Essays in corporate diversification

Abstract

This dissertation finds new evidence on the implications of corporate diversification on profitability, risk, and the information environment of firms. In the first essay, we focus on U.S. supplier firms with major corporate customers and examine how customer-base diversification affects firm profitability and distress risk. We propose and find that the relation between customer-base concentration and profitability is non-linear and dynamic. We show that customer concentration promotes operating efficiencies for profitable firms, but we find the opposite result for younger, less profitable firms. The reason for this dynamic relation is that firms who serve a few major customers make customer-specific investments that result in larger fixed costs and greater operating leverage. The first essay also analyzes whether a concentrated customer base increases the distress risk of the firm. We hypothesize and show that higher customer concentration is also associated with higher demand uncertainty as well as higher operating leverage. Due to higher operating leverage and demand uncertainty, firms with higher customer concentration are not able to reduce their expenses when the demand drops, leading to higher probability of default. The second essay examines whether segment diversification leads to slower information processing by investors. We hypothesize that a more diversified revenue base should increase the complexity of a firm's earnings, which in turn should hamper investors' speed of information processing. We utilize the post-earnings-announcement drift (PEAD) to test this hypothesis. We propose to use firm complexity, a measure of corporate diversification, as a new limits-to-arbitrage variable. We show, using cross-sectional regressions, that PEAD is twice as strong for more diversified firms as it is for single segment firms. This is a surprising result because diversified firms are larger, more liquid, and more actively researched by investors. Unless firm complexity severely hampers the ability of investors to process information, one should expect to find weaker, not stronger, PEAD for diversified firms, because all other firm characteristics suggest that diversified firms should have lower limits to arbitrage.