All Things Money
They say beauty is in the eye of the beholder. One Australian chief executive learnt last week that his idea of beautiful was vastly different from his fellow shareholders’.
Grant Fenn, chief executive of Sydney-based company Downer EDI, announced a A$1.2 billion ($1.3b) takeover offer for Spotless Group. The market was gobsmacked at the bid and immediately wiped 25 per cent off the value of Downer’s shares. Why such a harsh reaction? Shareholders couldn’t understand the logic of Downer — a construction and infrastructure business — buying Spotless, a cleaning and catering company. Towels and school canteens are not logically aligned with roads and mines.
Fenn’s logic is that Downer is a service business.
On that basis it is okay to lump together two incongruous businesses and just deliver great service to each of their customers.
There are countless examples of companies diversifying into unrelated businesses to increase revenue (and hopefully profit) from new markets and new customers.
A company whose existing business is reaching maturity or has limited growth potential might diversify into new markets to give it new growth opportunities. Or a business might look to leverage its existing business by launching new products complementary to its existing ones.
But a diversification strategy is not without risks. Going into an unknown market with an unfamiliar product introduces uncertainty. The company can’t rely on the skills and expertise developed in its core business, because it is all new territory.
Veteran investor Peter Lynch talked about “diworsification” in his book One up on Wall Street, where he suggested a business that diversifies too widely risks destroying its original business — as management time, energy and resources are diverted from their core investment.
I remember back in the 1990s, when Michael Hill International diversified into the shoe business. Their logic was that they’d been successful in selling jewellery and they understood the buying habits of their mainly women clients. It therefore made sense to apply their knowledge to selling shoes which, like jewellery, are a discretionary purchase for women.
The strategy was not successful, as the businesses and their customers proved more diverse than expected. To its credit, the company realised its mistake, closed the business and went back to what it was good at.
In late 2015, US clothing retailer Urban Outfitters copped a similar market reaction to Downer when they announced the purchase of a small