The Success and Failures of Diversification Strategies - Essay Example

 Introduction Diversification is a business strategy that was born of necessity when corporations in the first half of the 20th century maxed out their growth in their founding purpose and discovered that branching into other ventures provided increased returns. As a theory, diversification is a standard in business operations, creating a sound base for increased profits and as a buffer against problems that might arise in one area of interest. In practical terms, the way in which a business diversifies is dependant upon a strategy that will benefit the corporate a whole. In the present economy, there can be advantages and disadvantages to diversification, dependent upon the methodology employed in creating multiple revenue streams. In order to examine the corporate strategy of diversification, it is important to gain an understanding of the concept. Looking at the theories and types of diversification potentials allow for a developed knowledge of this business strategy. As well, looking at firms who have diversified and the eventual results will further the investigation. Specific examinations of General Electric and Berkshire Hathaway in comparison with Tesco, HSBC, and Vodafone will allow for examples of diversified interests to reveal how these strategies are successful or without success. History DuPont is considered the leading pioneer of diversification. The Clayton Antitrust Act of 1914 in the United States limited the ability of a corporation to grow through acquisitions and mergers. In 1916 DuPont became the target of an investigation that was pivotal in the future of the strategy of diversification. DuPont, however, did continue to grow through the additions of The success 3 chemicals and paints to its gunpowder. The Cellar-Kefauver Act of 1950 made it more difficult to achieve vertical and horizontal integration, thus promoting more diversifications that were the beginnings of the conglomerations (Heinrich & Batchlelor, 2004, pp. 208). New tariff policies that grew through the 20th century also encouraged companies to turn to diversifications strategies in order to compete with foreign imports that were cheaper and impeded the progress of companies that depended on the products that were not available. Products such as steel and textiles were vulnerable to the importing of commodities in the United States. Kimberly-Clark is an example of a company that had to turn to a diversification strategy in order to survive. The company was founded in order to create newsprint paper, but when imports from Canada were opened up through the Underwood Tariff Act of 1913, the company had to find new ways in which to continue forward. The Act allowed for the company to not only create a diversified product base, but opened up the opportunity to utilize Canadian manufacturing options which led to expansion into the British market. This led to further opening up the Western European markets after World War II (Heinrich & Batchlelor, 2004,pp. 208). Studies of Diversification Strategies According to Sutton (1980), a study done by Utton in 1977 of the two hundred largest U. K. companies concluded that companies tend to diversify into closely related industries in order to take advantage of operations that are already in place (pp. 75). However, Sutton (1980) also reports that empirical evidence shows that companies that remain specialized do not notice decreased returns in comparison to companies that diversify (pp 75). This does not suggest that diversification is not a recommended method of increasing profits and hedging against industry changes that might affect a primary product. The success 4 Diversification is used as a strategy for companies that might not be seeing profits at a higher end for their main and original product. As well, an exceptional opportunity will provide a foundation for diversification for increased profits. The purposes of diversification are varied depending on the company and the intent. Sutton (1980) reports that a study by Rumelt in 1974 suggests that firms that remain within a similar industry for their diversification efforts show a greater return than companies that go outside of their original product classification (pp. 76). This suggests that companies who remain within a similar range of production do better than those who try to diversify into products that have no relation to their main source of income. Pettigrew, Thomas and Whittington (2002)confirm that firms that stay within a related field of business for their diversification efforts have higher returns than those who go into unrelated fields of interest. They quote Peters and Waterman from a 1982 study as saying “virtually every academic study has concluded that unchannelled diversification is a losing proposition” (pp. 80). However, this is not conclusive. Some examples of diversification into unrelated fields are successful. Pettigrew, Thomas, and Whittington (2002) show that it is also probable that diversifying into multiple streams of income is only profitable to the point that the complexity and difficulty in maintaining more than one product doesn’t overwhelm the potential profit (pp. 80). Hit, Ireland, and Hoskisson (2009) “ a corporate level strategy specifies actions a firm takes to gain a competitive advantage by selecting and managing a group of different businesses competing in different product markets” (pp. 154). In utilizing diversification, there are two avenues of pursuit that might be taken by a firm in order to maximize profit potential. There are two aspects of consideration when developing a diversification potential. The first is what The success 5 product will be chosen for diversification and the second is in how the corporate office will manage the product. An issue that is concerned with the diversification of a firm is whether or not that action will create value. A discussion of the potential for value of diversification is concerned with whether or not a product will flourish in a corporate portfolio or will have done just as well or better under other management. The costs and benefits of diversifying interests must take into consideration the level of costs that research and development will burden the firms resources, necessitating higher profits in order to cover such costs. In creating value in diversification, these considerations must be met and exceeded (Hit, Ireland, & Hoskisson, 2009, pp. 155). Corporate Strategy According to Pettigrew, Thomas, and Whittington (2002), three mechanisms are used by corporations in order to exercise market power. The first of these mechanisms is predatory pricing in which competitors are undercut through the power of the corporation to offer lower pricing for similar products. Another power that can be exercised by a diversifying firm is to offer reciprocal buying so that preferential treatment is given to those who become loyal customers for another part of the business. An example of this would be to give better pricing to a retail outlet when more than one product is purchased. Mutual forbearance is a strategy of marketing that suggests that in competing with similar conglomerates, the power of that competing firm may be more than is worth the effort to compete at a high level. In other words, some giants are better off not being challenged (pp. 81). There are levels of diversification from which a company may choose to pursue. According to Hitt, Ireland, and Hoskisson (2009), there are five levels of diversification that a The success 6 company may choose as a strategy for expansion and growth. Low levels of diversification can be found to be separated into two categories. The first is single business strategy in which 95% of the revenue of a business comes from a single product where as the second is a dominant business in which 70% to 95% of the revenue comes from a single product. Moderate to high level forms of diversification also comes in two forms. The first is related constrained in which less than 70% of the business comes from the primary business and all business share product, technological and distribution linkages. The second related linked (mixed related and unrelated) in which less than 70% of the income is from the primary business and diversified product lines share limited linkages. The last level of diversification is a very high level which is termed as unrelated in which less than 70% of the revenue comes from a single product and there are no links between the diverse offered products (pp. 156). Six guidelines for determining the effective use of diversification by a firm are suggested by David (2006). When an organization’s basic industry is experiencing declining annual sales and profits. When an organization has the capitol and managerial talent needed to compete successfully in a new business. When an organization has the opportunity to purchase an unrelated business that is an attractive investment opportunity. When there exists financial synergy between the acquired and acquiring firm (note that a key difference between concentric and conglomerate diversification is that the former should be based on some commonality in markets, products, or technology, whereas the latter should be based more on profit consideration). When existing markets for an organizations’ present products are saturated. When antitrust action could be charged against an organization that historically has The success 7 concentrated on a single industry (pp. 172). According to Saee (2007), “more diverse firms have developed complex organizational structures, generally divisionalized ones, and sophisticated management control systems that allow managers to control quasi-independent subsidiaries or divisions (pp. 50). However, the level of diversification determines the level to which internal management resources are used to accomplish the goals of the strategy. The use of acquisitions may be the method of diversification should the cognitive abilities of a management team be saturated beyond its ability to effectively manage growth (Saee, 2007, 51). Because the world has become a place of immediacy, the new trend in marketing is reaching the consumer through multi-channel marketing. This creates a situation where the consumer is promoted to through the diversified interests. Another advantage to this is that in creating diversified interests, a company is doing research, community marketing, and conducting day to day operations all in one package (Wilson, Street, & Bruce, 2008, pp. 32). An advantage to acquiring diversified interests is that further study of the market is combined with potential profits which can create a stronger managerial system within a company. Forms of Diversification Conglomerate When a company adds products or services that are unrelated this is called conglomerate diversification (David, 2006, pp. 171). However, the stock market reaction to diversification is that stock form the parts of conglomerate are worth more separately than they are together. Therefore, the trend of selling off acquired assets becomes a strategy intended to raise stock The success 8 prices on the individual assets compared to profits that are not realized in the expected way. Examples of conglomerate diversification include electric utility companies who routinely acquire gas companies. Reader’s Digest made an attempt to go into internet gift sales. Federated Department stores which include Macy’s, Bloomingdales, and Nordstrom, have made attempts to take their credit card subsidiaries into full banking systems (David, 2006, 171). Concentric Diversification When a company chooses to sell a related service or goods it is referred to as concentric diversification. An example of this type of diversification is found in the example of Amazon.com who has added items such as computers to its online store. Dell computers has also chosen concentric diversification routes as it adds other electronics to its line. Items such as TV’s, for instance, attracts a new customer base as well as expands upon the services to its existing customer base. This type of diversification can be done in order to better compete with companies that already offer an extended line of products or to rise above those who offer the same products by adding additional products (David, 2006, pp. 170). One way in which this can be accomplished is through creating relationships with manufacturers who then ship directly from their plant rather than through the main business warehouses. As an example, when Amazon began to sell computers they contracted with Ingram Micro in order to have their orders filled rather than stock their own inventory (David, 2006, 170). By using service strategy logic in marketing, diversification becomes dependant upon relationships that ease the burden of a single entity. Horizontal Diversification happens when a company provides goods or services to existing customers in order to improve overall service and profit margins. As an example, a The success 9 hospital that provides gift shops, banking services, pharmacy services, etc, has diversified horizontally and provided convenience to its base of customers (David, 2006, 171). Horizontal diversification is achieved when the company works towards remaining on the same level in providing new items to its consumers. The products would common consumers or distribution channels (Hussey, 1998, pp. 304). Vertical Diversification Vertical diversification is achieved by moving backwards through the raw materials in order to acquire related diversified interests. It may also be achieved by moving closer to the consumer (Hussey, 1998, pp. 304). An example of this is simplified by looking at a toy wholesale distributor who acquires a toy manufacturing firm to make the toys it distributes, or conversely acquires a retail outlet to sell directly to the consumer. Examples of Diversification In 2003, the coffee shop Starbucks decided to diversify by creating a duel product prepaid/credit cart called Duetto. This card intends to compete with Visa, Mastercard and American Express. The purpose of this move is to create customer loyalty and return business into the coffee shop. The intent is that the lure of the card will keep people interested in returning to their coffee outlets (David, 2006, pp. 172). Wrigley is intending to diversify into the confectionary business by acquiring aspects of the Kraft business in the form of well known brands such as Life Savers and Altoids. This has presented a problem for the business because in recent times the share price of Wrigley has dropped, thus putting a deeper burden on the Wrigley management team. Hitt, Ireland, and Hoskisson (2009) further suggest that if Wrigley were to try to acquire Hershey, there would be The success 10 high costs as Hershey has recently tried to merge with Cadbury (pp. 156). As the moves of differing companies make competition ebb and tide, the amount of risk involved becomes a game of moving the competition around from company to company in order to minimize the competition and maximize the returns in such a way that the competing companies do not out maneuver themselves. General Electric General Electric is an example of a highly diversified company. The company makes locomotives, light bulbs, power plants, and refrigerators, as examples of the diversified product lines under the GE name. In addition, GE manages more credit cards than American express and owns more airplanes than American Airlines (David, 2006, pp. 172). General Electric also owns 80% of NBC the National Broadcasting company that it acquired from Vivendi who retains 20%. This includes NBC Universal which provides a large profit for the corporation. GE is a very successful company that is only successful because of management that is aware of its successes and failures at all times. In understanding the aspects of each of its holdings, control can be held so that no one subsidiary pulls the rest of the company down. An example of this can be found in the attempts GE made in going into the insurance business. The company admitted that insurance was not a good fit and cut its losses by selling its acquisition, Swiss Re, a reinsurance business, after losses of $700 million in the previous five years. This was also done when Trane air conditioning failed to produce a profit and was “more trouble than it was worth” to the parent company (Gaughan, 2007, pp. 137). Berkshire Hathaway Financial icon Warren Buffet’s holding company is Berkshire Hathaway. In the current The success 11 economy, Berkshire Hathaway is recognized for having strong defensive strategies for the short term and solid offensive strategies for the long term (Haque, 2008, pp. 40). Much of the trust put into the company is based on Warren Buffet’s strength of reputation as a man who can hold onto his profit margin. Investing in Berkshire Hathaway in 2008 when the market was on a severe downturn was considered a safe interest. According to the wisdom of Buffet, diversification is not a way to guarantee that one will not lose everything, only that one will not lose it all at the same time (Tavakoli, 2009, pp. 17). Buffet looks at diversification from a somewhat conservative and practical point of view. He believes that “Highly skilled managers diversify less and perform better than less skilled managers” (Tavakoli, 2009, pp. 17). Looking at a business from the point of view of the entire process, not just the bottom line, allows Berkshire Hathaway to be able to retain a certain amount of predictability in the way its investments will weather the long term. Buffet believes in extensive study of failure in order to be able to recognize the signs and future of companies in whom he will invest (Reichheld & Teal, 2001, pp. 191). One of the most powerful indicators of failure is a marked defection in the customer base. When a company experiences a drop in revenue due to a competing company providing a better service, failure is eminent unless that competition can be revived and some of that loyalty revitalized. A customer defection reveals two aspects of failure in value. The first is in the direct line between the company and the customer. The customer has detected a reason for a decrease in the value of a service or product and therefore changes buying habits. The second comes as cash flow from the customer to the company then diminishes, further affecting overall value (Reichheld & Teal, 2001, pp. 192). Understanding this type of failure, even though it might The success 12 sound rudimentary, requires studying the signs and commonalities that exist between companies who have experienced this effect of failure. Berkshire Hathaway utilizes resources for research in order to understand these types of failures and judge businesses in terms of understanding a well rounded theoretical framework for business and futures. Tesco Tesco has had a more focused sense of business strategy as it has stayed centered on its supermarket central core of business. However, in order to fully stay engaged to consumer needs a business needs to look into other streams of business even as they relate to the core product. Tesco has looked into and begun to expand into web-based home delivery services in order to stay current and respond to consumer needs. This response to the needs of its highest income consumer allowed for a successful expansion. As well, the company expanded into convenience markets in order to respond to the needs of consumers who need a quick service at smaller locations. Quick, but well positioned expansions within the related markets allow for a solid retention of value for a large corporation (Wilson, Street, & Bruce, 2008, pp. 33). HSBC Banking has become a more global experience and in order to take advantage of this HSBC has expanded into international banking operations. There are ten advantages for expanding into a global market. Low Marginal Costs - Managerial and marketing knowledge developed at home can be used at abroad with low marginal costs. Knowledge advantage - The foreign bank subsidiary can draw on the parent bank’s knowledge of personal contacts and credit investigations for use in that foreign market. The success 13 Home nation information services - Local firms in a foreign market may be able to obtain more complete information on trade and financial markets in the multinational bank’s home nation than in otherwise obtainable from foreign domestic banks. Prestige - Very large multinational banks have high perceived prestige, liquidity, and deposit safety that can be used to attract clients abroad. Regulation advantage - Multinational banks are often not subject to the same regulations as domestic banks. There may be reduced need to publish adequate financial information, lack of required deposit insurance, and reserve requirements on foreign currency deposits, and the absence of territorial restrictions. Wholesale defense strategy - Banks follow their multinational customers abroad to prevent the erosion of their clientele to foreign banks seeking to service the multinational’s foreign subsidiaries. Retail defense strategy - Multinational banks prevent erosion by foreign banks of the traveler’s check, tourist and foreign business market. Transaction costs - By maintaining foreign branches and foreign currency balances banks may reduce transaction costs and foreign exchange risk on currency conversion if government controls can be circumvented. Growth - Growth prospects in a home nation may be limited in a market largely saturated with the services offered by domestic banks. Risk reduction - Greater stability of earnings is possible with international diversification. Offsetting business and monetary policy cycles across nations reduces the country specific risk of any one nation (Cherunilam, 2007, pp. 279). In embracing growth through expansion into foreign markets a bank such as HSBC creates a larger reputation and offers services to multinational companies that a nation local bank would not be able to provide. This type of diversification has created a firm that has increased trust and position in dealing with larger customers. The multinational services that are provided allow for a larger share of profits for the bank. Vodafone The success 14 Vodafone is a communications company that is based in the U.K. Due to new regulations on communications, companies such as Vodafone have had to branch into foreign markets in order to position themselves for growth. Innovations in technology and marketing provide the strength needed to compete when laws are enacted that slow growth. Vodafone has now become the leading mobile telephone company in regard to the European market and in its globalization efforts (United Nations, 2008, pp.113). However, this has the potential for some problems as the technology has changed and the ability for smaller companies to offer cheaper rates has undercut some of their market share. This dependence on one stream of profit might cause the company to become obsolete. Conclusion Diversification is a strategy that is powerful for helping to achieve continuing growth for a company when the primary or dominant industry has reached its limits of expansion. By providing additional products in a line, related diversification creates expansion that is centered on the main business operations and can easily utilize management and resources that are already in place. In diversifying into unrelated areas a company may have to stretch resources, but if done with wise planning and through acquisitions that already have an infrastructure of resources in place, the company can increase its profits and promote growth. Although, as in evidence in General Electric, there is a risk that an acquisition will not perform well and must be sold in order to not drain the core resources. While there are many forms of diversification, the core of the strategy is to choose to either go with related or unrelated products. There are risks in both avenues of expansion that must be considered before adapting a diversification strategy for a company. Warren Buffet, who The success 15 uses a methodology of acquisitions of unrelated businesses in order to increase profit margins through stock ownership, urges a rigorous study of the past in order to protect the future. He studies failure in order to see the signs of impending collapse within the companies that he invests (Reichheld & Teal, 2001, pp. 191). After reviewing the diversification strategies of GE and Berkshire Hathaway against the strategies of Tesco, HBSC, and Vodafone, it would seem that a strategy of high level diversification has the strongest potential for protecting an overall business in that the various revenue streams are not dependent upon one another for success. The company has the power to release its control when an acquisition is not working as predicted, while still maintaining its core financial strength. If an industry wide catastrophe causes disruption in a business, a related distributions strategy is likely to find that all aspects of the business will be affected. However, if a variety of industries are part of the company portfolio, then a problem in one area will not necessarily affect another. While it might seem prudent to stick to what a company knows best, in the long term, a business will profit more from a variety of resources. However, this is limited to the ability the company has in providing appropriate capital, research, and corporate management to the venture. Without good business practices, all forms of diversification is doomed. However, by implementing an approach that is dedicated to the increase and growth of a business without the emotional attachments to a product that might impede a decision to end an association, growth can be found to exist within the overall profits. Having studied the various forms of diversification, it is clear that the unrelated strategy has the most potential but must be utilized by intelligent and well crafted corporate management of the portfolio. The success 16 References Cherunilam, F. (2007). International business: Text and cases. New Delhi: Prentiss-Hall. David, F. R. (2006). Strategic management: Concepts and cases. Beijing: Qing hua da xue chu ban she. Gaughan, P. A. (2007). Mergers, acquisitions, and corporate restructurings. Hoboken, N.J.: Wiley. Haque, M. 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