Deltacom/Earthlink is facing a challenging operating environment. As a regional player in an intensely-competitive market, we face an uncertain future. We acquired Deltacom in order to facilitate future growth, but a quick look at our financials indicates that our growth has flatlined and our profits declined to almost nothing last year (MSN Moneycentral, 2013). One of the issues is that there was considerable overlap between Earthlink and Deltacom, and we felt that this would provide us with synergies, in reality it simply made us bigger without enhancing our operations or reducing our risk. At this point, we probably need a new strategic direction in order to ensure our future survival. Diversification is one of the best strategies to achieve this.
In portfolio management, diversification is a strategy where a number of different types of investments are created in a single portfolio (Investopedia, 2013). The underlying logic is that when one investment goes up, another goes down, and the offset leads to a much smoother, more predictable growth pathway. In plain English, this means not putting your eggs into one basket. Right now, Deltacom has all of its eggs in one basket. To make matters worse, it's a small basket. Most of our competitors, companies like AT&T, are national in scope, while we are a regional Southern firm. When we look at our competitors, however, we can see the logic in diversification.
There are two major benefits of diversification. First, as noted, is that it helps to spread risk around. We have one business, and right now that business is being squeezed by larger competitors. If we found ourselves in a position where we could no longer be competitive, we would simply go out of business, because we have nothing else. So it is important just for the survival of the company that we start to look at other approaches. Second, our competitors are able to win business customers away from us by offering bundles of telecommunications services. We lack that ability, because we do not have the full range of services that companies like Verizon and AT&T have. For us, this is a major problem because our lack of diversification not only increases our risk but also puts us at competitive disadvantage.
Strategy for Diversification
There are several different diversification strategies. The first is the multi-industry strategy, the second is geographic diversification. In either case, the strategy needs to take several different factors into account. In general, the key to diversification is to find the right fit (Katzenstein, 2013). One thing that must be remembered is that synergy is important. We can expect to pay, as we did with Deltacom, a premium over the intrinsic market value for the company. Therefore, in order for the investment to be justified, we should gain synergies of some sort. Thus, we should examine how any potential acquisition will deliver such synergies.
Geographic diversification implies that we would buy a company in another area. There are two approaches to this -- buying a company elsewhere in the United States and buying overseas. The philosophies are entirely different. Buying in the States means seeking synergies such as cost savings, where we can absorb the new company into our existing fixed cost base, allowing us to operate the combined company at a lower cost than operating both of them independently. There may also be some synergies with our customers as well, as we might be able to provide better customer service as the result of having a larger organization, especially if the final objective is to build a truly national company. Expanding internationally has its own benefits, such as having cash flows that are not related to our own market. We can take our marketing expertise to a market that is less competitive and use that expertise to outcompete the other companies in that market.
Diversification to another industry is perhaps a riskier form of diversification (WiseGeek, 2013). Sometimes, this form of industrial diversification allows the company to utilize its skills in one area to succeed in another -- for example Apple used its design skills from the computer market to build a smartphone that was better than any other on the market at the time. Sometimes, this type of diversification does not work. There needs to be strategic fit. There are four different types of fit: technology fit, operating fit, distribution and customer fit and managerial fit. For our company, I am not sure what sort of fit there might be with other companies outside of our industry, so it might be better to pursue geographic diversification so that we can move quickly to bring our skills to another company that needs them.
Before we leap into a foreign market, it is worth noting that there are many types of risk. For example, there is going to be foreign exchange rate risk. This means that the value of cash flows when we make a deal can change before the cash is received. Also, the time lag between earnings and financial report creates translation risk when foreign profits are translated back to U.S. dollars for our income statement. There are other risks as well, for foreign market entry.
One of these other risks is market risk. We know the South, what we do not know is foreign markets. There are a lot of unknowns when dealing with foreign markets and it can be challenging for us to make the right moves. We can find ourselves facing negative circumstances that we were unable to predict simply because of our unfamiliarity with the market. There are a whole host of legal, language and cultural issues that can arise, even with relatively easy foreign markets like Canada, much less markets like Mexico or China that have very few similarities with ours. Political risk is a big one, because in some cases we could lose our entire investment from expropriation, or face laws that are so unfriendly to our business that we are forced to exit the market, causing us to lose our entire investment (Investopedia, 2013).
Strategically we would need to do everything in our power to minimize these risks. The first thing we would want to do is begin to investigate the culture before we enter the market, to gain as much knowledge as possible about the potential risks we face. Furthermore, we need to find a way to keep the local management. Even if we want to change a lot of the management practices, the local management can be very helpful with their expertise and contacts with respect to navigating a smooth transition. Another thing that can be done to minimize the risk of entering a foreign market is to hedge the foreign exchange risk, so that we have certainty of cash flows. This will help us to make better operating decisions.
When To Enter a Foreign Market
Essentially, a foreign market should be entered when there are good synergies in the business model or the customer. A good example was Wal-Mart when it entered China. Chinese consumers love low prices, so there is a natural fit They had to learn how to shop in giant stores, but in terms of buying habits Wal-Mart was able to meet the core needs of the consumer. It entered the company as an operating hedge because it was so dependent on China anyway, so there were a number of synergies that made this diversification worthwhile.
An example of perhaps a less successful geographic diversification can be seen with Wal-Mart's experiences in Germany. The company felt that its business model could translate anywhere, but German prefer smaller stores, and are willing to pay more to shop in them. They specifically were not attracted to the size and culture of a Wal-Mart store, and the company had to withdraw from the market. Yes, there was operating synergy as the Germans are as appreciative as anybody of Wal-Mart's efficiency, but the assumption that there was customer synergy proved to be disastrously false.
I think the question of ethics comes a up a lot when talking about overseas business. If laws are different -- especially when they are more lax -- and cultures are different, managers may be tempted. But it is important to keep in mind that ethical business behavior contributed to the company's success and is one of the reasons we have succeeded to this point. So we have to ensure that there is a high level of training about ethical issues, and that ethical behavior is built into the corporate culture. We will also need for our managers to review things like the Foreign Corrupt Practices Act, which governs the ethical behavior of American companies when they go overseas.
A major challenge is to get the target firm to adopt our ethical standards, because they might be quite different from their own. This is tough, but it must be done. Training is usually the pathway, and finding champions among the leaders…
Katzenstein, J. (2013). Diversification strategies. California State University. Retrieved November 22, 2013 from http://som.csudh.edu/depts/adjunct/jkatzenstein/mgt490/Diversification%20Strategy%20Presentation.ppt
MSN Moneycentral (2013). Earthlink. Retrieved November 22, 2013 from http://investing.money.msn.com/investments/stock-income-statement/?symbol=elnk
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