The Diversification Debate

Companies continue to stumble over whether, and how, to diversify.
Tim Reason and Ronald FinkDecember 1, 2001

To diversify or not to diversify? For corporations in pursuit of a sound acquisitions strategy, this is indeed the eternal question. Traditional wisdom holds that diversification offers protection against the vagaries of the business cycle. But throughout the mergers-and-acquisitions boom of the 1990s, the business cycle seemed to have disappeared and a relentless focus on core competencies was all the rage. Diversify if you must, the markets urged, but only if you can demonstrate synergies between businesses as you do so.

Few companies mastered this feat as well as The Walt Disney Co., whose move into television broadcasting made it the very model of a synergistic conglomerate. Of course, such companies used to be called vertically integrated, and everyone who has forgotten the risks inherent in such structures could learn a lesson from Disney’s recent troubles in the capital markets. These days, diversification is back in favor. But as with “synergies,” the advantages of diversifying aren’t always what they seem, especially in the wake of September 11.

To be sure, Disney managed to raise $1 billion in two- and three-year notes the first day the markets reopened after the attacks. But roughly $200 million of the debt was initially left in the hands of Goldman Sachs, which underwrote all but 3 percent of the deal. Not surprisingly, some three weeks later, Disney enlisted the help of nine underwriters besides Goldman to raise another $830 million in yen-denominated medium-term notes, and in mid-October used six banks for $275 million in 30-year bonds aimed at individuals.

The more underwriters an issuer needs, of course, the more it pays in fees. And Disney’s capital requirements remain considerable: It must finance the acquisition of Fox Family Worldwide, a cable TV operation, for $5.2 billion in cash and assumed debt. Yet even before the terrorist attacks, Disney’s two most important business segments, theme parks and television advertising, were suffering. And while the prospects of both have since shown some improvement, Disney’s difficulties have nonetheless led to its first credit downgrades since 1996, when it borrowed heavily to finance the acquisition of Capital Cities/ABC.

“Most investors thought Disney was well diversified,” notes Glenn Eckert, a senior analyst for Moody’s Investors Service. But he says the attacks, along with the economic downturn, have revealed how closely correlated the travel and entertainment businesses can be. Yet anyone who took Disney’s own discussions of its strategy seriously shouldn’t have been surprised, as success was predicated on each of its business segments, in effect, feeding the others. CFO Thomas Staggs recently told Bloomberg News Service that the company was comfortable with its balance sheet and liquidity.

What Downturn?

At first glance, Disney’s problems seem to suggest that companies are better off diversified. Yet the poster company for diversification–General Electric–got hammered along with the rest of the market in the wake of the terrorist attacks, even though it went to great lengths to distinguish the “short-cycle” businesses within its variegated portfolio from those considered “long cycle.”

Indeed, three days after the attacks, GE quickly produced a preliminary estimate of the net loss to its insurance division–$600 million. “We want to give investors some measure of assurance [by] providing the best estimates we can make at this time,” said CEO Jeff Immelt. But if the move was meant to assure investors that the losses were manageable and contained within a single division, it backfired, forcing GE to remind investors a week later that it was on track for double-digit earnings growth despite the insurance hit. But any soothing effect that announcement may have had was undermined by the added mention of the “manageable” impact on GE’s airline business, and the mention of anticipated cutbacks by NBC advertisers. In the two weeks following the attacks, GE’s stock fell by 28 percent–twice as much as the Dow’s 14 percent dip.

In fact, investors prefer a company to be totally immune to the business cycle–something, of course, that is rarely achieved. One exception seems to be Bristol-Myers Squibb, which experienced no trouble whatsoever issuing $5 billion in medium- and long-term bonds in late September, the largest by an investment-grade company in the two weeks following the attacks.

Bristol CFO Fred Schiff says he and his finance team spent a great amount of time and energy in the months preceding the deal explaining to analysts and credit agencies how the proceeds would be used, and he describes the offering as “the proof of the pudding.” But it didn’t hurt that Bristol depends heavily on sales of pharmaceuticals, which have held up well despite the downturn in the economy.

That suggests that diversification won’t help unless virtually all of a company’s business is recession-proof. More evidence? Consider wine and spirits maker Constellation Brands, which easily raised $97 million in a secondary equity offering two weeks after the terrorist attacks. While September proved to be the first month since December 1975 in which not a single initial public offering went to market, and secondary offerings were few and far between, Constellation was able to raise the money through a single underwriter, Salomon Smith Barney. Although the road show that preceded the offering was suspended for a week because of the attacks, CFO Tom Summer reports that the deal ended up being oversubscribed fivefold. And the offering was no less successful than another equity deal by Constellation, this one for $120 million, only last February. “We’re lucky to be in a business that’s healthy,” says Summer.

So is BJ’s Wholesale Club Inc., the retail-buyers-club chain. “About 75 percent of what we sell, you would also find on grocery store shelves,” says CFO Frank Forward. As a result, he adds, “we are going to continue with our plan to open 13 to 14 stores next year.”

To be sure, the stock was actually in decline before the attacks, closing near $46 on September 10, down 19 percent from mid-July. No surprise, then, that BJ’s plans to add as many as 25 gas stations. Diversification? Not really, explains Forward. The gas stations–which are co-located with stores–are more about pumping up existing business. “We sell gas at 8 to 10 cents below the market,” he explains. “We don’t make much money on it, but it drives incremental membership and sales.”

BJ’s rebounded strongly when the market reopened after the attacks, rising 17.5 percent to $51 on October 31, while the S&P 500 rose only 2 percent in the same period. “We like our business model in this environment,” says Forward.

Indeed, BJ’s is no less fortunate than Constellation and Bristol in that its business isn’t cyclical. GE and Disney can only wish the same could be said for theirs.

Higher, Mickey

Credit analysts certainly don’t think The Walt Disney Co.’s diversification is significant enough to outweigh new concerns about its balance sheet. And that means higher financing costs for the company.

Earlier this year, Moody’s Investors Service put Disney on review for a possible downgrade because the company was buying back stock. Six days after September 11, Moody’s reduced Disney’s ratings from single-A-2 to single-A-3 on senior unsecured debt and from P1 to P2 on commercial paper, even though a $1 billion bond offering issued several days earlier helped reduce the company’s dependence on commercial paper. A few weeks later, Standard & Poor’s Corp. followed suit, cutting its ratings from A to A- on Disney’s bonds and from A1 to A2 on its commercial paper.

Although the $1 billion in notes were originally intended to lengthen the duration of Disney’s liabilities, some of the proceeds went instead to buy back 50 million of the 135 million shares that Sid Bass and other members of his family, who had helped the company through its financial difficulties in the mid-1980s, sold in September.

Disney’s cost of capital is rising just as it seeks to finance the acquisition of cable TV operation Fox Family Worldwide, announced last July for $5.3 billion in cash and assumed debt. According to data compiled by Bloomberg News Service, companies with single-A-3 ratings from Moody’s currently pay about 0.21 percentage points more to borrow than do those with single-A-2 ratings. And the cuts in Disney’s commercial-paper ratings to P2 by Moody’s and to A2 by S&P raise its borrowing costs by limiting the extent to which the company’s paper can be held. The biggest investors in commercial paper are money-market funds, but under SEC rules, they can invest no more than 5 percent of their assets in paper rated below the agencies’ top levels. –Ronald Fink

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