DIVERSIFICATION

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DIVERSIFICATION
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Outline

• Development of diversified firms and the
  measurement of diversification
• The reasons for diversification
• Economies of scale and scope
• Economizing on transactions costs
• Internal capital markets
• Shareholders diversification
• Identifying undervalued firms
• Performance of diversified firms

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Development of diversified firms and the
measurement of diversificationWhy Diversify?

• Most well known firms serve multiple product
  markets
• Diversification across products and across
  markets can be due to economies of scale and
  scope
• Diversification that occurs for other reasons
  tends to be less successful

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Measuring Relatedness

• To identify economies of scale in multi business
  firms, the relatedness concept was developed by
  Richard Rumelt
• Two businesses are related if they share
  technological characteristics, production
  characteristics and/or distribution channels

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Classification by Relatedness

• A single business firm derives more than 95
  percent of its revenues from a single activity
• A dominant business firm derives 70 to 95 percent
  of its revenues from its principal activity

• 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

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Classification by Relatedness
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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

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Entropy Measure of Diversification

• Entropy measures diversification as 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, 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

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Merger Waves in U.S. History

• First wave that created monopolies like Standard
  Oil and U.S. Steel (1880s to early 1900s)
• The merger wave of the 1920s that created
  oligopolies and vertically integrated firms
  (General Motors).
• The merger wave of the 1960s that created
  diversified conglomerates (American Can, ITT)
• The merger wave of the 1980s when undervalued
  firms were bought up in the market place (Philip
  Morris and 7 Up).
• The most recent wave of the mid 1990s in which
  firms were pursuing increased market share and
  increased global presence by merging with
  related businesses (AOL Time Warner, Pfizer
  Warner Lambert, Exxon Mobil).

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Ways to Diversify

• Firms can diversify in different ways
• They can develop new lines of business internally
• They can form joint ventures in new areas of
  business
• They can acquire firms in unrelated lines of
  business

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2. The Reasons for DiversificationWhy do
Firms Diversify?

• Efficiency based reasons that benefit the
  shareholders
• Economies of scale and scope
• Economizing on transactions costs
• Internal capital markets
• Shareholders diversification
• Identifying undervalued firms

EFFICIENCY BASED REASONS
FINANCIAL STRATEGIES
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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 (Mercator Wal
  Mart)
• Data from manufacturing industries (Thomas Brush
  study) show that changes in market share were 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 (Nokia).
• Evidence (Nathanson and Cassano study) indicates
  that this happens only occasionally.
• Several firms produced unrelated products and
  served unrelated consumer groups.

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Sales of Nokia, 1988
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Sales of Nokia, 1998
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Norwegian School of Management

• One of the biggest Business Schools in Europe
• 18000 students - 9000 part time
• 750 full time employees, 750 part time employees
• Income of 100 mio ECU, state funding11
• International network with more than 20 locations

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Norwegian School of Management, int.
diversification
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International network for exchange of teachers
and students
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Europe
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BankAmerica buys Continental

• BankAmerica
• The second largest american bank
• Strong credit rating
• Loans with low interest rates.
• Location West Coast
• Continental
• The majosity of business with big firms
• Central office in Chicago
• The limited financial strength
• Inovative in marketing operations

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BankAmerica buys Continental, cont.

• BankAmerica Continental
• geografic diversification product
  diversification with focus on firms
• Economy of scale Economy of scope

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Scope Economies Outside of Technology and Markets

• Firms that produce unrelated products and serve
  unrelated markets could be pursuing scope
  economies in other dimensions
• Two explanations that take this approach are
• Resource based view of the firm (Penrose)
• Dominant general management logic (Prahalad and
  Bettis)

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Resource based view of the firm

• The employment of surplus managerial and
  organizational skills and ability in various
  fields of activity may lead to economies of
  scope.
• The more the company is moving away from a stable
  of business activity, the more resources needed
  to implement the new business.
• Examples Autocommerce, Sava Kranj

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Dominant general management logic

• Top managers have special knowledge and skills in
  certain areas, such as information technology,
  management of human resources, or advertising.
• This knowledge and skills can be used in the
  field of unrelated activities
• Example Krka Novo mesto

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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

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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 departments investments depends on
  the actions of the other departments
  (relationship specific assets, promotion
  committee)

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FINANCIAL STRATEGIES 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 issue is whether the firm can do a better
  job of evaluating its investment opportunities
  than an outside banker can do
• Internal capital market also engenders influence
  costs

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Diversification and Risk

• Diversification reduces the firms risk and
  smoothens the earnings stream
• But the shareholders do not benefit from this
  since they can diversify their portfolio at near
  zero cost.
• Only when shareholders are unable to diversify
  (as in the case of owners of a large fraction of
  the firm) do they benefit from such risk reduction

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Identifying Undervalued Firms

• When the target firm is in an unrelated business,
  the acquiring firm is more likely to have
  overvalued the target
• The key question is Why did other potential
  acquirers not bid as high as the successful
  acquirer?
• Winners 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

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Managerial Reasons for Diversification

• Growth may benefit managers even when it does not
  add value for the shareholders
• When growth cannot be achieved through internal
  development, diversification may be an attractive
  route to growth
• When related mergers were made difficult by law
  (Anti-trust legislation) conglomerate mergers
  became popular

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Managerial Reasons for Diversification

• Managers may feel secure if the firm performance
  mirrors the performance of the economy (which
  will happen with diversification)
• Diversification will offer managers room for
  lateral movement and allow them to invest in firm
  specific skills.
• Unrelated diversification may make it easier to
  motivate managers with pay for performance
  incentives
• Managers could be engaged in empire building and
  enhancing their status in their network at the
  expense of the shareholders

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PERFORMANCE OF DIVERSIFIED FIRMSMarket for
Corporate Control in the Economic Literature

• Publicly traded firms are vulnerable to hostile
  takeovers
• Forcing managers to take decisions for the
  benefit of shareholders
• In order to be credible risk of hostile
  takeovers, managers must possess a special
  expertise that enable the creation of the
  benefits of the acquisition.

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Market for Corporate Control in the Economic
Literature

• 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

• 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

• 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 managers ability to expand
  the business

• EVIDENCE
• Hostile takeovers tend to occur in declining
  industries and industries experiencing drastic
  changes where managers have failed to readjust
  scale and scope of operations
• Corporate raiders have profited handsomely for
  taking over and busting up firms that pursued
  unprofitable diversification

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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

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Diversification and Performance

• Gains from diversification depends on specialized
  resources of the firm
• Unrelated diversification harms productivity
  (product-related, market-related).
• Diversification into narrow markets does better
  than diversification into broad markets
• Improvements in newly acquired plants may come at
  the expense of performance at the existing plants

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Diversification and Long Term Performance

• Long term performance of diversified firms appear
  to be poor
• One third to one 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 and Long Term Performance, Cont.

• Another view is that both the conglomerate
  diversification of the 60s and the refocusing of
  the 80s could be value creating
• Conditions in the 60s could have favored
  unrelated diversification and these conditions
  could since have changed (Example Anti-trust
  climate)

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Diversification and Tobin q

• Tobin q is the ratio between the market value of
  the company and replacement costs of fixed
  capital
• Tobin q is higher in more focused than in the
  diversified firms. This indicates their lower
  efficiency.