What Is a Diversification Acquisition?
Diversification acquisition is a corporate action whereby a company takes a controlling interest in another company to expand its product and service offerings. One way to determine if a takeover comes under diversification acquisition is to look at the two companies Standard Industrial Classification (SIC) codes. When the two codes differ, it means that they conduct dissimilar business activities. The acquirer may believe the unrelated company unlocks synergies that promote growth or reduce prevailing risks in other operations. Mergers and acquisitions (M&A) often take place to complement existing business operations in the same industry.
How a Diversification Acquisition Works
Diversification acquisition often occurs when a company needs to lift shareholder confidence and believe making an acquisition can facilitate a pop in the stock or buoy earnings growth. Takeovers between two companies that share the same SIC code are considered related or horizontal acquisitions, whereas two different codes fit in the framework of an unrelated takeover.
Big corporations typically find themselves involved in diversification acquisitions either to minimize the potential risks of one business component not performing well in the future, or to maximize the earnings potential of running a diverse operation. For example, in 2017 Kellogg's (K) snapped up organic protein bar manufacturer RXBAR for $600 million to lift its struggling line of cereals and bars. It also presented an opportunity for the legacy food manufacturer to make headway in the rapidly growing natural food industry. We've seen similar moves from other large consumer staples companies struggling to stay relevant with cookie cutter products and minimal digital presence. In 2016, consumer products giants Unilever (UL) forked over $1 billion for Dollar Shave Club in its first foray into the razor business.
Common Misconceptions about Diversification Acquisitions
There's a common belief that acquisitions instantly bolster earnings growth or reduce operational risks, but in truth, creating new value takes time. Not every purchase will generate greater returns, higher earnings, and capital appreciation. In fact, many companies don't ever live up to their acquisition valuation. Some companies will never get enough traction to push a product while others may be limited in the resources they receive from the parent company.
Some investors also assume unrelated acquisitions are a superior method of reducing risk. Two unrelated companies with separate revenue streams and earnings drivers should theoretically face different challenges. The trouble is the parent company plays an instrumental role in molding investor's sentiment around subsidiary brands. If the corporation is faced with backlash for misconduct, it would trickle down and infect the smaller business units.