Roland Berger study on diversification

• Crowding out/price wars are often the only way for companies to grow their core business
• Diversified companies grow faster than companies with focused portfolios
• Investor willingness to diversify will continue to rise
• Crucial for success: stringent search process and rigorous integration

Companies are focusing more on diversification once more. Even capital markets are starting to look favorably at conglomerates again. These are the results of a study by Roland Berger Strategy Consultants. The consultancy examined developments at 1,200 large companies between 1995 and 2004. According to the study, the degree of diversification has no significant impact on ROS (Return on Sales) and ROCE (Return on Capital Employed). What's more, 80% of the diversified companies grew in terms of sales and EBIT (vs. 73% of the focused ones). 44% of the examined companies are from Europe, 33% from the US and 23% from Japan. Slightly more than half of these companies generated annual sales between EUR 10 billion and EUR 100 billion. Using this analysis as a basis, Roland Berger consultants surveyed 39 companies in Germany. These companies confirmed this new trend: companies are increasingly willing to enter business segments outside their core business. And investors are supporting this. However, diversification success depends heavily on a stringent search process and rigorously integrating the new business segments.

Diversification vs. focusing – the trend toward focused portfolios appears to be going into reverse once again. The reason: companies have to grow profitably to remain successful in the long term. However, a Roland Berger study ("Diversify – but do it the right way!") showed that only 28% of companies achieve sufficient profits with their core business. To achieve the required returns, they had to crowd out competitors, engage in prices wars or acquire new businesses. 49% grow mainly by snatching market share from competitors. "Weak growth forces many companies to look for promising business segments outside their core business," says Hauke Moje, Partner at Roland Berger Strategy Consultants and author of the study. "Companies are finding diversification strategies attractive again," he adds. Over 80% of the companies surveyed have diversified in the last five years.

Investors are financing diversification

The surveyed companies indicated that investors, especially major shareholders, owning families and private equity companies, are increasingly willing to provide financing. In contrast, small shareholders and banks are taking a more conservative position. "Investors are making considerable demands," says financial expert Moje. "Investors expect new business segments to produce EBIT margins of around 15% – within four or five years!" 55% of the companies surveyed were able to generate a clearly higher return. Only 21% of the companies surveyed did not meet their return targets in the new business segment.

Main factors in deciding on diversification

"Although companies are diversifying again, they are placing special emphasis on a structured selection process with clearly defined criteria," explains Moje. Almost 80% of the respondents use benchmarks and industry analyses to investigate new business segments. More than one-third of the respondents monitor current market trends. 28% decide on entering new business segments using expert industry advice.

Companies are using various filter mechanisms to define target industries. The study lists five key filters: The basic value filter (1) eliminates business segments with poor images. The market filter (2) then weighs the specific elements of the relevant market. Marketability, average returns and competitive structure are key elements, compared to government and economic influence, which play a secondary role. The strategic filter (3) examines the ease with which core business can be transferred from the current to the new business segment. All surveyed companies rated this requirements as "very important". Client structure and labor intensity of the target industries are considered as being less crucial. The regional filter (4) examines the political stability of the target region. Investors avoid locations with considerable political risks. As a fifth filter, the survey participants listed other assessment criteria. Number one was employee skills followed by government aid and transaction project size.

First powerful corporate centers, then decentralized management

After deciding on a new business segment, management must integrate this properly into the company. The respondents suggest centralized management of the new segment in the first few years. However, companies favor decentralized operational management in the long term. "Ultimately, the right balance of centralized power and decentralized flexibility is crucial for success," says Hauke Moje.