Corporate diversification

A project in financial risk

Anton Krkk 880208-6937 Sandra Johnsson 890315-4600

Both group members have been more or less involved with all parts of the report, but Sandra is the main author of the Background and history, Different kinds of diversification, How diversification may reduce risks, Agricultural Diversification and Snapple parts, and Anton is the main author of the following parts: Risk related to diversification, Trends in diversification, Google, Armani, How to analyze the consequences of diversification.

Contents
Introduction ......................................................................................................................................... 3 Background and history....................................................................................................................... 3 Trends of diversification (USA) ............................................................................................................ 3 Different kinds of diversification ......................................................................................................... 4 How diversification may reduce risks .................................................................................................. 4 Risks related to diversification ............................................................................................................ 5 How to analyze the consequences of diversification .......................................................................... 5 Agricultural diversification .................................................................................................................. 6 Google and diversification ................................................................................................................... 6 Armanis diversification ....................................................................................................................... 7 An example of an unsuccessful diversification: Quaker Oats and Snapple ........................................ 7 Personal conclusions ........................................................................................................................... 8 Reading guide ...................................................................................................................................... 9 References ......................................................................................................................................... 10

Introduction
Assume youre a farmer and your only source of income is growth of staples. What happens if bad weather destroys your entire crop? How can a corporation prepare for fluctuations in the market? Regardless of if youre a farmer or a company you want to protect yourself from risks. One way of doing this might be by expanding your activities. The farmer might consider broadening his business by investing in livestock, and the company might want to introduce different products on the market, or in new markets. This tactic, to expand your business with new products or other services is called diversification or market diversification and is used to reduce risks, but also to stimulate growth and increase profits. Portfolio diversification is known to decrease risks, but does corporate diversification serve the same purposes? This essay gives an introduction to what corporate diversification is, where and when its used, which kinds of risks it might reduce and what types of risks that are involved. This is followed by a few examples of corporate diversification in practice. Unless otherwise stated, from now on the term diversification refers to corporate diversification.

Background and history

Diversification is a market strategy, which is about expanding the business of the company in some way. It stretches from adding new products or services, which in some way are related to the corporations previous products or services on the market, too establish oneself with new, on a from the corporations point of view, completely unknown market (Grant). Although the idea of diversification as a strategy for growth and risk reduction is rather old, it was only after 1950 it became popular to let the corporation expand over different markets and product lines. This growth strategy continued to attract more and more companies, until it culminated in the 1970s when it became popular to build conglomerates, that is, companies expanding by adding more and more unrelated business to the corporation, often via acquisitions. In the following decades, the trend of diversification went down, for the benefit of focusing on core competences. This as a result of financial economists and business leaders starting to doubt the value of diversification. One reason for this was the increased focus on shareholder values, which requires transparency, which is difficult to achieve in companies with multiple businesses (Grant). Today diversification still exists as a strategy, although its glory days seem to be in the past. It is considered to be motivated essentially by three things; growth, profitability and, as focused on in this essay, risk reduction. This is the motives of diversification; by using it you might get both risk reduction, greater profitability and growth. Many risk reducing strategies, like buying different kind of financial derivatives and insurances might be a more successful method to reduce risks but diversification provides greater opportunities for increased profitability and growth (Grant).

Trends of diversification (USA)

As mentioned earlier, diversification became popular among corporations in the 1950s and in the 1970s the number of diversified corporation reached its highest level. Since 1970 the trend changed and the focus of the core competence became more important. There are several studies from the 1990s (Berger) that indicates benefits of focus on core business, in the 2000s there are studies pointing in both direction, which have created a debate about the consequences of diversification. The percentage of diversified corporations in the USA from 1980 to 1997 can be seen in table 1. Here a corporation that has more than one sic code1 is seen as diversified. The data is taken from
1

SIC, Standard Industrial Classification, codes are used in the USA to classify corporations. A sic code is a four digit code. A corporation that has two SIC codes are active in two separate industries, and so on. The more of the digits in the sic code that deviates from the other sic code the more is the diversification. If all the digits deviates its a total unrelated diversification. A popular measure of diversification is the Herfindahl index that is based on the sic-codes, another method is the entropy measure that is calculated as ln(1/ ) where is the procent of a firms employed in industry i (based on sic-code).

companies that have been on the market for a while. The reason for that is that companies in general start up as single segment companies. If taking them into the statistics the amount of starts-ups influence the result a lot. Year 1980 1986 1992 1997 Table 1: Trend in diversification (Basu) Percent of diversified companies (USA) 40.5% 37.5% 21.5% 16.7%

In the 21st century the level of diversified companies have had a stable level but in the end of the 90s and the beginning of the century the number of single segmented companies dropped due to the .com crash (Basu).

Different kinds of diversification

Market diversification can be divided into two subgroups, related and unrelated. Related diversification means adding new products that somehow can make use of resources that already exists within the corporation. Unrelated diversification, on the other hand, means adding new products who cannot take advantage of existing resources and knowledge. This can be done in two separate ways, for the corporation to develop and release new products itself, or by buying companies in other sectors. Diversification may also involve expansion into new markets (Grant). Diversification is quite popular in businesses that are known to be associated with high cash flow but lack of high growth potential, for example tobacco and oil industries. The largest motive for applying diversification as a strategy in these industries is seldom to reduce risks, but to stimulate growth (Grant). There are also other kinds of diversification to reduce risks, for example by using several subcontractors or spread business geographically. By using several subcontractors there will not be a major impact if a subcontractor goes bankrupt or gets big troubles. And by spreading geographically to other countries the dependence of the situation in ones country decreases. Thus, diversification can also be divided into the following three subgroups: Within the industry, within the company or geographically (Hoopes).

How diversification may reduce risks

As mentioned earlier, applying a diversification strategy involves conquering new markets and/or developing new products. A broader market helps to minimize risks considering for example cyclical fluctuations or, for farmers etc., weather bound conditions (Proctor). Related diversification can, in best case, lead to synergies when functions that are already developed within the company can be used of the new product as well and thereby increase cost efficiency. Related products can for example take advantage in using the same distribution channels, facilities, production processes, staff needs or in efforts in among other things sales and advertising or research and development. Also, if the company grows bigger, it might get more power and be more able to influence suppliers and so on. If the company uses related diversification there will most probably be a positive correlation of the profitability between the diversified parts of the company, which truly will increase revenue (Proctor). Unrelated diversification lacks these synergies, but, if successful, it tends to reduce fluctuations in cash flow. Also, for a corporation to rely on only one or a couple of product lines is united with large risks as the market fluctuates over time. Therefore, both related and unrelated diversification can be motivated as risk reducing factors. A corporation that uses unrelated diversification can in the best

case get a negative correlation of the probability between the diversified parts in the corporation, which hopefully leads to increased stability (Grant). It is not clear whether the related or unrelated diversification reduces risk in the best way. With unrelated diversification you might get a negative correlation of the return but on the other hand it is harder to diversify into a new market where you cant use the knowledge and experience of the related market that is within the corporation (Grant).

Risks related to diversification

Even though the method of diversification can be used to decrease the dependence of the market fluctuations, a company that diversifies their business often exposes itself to other risks. There are many puzzle pieces that have to fall into place to get a diversification to be successful. One issue is that a corporation that diversifies might lose commitment to its core business, and a possible consequence is therefore that it harms the core business (Grant). Another risk is that the corporation will need new proficiency, new facilities and the organization may have to change rapidly in order to make a diversification successful. This risk is extra big when a corporation diversifies into new, unrelated markets. This means that corporations must have an initial capital that weigh up the startup costs that arise when they expand their business. If not, the diversification risks being a failure and the corporation might experience major losses (Grant). A risk of diversification into a related market is that expected synergies dont arise, which might lead to increased, unexpected costs. Another problem that can occur is that the brand reputation gets damaged. If for example a corporation that is associated with luxury products starts to sell lowbudget products, the luxury association might disappear (Grant). According to Does corporate diversification reduce firm risk?, a study made by Randy I Anderson, John D Stowe and Xuejing Xing, it is not clear that diversification reduces risk. The findings of their study was that diversification in many cases seemed to increase the risk, even though it sometimes worked successfully as a risk reducing method. In this study, 320 diversifications between 1981 and 1997 were analyzed. All of the investigated diversifications in this study were made by acquisitions, which is the most common form of corporate diversification. The study showed that corporate diversification had different effects on risks in different firms, but that one cant say that it reduces risks in general. Some of the reasons for this are that it seldom is managers alone who have the power to determine diversification strategies; it often requires shareholders approval. Risk-increasing strategies are in general more preferred by shareholders, because it often takes risks to earn big (Xing). The companies that seemed to decrease their risks when diversifying were those who prediversification was high risk companies. One reasons for this is that diversification in those cases leads to less fluctuation in cash flow but also that leaders of such companies in addition to the diversification implement other risk reducing actions (Xing). Findings show that diversification in companies associated with low growth opportunities and weak cash flow often leads to bad consequences (Chiu).

How to analyze the consequences of diversification

A way to investigate whether a diversification was successful or not from a risk reducing point of view, is to calculate the variation of the profits from a corporation before and after the diversification. Before a company decides to diversify it is reasonable to theoretically estimate what consequences it will have on the variance of the profit of the company. One way to do that is to estimate the correlation between the new business and the present. After that, one can estimate the expected variance of the present and new businesses. The variance formula for a sum of random

variables can be used to estimate the risk reduction, which if the correlation isnt one gives that the risk will be reduced. The biggest risk associated with diversification lay in connection with the time of the diversification and the period after that. At the time of diversification money is invested and it takes some time before your diversified business can stand on its own, this is associated with great risks. So in a short period diversification is most likely to increase risk (variance), and those risks (variance) are difficult to estimate (Xing). When measuring the variance of the return (or log return) before and a time after the period using data you can see how the deviation changed. If the variance is lower after the diversification that might indicate that the diversification was successful, but it is important to remember that deviations of the returns might vary in time and there are several factors that affects this variance (Xing). To minimize the market factor it is common that instead of using variance as a measure you use a variance that is weighted by the CPRS-value. The CPRS value is a variance measure of the market. The risk is then defined as the CPRS value (Xing). Further it is important to estimate a confidence interval for the random error of the estimated risk. It is also important to remember that even if the risk is decreased the profitability might have been affected negatively. Therefore it is healthy to analyze effects on the profitability caused by the diversification. This is often even harder. , where is the variance of the stock changes of a corporation and

Agricultural diversification
In the society of today, when both urbanization and agricultural industrialization is common, the chances of survival among smaller farms is threatened. Fewer farmers are active and those who are active live on tight margins, as the larger companies tend to push down the prices. Add to this the weather bound conditions, that farmers in all times have had to face. By diversification of the business, farmers may reduce the risk of bankruptcy. To support diversification in the agricultural sector, several counties in Sweden offer financial aid to help farmers broaden their activities. Examples on new activities for farmers could be tourism, bioenergy and contract work (Lnsstyrelsen). In third-world countries financial aid is spent on stimulating farmers to diversify their business, to make them more resistant to external influences such as weather conditions and climate changes. In developing countries farming often employs a large part of the population, often about half of the labor force, and therefore it is an important sector to invest in for reducing poverty (Csaki). By supporting farmers in these areas to diversify their business from simply staple products into for example livestock, cash crops and non-farm activities, they can increase their chances of escaping poverty. By converting into these higher value products farmers can increase their revenues without increasing farm area (Csaki). For farmers to broaden their business also helps to reduce variations in income and therefore makes them more resistant to external changes. Another reason for expanding into producing products of higher value is that as the population becomes wealthier they tend to change their diet from mainly staples into for example, meat, fruits, vegetables and processed foods (Csaki).

Google and diversification

Google were founded in 1998, and soon it became the leading search engine. Since then, Google have expanded, and have today a diversified business that includes YouTube, Picasa, Google+, Gmail,

Google earth, chrome, Android and much more. Google also has the upcoming mobile phone Galaxy Nexus, manufactured by Samsung. Their diversification strategy includes both development of own products and services and acquaintances with companies like YouTube and Picasa. Even though Googles business is widely diversified, they are still mainly in the internet market and almost 90 % of their income comes from the ads on their search engine (Wikipedia). Is Google reducing their risks with the diversification strategy? Today it feels distant that Google will not maintain its position as the leading web browser. In the late nineties the web browser AltaVista was the leading web browser, but Google took the position from AltaVista. In 2010 Yahoo, the owner of AltaVista, announced that AltaVista was to be shot down. Today Yahoo search and AltaVista is practically the same search engine. Is this scenario possible today, will there be a search engine that can outcompete Google? If so, their diversification strategy might be a good move in a risk reducing manner (Socialmachinery). Googles strategy makes it possible to move their focus into what they find important. So if their search engine would fail in the future they have other services they can focus on. As long as Google search is the leading search engine, they will not lose focus on this service and if someone starts a search engine war against them they have built up a huge organization that can be mobilized to fight back. Two possibly great competitors against Googles search engine in the long run might come from Apple or Microsoft mainly due to their big organizations and financial resources (Socialmachinery). www.buzzom.com lists 10 reasons why Google will fail. The list includes services chrome and Gmail which they see as risky. They also criticize their customer support and data privacy. Further they see problems in Googles entrance to mobile phone market. Further they comment the risk of losing focus on the search engine, which is Googles core business, as a result of the diversification.

Armanis diversification
Armani is a company that really takes advantage of what their brand stands for. Armani have succeeded to spread the brand as a lifestyle. For many people Armani stands for quality and they have used this to diversify into other areas than their original business of suit selling. Today they sell all different types of clothes. Further they have diversified into eye wears, perfumes and you can even buy a flower arrangement or a chocolate box from Armani. None of this has damaged their reputation and today they even have a hotel in Dubai, using the fact that people associate Armani with luxury. An unsuccessful diversification was their cooperation with Samsung. Their Samsung-Armani mobile phone wasnt a hit. The phone could be bought anywhere and most people could afford it, which meant that Armani could not use their reputation in advantage. This experience shows that theyve been most successful when their products have focused on their original consumers that are looking for luxury. This example shows the importance for companies of knowing what they stand for before diversifying (cpp-luxury).

An example of an unsuccessful diversification: Quaker Oats and Snapple

In December 1994 Quaker Oats chose to diverse their business by purchasing Snapple, the, at the moment, fastest growing beverage corporation. Since Quaker Oats already had one successful beverage corporation, Gatorade, in its portfolio, they saw an opportunity of growth and synergies. In the summer of 1994, the competition in the market segment, which Snapple was trying to reach, grew, in the same time as weather conditions lead to a decreasing demand. Even though Snapple already had begun to wobble, Quaker Oats saw an opportunity and thought they had the resources to make Snapple expand internationally. In December 1994, Quaker Oats acquired Snapple for $1.7 billion (businessweek.com).

To be able to purchase Snapple and try to let it expand, Quaker Oats chose to sell off other some other businesses, among others their pet food and candy businesses, which had a history of providing steady streams of incomes to the corporation. The reason for this was that they saw no ability of growth in those businesses. Unfortunately, the expected synergies between Snapple and Gatorade did not occur, and Quaker Oats had trouble to turn Snapples downward trend. Some of the causes of this failure were cultural differences between the two companies and that Gatorade and Snapple wasnt as similar as they first appeared to be. When they realized the extent of losses related to Snapple, the leaders of Quaker Oats demanded the top managers to focus on the core business, and not let the losses of Snapple destroy the other businesses (businessweek.com). In 1997, Quaker Oats decided to sell of Snapple for 300 million USD. This attempt to economic growth turned out to cost the corporation somewhere between $1-1.5 billion, depending on what aspects one chooses to rely on (Winer).

Personal conclusions
Because the fact that portfolio diversification is in most cases a good way of reducing risks, one might believe that the even corporate diversification is a solid risk reducing strategy. Although it in these terms theoretically seems to be a successful strategy, it appears to often not work out in practice. We believe that diversification under certain conditions might be a good way of reducing risks, for example for companies that are affected by external conditions such as season changes, weather and climate changes. But in even in these cases, it is important for the company in mind not to lose focus on its core business and always remember why it chose to diversify its business. This is to ensure that the diversification doesnt damage the public view of the corporation if the new area for example is inconsistent with what they normally stand for. Also, for diversification as a risk reducing strategy to be successful, it is important for the corporation to only focusing on those aspects, and not trying to combine the risk reducing benefits with for example growth benefits. It seems like many diversifications fail because of mixed interests. The management might want to reduce risks, while shareholders want to increase revenues. Shareholders therefore are more likely to prefer to enter businesses with more growth potential. But where there is big growth potential, there are often big risks. This might lead to that a strategy aimed to reduce risks, actually turns out to increase risks instead. Therefore, before a corporation diversifies it seems to be important to carefully analyze for example the attractiveness of the new market, what mutually benefits that exists and what the cost of entry is. We further believe that diversification within the land area might lead to simplification to relocate staff and maybe other resources from one kind of business to another if the market goes down in one area. The ability to keep the knowledge and resources within the corporation therefore increases, which hopefully will lead to that it will be easier to restart, or increase, production when the market changes and better times comes along. Different types of diversification lead to different kinds of risks. One risk considering related diversification might be that the expected synergy gain simply does not exist, and therefore the costs of the corporation rise. Risks with unrelated diversification might be that the corporation lacks knowledge in the new industry and therefore fails. This might lead to economic problems and, even worse, damage to the brand. Sometimes consequences of diversification might be quite obvious, especially when crisis occur. If the core business crashes due to for example the market of the core business crashes an earlier, unrelated diversification can keep the company alive.

We believe that agricultural diversification will continue to be more used, both in countries like Sweden and developing countries. In Sweden the reason for this kind of diversification might be more about keeping the countryside alive than avoiding financial risks. In developing countries, on the other hand, the support for agricultural diversification seems to be more about helping farmers to be more resistant to financial risks. These risks are about keeping up with the market as the area develops and gets wealthier, and avoiding risks considering for example weather conditions and climate change. In our opinion, the reason that diversification in many ways have worked well for Google might be that they already have a very strong brand. Also, they have made diversification projects that did not go well, but since the corporation is huge they can afford to make mistakes, at least financially and even the brand is probably strong enough to survive some mistakes. The major motive for Google to diverse their business is probably growth and not reducing risks. We find it interesting how, in line with the arguments, which caused the trend of diversification to turn downwards, Quaker Oats realized the importance of focusing on the core business when times got harder. One of the reasons for failure in this case was that the cultures of the two companies where quite different, they simply did not understand each other. Also, since the expected synergies did not occur. Our final conclusion is that diversification might be a good strategy for reducing risk with a side effect of growth and increased profitability. But we believe that it is easy to overestimate the potential positive effects of diversification. What we find most important when diversifying is to not lose focus on the core business.

Reading guide
For further reading, we strongly recommend the article Does Corporate Diversification Reduce Firm Risk? Evidence from Diversifying Acquisitions. It provides a broad perspective of corporate diversification and its consequences. Grant (Contemporary strategy analysis) gives a good introduction to value creation in corporation. The chapter about diversification is insightful and a good introduction to the thought of diversification.

References
Books: Csaba Csaki (2003). Reaching the rural poor a renewed strategy for rural development. The World Bank Publications Robert M. Grant (2008). Contemporary strategy analysis. Blackwell Tony Proctor (2000). Strategic Marketing: An introduction. Routledge Internet: Randy I Anderson, John D Stowe, Xuejing Xing. Does Corporate Diversification Reduce Firm Risk? Evidence from Diversifying Acquisitions.(2011) www.ssrn.com/abstract=1755654 (2011-11-09) Nilanjan Basu. (2010) Trends in corporate diversification. Financial Markets and Portfolio Managementhttp://www.springerlink.com/content/m662n18063453262/ (2011-11-13) Google diversification strategy? http://www.socialmachinery.com/2010/03/12/googlediversification-strategy/ (2011-11-20) Google. http://sv.wikipedia.org/wiki/Google (2011-11-20) Luxury fashion brands and diversification. (2010) http://www.cpp-luxury.com/en/luxury-fashionbrands-and-diversification_858.html, (2011-11-22) What prize the Snapple debacle? (1997-04-14) http://www.businessweek.com/archives/1997/b3522072.arc.htm, (2011-11-22) Crunch time at Quaker Oats (1996-09-23) http://www.businessweek.com/archives/1996/b3494094.arc.htm, (2011-11-22) Barry Winer. Quaker Oats and Snapple (2001) http://mba.tuck.dartmouth.edu/pdf/2002-1-0041.pdf (2011-11-22) Std till diversifiering av jordbruk. http://www.lansstyrelsen.se/ostergotland/Sv/lantbruk-ochlandsbygd/lantbruk/stod-ochersattningar/foretagsstod/Pages/Stod_till_diversifiering_av_jordbruk.aspx (2011-10-30) http://www.thefreelibrary.com/Measuring+Geographic+Diversification+and+Product+Diversification .-a057590762 Hoopes, David G. (2011-11-27)