To Diversify or not to Diversify…that is the question

Diversification gone bad!

When seeking growth, companies sometimes marry themselves with a similar organization of complementary strengths. A synergistic relationship with a final outcome greater than the sum of its parts is the ultimate goal. There are, however, cases in which perceived synergies simply did not materialize or excessive excitement proved disastrous for the merged entity. For example, in 1993, Quaker paid $1.7 billion for the Snapple brand, even outbidding Coca-Cola among other interested parties (Deighton, 2002, p.47). Although there existed a competitively valuable cross-business value chain relationship, Quaker eventually sold Snapple for less than a fifth of the purchase price a mere 4 years later. Issues surrounding distribution-related strategic fit where not understood or even realized until after the merger. As Deighton (2002, p.47) points out, “the debacle cost both the chairman and president of Quaker their jobs and hastened the end of Quaker’s independent existence (it’s now a unit of PepsiCo).”

Why diversify?

Depending on whether diversification is attempted in related or unrelated businesses, there are numerous reasons for corporations to diversify, including strategic fit, economies of scope, synergies (perceived in the aforementioned Quaker example), or the expanding of core competencies, to name a few. While there are significant benefits to diversification, with none larger than that of enhancing shareholder value, it is also important to note that there are times when it may be advantageous for a company to stay focused on the core competencies and competitive advantages that it was founded on, that is, not to diversify.

It must first pass the test

Creating shareholder value is at the heart of diversification. The test of a sound diversification strategy is that the businesses in the portfolio are worth more under that particular strategy than under any other management team (Goold & Luchs, 1993, p.22). When that strategy fails and the focus on shareholder value is lost, contraction will most likely result. Porter (1987, p.43) highlights this by noting that 33 large US corporations between 1950 and 1986 divested themselves of more acquisitions than they kept. In order to determine if a company’s diversification initiatives will ultimately lead to shareholder value, Thompson et al (2010, p.242) cite Porter (1987, p.46) and recommend that 3 tests be passed:

• The attractive test: The industry must be structurally attractive (or able to be made attractive)

• The cost-of-entry test: The cost of entry must not capitalize all future profits

• The better-off test: The sum of the parts must be greater than the whole

It behoves any strategy team to ensure that all three criteria are met. As Porter’s aforementioned study of 33 US firms indicates, failure to do so will quickly erode shareholder value and may prove devastating for the expanding company.

For a related business…

To achieve shareholder value via diversification within related business requires a substantial amount of strategic fit. Success by means of related value chain activities including, but not limited to, supply chain, manufacturing and distribution activities, is critical due to how these discrete components of the value chain interact and affect one another. Porter (1996, p.73) suggests that strategic fit is fundamental to competitive advantage as well as its overall sustainability, as it is exponentially more difficult for a competitor to match tightly coupled activities than it is to copy an individual process or product feature. With strategic fit come economies of scope or “cost reductions that flow from operating in multiple businesses” (Thompson et al, 2010, p.250). If cost benefits and efficiencies can be obtained along the value chain of related businesses, economies of scope provide a recognizable justification for diversification (Nayyar & Kazanjian, 1993, p.738).

…and an unrelated business

Although strategic fit or economies of scope may not apply to unrelated business diversification, the grounds in which a company should undertake this strategy remain. Of the three tests previously mentioned, the focus should be on attractiveness and cost-of-entry tests, with consideration of the financial performance for each prospective business (Thompson et al, 2010, p.251). Although conglomeration may not fit the strategic vision of the company, a firm with a single offering needs to consider what options exist when its product or service reaches the end of its life. Whereas single businesses may be successful in the short term, they simply cease to exist in the long run (Stadler, 2007, p.68).

Does it make sense to diversify?

Although the benefits of diversification are numerous, it is important for a company to recognize when diversification might be a poor strategy. As previously mentioned, failing even just one of the 3 tests should raise cautionary flags about proceeding and should result in serious reconsideration. To diversify, a company must have all the necessary competitive strengths, not just some of them (Markides, 1997, p.95). Furthermore, core competencies must be transferable and applicable to both the new company (related business) as well as the new industry (unrelated business). Excelling in one sector does not necessarily equate to success in another. This is especially true if the diversification strategy involves unrelated businesses.

“To acquire, or not to acquire: That is the question. Whether ’tis nobler to grow through acquisition, or to expand internally through increased R&D and capital investment?” (Terry, 1983, p.24). To be certain, this question is discussed on a daily basis in board rooms across the corporate world. Although there are clear benefits to both related and unrelated business diversification, there are situations in which a prudent manager should refrain from diversifying at the risk of destroying his or her business. Unless most of the aforementioned indicators are met, diversification could be, at best, nothing more than a bad investment, but at worst, a lost company and career.

References:

Deighton, J. (2002) ‘How Snapple Got Its Juice Back’, Harvard Business Review, 80 (1), January, pp. 47-53.

Goold, M. & Luchs, K.S. (1993) ‘Why diversify? Four decades of management thinking’, Academy of Management Executive, 7 (3), August, pp. 7-25.

Markides, C.C. (1997) ‘To diversify or not to diversify’, Harvard Business Review, 75 (6), November/December, pp. 93-99.

Nayyar, P. & Kazanjian, R. (1993) ‘Organizing to attain potential benefits from information asymmetries and economies of scope in related diversified firms’, Academy of Management Review, 18 (4), October, pp. 735-759.

Porter, M. (1987) ‘From competitive advantage to corporate strategy’, Harvard Business Review, 65 (3), May/June, pp. 43-59.

Porter, M. (1996) ‘What is Strategy?’, Harvard Business Review, 74 (6), November/December, pp. 61-78.

Stadler, C. (2007) ‘The 4 principles of enduring success’, Harvard Business Review, 85 (7/8), July/August, pp. 62-72.

Terry, R.J. (1983) ‘Ten requirements for acquisition success’, Strategy & Leadership, 11 (2), March, pp.24-48.

Thompson, A., Strickland, A., & Gamble, J. (2010) Crafting and Executing Strategy:The Quest for Competitive Advantage: Concepts and Cases. 17^th ed. New York: McGraw-Hill Irwin.