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In the eye of the beholder

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In the eye of the beholder.

They say beauty is in the eye of the beholder. One Australian chief executive learned last week that his idea of beautiful was vastly different from his fellow shareholders’.

Grant Fenn, CEO of Sydney-based company Downer EDI announced a $A1.2 billion 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 in order to increase revenues (and hopefully profits) 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 their 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 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 their credit, the company realised their mistake, closed the business and went back to what they were 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 Philadelphia-based pizza restaurant operator called Vetri.

The company reasoned that because consumers were spending less on apparel and more on travel, dining out and other experiences, they should make clothes shopping more of an event. Serving a slice of margherita pizza while customers tried on clothing would drive traffic to their stores and keep people in the stores for longer.

Urban Outfitter’s recent profit result confirmed that unfortunately pizza can solve some, but not all, of life’s problems.

I understand the benefits of diversification. Goodness knows, I preach to investors often enough about spreading their wealth across multiple assets.

But at some point you can have too many eggs in too many baskets and something will end up breaking.

In the case of Downer, its core business is already diversified and is by no means a simple, hands-off operation. Add an underperforming business like Spotless into the mix and problems, or at least a truckload of challenges, seem inevitable.

It will be interesting to see whether Downer’s diversification experiment suffers a similar fate to others before it.

 

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