The acid test of competitive success is the ability of the firm to generate cash flow for the shareholders in the long run. Yet the successful firm ultimately runs into barriers defined by the natural limits of expansion in its chosen domain. Some companies, such as General Motors, Toyota, Boeing and Microsoft, have remained focused due to the unique nature of their business. GM, Toyota and Boeing are in large fixed cost businesses with little relevant spillovers and mature demand, while Microsoft operates in a market still in the growth phase of its industry life cycle. It would hardly pay for Microsoft to abandon the growing software market to move on to some other venture. However, even these companies have ‘diversified’ themselves over the years. Boeing moved from military applications to civilian airline production after World War II. Although done at different points in time, both Toyota and GM have expanded their model base and moved production to new markets. Microsoft moved out of operating systems into spreadsheets, word processing and database management programs, and is now expanding its presence in the network architecture market. At some stage in the firm’s development, management face a critical decision: do we pay the net cash flows out as dividends or do we seek new investment opportunities? Rarely, if ever, does management make the decision to liquidate the company, believing that new investment opportunities always exist. Some experts view this as little more than managerial hubris sustainable only by the inability of shareholders to police management effectively.1 Classic examples of unjustified investment include the expansion of American cigarette companies, Philip Morris and R. J. Reynolds, into food operations. In both cases, the companies were generating enormous positive cash flows due to the structure of their tobacco operations. Rather than pay out the money to shareholders (who could have reinvested it and achieved a return of around 14 percent), both companies expanded into food operations that earn, at best, 5 percent. Of course, management is not so naive as to believe that they can simply spend shareholder’s money without some justification. Therefore, they justify their investments based on synergy. In both the Philip Morris and R. J. Reynolds expansions, the synergies were argued to be in marketing and distribution, although one would be hard pressed to find Nabisco managers or workers who knew anything related to cigarette production or sales and R. J. Reynolds executives and managers who understood the intricacies of the biscuit and cracker market. The same can be said of Philip Morris. Which capabilities built up in cigarette production and sales can be transferred to the beer (Miller Brewing) and cheese (Kraft) markets?
is Jensen’s free cash flow argument. See M. Jensen, The Eclipse of the Public Corporation, Harvard Business Review, 67, September/October 1989, 61–74. The Essence of Corporate Strategy © 1996
The differences between the Boeing-GM-Toyota and Microsoft examples and the Philip Morris-R. J. Reynolds example is that the former based their expansion into new products and markets on the distinctive skills and competencies of the firm as they related to new markets or products while the latter based their expansion on the necessity of spending the cash that was pouring out of their base operations in cigarettes.2 The Boeing-GM-Toyota diversification was purposeful and rational...