Diversification for dummies

Diversification for dummies

Even as recession-battered companies in many industries are starting to feel some lift, the aerospace and defense (A&D) sector is being buffeted by new challenges that threaten to stall their growth. Congress and the Pentagon are eliminating major programs of record, cutting budget forecasts, and postponing or drawing out new and existing programs.

A&D and other government contractors are trying to maintain revenue growth by branching into adjacent businesses, such as foreign sales, security and soft power. However, many also are pursuing businesses that are farther afield from their cores, investing in hot opportunities in areas such as health care, energy and environmental sciences.

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If this passion for diversification sounds familiar, it should. It is reminiscent of what many of the same companies did during the last big defense downturn. And that path was littered with examples of new ventures gone bad: head-up displays for automobiles, space-based remote-sensing for precision farming and transportation and perhaps the biggest of all failed forays-the satellite-based commercial broadband data services and mobile telephony. Remember Iridium, Teledesic and Globalstar?

By some estimates, the rate of commercialization flops during the last downturn was more than 95%. Why such an abysmal success rate? Broadly speaking, these ventures bucked up against two critical laws of growth that have been seen in Bain & Co. research across thousands of companies. First, the best time to pursue new adjacencies is when core businesses are strong and nearing full potential. Second, the likelihood of success declines as companies move farther from their cores.

A&D companies in 1990s were the serial violators of these two rules. As they strayed far away from their core businesses, they failed to understand such critical elements of commercial success as the role of distributors, resellers and other channel partners; the need for market-based pricing instead of cost-based rate structures; the existence of alternative commercial technologies, and the challenge of managing complex value chains that were often global.

Yet A&D companies clearly cannot afford to wait for the next defense market rebound. So what should they do to avoid repeating mistakes? They should strive for innovation and new sources of growth but be much more discriminating about where to look. Starting with opportunities close to their cores, they might seed their own R&D investments to develop innovative products and services that can be marketed to existing government customers, rather than waiting for the next program to fund development. They could also partner with overseas companies to gain access to new customers or apply new technologies to upgrade systems for current customers. There may also be near-in adjacencies in markets they already know.

But if the commercial market still beckons, they should heed the lessons of the past and follow these five rules:

  • Do your homework. Before committing scarce resources, assess each new opportunity by realistically appraising its size and market-share assumptions and fully understanding what influences its growth.
  • Be discerning. Choose one or two ventures or markets to pursue. Placing a lot of small bets to diversify risk usually ends up increasing it.
  • Have a commercial value proposition. It is not enough to say, "We have great technology, someone must want it." For any business you are tempted to enter, it is critical to ensure there is real market pull and that your company can offer a truly differentiated product or service that identifiable customers will pay for.
  • Build or buy a commercial support model. Be ready to adopt a wide range of new business processes, from mastering unfamiliar contracting terms to applying different accounting standards and capabilities. Recruit executives who know the target customers, channels and competitors well, or form partnerships with companies that do.
  • Create separation. The new business needs distance from the burdensome oversight and cost structures of the defense parent. This does not mean leave it alone, but don't manage it the same way, either.

With plenty of capital to invest, many contractors can be tempted to abandon their core businesses for the lure of commercial markets. Their better option is to position the core business for strength first. And if the commercial sirens continue to call, they need to be very discriminating on those they choose to follow.

Michael Goldberg is a Bain & Co. partner in Los Angeles and leads the firm's Global Aerospace and Defense practice.