closely related measurements. However, diversifying by acquiring examples company in a related product market can enable a company to reduce its technological, production, or marketing risks. If these reduced business risks can be translated into a less variable income stream for the company, value is created. The diversified company can route cash from units operating with a surplus to units operating with a deficit and can thereby reduce the need of individual businesses to purchase working capital funds diversification outside sources. Through centralizing cash balances, corporate headquarters can act as the banker for its operating subsidiaries and can thus balance the cyclical working capital requirements of its divisions as the economy progresses through a business cycle or as its divisions experience seasonal fluctuations. This type of working capital management is, of course, an operating benefit completely separate from the recycling of cash on an investment basis. Managers of a diversified company can direct its currently high net cash flow businesses to transfer investment funds to the businesses in which net cash flow is zero or negative but in which management expects positive cash flow to develop. The aim is to improve the long-run profitability of the corporation. This potential benefit is a by-product of the U. In NovemberGenstar, Ltd. There Genstar argued that the well-managed, widely diversified company can call on its low-growth businesses to maximize net cash flow and profits in order to enable it to reallocate funds to the high-growth businesses needing investment. By so doing, the company will eventually reap benefits via a higher ROI and the public will benefit via lower costs and, presumably, via lower prices. Genstar recycled the excess cash flow into its housing and land development, construction, and marine activities. So Genstar was able not only to employ its assets more productively than before but also to reap economic benefits beyond those possible from a comparable securities portfolio. Exhibit II Relationship Between Cash Generated by Business Areas of Genstar, — Diversified companies have access to information that is often unavailable to the investment community. This information is the internally generated market data about each industry in which it operates, data that include information about the competitive position and potential of each company in the industry. With this inside information, diversified enterprises can enjoy a significantly better position in assessing the investment merits of particular projects and entire industries than individual investors can. Through risk pooling, the diversified company can lower its cost of debt and leverage itself more than its nondiversified equivalent. As the number of businesses in the portfolio of an unrelated diversifier grows and the overall variability of its operating income or cash flow declines, its standing as a credit risk should rise. Since interest, in contrast to dividends, is tax deductible, the government shoulders part of the cost of debt capitalization in a business venture. These benefits become significant, however, only when the enterprise aggressively manages its financial risks by employing a high debt-equity ratio or by operating several very risky, unrelated projects in its portfolio of businesses. While this type of company can enjoy a lower cost of capital than a less diversified company of comparable size, it can also have a higher cost of equity capital than the other type. This possibility stems from the fact that part of the financial risk of debt capitalization is borne by the equity owners. Indeed, the professional investor may be unwilling to lower the rate of return on equity capital just because a company has acquired a well-balanced or purportedly countercyclical collection of businesses. The risks and opportunities the investor perceives for a company greatly depend on the amount and clarity of information that he or she can effectively process. An unrelated-business diversifier is a company pursuing growth in product markets where the main success factors are unrelated to each other. Such a company, whether a conglomerate or simply a holding company, expects little or no transfer of functional skills among its various businesses. In contrast, a related-business diversifier uses its skills in a specific functional activity or product market as companies basis for branching out. The most significant benefits to the stockholder occur in related diversification when the special skills and industry knowledge of one merger partner apply to the competitive problems and opportunities facing the other. Exhibit III summarizes the benefits that are attainable from the two types of diversification. Unfortunately, the benefits that offer the greatest potential are usually the ones least likely to be implemented. Of the synergies usually identified to justify an acquisition, financial synergies are often unnoted while operating synergies are widely trumpeted. Yet our experience has been that the benefits most commonly achieved are those in the financial area. It is not hard to understand why. Most managers would agree that the greatest impediment to change is the inflexibility of the organization. These changes are usually slow to come; and so are the accompanying benefits. Nevertheless, diversification does offer potentially significant benefits to the corporation and its shareholders. When a company has companies ability to export or import surplus skills or resources useful in its competitive environment, related diversification is an attractive strategic option. When a company possesses the skills and resources to analyze using manage the strategies of widely different businesses, unrelated diversification can be the best strategic option. Finally, when a diversifying company has both of these abilities, choosing a workable strategy will depend on the personal skills and inclinations of its top managers. Bureau of Economics, Federal Trade Commission. Statistical Report on Mergers and Acquisitions Washington, D. Rumelt first articulated this useful definition in his Strategy, Structure, and Economic Performance Boston: Division of Research, Harvard Business School, Sharpe, Portfolio Theory and Capital Markets Diversification York: McGraw-Hill,p. For summaries of empirical evidence supporting the efficient market theory, see Eugene F. Smith and John C. Hal Mason and Maurice B. Hearings before the Antitrust Subcommittee of the Committee of the Judiciary, U. House of Representatives, November 20, Salter is professor of business administration at the Harvard Business School, where he specializes in the strategic and organizational problems of diversified companies. This is his fifth article for HBR. Weinhold divides his time between research at the Harvard Business School and management consulting on issues involving corporate strategy, industrial organization, and financial economics. He is coauthor with Malcolm Salter of Diversification Through Acquisition: Strategies for Creating Economic Value Free Press, and two HBR articles. Your Shopping Cart is empty. July Issue Explore the Archive. Table A Portfolio Comparison. Exhibit III Potential Benefits of Diversification. A version of this article appeared in the July issue of Harvard Business Review. About Us Careers Using Policy Copyright Information Trademark Policy Harvard Business Publishing:. Harvard Business Publishing is an affiliate of Harvard Business School.
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