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Domotechnics is a small company founded in Astrakhan (Russia) in 1999 a city of 500 thousands population in the south of Russia. Initially specialising in retail this company is a successor of another company owned by three shareholders who decided to sale their share to the current owner after the Russian financial crisis of 1998 when the national currency (rouble) slump down during a few days from 6 to 23 for 1 US dollar.
The company main activity is home appliances trading including a large range of audio, video and other household appliances like fridges, washing machines, dishwashers and so on. Some other additional activities were photo services provided by a professional photolaboratory, cosmetics trading and mobile phone sales of handsets and contracts as well since the company was a dealer of the main federal mobile operators from whom it was receiving a $10 bonus for each sold contract.
The company was operating three stores of 2,000 sq ft. and a warehouse of 6,500 sq ft. with an annual turnover of approximately $ 1.5 million (2005) and was employing 35 persons.
The company's customers were a well established middle class people living in the suburbs and surrounding the town villagers since the stores were located at the city's main way out and in the central market where farmers come every day to sale their agricultural products. An important part of the customers were almost the same buying firstly a TV than after coming for a video-DVD player than again returning for a more expensive refrigerator. Most of them were bringing their friends or family members since they were happy with the service provided.
The nature of this business is that the company had to keep a costly large constant stock because of two reasons:
- First of all the buying culture in Russia was that people wants their goods immediately and do not shop by catalogue.
- There is no suppliers' warehouse in the Russian market.
One more disadvantage is that market is set so that the company's main suppliers are situated very far in Moscow (1500 km), Rostov (900 km) and Lipetsk (900 km) and supply goods only on a full prepaid basis without possibility of a goods credit.
Finally another burden was that the company had to run its own service centre because of the total absence of manufacturers or brandname owners' service centres at that time in this city.
One of the critical determinants of any company's strategic management is the external environment conditions. Barney and Hesterly (2008) argue that ‘any analysis of the threats and opportunities facing a firm begin with an understanding of the general environment' (p. 32).
For this case study the PESTLE analysis has been chosen because the strategy of this company is principally dictated by its macroenvironment. Failing to understand and torespond to such unfriendly business environment may cause to the company to cease existing. This method implies a strategic scanning process coupled with an investigation of the dynamics of the business milieu with the purpose of elaboration of an adequately responsive strategy.
Promptly apprehending its wider external world provides serious leverage for a business because indeed this analysis is an audit of its continuously changing operating conditions which facilitates strategic decision making process.
In the same time PESTLE is a coordinates system that allows the company to situate itself and its products in its business world and allows appropriately planning and orientating business activities.
This tool allows companies locating in time the opportunities and openings that may arise from any change occurring in its surrounding world and fully exploit their potential and helps to anticipate future risks and impediment to their activity and progress.
The slight inconvenience with this analysis is that it has to be conducted with different analysts to assure its impartiality and must be considered and matched with the company's micro and internal environments
Chien-pin (2004) explained that ‘Investors, traders and business managers do not operate in a vacuum; all of their decisions and actions are carried out in legal and political environments' (p. 2).
Pearce and Robinson (2008) sustained that the best approach to assess the external environment is to conduct its PESTLE analysis:
- Political and Legal Factors: define the regulatory framework, like far trade decisions and antitrust laws, policies...etc. In Russia always restrictive.
- Economic Factors: Assess the economy of the milieu, economics trends and segments.
- Social Factors: Cultural and demographics issues, attitudes and beliefs.
- Technological Factors: Technological changes and trends, innovations, avoid obsolescence.
- Environments Factors: Ecological issues, pollution of air, land and water that may cause significant damages.
- Very high uncertainty coupled with unpredictability of the system because of incomprehensible procedures of decision making.
- State power re-centralization and a revival driven by natural resources.
- Political stability is being achieved at the expense of democratic fundamentals.
- Movement towards greater economic control.
- Significant reinforcement of the consumer law protection raising a new consumer extremism culture becoming increasingly costly.
- Large monopolies with lobbying power may be protected whereas smaller companies with less influence may feel the full force of the competition laws.
- Judicial system subject to an increasingly harsh campaign of manipulation and control in which the executive branch regularly interferes in political or economically consequential cases.
- Very high level of countrywide corruption occurring at all levels.
- Official statistics, Russia's GDP grew by 6.7% in 2006, following a 6.4% rise in 2005
- Inflation reached a rate of 9% in 2006; annual accumulated inflation for 2007 had reached 8.5% by October.
- The rouble steadily gained value against the dollar during 2007. The central bank rate moved from Rub. 26.3: US $1 at the beginning of the year to Rub 24.9: US$1 in late October.
- The benchmark RTS stock exchange rose by 60% in 2006.
- The Russian economy's strong growth is driven by continuous expansion in internal demand, growing capital investment, high oil prices and a relatively cheap rouble.
- Natural resources based growth is not being diversified.
- Extremely dependent on exporting natural resources, hence especially on natural gas and oil price
- A declining and ageing population along with the growth of urban agglomerations.
Development of an investor-friendly climate faces obstacles of corruption and organized crime
- Despite government intervention, income disparities, poverty and regional imbalances remain high.
- High level of education and strong culture.
- Active government involvement to support the growth of the ICT sector, though software piracy is still rampant.
- The Russian government is actively encouraging research and development in the technology sector.
- Software Piracy continues to be a major inhibitor to the growth of the ICT industry.
- Economic progress is taking priority over environmental concerns.
- Heavy pollution and environmental damage inflicted by decades of irresponsible mining, production, dumping and weapons testing is already taking its toll on public health in some areas.
- Russia's vast network of oil pipelines and nuclear waste disposal system need urgent upgrading and maintenance.
- Increasing deterioration of environmental condition due to an almost total absence of control and application of nature protection laws.
- Oligarchic exploitation of resources and main polluting industries and agents very politically powerful.
- Local environmental groups still have less public support than their Western colleagues do.
Diversification is one of the main use strategies by companies to create or sustain competitive advantage.
Barney and Hesterly (2008) defined ‘corporate diversification strategy as when operating in multiple industries or markets simultaneously and product diversification strategy when in multiple industries' (p.208).
Besanko et al. (2007) reported that there are two main reasons for this: managerial benefits or business reasons (profit and growth) that are related to economy of scale and scope by sharing activities or core competences, economy on transaction costs, creation of internal capital market or diversification of portfolio and risk reduction. Sometimes diversification is carried out to exploit anticompetitive economies of scope by multipoint competition to balance power with the main competitor and by exploiting market power using allocation of capital and subsidisation between businesses (Barney and Hesterly, 2008).
Pearce and Robinson (2005, p. 210) argued that there is:
- - Concentric Diversification: when parallel business is generated by exploiting similarities in operations or by-product production leveraging the company's capabilities with the synergetic effect.
- - Conglomerate Diversification: its principal distinction is that it is not based on commonness of markets, products or technology but focuses mainly on profit factors.
Another method of diversification classification had been suggested by Rumelt (1982) who coined the term of relatedness and developed a notion that emphasises on the degree or extent of similarity and differentiation of the pursued activities of a company. He focused on three characteristics: the largest business, the largest group of related business and the stages of business integration.
Using this approach three strategies are reported by Barney and Hesterly (2007) and Rumelt (1982) based essentially on the size and the source of income:
- Limited corporate diversification:
- A single-business company: engage in one business which falls into one industry or market.
- A dominant-business company: engages in two businesses a big one and a smaller one that are tightly linked between them.
- Related corporate diversification:
- A related-constrained: the company seek business opportunities in new markets and industries only if they have the same resources and capability requirements.
- A related-linked the company has different businesses that have little in common, merely or not linked between them.
- Unrelated corporate diversification:
- A company that engage in different businesses without any links between them
Furthermore diversified businesses can be related by using the same company's core competences to achieve their competitive advantage. Activities in their value chain necessitate almost the same skills although they produce different products and operate in different markets.
Finally, according to Barney (1991) in order to achieve competitive advantage when diversifying, new resources have to be able to exploit opportunities or neutralize threats, be rare, hardly imitable and substitutable.
In such hostile business environment like Russia small companies instinctively try to grow rapidly because there is a real danger that the business will not survive for a long time. The sole guaranty against this threat is the size and heterogeneity of the business.
Over the years the concept of growth of Domotechnics has been developed from a vague plan to a strategy that promotes maximum accumulation of profits coupled with a program of constant investment in different businesses. Till 2006 the strategy was a combination of several grand strategies and because the market was new and not product saturated it was mainly Concentrated Growth based on the company's core competences such cost leadership, speed and emerging industry. From 1999 to 2006 the company enlarged its activities from one small store (1000 sq ft) to three stores (6000 sq ft) and a warehouse.
Diversification strategy had always been used, in the beginning being Concentric exploiting sometimes a spin-off like the sale of mobile phones that generated a profitable parallel business of being a dealer of the federal network companies, receiving bonus from contracts, or the sale of cameras that provoked the birth of the photolaboratory business selling films, frames...etc and providing the full range of print services (photos, calendars...etc).
But this strategy could not damp the main problems of the business: the need of huge amounts of money to run operations because of the costly inventory and high cost of order fulfilment process due to the long distances that separate it from Suppliers. This situation became especially unbearable when because of the competition the ratios (gross profit ratio and return on capital employed) fell down further and equalled the bank deposit rates making the business abnormally low profitable in a highly risky environment.
Pearce and Robinson (2005) suggested that in such situations businesses adopt retrenchment strategy and withdraw funds to make them available for investments in other businesses.
5.1. Acquisition of an existing business
During 2006 year Domotechnics manager decided to reduce the business from three to one store gradually pumping out $ 500 thousands that had been used to buy an early rented store of 3650 sq ft from its owner. In the next years this store was reconditioned and rented to new tenants increasing the company's revenues.
5.2. Stock market diversification
In 2006-07 around $ 300 thousands were withdrawn from the business and were invested in shares in the Russian stock market (MMVB). This is because of the previous year's 60 % index growth rate performance in 2006. Using credit leveraging the management invested around $ 500 thousands in shares. The principal issue encountered here was that as Thompson Jr. et al. (2005) noticed, when managing fundamentally different businesses there a lot of risk of incompetence because of lack of knowledge.
5.3. Investment in real estate
During 2007 and 2008 Domotechnics organised a joint-venture with Arkadiya (a real estate company) providing finance for buy-sale activities of flats. This business was very attractive because it was very profitable and did not involve a day to day management.
5.4. Investment in construction
Very fortunately shares had been sold in time before the market slump down and investment in stock markets had been significantly reduced to $ 40 thousands (that worth now around $ 20 thousand) and $ 350 thousands had been invested in a joint-venture created with MTM Trading (a building company) in order to manage a project of building an apartment block of 73 flats which started in 2008.
5.5. Investment in Land
In 2007 Domotechnics invested $ 100 thousands and bought a land of 8000 sq ft in a very good place situated near a high street in Astrakhan. This land was acquired in order to be developed by building a 24000 sq ft store but the project did not even start.
Barney and Hesterly (2007) argued that ‘the ability of a diversification strategy to create sustained competitive advantage depends not only on the value of that strategy, but also on its rarity and imitability' (p.239). It is fair to state no company from this sector of activity in Astrakhan had undergone this diversification process.
In the same time De Wit (2005) he sustained that ‘diversification into new business areas can only be economically justified if it leads to value creation' (p. 136). In this case the aggregate value of created businesses is greater than the value of the initial one. It is possible to use Thompson Jr. et al. (2005) approach who stated that although ‘there is merit of evaluating strategy from qualitative standpoints (completeness, consistency and relevance), the best quantitative evidence of how well strategy is working comes from its results' (p. 88). So let's have a look at the results of Domotechnics diversification outcomes:
After a long list of problems with local authorities, the store is now fully rented and operates without day to day involvement of the managers. Its actual market value is estimated around $ 800 thousands.
In 2007 the net profit from Domotechnics' activities of buying and selling share was equivalent to a ratio of 14.5 %. This could seem to be acceptable but: inflation rate in Russia during that year was around 11 % making real profits lower and the deposit bank rate was around 13 %. For these reasons this activity was assessed as not very profitable and in the same time as highly risky. Although the funds invested were significantly diminished, the company suffered serious losses during 2008 and 2009 due to the worldwide slump in stock markets.
The company did not suffer from losses although efficiency ratios seriously declined because the average length of time required to sale a flat increased from one to almost six months making again this business unprofitable because of the cost of money.
The project has been frozen for two years now due to lack of funds that occurred because of the collapse of the real estate market. It is estimated that during this year it should be carried on. This is bearable since the profit in such projects is around 100%.
In October 2007 Domotechnics very fortunately fully stopped this activity. Transfer of activities cost around $ 50 thousands, but this is better than to endure what happened to this business activity based on import when the rate of US dollar rose from 23 to 33 during six months.
The Land has been seized by local corrupted authorities without any compensation. Corrupted courts did not help the company from suffering losses of $ 100 thousands.
It is evident that the synergic effects of the businesses in the company as suggested Hamel and Prahalad (1993) come more from leveraging resources and sharing value adding activities (i.e. real estate joint-venture selling flats built by the construction company).
Unfortunately in certain cases the cost of entry test suggested by Porter (1987) is not passed since the cost o entry (i.e. Land) is higher than generate profits.
It is possible to explain Pitfalls in Domotechnics strategy by the high pace of change or by using Thomson Jr. et al. (2005) suggestions to ‘avoid strategies capable of succeeding only in the most optimistic circumstances' (p. 230) for the land acquisition and secure all the financial resources to succeed that are needed (ibid) for the construction project.
Another method to assess this strategy is to consider that Anand and Singh (1997) sustained ‘to the extent that some resources are fungible, firms should be able to redeploy them to enter new markets when their existing businesses decline' (p. 99) and compare it post factum with the best choice possible knowing now what happened:
- Convert withdrawn funds from the initial business activities into cash.
- Convert this cash into US dollars and keep them in a currency deposit account in a state owned bank where rates are usually around 5-6 %.
- Buy fallen in price assets like real estate.
Despite that Anand and Singh (1997) claimed that ‘focus may be seen as a more attractive strategy than diversification into a potentially less troubled environment, because the costs and risks of transformation of the firm may be too high'(p.113) in the case of Domotechnics it would be more destructive if it kept and enlarged the initial business.
The PESTLE analysis above clearly reports that the danger for the existence of Domotechnics still high; as Abbey cited in De Wit (2005) explained ‘growth for the stake of growth is the ideology of the cancer cell' (p. 151). Although the diversification strategy was in general the right one, the mistake was in the scope and the geography
It is difficult to expect Domotechnics to adopt other strategies (i.e. FDI, M&A, and CSR) because of its size and lack of finance. The main mistake was in risk management strategy that did not as suggested by Froot et al. (1993) secure ‘sufficient internal funds available to take advantage of attractive investment opportunities' (p. 1629). But ‘unfortunately, finance theory has had much less clear cut guidance to offer on the logically prior questions of hedging strategy' (ibid) and ‘Academics know remarkably little about corporate risk management practices'(Tufano,1996, p.1097).
Except economical risks Domotechnics had to hedge political risks as well that ‘link unpredictability in firm performance to specific uncertain environmental components' (Miller, 1991, p.311).
Chien-pin (2004) argued that ‘there is a significant level of analytical and conceptual confusion surrounding the definition and research of political risk...specifically, there is little consensus in financial circles concerning what constitutes political risk and how it can be measured' (p. 3).
The company's managers acted as it is suggested by Miller strategic risk management ‘for a firm already active in a highly uncertain market...involves exiting through divestment of the specialized assets committed to serving the market' (p. 322). Another strategic response indicated by Aaker and Mascarenh (1984) is flexibility‘the ability of the organization to adapt to substantial, uncertain, and fast-occurring (relative to required reaction time) environmental changes that have a meaningful impact on the organization's performance' (p. 74).This in contrast to control strategies when companies seek control over external environment (almost all businesses in Russia have their people in legislative branch of power).
Domotechnics strategy was designed to damp the negative factors reported in the Pestle analysis and drawbacks of the business not for an action to carry out during crisis periods. It is true that the real estate business in Russia was the one that had most suffered but as Skoufias (2003) noticed ‘the aggregate nature of these shocks strain market-based coping mechanisms and many of the informal mechanisms for mitigating and coping with risk become ineffective' (p.1089). Yet other industries suffered not less because they are related between them (auto traders for instance reported significant drops in their sales).
Before the expropriation of the land Domotechnics managers were thinking like West (2001) that ‘risk is not a quality inherent in a country, a government, or an environment; risk is a property associated with an individual investor and prospective investment. What represents an unacceptable risk to one investor may be simply a routine manageable situation for another' (p. 49). But this approach has been totally reviewed and now the main focus of Domotechnics is on internationalising diversification strategy as a sole sustainable way to grow.