What we saw with ITT has been confirmed to be the more general pattern observed in research when looking at the relationship between diversification and firm performance. Unrelated diversification is generally associated with lower performance, which indicates a diversification discount at least in the United States. A diversification discount implies that the value of the combined business is lower than the sum of its parts. By the way, the so-called dominant business firms in this graph are diversified firms that still have most of their revenues coming from a single dominant business. Now interestingly, the graph also indicates that the best performance is associated with firms that undertake related diversification and we will come back to this very shortly. But first we need to go back to our story about conglomerates and what happened to them in the 1980s. In other words, what was Gordon Gekko doing in Wall Street that was making him all this money? And by the way also making a lot of money for other shareholders. Well, if you understood that many conglomerates were experiencing a diversification discount, you already know the answer. A diversification discount means that the value of the diversified firm is less than the sum of its SBUs, the sum of its separate businesses if they operated independently. So Gordon Gekko strategy was quite simply to forcibly take over these conglomerates and then create value by breaking them up into their component parts. And also by getting rid of a lot of their headquarter staff who are not adding much value. During this period, many takeovers were also structured as so-called leveraged buyouts, which meant that they were financed with a lot of debt at very high interest rates and this debt was simply added to the company's balance sheet. Private equity firms use a version of this approach even today, although they're usually not working with conglomerate targets. One big conglomerate still left in the United States is GE which has been going through its own slow and painful process of unwinding. A stock market darling in the 1980s and 1990s, GE managed to survive as a conglomerate because it was much more aggressive in shedding many of the excesses of the conglomerate model. GE CEO, Jack Welch, got rid of most staff and corporate headquarters for example. Neutron Jack, they called him because it was like a neutron bomb had gone off that got rid of all the people and only left the empty building standing. Welch also brought very strong focus and incentives to each SBU in GE's portfolio through his number one number two mantra. All businesses were required to become number one or number two in their industry or they would be divested. This was also a way to ensure that GE had a lot of good star and cash cow businesses for the future. You may know that GE has been struggling after the 2008 recession exposed the risks that it had been taking in its capital business. After narrowing its focus considerably, GE is today figuring out how to create value from a set of fewer and more related businesses. In other words, GE is trying to figure out how it can create a diversification premium. So let us now turn our attention to this question. How can companies create value through diversification? As we have seen with vertical integration, it might be useful here as well to consider the different motivations why companies may enter into diversification. So, for example, companies may enter related businesses to increase their market power by reducing competition from related products. For example, a chain of pizza restaurants may also operate a Mexican fast food chain as Yum brands does with Pizza Hut and Taco Bell. But I will caution again that overt attempts at reducing competition are likely to run a foul of antitrust laws and often these attempts don't actually work in a free and dynamic economy. The second and possibly more important motivation for diversification is what people often called synergies. Essentially, synergies are complementarities between businesses or so-called economies of scope from operating in more than one business at the same time. To take the Yum brands example again, Pizza Hut, Taco Bell, and KFC, all part of Yum brands can lower costs by buying supplies in bulk or developing restaurant sites together. Two types of synergies are often highlighted in the literature. One, firms can scale common resources that can be used in multiple businesses. For example, Nike and Under Armour can use their brands to sell both clothes and shoes at the same time. Amazon can use its technology platform originally created to sell books to sell a wide range of different products. Incidentally, the types of general management skills that conglomerates used across multiple Industries in the early years can be seen as example of scaling, but these days scalable resources are typically much more specialized so that they only apply to a limited set of businesses. Now, seond, firms can develop slack resources in one business and redeploy these resources to other businesses. In fact, the allocation of cash between SBUs in a conglomerate is an example of such redeployment. But again, today's businesses can easily obtain a very general resource like cash from the financial markets. So resource allocation needs to be about much more specialized resources that are unique to the firm. So, for example, Uber can redeploy some of its fleet of cars and drivers to its food delivery business and possibly even some of its technology development and managerial talent to this business. Managers may also sometimes diversify to reduce risk or grow the size of the firm. These motives are a bit problematic because shareholders are generally able to reduce risk by diversifying their asset portfolios. So, diversification of the firm level may serve mainly to reduce manager's risks rather than those of shareholders. Similarly, it is often argued that diversification driven by empire building may be the result of managerial hubris or even misaligned incentives because top managers are often compensated in proportion to the size of the company they manage. So they have incentives to simply diversify in order to grow the size of the company. Finally, diversification may also be undertaken to pursue profitable opportunities. However, if these opportunities have no relation with the firm's other businesses, it may be optimal to spin out these new businesses at the earliest chance. All in al, the core motivations for diversification that are generally accepted to create value for the company are the ones related to resource and capability-based synergies between businesses. Having listed some motivations to diversify, it is important to return again to the Williamson approach of competitive organizational analysis. Now, this may be a little less obvious for diversification than it is in the case of vertical integration. But with diversification as well, there is typically some market type arrangement and alliance, long-term contract, licensing, etc. That might be a plausible alternative to diversification. For example, if Pizza Hut, Taco Bell, and KFC were separate companies, couldn't they still cooperate through an alliance say to develop real estate locations for the restaurants? And it is important to consider the relative pros and cons of such alternatives. To underscore this point, let me take you to my interview with Mark Moran a senior executive at John Deere and Company who you might know as the largest manufacturer of electrical equipment in the world. Mark is the head of John Deere's very successful corporate innovation center located in the University of Illinois' Research Park. Home to many other prominent companies working with our University to advance their innovation and product development. I asked Mark, why Deere was diversified into some product categories, but not others even though there may be some synergies with those products? >> If I think about Deere, there are a number of areas having to do with agriculture and so on. Where Deere is very prominent in, but there's some areas that you've chosen not to be in so mining is one that I think about and especially think about some of your competitors they seem to be in many of the same areas as you but are also in mining but there might be other examples of this. I'm wondering what some of the logic is in how you diversify and where you're not diversifying to. >> Sure, I think if you go back over our history go back to early 80s the farm crisis in the US. We weren't terribly diversified at that point. We were an Ag equipment company, and there were 16 US based Ag companies going into the 80s. I think I have this right, there was one that had not either ceased to be or been renamed or acquired over the course of that decade. We're the only ones that made it. So that was the aha moment for us that we need to diversify and get out of our very cyclical market. Diversification comes in a couple of ways. In one level, globalization's a form of diversification, right? Especially for cyclical markets that have some tie to weather patterns, so that helps, but at the same time we knew we needed to get into things that weren't on that same cadence. And I think I don't know that we would articulate it this way. But if you look back at it, I think it's fair to say we just looked at one of the things look like a tractor and have a lot of common components. So how do we bring some scale to our channel and to our engineering and what our businesses that are big enough to get into. Mining is really big really, really, really demanding. So our equipment gets bigger and bigger organically. Where we need to be in that space, we have tended to lean on Hitachi as a partner. They make equipment like that. We have a great relationship with them for excavators so we've just said let's use our channel for Hitachi equipment. It's pretty specialized and not as much in common with normal construction equipment as you'd think because the duty cycle. >> Yeah, that's wonderful. Actually, it's a very nice example of highlighting that acquiring or diversifying yourself is not necessarily the only solution to achieve the same goal, right? The goal here might be to have a full fleet of vehicles of different kinds and you could achieve the same goal through alliance partnerships with somebody else. >> Yeah, that's exactly right. So in mining where they're probably going to want construction equipment as well, Hitachi is a good partner for us, for more of a yard landscape. We have partnerships where some steel products and some Honda products will appear at our dealerships because those are things just they don't make sense for us to make but we know the customers are going to want them. So how do we get them into the dealership? And while they're there, we'll assume they'll buy some great stuff out of the deal. >> I want to recommend to you the mode of thinking that Mark highlights that actual diversification can be viewed as an alternative to and be compared with other organization alternatives such as an alliance to achieve the same ends. Such a comparative organizational analysis would again return us to analyzing the relative advantages and disadvantages of organizing within a firm as is the case with diversification versus organizing through the market as is the case with any alternative diversification such as an alliance. I will not belabor the points made on this chart about these relative advantages and disadvantages, which we have already discussed in the context of vertical integration. The implications for diversification therefore, can be summarized in the form of two key tests for the diversification to be considered value creating. The first test is what one often calls the better off test. Does the combination of businesses create value? Or in other words, do synergies exist? The second test is the ownership test, which is the outcome of your comparative organizational analysis. To access the value from the presumed synergies, does the same company need to own the businesses? Or in other words, do we need a hierarchy organized within a single company to achieve the synergies or can we do it better with a market like arrangement? The importance of resource-based energies in our analysis of diversification also suggests a link between resources and the idea of relatedness in diversification. Quite simply, relatedness and diversification implies relatedness in the underlying firm specific resources. The logic here is straightforward. The reason that diversification may be better than market alternatives is that the synergies arise out of resources that are highly firm-specific and not available in the market. Does relatedness emerges because these firm specific resources are either scaled or redeployed across businesses in order to generate synergies and this can only be done inside a company.
