Why Might CVS Be Breaking Up?

News reports indicate that CVS Health may be splitting up in the months ahead.   Company leaders apparently are mulling their strategic options while under pressure from Glenview Capital and other investors.  CVS Health has diversified through acquisition over the past two decades.  In 2006, CVS acquired Caremark, a pharmacy benefit manager.  Then in 2017, CVS acquired Aetna, making a major move into the health insurance business.  More recently, they have made other moves to expand in the healthcare delivery space, such as by acquiring Oak Street Health - a primary care provider.   Unfortunately, the company's stock has underperformed the S&P 500 by a wide margin over the past two years, leading to increasing pressure from investors. 

Why might CVS Health be considering a break-up after moving so aggressively to transform themselves from a pharmacy retail chain to an integrated healthcare company?  Several factors may explain the potential strategy reversal.   

1.  Diversification works best when the different business units within a corporation operate by the same "dominant logic."  C.K. Prahalad and Richard Bettis coined this term in a very famous academic paper published in the 1980s.  They defined dominant logic as "the way in which managers conceptualize the business and make critical resource allocation decisions..."   In short, what is the mental model that leaders use to think about the business and make choices?  Do the businesses make money in a similar manner, or are the value propositions and business models fundamentally different?  They argued that strategic variety and complexity means that multiple "logics" exist across the portfolio of businesses, making it very difficult for the top management team to lead them all effectively.  They cannot apply the same criteria, rules, and principles when making decisions across the businesses.   One could easily argue that the dominant logics at CVS vary considerably from pharmacy retail to health insurance to primary care provision.  Can one CEO and her leadership team manage all these businesses effectively?  

2.  Scale and scope do not always yield economies.  We often hear about the benefits of bringing multiple units together.  In short, what are the economies of scale and scope?  I would argue that managers often focus on these potential economies when justifying acquisitions, yet they underestimate the potential diseconomies of scale and scope.  How might the increased complexity of the business make it more difficult to manage effectively?  What conflicts might emerge among business units?  What costs and disruption might occur as a company tries to secure key synergies?  Do the costs outweigh the benefits of collaboration and integration?  CVS Health has become a behemoth, and at some point, that sprawling conglomerate becomes very hard to manage.  

3.  The existence of potential synergies alone does not justify mergers.  One has to ask whether one could achieve some of these benefits through some other sort of organizational arrangement (stretching from contracts and partnerships through strategic alliances and joint ventures).  Firms don't always have to merge to coordinate and collaborate in pursuit of certain economies of scale and scope.  Consider Target's decision about its own pharmacy business.  The company wanted to continue to have pharmacies within each of its stores.  However, it came to the conclusion that it was best not to try to manage and operate these pharmacies themselves. Instead, they sold the business to CVS, letting the pharmacy experts run the "stores within a store" at each Target location.  Target shed a business, but it retained some of the benefits of having a pharmacy within each of its stores (the pharmacies are good traffic drivers and lead to other incremental sales for Target).  

4.  Vertical integration has many potential benefits, but it does not come without substantial risks. One risk is that you find yourself competing with your own customers at times.  That brings challenges for many companies, including in the healthcare space.  CVS Health has embarked on quite a bit of vertical integration over the years, creating these potential conflicts of interest that can be challenging to manage. 

Will Disney Sell ABC, Other TV Networks?

Source: NBC News

In an interview with CNBC yesterday, Disney CEO Bob Iger acknowledged that Disney may divest its struggling legacy TV businesses. It may also seek a "strategic partner" for ESPN.  Reporting for CNBC, Lillian Rizzo and Alex Sherman wrote:

Disney is going to be “expansive” in its thinking about the traditional TV business, leaving the door open to a possible sale of the networks. “They may not be core to Disney,” Iger said, adding the creativity that has come from those networks has been key for Disney.

The press coverage regarding Iger's statement has focused on the decline in the traditional television business, particularly as more and more people "cut the cord" regarding cable television.   I think that's only part of the story though.  One can ask whether the legacy TV networks, such as ABC, ever belonged in the Disney portfolio.  

I've been teaching case studies about the Disney corporate strategy for two decades.  For the most part, Disney has always been a positive example of an effective diversification strategy with powerful synergies among the various divisions.  However,  the ABC acquisition (mid-1990s) has always been a more contentious issue.  What is the argument for Disney owning ABC?  Does Disney have a more powerful competitive advantage because it owns ABC?  It's not easy to see why it would.  If you examine Disney's stock performance during Michael Eisner's tenure, you can see two contrasting eras.  Prior to the ABC deal, the Disney stock outperformed the S&P 500 by a wide margin during Eisner's tenure.  After the deal, Disney stock underperformed the market during the second half of Eisner's tenure as CEO.  

While ABC does have studios that develop programming, it's first and foremost a broadcast network.   Acquiring a broadcast network is essentially forward integration for Disney.  My students and I have always debated whether there is a persuasive argument for vertical integration here.  Does Disney need to own ABC to have effective ways to distribute its content?  Hardly believable.  Disney has highly attractive content that clearly would be of interest to many different distribution partners.   Does Disney have negotiating leverage with other distribution partners because it owns ABC?  One might think so, but on the other hand, Disney may have some challenges when it comes to selling content to outside partners.  If you were another broadcast network, wouldn't you wonder why Disney was trying to sell great content to you, rather than putting that content on its own broadcast network?  When you forward integrate, you create potential conflicts of interest because you are now competing with your own customers.  Finally, could Disney achieve many benefits of collaboration without having to own ABC outright?  It would seem so.  After all, Disney and ABC worked together for years on a contractual basis when the network aired the Disney movie each Sunday evening for years.  Disney CEO Michael Eisner even used to introduce the movies on the network long before the company acquired ABC.  It would seem that contracts, partnerships, licensing deals, and the like could enable the Disney and ABC to collaborate effectively without having to be part of the same corporation.  

In sum, Disney divesting the legacy networks might be the right strategic move, but not because people are cutting the cord.  It might be the right move because the case for synergies was far weaker than ever acknowledged.  

Is One-Stop Shopping a Good Thing?

When many firms pursue diversification strategies, they argue that they can provide one-stop shopping for clients.  This logic implies that one-stop shopping adds value for the customer, and that the multiple business units inside the corporation are more valuable together than apart.  For many firms, cross-selling becomes a key initiative, to try to provide that one-stop shopping experience (Wells Fargo, anyone?).   Does one-stop shopping make sense though?  Do customers actually want to purchase a series of related services from one supplier?   Would you like to have all your financial relationships with one firm, or would you prefer to purchase your insurance at one firm, secure a mortgage at another, and invest in bonds at yet another company?

Olivier Chatain and Denisa Mindruta have written a paper on this topic. The paper is titled, “Estimating Value Creation From Revealed Preferences: Application to Value-based Strategies."  The authors presumed initially that one-stop shopping created value for clients.  After all, the firm provided customers more convenience, and it could apply learning from one aspect of a customer relationship to the provision of other products and services.   Synergies seemed readily available.  The research, however, demonstrated that significant drawbacks may exist to a one-stop shopping strategy.   I'm not shocked; I've always been skeptical of such strategies.   I think firms overvalue synergies routinely.   Moreover, I'm not sure customers actually want to put all their eggs in one basket.   They also get annoyed at times when firms are constantly engaging in cross-selling tactics.  

Chatain and Mindruta studied law firms in this research.   Chatain explains the findings:

What we think is that — especially for the law firms we were looking into — … even though you may know a client well, each time [you provide a new service to him], it’s almost like [starting] a different subject. You really have to start over and learn a lot about the client.

An alternative explanation [for our results] is that some clients are very worried about having one supplier of service serving multiple areas. So even though you might be the best expert for me, if you’re already my best expert for two or three other subjects in law, I may want to deal with someone else because I might be afraid if I get all the information from the same supplier, I might be missing out on some important themes.

I might have a preference of diversity in terms of input, which was something that is apparently more important than the savings you can realize by bundling all these products together.

When You Are Overly Dependent on One Product: Apple's "Problem"

The Wall Street Journal has a great chart today (shown here) that highlights how increasingly dependent Apple has become on the iPhone as the one product driving a substantial portion of revenue and profit.   Many analysts have expressed concern about this dependency.  I find it an interesting discussion.  On the one hand, it does appear worrisome to have so much of the company's fate reliant on one particular blockbuster product. On the other hand, a firm has to be careful how it responds to this type of "problem" that emerges with success.  Diversifying recklessly simply to reduce dependency on a single product can be a recipe for disaster...yet many firms have made that mistake when faced with this situation.  Moreover, we know that focus can be a powerful dimension of any strategy.  Jobs preached focus relentlessly during his time at Apple (and at Pixar).   Will a company lose focus if it tries "too hard" to reduce reliance on one hit product?  It's a delicate balancing act, and it will be interesting to see how Apple navigates this situation in the years to come. 

Google and Alphabet: What are the risks?

Should we have been shocked by the Google/Alphabet news?  Actually, I don't think so.  Let's step back for a moment and think about Google's collection of businesses.  The company is incredibly creative and innovative, but in the end, one major business generated most of the profits: search.   That business is certainly as mature as a steel company, but it's much further along in the life cycle than many of the new ventures that Google has launched (such as driver-less cars).   How do investors look at companies with a big business generating lots of cash, and a set of smaller more speculative ventures that are users of cash.  Well, they become skeptical of too much cross-subsidization, particularly if the synergies among the businesses are limited.  We have seen the pressure on Google in recent quarters, as investors demand returns from the high-profit search business.  They don't want to see too much of that cash diverted to unprofitable and speculative ventures.  On the other hand, we know that new ventures often struggle when embedded in larger organizations.   They need a certain level of autonomy to flourish.  Therefore, it makes sense to separate out the new ventures.  It gives them a better chance to grow with some independence, and it enables the main search business to focus on optimizing returns.  

Are there some risks though of this new structure?  A discussion on the Knowledge@Wharton site has highlighted some of those key risks very well.  Here's an excerpt:

According to Wharton emeritus management professor Lawrence Hrebiniak, “transparency … is good, [but] I don’t know if transparency translates into profits.” Trouble could follow if Google’s investments in projects like driverless cars and drones don’t make money, he adds. “The transparency could cause some investors to rethink whether they want to be invested in these other businesses and prefer to put their money in Google,” he says. “There might be some pressure, in time, to divest some of these bad businesses on the non-Google side.”

Disney: Eisner vs. Iger

The Wall Street Journal published a good article this week about the Disney strategy under CEO Bob Iger.   Writer Ben Fritz summarizes the shift in strategy that has taken place since Iger replaced Michael Eisner as CEO.  

Mr. Iger has refocused Disney around what it calls “franchises”—or entertainment juggernauts that live on for many years as theme-park rides, toys, videogames, television shows, pajamas and just about anything else that keeps revenue rolling in.  The consistent performance of those franchises is helping Disney outshine competitors by measurements ranging from stock-price growth to product licensing to ticket sales per movie. “Ten years ago, we were more like other media companies, more broad-based,” Jay Rasulo, then Disney’s chief financial officer, told analysts last fall. “Almost every aspect of the company” is now “oriented around brands and franchises.”

I have been teaching a corporate strategy case study about Disney for many years.  I often show a series of charts that shows the Disney stock performance during three periods of time:  Eisner's tenure pre-ABC acquisition (roughly his first decade as CEO), Eisner's tenure post-ABC acquisition, and Iger's tenure.  What do you see when you examine these charts?   Disney outperformed the S&P 500 by a wide margin during the first half of Eisner's tenure, underperformed during the latter stages of his time as CEO, and has outperformed the S&P during Iger's tenure.  Several factors contribute to these performance changes, but I believe the shift in strategy over time plays a key role.   

During Eisner's early tenure, he focused on cultivating economies of scope among the businesses at Disney (i.e. synergies). The company leveraged characters in the Disney vault, and it created great new characters in films such as Beauty and the Beast, Aladdin, and The Lion King.  In the latter stages of Eisner's tenure, they diversified much more broadly.    The company begin to define itself not as a company that was simply great at creating franchises based on great characters, but instead as a leading entertainment company.   They were defining their capabilities more generally.... but of course, they were also less distinctive, and less clearly superior when talking in general about entertainment.  The stretched definition of who they were and what they were good at served as justification for moving well beyond the core "characters" businesses at Disney.   

What has Iger done?  He's returned to character development and the building of franchises based on those characters as the heart of Disney's strategy.  Look at the three major acquisitions of Iger's era:  Pixar, Marvel, and Lucas Films.  What do they all have in common?  Powerful characters around which Disney can leverage economies of scope across its many businesses and platforms.   Defining what Disney does best a bit more narrowly has limited the scope of the firm a bit, but it has elevated performance greatly.  Why?  Disney now competes in areas in which they are clearly world class and superior to the competition.  They are not competing as much in areas of entertainment where they are less distinctive. 

Amazon Reports Earnings for AWS

Amazon reported quarterly earnings yesterday.  For the first time, the company split out financials for its Amazon Web Services (AWS) business.  That unit provides cloud computing services.   Amazon indicated that AWS generated $1.57 billion in revenue and $265 million in operating income for the quarter.  Overall, Amazon reported revenue of $22.72 billion and a net loss $57 million for the company as a whole.  Amazon continues to argue that they are investing for the future, thereby explaining the continuing escalation of expenses and yet another net loss. 

Clearly, losses in the retail business are more substantial than previously thought.  AWS appears to be profitable, while the company as a whole lost money.  The earnings reports raises a few questions for me, inquiries that I believe many investors and analysts will be putting forth in the coming months.  

• Has Amazon been reluctant to split out financials for AWS because they know that it may cause more questions to be asked about the profitability (or lack thereof) of the core retail business?   
• Are the continuing losses related to investments and expenses that will eventually create a high profit retail business, or are those costs associated with many diverse lines of business that have been launched?  
• Is Amazon spreading itself too thin with so many strategic moves in a wide variety of areas?  
• Perhaps most importantly, what is the strategic logic for keeping AWS and Amazon's retail business together?  Will some investors begin to argue for a breakup at Amazon?

GE's Changing Corporate Strategy

General Electric announced this week that it would divest nearly all of GE Capital, the financial business that had been a major profit generator in the past.  The latest strategic shift at GE marks the continued move away from the firm's historic strategy of unrelated diversification.  Few true conglomerates (i.e. unrelated diversifiers) remain in the United States.  Investors can diversify risk more efficiently than corporate executives.  Without true economies of scope, conglomerates could not justify their existence.  The argument that governance economies existed did not hold water in many cases, i.e. corporate parents could not argue that they simply had better many management systems through which they added value to each of the business units.  For this reason, many conglomerates have broken up over the past two decades.  GE remained an exception to the rule for many years.  Investors did not push for a breakup when the company routinely outperformed competitors for each of its major business units.  The whole seemed clearly greater than the sum of the parts.  Governance economies did seem to exist.   People raved about the quality of the management systems and the leadership talent at GE.  A lagging stock price in the past decade shifted the conversation.  Investors begin to ask a question that once seemed unthinkable to ask: Should GE break up?   Could the whole no longer be worth more than the sum of the parts?  

The divestiture of GE Capital does not end this conversation though.  GE has returned to its industrial roots in many ways.  It no longer owns a television network or a major financial business.  However, it still owns quite a wide array of industrial businesses.  Investors will continue to ask the question:  Are these businesses worth more together than apart?  They will continue to ask:  Where are the economies of scope (i.e. the synergies)?   Are the governance economies sufficient to justify keeping all the units together?  Yes, these businesses are more similar than the portfolio was in the past.  However, we still aren't talking about the type of relatedness that we see at a company such as Disney.  If performance lags, the questions will continue.  GE has moved in the right direction, but the strategy will likely continue to evolve. 

Breaking Up Isn't Always the Optimal Solution: The Curious Case of Dan Loeb and Amgen

Corporate breakups seem to happening every other day.   I blogged last week about some of the reasons for the recent surge in breakup activity.   In general, I think many of these breakups make sense, as firms tend to prosper when they are more focused.  Moreover, many of these firms are experiencing significant diseconomies of scale and scope.   However, I think we may be taking it too far in some cases.

Let's take the case of hedge fund investor Dan Loeb pushing Amgen to break into two independent firms.   Loeb proposes that Amgen split into one business focused on its mature products and another focused on its high growth products.   Typically, when investors propose such splits, they want the mature business to generate lots of cash and return much of it to shareholders.  They want the growth business to reinvest profits to stimulate even more growth.   

Here's the problem with proposals such as the Amgen deal though.   In the old BCG model of corporate strategy, firms were supposed to milk the cash cow and use those proceeds to fund promising growth businesses.   That model has since been completely debunked.  Cross-subsidization amongst unrelated business units makes no sense if external markets are reasonably efficient.  Chas cows should return excess cash to shareholders, and growth businesses should find their own sources of funds from private equity, venture capital, or public equity and bond markets.  Note the word "unrelated" though.  The BCG model is faulty if we are talking about using it to justify an unrelated diversification strategy.  However, a firm such as Amgen is clearly not an unrelated diversifier.  It has a set of highly related businesses.  Strong synergies exist among its lines of business.  In fact, some would say that it's a focused firm, not even a related diversifier.  Thus, Amgen is not in any way inappropriately using funds from a cash cow to fund a growth business. They are managing multiple products that each have stronger competitive advantage because they co-exist together in the same firm.  I don't see how you create real value by splitting a firm such as Amgen in two.  In fact, you may destroy value by doing so, because synergies are lost.  You create real value if you split an unrelated diversifier in two. 

Breaking Up Isn't So Hard to Do

HP announced yesterday that it would be splitting into two companies.  One will focus on personal computers and printers, while the other will focus on computer hardware, software, and services.  Interestingly, this breakup represents the second split for HP in its history.  In 1999, HP spun off its measurement instruments business as Agilent Technologies.  Could the deal increase shareholder value?  Perhaps, as it has become increasingly difficult to argue that the synergies between the two sides of HP are significant enough to outweigh the costs associated with managing and integrating such a large, bureaucratic, and highly complex organization.  Of course, the deal also opens up the possibility that one or both of the new entities could be takeover targets.  Here in Massachusetts, we have been reading rumors about EMC exploring talks with HP about a merger.  The breakup at HP probably makes such a deal more likely.   Of course, it's not entirely clear why or how a merger would be beneficial.  While some synergies might exist, again the key question is whether the benefits outweigh the costs associated with integrating such large, complex organizations. 

Beyond this particular deal, the Wall Street Journal reports that, "Corporations around the world have sold or spun off $1.6 trillion worth of subsidiaries and business lines so far this year, just behind 2007’s record-setting pace, according to data provider Dealogic."   We have seen some high-profile moves by diversified firms to become more focused.    GE sold its appliance business.   Gannett announced  a split into two entities, one focused on newspaper publishing and the other on television broadcasting.  Other firms, such as Pepsi, face pressure from activist investors to break up.  What's behind these moves?  The Wall Street Journal cites research showing that U.S. conglomerates tend to under-perform more focused firms:  "Shares of North American conglomerates underperformed their more focused rivals by 11.4% on average from 2000 to 2010, according to a study from Anil Shivdasani, a finance professor at the University of North Carolina Kenan-Flagler Business School... Professor Shivdasani said Monday the data remained similar through the end of last year."

This research has been well known for many years though. Why the pickup in breakups lately?  I think several reasons may exist.  First, economic growth has been very low in this "recovery."  As a result, many firms have businesses in mature markets that are struggling to find ways to grow revenue.   Without sales growth to help drive share prices upward, they are looking for other ways to create value for investors.  Second, a new class of activist investors has become very vocal and has challenged the diversification strategies of many of these large firms.   Third, more investors have begun to question the economies of scale and scope rationale behind these large firms.  They are wondering if, in fact, these organizations are experiencing significant diseconomies of scale and scope. Finally, investors have become quite concerned that CEOs are cross-subsidizing extensively, milking cash cows to fund other initiatives.  Such practices used to be quite commonplace and accepted, but increasingly, they are being challenged.  These investors would rather see the CEOs return cash to shareholders from mature units, and let the newer, higher growth entities seek capital directly from the markets. 

Lego: Sticking to Bricks

LEGO faced a perilous strategic and financial situation roughly a decade ago.   Since that time, the company has experienced a remarkable turnaround.  The LEGO story reminds us of the folly of poorly designed diversification strategies, as well as the value that can be created by renewing the core business.  

Jos. A. Bank to Acquire Eddie Bauer: What Does "Related" Mean?

The Wall Street Journal reports that Jos. A. Bank has agreed to acquire Eddie Bauer for $825 million.  As you may recall, Jos. A. Bank has been in a back-and-forth contentious situation with Men's Warehouse, with each firm trying to take over the other over the past few months.  Now, Jos. A. Bank has moved in a different direction.   Does it make sense? Are there true economies of scope here between the retailer of men's suits and the seller of outerwear and sportswear? 

As an outsider, it's hard to determine if the synergies justify such a merger.  However, I would argue that we should be cautious about such a deal.  When we think about mergers, we often look for signs that the firms are engaging in "related" diversification, i.e. that significant synergies exist.   At first glance, we might conclude that these two firms are related, since they both sell apparel.  However, we should be much more disciplined about what "related" truly means.  Consider the cases from a decade ago, when many companies who sold alcoholic beverages combined in a wave of mergers and acquisitions.  Many people initially endorsed these deals.  After all, a beer producer buying a winemaker looked like "related" diversification . Surely, significant synergies existed.  Yet, it turns out that beer and wine companies are not as related as we might think, even though both are in the business of selling alcohol.  The synergies turned out to be much less substantial than many players thought.  The challenges of integration were substantial.   That lesson should be applied here, before we jump to the conclusion that these two apparel companies can easily combine to achieve significant synergies.  

Break Up the Washington Post Corporation

If I told you that a company had the following business units, what would you say? 

• an education and test preparation business
• a set of local television stations
• an internet company that helps churches engage in outreach and raise money
• a company that makes components for industrial furnaces
• a home healthcare and hospice provider

Most analysts would say that this company has a scattered strategy.   The company: the Washington Post Co. - or whatever it will be called now that Jeff Bezos has bought the flagship newspaper for $250 million.   With the newspaper gone, the Washington Post Co. will soon face pressure for more strategic change.  Investors will argue that this unrelated diversification strategy makes no sense.  Investors can diversify risk much more effectively and less expensively on their own.  They don't need the executives at the Washington Post Co. to do that diversification for them.  

Most people are focused on the Bezos' acquisition right now.  They are examining the future of the newspaper.  Can Bezos transform it?  Soon, though, many eyes will turn to the company that remains.  Expect investors to push for more change.   They will, rightfully, demand a clear strategy moving forward.  The key question: What does the Washington Post Co. want to be moving forward?

Is the Sum of the Parts Worth More Than the Whole at Sony?

In May, hedge fund investor Dan Loeb proposed a break-up of Sony, the Japanese electronics and entertainment giant that has struggled over the past decade.   Actually, he's not proposing a complete break-up, but rather an initial public offering whereby Sony would sell a 20% stake in its music and movies business to outside investors.  Loeb argues that the sum of the parts is greater than the whole.  Sony has an entertainment division that produces movies (Skyfall, Spiderman) and represents recording artists (Adele, Springsteen).  The entertainment division has been more profitable than the electronics division in recent years.  Investors recognize that Sony has been subsidizing losses in areas such as its television business with profits from its entertainment division.   Sony also still owns a majority stake in a firm called Sony Financial Holdings, which operates in the banking and insurance business.  Here's an excerpt from a Bloomberg article about Loeb's push for a partial break-up at Sony:

The value of Sony’s entertainment division -- which makes the “Spider-Man” movies through its Culver City, California-based Sony Pictures and also represents music artists including Grammy winner Adele -- isn’t being realized in the company’s current structure, said Michael Souers, an equity analyst at Standard & Poor’s.  “It’s totally being weighed down by the struggling consumer electronics unit and the fact that it’s had to subsidize that unit,” Souers said in a phone interview from New York. A partial spinoff “would make sense for them. And from a managerial perspective, they could focus a little bit more on turning around the electronics business.” A sum-of-the-parts analysis by Christian Dinwoodie, a Tokyo-based analyst at CLSA, values Sony at 2,400 yen a share, 28 percent higher than its price May 14, before Loeb’s proposal lifted the stock. Spinning off part of the entertainment business would give Sony an infusion of capital and allow it to transfer some debt to the new entity, Dinwoodie wrote in a May 14 report. 

In late June, Sony CEO Kazuo Hirai announced the board of directors would be conducting a thorough review of the Loeb proposal.   The board has yet to make a decision on the Loeb proposal, to my knowledge.  Will Loeb succeed in his efforts?   It will be a tough slog, given that activist investors from foreign countries have not fared well historically in Japan.  Having said that, Sony did sell a stake in its financial services business several years ago; there is precedent for a refocusing of the company's strategy.  

Sony should consider Loeb's proposal seriously.   Years ago, many firms pursued strategies that combined media content with hardware/electronics businesses.  Most of those companies failed to realize the purported synergies.   Focused firms outperformed many of the integrated players (think Apple outmaneuvering Sony, not by owning media content, but by negotiating to secure access to content for iTunes).   One of the problems with integration in the entertainment business is the conflicts of interest that arise.  If you tailor content to your devices or vice versa, you run the risk of losing certain customers and partners. CEO Kazuo Hirai will have to explain clearly how he will make synergies materialize between the two arms of Sony, if he wishes to allay the concerns of investors.   If he holds onto both businesses, he has to explain why the entertainment business isn't going to continue subsidizing unprofitable elements of the electronics business. 

Iger's Long Term Strategy at Disney

As you know by now, Disney acquired Lucas Films last week. With that, Disney now owns the Star Wars and Indiana Jones franchises. I'm not surprised by the move. In fact, you can see a pattern emerging to Bob Iger's strategy at Disney, which is quite in contrast to the strategy during the second half of Eisner's tenure at the company. In Eisner's later years, he moved away from simply focusing on the characters as the central driver of synergy among Disney's businesses. He acquired ABC and Miramax, and he owned a baseball and hockey team for some time - among other moves. Now we see Iger refocusing on characters as the heart of Disney's corporate strategy. We see three major moves (Pixar, Marvel, and now Lucas) during his tenure that all involve expanding the universe of characters which Disney can leverage across its many businesses. I think the focus on characters makes a great deal of sense. Here's why...

When thinking about the characters at Disney, we should note those resources are quite valuable because they are highly durable and inimitable. Moreover, Disney can appropriate the value associated with those resources (as Buffett says, "the mouse has no agent"). How then can one think about leveraging such a valuable resource across multiple businesses? A strategist needs to think about how specialized vs. fungible/general the resource is. A highly fungible resource/capability would be something like “brand management expertise” or “innovation” or “risk management.” A highly specialized capability might be patented product formulas or engineering expertise in a very narrow discipline. Fungible capabilities can be easily transferred across lines of business. However, they are often too general/not unique enough to convey a substantial competitive advantage. On the other hand, highly specialized capabilities tend to provide powerful competitive advantage in a particular business, but they lose value very quickly when a firm tries to transfer them to a wide array of businesses. In other words, there are only so many areas in which you can grow based on a highly specialized set of capabilities.

In the 1980s, Disney’s core capabilities revolved around animated character development and deployment. Those tended to be highly specialized capabilities; Disney was able to leverage those capabilities to enter the hotel and cable television business, but ultimately, growth was constrained by the specialized nature of that capability. To move into even more diverse businesses, Disney had to be able to make the case that it had a broader/more general/more fungible capability such as “managing creativity.” That's the argument that Eisner used to move into a variety of businesses that did not have to do with characters (ABC, Miramax, etc.) There are two challenges associated with defining a firm’s capabilities so broadly. First, it is more difficult to make the case that the firm is truly unique and superior to all rivals in that set of capabilities. Second, it becomes rather difficult to discriminate among various options for diversification, i.e., how many businesses have something to do with managing creativity vs. developing and deploying unique characters?

The Washington Post Enters the Healthcare Business?

Reuters reports this morning that the Washington Post has acquired Celtic Healthcare, a home healthcare and hospice services provider here on the east coast of the United States.   I have to admit to being puzzled by the move.  I'm curious to learn more about the rationale for this acquisition.   As many of my readers know, the Washington Post has moved away from a reliance on the newspaper business given the disruption that has taken place in that industry.   For a number of years, the company generated strong growth from its other major line of business - the Kaplan education unit.  However, that unit has been plagued by the controversies surrounding for-profit educational institutions in the past couple years.   Therefore, perhaps the Washington Post is looking for another new line of business from which it can generate the growth that is lacking in the core newspaper business.    The question, though, is how investors will react to what looks like a strategy of unrelated diversification.  Why would the Washington Post be better at operating a healthcare company that a firm focused in that industry?  

Reuters offers a brief statement by Donald Graham, CEO of the Washington Post, explaining the deal:  "Our acquisition of Celtic Healthcare is part of the Post Company's ongoing strategy of investing in companies with demonstrated earnings potential and strong management teams."  While that may be true, strong earnings and great management talent alone do not justify an acquisition in an unrelated business (in most circumstances).  The question is what value can the Washington Post add to this business.

Diversified Firms in Emerging Markets

Harvard Professor Tarun Khanna has conducted extensive research on large business groups (conglomerates) in emerging markets.  He has found that the so-called conglomerate discount doesn't exist in many emerging markets.  Why?  Khanna argues that institutional voids exist in these countries.   Capital, labor, and product markets are not very efficient.  Therefore, large organizations and their management teams fill these "voids" in those countries.  In other words, the conglomerate serves a useful function, because it does what the efficient labor, product, and capital markets do in more developed countries. 

On the other hand, in more advanced economies like the United States, unrelated diversification makes much less sense.  Investors, for instance, can diversify risk quite inexpensively on their own; they don't need a CEO to diversify into many unrelated units to reduce risk.   That type of strategic move proves far more expensive than simply having the investor buy an index fund to achieve risk diversification.  

A new paper by Venkat Kuppuswamy, George Serafeim, and Belén Villalonga examines this concept in more detail.  They look at capital, product, and labor market efficiency in 38 countries over a 15 year period.   They find that the value of corporate diversification does indeed fall as capital and labor markets get more efficient.   However, they did not find a significant effect for product market factors.   In sum, corporate strategy should look different as we move across the globe, and not just because of cultural differences.  Fundamental differences in the institutional environment call for different approaches to corporate strategy as we move from more advanced economies to emerging markets. 

GE: Changing the Vaunted Leadership Development Model

GE appears to be making a significant shift in its leadership development philosophy.  According to the Wall Street Journal,

The conglomerate that once groomed jack-of-all-trades generalists is now betting on deep industry experts instead. The shift is a change in philosophy at a corporation that for decades had made a rigorously applied but generic management tool kit central to its identity. Like all companies, GE wants some of both traits in its leaders, but the balance has tipped toward expertise. For years, GE wanted its top managers to be experts in managing. Now, it's increasingly looking for them to be deep experts in their fields. Rather than purposely relocate its senior leaders every few years to expose them to more of the company, GE now is leaving them in their business units longer than it used to, in hopes their deeper understanding of products and customers will help them win sales.

Susan Peters, head of leadership development at GE, explains the need for the change: "The world is so complex. We need people who are pretty deep." Interestingly, this shift in philosophy has occurred as the firm continues to face critiques of its corporate strategy. As this article on Forbes.com suggests, GE may be trading at a conglomerate discount because of its complex unrelated diversification strategy.   For years, GE remained an exception to the rule when it came to unrelated diversification.  Its whole was worth more than the sum of the parts, in contrast to many conglomerates that have since broken up.

When a firm pursues a conglomerate strategy, it strives to achieve governance economies.  Governance economies emerge when a firm shares management systems, processes, and talent across a variety of businesses.  Most related diversified firms, such as Disney, strive for scope economies - i.e. synergies through the sharing of intellectual property, manufacturing plants, distribution channels, and the like.   A conglomerate often does not have these types of synergies, so governance economies become critical to justifying the fact that so many seemingly unrelated businesses are being kept together.   However, if GE isn't sharing management talent across the businesses as much any longer, then it seems as though governance economies will shrink.  Of course, the units will still share many excellent systems and processes.  Those processes can be a key source of governance economies.  Will that be enough to convince investors that the parts are worth more together than apart?  That will be the key question moving forward. 

Another Break-up at Tyco

The recent burst of break-up activity among diversified companies continues.   Tyco has announced its intention to break up into three separate firms:  security, fire- protection and flow-control.    The split follows a 2007 break-up in the wake of the Kozlowski scandals.  At that time, Covidien and TE Connectivity became independent companies.  With this announcement, the Kozlowski empire has been dismantled completely.   I'm not surprised by the move.  The firm had become more focused after the 2007 spin-offs, but it still remained a company with limited synergies among these business units.   In an era of lower economic growth, firms cannot justify these diversification strategies as easily.  They have to show the economic value of diversification.  If not, they must try to create shareholder value by freeing the units to operate as independent, focused companies.  In the past, economic growth masked some of these sins of diversification at many firms.