We begin by discussing both the benefits and the costs of corporate diversification to a firm’s shareholders.
Scope Economies
One motive for diversification may be to achieve economies of scope. Although there may be little opportunity to spread fixed production costs across businesses like auto- mobiles and pharmaceuticals, scope economies can come from spreading a firm’s underutilized organizational resources to new areas.14 In particular, C. K. Prahalad
and Richard Bettis suggest that managers of diversified firms may spread their own
managerial talent across business areas that do not seem to enjoy economies of scope.
They call this a “dominant general management logic,” which comprises “the way in which managers conceptualize the business and make critical resource allocations— be it in technologies, product development, distribution, advertising, or in human resource management.”15 The dominant general management logic may seem at
odds with the notion of diseconomies of scale, discussed earlier, that result when talent is spread too thin, which is why we emphasize the gains from spreading under-
utilized resources.
EXAMPLE 2.5 APPLE: DIVERSIFYING OUTSIDEOFTHE BOX
Over the past decade, Apple has gone from being a focused computer maker given up for dead to the world’s most valuable technology company. From the Mac to the iPod, iPhone and iPad, Apple has thrived by leveraging economies of scope to suit changing trends and times. Constant innovation and efficient diver- sification have helped Apple excite its custom- ers and build remarkable brand loyalty. As a result, Apple dominates its markets and com- mands a price premium.
Steve Jobs, Steve Wozniak, and Ronald Wayne founded Apple in the 1970s. With Jobs at the helm, the company quickly became known for its personal computers with a user- friendly operating system. Apple garnered rave reviews from loyal users, but most consumers purchased Microsoft-based personal comput- ers because of Microsoft’s lower price and greater availability. Apple made a big splash in 1984 when it ran a famous commercial for its McIntosh computer during the Super Bowl. But an industrywide sales slump led to Jobs’s dismissal later that same year. Despite constant design innovations and ongoing problems with Microsoft Windows operating systems, Apple could not build its market share of the PC busi- ness much above its loyal 10 percent.
In an effort to reverse its fortunes, Apple brought Jobs back in 1996. He immediately terminated several ongoing projects and focused
on a question that must have seemed anything but innovative at the time: “What can we do to make more people buy the Mac?” Apple intro- duced the iMac, with its revolutionary design that integrated the computer into the monitor, doing away with the traditional big black box. With sales of the Mac on the rise, Apple began looking outside of the box for further growth.
Apple saw great opportunities in personal digital devices. Digital cameras and camcorders already had well-established markets, but exist- ing digital music players were either big and clunky or small and useless, with unfriendly user interfaces. Jobs asked veteran engineer Jon Rubinstein to build a better product, one that used the iMac as a programming engine. Rob- inson had been responsible for many of the company’s hardware innovations and saw the potential of a miniature hard drive newly devel- oped by Apple’s supplier Toshiba. This little disk became one of the core technologies of the iPod. Apple licensed the SoundJam MP music player from a small company and retooled it into its own media player, iTunes. Apple also relied heavily on its own capabilities. Apple’s prestigious design group made prototype after prototype to ensure that iPod would fit Apple’s “user friendly” brand image. The design group worked with Apple’s hardware engineers, power group, and programmers, leveraging technolo- gies and skills used on the iMac.
Why Do Firms Diversify? • 85
The dominant general management logic applies most directly when managers develop specific skills—say, in information systems or finance—that can be applied to seemingly unrelated businesses without stretching management too thin. Managers sometimes mistakenly apply this logic when they develop particular skills but diver- sify into businesses that do not require them. For example, some observers of the 1995 Disney–ABC merger wondered whether Michael Eisner’s ability to develop market- ing plans for Disney’s animated motion pictures would translate into skill at the sched- uling of network television programming. The dominant general management logic is more problematic when managers perceive themselves to possess superior general management skills with which they can justify any diversification. Indeed, the domi- nant general management logic may be used to justify any and all unjustifiable diver- sifications.
Internal Capital Markets
Combining unrelated businesses may also lead a firm to make use of an internal capital
market. The internal capital market, which we describe in more detail in Chapter 3,
describes the allocation of available working capital within the firm, as opposed to the capital raised outside the firm via debt and equity markets. To understand the role of internal capital markets in diversification, suppose that a cash-rich business and a cash-constrained business operate under a single corporate umbrella. The central office of the firm can use proceeds from the cash-rich business to fund profitable investment opportunities in the cash-constrained business. Thus, the diversified firm can create value in a way that smaller focused firms cannot, provided that diversifica- tion allows the cash-constrained business to make profitable investments that would
not otherwise be made, for example, by issuing debt or equity. This idea forms the basis
of the important Boston Consulting Group Growth/Share paradigm. Apple introduced the iPod in October
2001. Together with iTunes, it not only turned around Apple’s finances, it rewrote the entire digital music landscape. This remarkable suc- cess changed the face of Apple overnight from being a rebel computer company to the trendy digital electronics company. And the iPod had a “halo effect” on the iMac; Apple products were trendier than ever.
Apple next turned its attention to cellular phones. Inspired by tablet PCs, Jobs believed that cell phones were going to become impor- tant devices for portable information access. Although the headset business was highly com- petitive, one point of market share was worth $1.4 billion. More importantly, there were no products that integrated all of the functions that one could incorporate into a handheld device. Research in Motion’s Blackberry had taken a big step toward convergence, but Apple planned
to go further, and expected to command a steep price premium if it succeeded. Once again building on existing strengths, Jobs took the video iPod and stuffed it with a version of the OS X operating system, so that the phone could handle web browsers and e-mail clients. GPS and wireless capabilities were added. Indepen- dent programmers found the iPhone to be a perfect vehicle for new applications. Today’s iPhones are expensive and highly profitable. By the end of fiscal year 2011, Apple had sold a total of 140 million iPhones, which accounts for a market share of less than 10 percent of all cell phones. More important to Apple, the product generates over half of total industry profits.
With each innovation, from the iPod to the iPhone and the iPad, Apple puts its existing skills in design, engineering, and programming to surprising new uses. Time will tell what new surprises Apple has in store.
Beginning 30 years ago, the Boston Consulting Group (BCG) has preached aggressive growth strategies as a way of exploiting the learning curve. Figure 2.9 depicts a typical BCG growth/share matrix. The matrix distinguishes a firm’s product lines on two dimensions: growth of the market in which the product is situated, and the product’s market share relative to the share of its next-largest competitors. A prod- uct line was classified into one of four categories. A rising star is a product in a growing market with a high relative share. A cash cow is a product in a stable or declining mar- ket with a high relative share. A problem child is a product in a growing market with a low relative share. A dog is a product in a stable or declining market with a low relative share.
The BCG strategy for successfully managing a portfolio of products was based on taking advantage of learning curves and the product life cycle.16 According to this prod-
uct life-cycle model, firms use profits from established cash cow products to fund increased production of early-stage problem child and rising star products. Learning economies cement the advantages of rising stars, which eventually mature into cash cows and help renew the investment cycle.
BCG deserves credit for recognizing the strategic importance of learning curves. However, it would be a mistake to apply the BCG framework without considering its underlying principles. As we have discussed, learning curves are by no means ubiqui- tous or uniform where they do occur. At the same time, product life cycles are easier to identify after they have been completed than during the planning process. Many products ranging from nylon to the Segway personal transporter that were forecast to have tremendous potential for growth did not meet expectations.
Perhaps the most controversial element of the BCG framework is the role of the firm as “banker.” Recall that diversification allows businesses access to a corporation’s working capital. Thus, the central office of the corporation must act like a banker, deciding which businesses to invest in. Given the sophistication of modern financial markets, one wonders if firms must really rely on “cash cows” to find capital to fund their “rising stars.” Jeremy Stein argues that the answer to this question may well be yes, for several reasons.17 First, a firm may find it difficult to find external providers
willing to fund new ventures due to asymmetric information. Firms seeking to expand usually know more about their prospects for success than potential bond- and equity holders outside the firm. Outsiders may suspect that firms disproportionately seek outside funding for questionable projects, saving their internal working capital for the most promising projects. When firms seek outside funding for projects that they believe are truly worthwhile, they can be met with skepticism and high interest rates.
FIGURE 2.9
The BCG Growth/Share Matrix
Relative Market Share High Low Relative Market Growth High Low Rising star Cash cow Problem child Dog The growth/share matrix divides products into
four categories according to their potential for growth and relative market share. Some strategists recommended that firms use the profits earned from cash cows to ramp up production of rising stars and problem children. As the latter products move down their learning curves, they become cash cows in the next investment cycle.
Why Do Firms Diversify? • 87
Second, outsiders will be reluctant to provide capital to firms that have existing debt. This is because new debt and equity are typically junior to the existing debt, which means that existing bondholders have first dibs on any positive cash flows. Third, external finance consumes monitoring resources, for bond- and equity holders must ensure that managers take actions that serve their interests.
If external finance is costly, then firms without adequate internal capital may have to forego profitable projects. Thus, firms may benefit by having their own “cash cows” to fund “rising stars” even if they are in unrelated businesses.
The benefits of using an internal capital market may extend to human capital, that is, labor. As John Roberts observes, firms usually have good information about the abilities of their workers, and large diversified firms may have greater opportunities to assign their best workers to the most appropriate and most challenging jobs.18 This may help explain the success of diversified business groups in developing nations, such as Mexico’s Grupo Carso SAB. We say more about these business groups in Chapter 4.
Problematic Justifications for Diversification
Some of the more commonly cited reasons for diversification do not stand up to scrutiny.
Diversifying Shareholders’ Portfolios
Shareholders benefit from investing in a diversified portfolio. By purchasing small holdings in a broad range of firms, investors can reduce the chance of incurring a large loss due to the failure of any single firm and thus insulate themselves from risk. A shareholder seeking to avoid large swings in value might wish to invest in a single diversified firm. But shareholders can diversify their own personal portfolios and sel- dom need corporate managers to do so on their behalf. Nowadays, investors can choose from countless diversified mutual funds, including some that are invested in thousands of different firms. Diversification to reduce shareholder risk is therefore largely unnecessary.
Identifying Undervalued Firms
Many firms diversify by acquiring established firms in unrelated industries. This can be profitable if the acquirer can identify other firms that are undervalued by the stock market. But how likely is this? This justification requires that the market valuation of the target firm (that is, the firm being purchased) is incorrect and that no other inves- tors have yet identified this fact. Given that speculators, fund managers, and other investors are constantly scouring the market in search of undervalued stocks, it seems hard to believe that a CEO whose attention is largely consumed by running his or her own firm could easily identify valuation errors that these other market participants have missed, unless the target firm is in a closely related business.
Consider also that announcements of merger proposals frequently encourage other potential acquirers to bid for the target firm. Bidding wars reduce the profits an acquiring firm can hope to earn through a merger. Consider Verizon’s February 2005 offer to purchase MCI for $6.75 billion. A rival telecom firm, Qwest, quickly entered the bidding with an even higher offer. After a protracted struggle, with offers and counteroffers going back and forth several times, Verizon purchased MCI for $8.5 billion. It is possible that MCI was a bargain at $6.75 billion, but the $1.75 billion premium Verizon paid may have significantly cut into its profit from the deal.
Finally, note that successful bidders tend to suffer from the “winner’s curse.” In other words, the firm with the most optimistic assessment of the target’s value will win the bidding. Given that all other bidders’ estimates of the target’s value are below the final purchase price, it is likely that the winner has overpaid. As Max Bazerman and William Samuelson point out in their article “I Won the Auction but Don’t Want the Prize,” unless the diversifying firm knows much more about the target than other bidders do, it will probably pay too much to “win” the bidding.19