Diversification Strategy

From Contemporary Strategic Analysis by Robert Grant

Before going into that

FOUR different types (not mutually exclusive, though) of Strategies to manage and sustain profitability
! Diversification Strategy ! Integration Strategy ! Intensive Strategy ! Defensive Strategy

Before going into that

FOUR different types (not mutually exclusive, though) of Strategies to manage and sustain profitability
! Diversification Strategy ! Integration Strategy --- backward, forward, horizontal ! Intensive Strategy ! Defensive Strategy

Before going into that

FOUR different types (not mutually exclusive, though) of Strategies to manage and sustain profitability
! Diversification Strategy ! Integration Strategy ! Intensive Strategy --- Market penetration, market

development, product development

! Defensive Strategy

Before going into that

FOUR different types (not mutually exclusive, though) of Strategies to manage and sustain profitability
! Diversification Strategy ! Integration Strategy ! Intensive Strategy ! Defensive Strategy --- divestiture, retrenchment, liquidation

Diversification Strategies
Concentric diversification Conglomerate diversification Horizontal diversification

Diversification Strategies
Concentric Diversification Adding new, but related, products or services

Diversification Strategies
Guidelines for Concentric Diversification

Competes in no-growth or slow-growth industry Adding new & related products increases sales of current products New & related products offered at competitive prices Current products are in decline stage of the product life cycle Strong management team

Diversification Strategies
Conglomerate Diversification Adding new, unrelated products or services

Diversification Strategies
Guidelines for Conglomerate Diversification

Declining annual sales and profits Capital and managerial talent to compete successfully in a new industry Financial synergy between the acquired and acquiring firms Existing markets for present products are saturated

Diversification Strategies
Horizontal Diversification Adding new, unrelated products or services for present customers

Diversification Strategies
Guidelines for Horizontal Diversification

Revenues from current products/services would increase significantly by adding the new unrelated products Highly competitive and/or no-growth industry w/ low margins and returns Present distribution channels can be used to market new products to current customers New products have counter cyclical sales patterns compared to existing products

Diversification Strategy
OUTLINE
! Introduction: The Basic Issues ! The Trend over Time ! Motives for Diversification

- Growth and Risk Reduction - Shareholder Value: Porters Essential Tests.

! Competitive Advantage from Diversification ! Diversification and Performance: Empirical Evidence ! Relatedness in Diversification

Basic Issues in Diversification Decisions

Superior profit derives from two sources:
INDUSTRY ATTRACTIVENESS NET OPERATING PROFIT > COST OF CAPITAL

COMPETITIVE ADVANTAGE

Diversification decisions involve these same two issues: How attractive is the sector to be entered? Can the firm achieve a competitive advantage?

Diversification among the US Fortune 500, 1949-74

70.2 29.8 63.5 36.5 53.7 46.3 53.9 46.1 39.9 60.1 37.0 63.0

1949

1954

1959

1964

1969

1974

Note:

During the 1980s and 1990s the trend reversed as large companies refocused upon their core businesses

Diversification among Large UK Corporations, 1950-93

70 60 50 40 30 20 10 0 1950 1960 1970 1983 1993 Single business Dominant business Related business Unrelated business

Diversification: The Evolution of Management Thinking and Management Practice

MANAGEMENT GOALS

Quest for Growth

Financial problems of conglomerates

Refocusing on shareholder value

Competitive advantage through flexibility, and capability

COMPANY DEVELOPMENTS

Rise of conglomerates Emphasis onrelated Refocusing on Related diversification core businesses & concentric by industrial firms Divestment diversification

Joint ventures, Alliance, corporate venturing

Financial Analysis Diffusion of M form structures

STRATEGY TOOLS & CONCEPTS

Analysis of economies of scope & synergy

Portfolio planning models

Value based Transaction management cost analysis Core competences Dominant logic Dynamic capability

Capital asset pricing model Development of corporate planning systems

1950

1960

1970

1980

1990

Motives for Diversification

GROWTH
! The desire to escape stagnant or declining industries

a powerful motives for diversification (e.g. tobacco, newspapers).

! But, growth satisfies managers not shareholders. ! Growth strategies (especially by acquisition), tend

to destroy shareholder value

Motives for Diversification

RISK SPREADING
! Diversification reduces variance of profit flows ! But, does not create value for shareholders ! Capital Asset Pricing Model shows that

diversification lowers unsystematic risk not systematic risk.

Motives for Diversification

PROFIT
! For diversification to create shareholder value,

then bringing together of different businesses under common ownership & must somehow increase their profitability.

Diversification and Shareholder Value: Porters Three Essential Tests

If diversification is to create shareholder value, it must meet three tests:

Diversification and Shareholder Value: Porters Three Essential Tests

If diversification is to create shareholder value, it must meet three tests:

1. The Attractiveness Test: diversification must be directed towards attractive industries (or have the potential to become attractive).

Diversification and Shareholder Value: Porters Three Essential Tests

If diversification is to create shareholder value, it must meet three tests:

1. The Attractiveness Test: diversification must be directed towards attractive industries (or have the potential to become attractive).

2. The Cost of Entry Test : the cost of entry must not overwhelm all future profits.

Diversification and Shareholder Value: Porters Three Essential Tests

If diversification is to create shareholder value, it must meet three tests: 1. The Attractiveness Test: diversification must be directed towards attractive industries (or have the potential to become attractive). 2. The Cost of Entry Test : the cost of entry must not capitalize all future profits. 3. The Better-Off Test: either the new unit must gain competitive advantage from its link with the company, or vice-versa. (i.e. some form of synergy must be present)

Diversification and Shareholder Value: Porters Three Essential Tests

If diversification is to create shareholder value, it must meet three tests: 1. The Attractiveness Test: diversification must be directed towards attractive industries (or have the potential to become attractive). 2. The Cost of Entry Test : the cost of entry must not overwhelm all future profits. 3. The Better-Off Test: either the new unit must gain competitive advantage from its link with the company, or vice-versa. (i.e. some form of synergy must be present)
Additional source of value from diversification: Option value

Competitive Advantage from Diversification

MARKET POWER 1. Predatory pricing/tie-in sales 2. Reciprocal buying 3. Mutual forbearance Evidence of all three are sparse

Competitive Advantage from Diversification

ECONOMIES OF SCOPE Sharing tangible resources (research labs, distribution systems) across multiple businesses Sharing intangible resources (brands, technology) across multiple businesses

Competitive Advantage from Diversification

ECONOMIES OF SCOPE (--- continued)

Transferring functional capabilities (marketing, product development) across businesses Applying general management capabilities to multiple businesses

Competitive Advantage from Diversification

INTERNALIZE TRANSACTION COST Economies of scope not a sufficient basis for diversificationmust be supported by transaction costs Diversification firm can avoid transaction costs by operating internal capital and labor markets Key advantage of diversified firm over external markets--- superior access to information

Relatedness in Diversification
Economies of scope in diversification derive from two types of relatedness:
! Operational Relatedness-- synergies from sharing

resources across businesses (common distribution facilities, brands, joint R&D)

! Strategic Relatedness-- synergies at the corporate level

deriving from the ability to apply common management capabilities to different businesses.

Relatedness in Diversification
Problem of operational relatedness: the benefits in terms of economies of scope may be dwarfed by the administrative costs involved in their exploitation.

Branson & the Virgin Companies: Making strategic sense of apparent entrepreneurial chaos
KEY RESOURCES

Virgin brand Branson -charisma/image --PR skills -networking skills -entrepreneurial flair

DOMINANT LOGIC

Seek competitive advantage by start-up cos. pursuing innovative differentiation in underserved market with sleepy incumbents
CHARACTERISTICS OF MARKETSTHAT CONFORM TO THIS LOGIC

DESIGNING A CORPORATE STRATEGY & STRUCTURE

Whats the business model? (Does Virgin create value by being an entrepreneurial incubator, a venture capital fund, a diversified corporation, or what?) Which businesses to divest? Criteria for future diversification What type of structure?Is there a need for greater formalization?

consumer dominant incumbent scope for new approaches to customer service high entry barriers to other start-ups Branson/Virgin image appeals to customers