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Step change: Diversifying to achieve growth

Businesses are considering ways to reposition themselves and diversify to achieve growth. Gavin Hinks looks at the FD’s role in making the risky venture a success

25 Oct 2012

By Gavin Hinks

Cover of the November edition of Financial Director

PEARSON, owner of the Financial Times, is increasingly moving away from publishing and towards education services. The Co-op, one of the nation’s favourite grocers, is now providing legal advice. Philips, the Dutch electrical giant, no longer wants to make TVs. Big companies are making even bigger decisions about their futures and employing new strategies to get ahead.

Much of this boils down to diversification and you would be forgiven for thinking the term had become a byword for these times in business. Just this month, MITIE, the facilities management experts, announced it had acquired a health service company. McLaren, famed for its Formula One team, is making a name for itself providing data capture tools, while Dell has been on a buying spree for the past few years in its efforts to do more than just build computers.

But repositioning the business or diversifying into new segments is a big decision and attracts much debate. For many, the rationale behind the policy is difficult to justify and a decision to go ahead raises some complex and penetrating questions about a business, its management and its strategy.

According to Lushani Kodituwakku, head of strategy at Grant Thornton, interest has intensified. “Over the last two years, we have seen a number of clients come to us to talk about diversification into new sectors,” she says. “This is something that is going to continue and, in the current climate, companies are very focused on growth and how they can grow.”

Of course, diversification is no new thing. Despite increased attention on Pearson’s move to education, it has always been changing the market position of the business. It began as a construction and engineering company, though its stable of businesses has been varied enough in the past that it has both owned Madame Tussauds as well as had substantial interests in the oil industry.

A renaissance

However, it is Pearson’s shift towards the educational services market - a repositioning process likely to run from 2012 to 2015 - which is gaining the most momentum at the moment.

The replacement of Dame Marjorie Scardino, who is stepping down as head of Pearson after more than 15 years in charge, by the head of the company’s successful education unit, John Fallon, has sparked rumours it will sell the Financial Times.

The company has just spent $650m (£400m) on EmbanetCompass, an American education business that supplies online learning technology to universities. As Pearson presses ahead with building on its learning credentials, the future of its older assets remain in doubt.

Diversification has been through phases of popularity. According to Marcus Alexander, a strategy expert at the London Business School, the 1950s and 1960s represented the heyday for the strategy as companies built large conglomerates. After this peak, companies in the US and western Europe became more focused. However, in addition to what some might claim is a renaissance, Alexander observes diversification still has traction in emerging economies where powerful group companies, able to leverage high concentrations of resources and management skills, move into fresh areas.

But diversification is happening and, anecdotally at least, appears to be attracting much attention.

The key issues, then, are really about preparation before diving in - as well as the motive behind doing it. Some see repositioning the focus of the business as the strategy of last resort when all other approaches have run out of juice. But this is not necessarily the case.

According to Simon Bittlestone, managing director at strategy consultants Metapraxis, “It is essentially always on the table if you have the cash to invest. The most obvious sign that diversification should be considered is where your existing products are either in low-growth markets or where they are highly seasonal or cyclical.”

Martyn Wates, deputy group chief executive and former group CFO at the Co-operative Group, comes at it from a different direction - that of a company looking for opportunities to “enrich the lives” of its customers and “members”.

The first of these approaches is about constant assessment of where existing businesses are, based on current performance and sales forecasts drawn from careful examination of the market. The other is much more about scouting for opportunities. Either approach will result in the same conclusion: opportunities demand careful assessment.

Wates puts it like this: “When we looked at legal services, we asked - ‘Does this fit with our values and beliefs?’”

The Co-operative has a particular set of brand values and wanted to know whether providing legal advice would fit with what the company stood for. Virgin Group has a similar approach, though its modus operandi is more about looking for places where its brand values - value for money, innovation and fun - can be leveraged.

There is a converse position to this. You don’t want to be involved in a product or service that would damage your existing business through conflicting business values. As the “father” of management theory H. Igor Ansoff pointed out - if your enterprise is about technological innovation, there’s no point investing in a business that sells on image alone. The two don’t mix.

Making the case

The next stage takes preparation into the realm of financial analysis. Wates insists the ambitious business has to do its sums - its due diligence - before pushing ahead. “How attractive an opportunity is it? We still have to make a return. We do a lot of work looking at the market size. We look at forecasts for market growth, and we look at the market structure and the number of competitors,” he explains.

According to Sam Baker, a strategy expert and partner at Deloitte, this is where CFOs will come into their own. Wherever the figures for this analysis come from, it will be the finance director who will need to be convinced.

“The CFO is going to be thinking about the incremental commercial impact on the business and the quantification of that. The CFO will want to understand the depth and extent of the business case, and the construction of a robust set of numbers that create that business case,” he says.

The quantification will need to be extensive, and Baker even suggests modeling the performance and cost base of competitors to fully understand the market context. This, he says, will involve interviewing potential customers and suppliers to fully grasp the financial implications. This should give a company the basis for understanding the kind of share it can poach after having entered a new market.

Without understanding this principle, the resulting calculation of investment needed - and the potential profits to be had - is likely to be no more than guess work. And speculation is not what a company wants to be doing when making these decisions, because it is at this point that a big decision will arise about whether entry will be made through acquisition or organically.

For example, the Co-op entered legal services by setting up its own business. It managed this process by leveraging the existing infrastructure of the Co-op bank where it ran what it judged to be successful pilot schemes. The search for opportunities to leverage existing resources makes diversification both “safer” and “more efficient”.

Interestingly, however, the Co-op’s Wates makes this admission about the acquisition as an alternative route: “Because we fundamentally believe that we make a real difference, and can do it so much better, we may well have gone into it if we didn’t have those adjacencies.”

Comments like that illustrate the level of belief management must develop in a diversification project. Wates adds that “it’s all about doing your due diligence”.

For example, the Co-op found that the provision of consumer legal services is mainly through small law firms, meaning the market for this advice is highly fragmented. This gives the Co-op a reason to believe that, by using its resources, it can create a national service with uniformity in quality, and have high hopes of achieving significant market share.

Star business

However, a business must internally identify the thresholds which it must achieve for each of its chosen measures before it can decide whether the diversification risk is worthwhile.

Bittlestone makes the same point. A diversifying company should ask if the new market has high growth potential. Metapraxis sets the threshold for such growth at 5% annually.

The company should also ask whether its diversification company could become a “star” business. It defines a star business as being “equivalent to that of the closest competitor. Anything above that means it is a major player, whereas anything below that means that it is - at best - second in the market.”

The importance of thresholds is also stressed by Martyn Wates. He won’t say what the Co-op’s are for its legal services, but simply states: “We need some means of deciding how to allocate scarce resources and people.”

But speak to anyone on diversification and they will raise this last issue as a major obstacle to overcome: does the management have the skills to operate a new business venture?

Corporate history is littered with diversification efforts which ended with a fairly prompt sale of the business that was bought. Indeed, one study (from Competitive Advantage to Corporate Strategy by Professor Michael E. Porter of Harvard Business School, in the 1995 book Managing the Multi Business Company) covering 33 US companies over 30 years found that, on average, corporations sold about half of all the acquisitions they make in new industries.

According to Sam Baker, company managers should have a “big concern” that they are “the right people to deliver value in this market place”.

Wates adds that the Co-op had to ask itself if legal services fitted with the management’s “skillset”. “Just because it may look attractive on a piece of paper - that doesn’t mean in real life it will be successful,” he warns.

Professor Alexander identifies the issue as a major problem, with high stakes. He says that companies need to be clear about what they’re investing in because they need to avoid “causing damage by getting into something that we don’t really understand”.

Alexander also observes that managers are most likely to understand sectors and industries that have similar “dynamics” to the one in which they already operate. Dynamics will be a number of underlying factors in the business - it could be variables like a shared reliance on certain kinds of technology, similar cashflow issues, whether the businesses sell their products on quality or through comparable brand values.

Alexander fears executives get caught out by “linguistic definitions”: companies are categorised into sectors, which leads executives to believe they understand them, when the underlying dynamics mean the businesses are, in fact, quite dissimilar. Discovering these dynamics after market entry may mean that a company will struggle to come to terms with them.

Despite all this talk of preparation, experts are also keen to offer a word of warning. The element of judgement will still remain in any decision to diversify. The decision is inherently a mix of hunch and analysis.

“It is neither gut feel or scientific in its entirety. Having said this, one cannot eliminate all risks - despite taking a very structured approach,” concludes Grant Thornton’s Kodituwakku. ■

 

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