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Economics of Strategy Fifth Edition

Slides by: Richard Ponarul, California State University, Chico

Copyright 2010 John Wiley Sons, Inc.

Chapter 7

Diversification

Besanko, Dranove, Shanley, and Schaefer

Why Diversify?

Diversification across products and across markets can exploit economies of scale and scope

Diversification that occurs for other reasons tends to be less successful

Managers may prefer diversification even when it does not benefit the shareholders

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Diversification and “Relatedness”

To measure the degree of diversification in multi business firms the “relatedness” concept can be used (Richard Rumelt)

Two businesses are related if they share technological characteristics, production characteristics and/or distribution channels

Classification by Relatedness

A single business firm derives more than 95 percent of its revenues from a single activity or line of business

A dominant business firm derives 70 to 95 percent of its revenues from its principal activity

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Classification by Relatedness

A related business firm derives less than 70% of its revenue from its primary activity, but its other lines of business are related to the primary one

An unrelated business firm or a conglomerate derives less than 70% of its revenue from its primary area and has few activities related to the primary area

Classification by Relatedness

Type Proportion of

Revenue from

Primary Activity

Examples

Single > 95 percent New York Times,

DeBeers

Dominant 70 to 95 percent Black & Decker,

Harley-Davidson

Related < 70 percent Abbott Laboratories,

RR Donnelly &

Sons

Conglomerate <70 percent 3M, General Electric

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Conglomerate Growth After WW II

From 1949 to 1969, the proportion of single and dominant firms dropped from 70 percent to 36 percent

Over the same period, the proportion of conglomerates increased from 3.4 percent to 19.4 percent

More recently the post-war trend towards diversification has reversed

Entropy Measure of Diversification

Entropy measures diversification (analogous to information content)

If a firm is exclusively in one line of business (pure play), its entropy is zero

For a firm spread out into 20 different lines equally (5% in each line), the entropy is about 3

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Entropy Decline in the 1980s

During the 80s, the average entropy of Fortune 500 firms dropped form 1.0 to 0.67

Fraction of U.S. businesses in single business segments increased from 36.2% in 1978 to 63.9% in 1989

Firms have become more focused in their core businesses

Merger Waves in U.S. History

First wave created monopolies like Standard Oil and U.S. Steel (1880s to early 1900s)

The merger wave of the 1920s created oligopolies and vertically integrated firms

The merger wave of the 1960s created diversified conglomerates

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Merger Waves in U.S. History

In the merger wave of the 1980s cash rich firms grew through acquisitions. Leveraged buyouts were also used by private investors.

In the fifth wave (mid 1990s through 2007) firms were merging with “related” businesses and private equity transactions were on the rise.

Why do Firms Diversify?

Diversification can improve corporate efficiency and benefit the shareholders

Diversification may reflect the preference of the managers when the owners have no say in the decision

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Efficiency Based Reasons

Economies of scale and scope

Economizing on transactions costs

Internal capital markets

Shareholder’s diversification

Identifying undervalued firms

Evidence of Scale Economies

If a merger is motivated by scale economies, the market share of the merged firm should increase immediately following the merger

Thomas Brush study of mergers in manufacturing industries show that market shares increased as expected

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Evidence Regarding Scope

If firms pursue economies of scope through diversification, large firms should be expected to sell related set of products in different markets.

Evidence (Nathanson and Cassano study) indicates that this happens only occasionally.

Scope Economies Outside of Technology & Markets

Firms that produce unrelated products and serve unrelated markets could be pursuing scope economies in other dimensions

Two such explanations are:

Resource based view of the firm (Penrose)

Dominant general management logic (Prahalad and Bettis)

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Resource Based View

Specific resources of the firm are not fully utilized in its current product markets

Applying them in other product markets creates economies of scope

Dominant General Management Logic

Managers develop specific skills (Examples: Information systems, finance)

Seemingly unrelated business may need these skills

The logic can be misapplied when the skills are not useful in the business I into which the firm diversifies

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Economizing on Transactions Costs

If transactions costs complicate coordination, merger may be the answer

Transactions costs can be a problem due to specialized assets such as human capital

Market coordination may be superior in the absence of specialized assets

The University as a Conglomerate

An undergraduate university is a “conglomerate” of different departments

Economies of scale (common library, dormitories, athletic facilities) dictate common ownership and location

Value of one department’s investments depends on the actions of the other departments

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Internal Capital Markets

In a diversified firm, some units generate surplus funds that can be channeled to units that need the funds (internal capital market)

The key question: Is it reasonable to expect that profitable projects will not be financed by external sources?

Internal Capital Markets

When outsiders are at an informational disadvantage they will be reluctant to buy equity or lend

New lenders will be reluctant if the investment benefits existing debt

Monitoring is costly in the case of external financing

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Diversification and Risk

Diversification reduces the firm’s risk and smoothes the earnings stream

But the shareholders do not benefit from this since they can diversify their portfolio at near zero cost.

When shareholders are unable to diversify (Example: owners of a large fraction of the firm) they benefit from such risk reduction

Identifying Undervalued Firms

When the target firm is in an unrelated business, the acquiring firm is less likely to value the target correctly

The key question is: Why did other potential acquirers not bid as high as the ‘successful’ acquirer?

Winner’s curse could wipe out any gains from financial synergies

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Cost of Diversification

Diversified firms may incur substantial influence costs

Diversified firms may need elaborate control systems to reward and punish managers

Internal capital markets may not function well in practice

Internal Capital Markets in Oil Companies

If internal capital markets worked well, non-oil investments should not be affected by the price of oil

Non oil investments tend to fall after a drop in the oil price (Lamont)

Managerial preference for growth may explain this link between oil prices and non oil investments

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Managerial Reasons for Diversification

Managers may prefer growth even when it is unprofitable since it adds to their social prominence, prestige and political power.

Managers may be able to enhance their compensation by increasing the size of their firm

Managerial Reasons for Diversification

Managers may feel secure if the performance of the firm mirrors the performance of the economy (which will happen with diversification)

Manager controlled firms tend to engage in more conglomerate diversification than owner controlled firms.

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Corporate Governance

Shareholders are not knowledgeable regarding the value of an acquisition to the firm

Shareholders have weak incentive to monitor the management

Acquiring firms tend to experience loss of value indicating that acquisitions are driven by managerial motives.

Market for Corporate Control

Publicly traded firms are vulnerable to hostile takeovers

Market for corporate control is an important constraint on the managers

If managers undertake unwise acquisitions, the stock price drops, reflecting Overpayment for the acquisition

Potential future overpayment by the incumbent management

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Market for Corporate Control

Acquirers profit by buying shares at the depressed levels and raising their value by imposing the necessary changes

The incumbent managers concerned about potential loss of jobs desist from unwise acquisitions

Market for Corporate Control

Free cash flow (FCF) = cash flow in excess of profitable investment opportunities

Managers tend to use FCF to expand their empires

Shareholders will be better off if FCFs were used to pay dividends

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Market for Corporate Control

In an LBO, debt is used to buy out most of the equity

Future free cash flows are committed to debt service

Debt burden limits manager’s ability to expand the business

Market for Corporate Control

LBOs may hurt other stakeholders

Employees

Bondholders

Suppliers

Wealth created by LBO may be quasi-rents extracted from stakeholders

Redistribution of wealth may adversely affect economic efficiency

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Redistribution and Long-Run Efficiency

Takeovers that simply redistribute wealth are rational from the point of view of the acquirers but sacrifice long run efficiency

Employees and other stakeholders will be reluctant to invest in relationship specific assets

Purely redistributive takeovers will create an atmosphere of distrust and harm the economy as a whole

Market for Corporate Control

Gains in efficiencies in LBOs were substantial

Even when firms defaulted on their debt the net effect was beneficial

Corporate raiders profited handsomely for taking over and busting up firms that pursued unprofitable diversification

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Market for Corporate Control

Possible reasons for the end of the LBO merger wave

Use of performance measures such as EVA

Increased ownership stakes by the CEO

Monitoring by large shareholders

Market for corporate control may be a costly way to motivate managers

Diversification & Operating Performance

No clear relationship exists between performance and diversification

Moderately diversified firms have higher capital productivity

Unrelated diversification harms productivity

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Diversification & Operating Performance

Diversification into narrow markets does better than diversification into broad markets.

Related diversification outperformed both narrower and broader strategies.

Improvements in newly acquired plants may come at the expense of performance at the existing plants.

Valuation and Event Studies

“Diversification discount” exists in valuation.

Discounts may have existed prior to acquisition for firms that elect to combine.

Market for corporate control counteracts the diversification discount. Diversified firms with the largest discounts get taken over

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Diversifying Acquisitions

Shareholders of the acquiring firms do not benefit from the acquisitions

Negative effects on the acquiring firms are more severe when:

the managers of the acquiring firms were performing poorly before the acquisition

the CEOs of the acquiring firms hold smaller share of the firms’ equity

Diversifying Acquisitions

The market value of the target firm tends to increase on announcement of the acquisition

Gain for the target outweighs the losses for the acquirer.

Though diversifying acquisitions create value, winners curse causes the acquirers to lose value.

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Diversifying Acquisitions

Acquirers had greater return when the targets were related firms.

Gains to unrelated acquirers get bid away in the auction for the target.

Firms with specialized resources engage in related diversification and achieve superior results.

Firms with unspecialized resources such as cash do not.

Diversification & Long-Term Performance

Long term performance of diversified firms appears to be poor.

A third to half of all acquisitions and over half of all new business acquisitions are eventually divested.

Corporate refocusing of the 1980s could be viewed as a correction to the conglomerate merger wave of the 1960s.

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Diversification & Long-Term Performance

Diversification should be based on a core set of resources and a view towards integration of the old and the new businesses.

To be worthwhile diversification should have a basis in economies of scope and efficiencies related to transactions costs.

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