Tuesday, July 10, 2007

Diversification vs. Focus at Limited Brands

Limited Brands announced yesterday that it had agreed to sell a 75% stake in The Limited chain of apparel stores to a private equity firm. That announcement comes on the heels of the sale of a 75% ownership stake in the Express chain to a private equity firm. The company will focus on the two business units that have delivered far better growth and profits in recent years - Victoria's Secret and Bath and Body Works. With these divestitures, the company looks far different than it did twenty years ago, when it was one of the leading specialty apparel retailers in the nation.

The transformation of Limited Brands mirrors the situation that many diversified firms encounter. As firms operate multiple businesses, the corporate office finds itself trying to manage a complex internal capital market. Senior executives typically allocate resources to the business units that show more promise in terms of revenue and profit growth. After all, higher growth and profitability makes additional capital investments appear much more attractive. Executives understandably want the best return on their investment, and they do not have unlimited funds; they must make tradeoffs. Perhaps just as importantly, senior executives allocate more of their time and attention to the more promising business units as well. That, in turn, can lead to a downward spiral at the less successful businesses in the portfolio - weak results lead to a decrease in capital allocated to the business, as well as a decrease in management attention, which together further diminish the prospects for enhanced revenue and earnings growth. Moreover, slower growth and lower rates of capital investment make the businesses less attractive to talented current and potential employees, causing a drain in the quality of human capital in those businesses. That, in turn, further weakens the financial results in those units.

This scenario, which we see unfold in many diversified firms, points out the dangers associated with trying to manage a portfolio of businesses with differing levels of growth and profitability. Moreover, it demonstrates why focused firms often are able to capitalize on the distractions faced by executive teams who are trying to oversee a wide range of business units.

Limited Brands deserves credit for ultimately recognizing that its apparel chains could be better off under management whose sole focus is on that particular brand. Moreover, Victoria's Secret and Bath and Body Works are likely to benefit too. Now senior management can completely focus on these businesses, which face increasing competition as new entrants chase the high profits in those sectors.