Diversification

Diversification Strategy
Strategy

OUTLINE

• Introduction: The Basic Issues

• The Trend over Time
• Motives for Diversification
- Growth and risk spreading
- Diversification and Shareholder Value: Porter’s
Three Essential Tests.
• Competitive Advantage from Diversification
• Diversification and Performance: Empirical Evidence
• Relatedness in Diversification
 Objectives
• Define corporate strategy, describe some of
the reasons why firms diversify, identify
and describe different types of corporate
diversification, and assess the advantages
and disadvantages associated with each.
• Identify sources of synergy in diversified
firms while also describing why synergies
are so difficult to achieve.
 Objectives (cont.)
• Explore the complex relationship between
diversification and firm performance.
• In particular, explore the influence of
managers and managerial thinking on the
relationship between diversification and
performance.
 Introduction
• Definition of Corporate Strategy
– Address the question: “What is the appropriate scale and
scope of the enterprise?”
• Influences how large and how diversified firms will be.
• Successful corporate strategies are not only the product of
successful definition
– Also the result of organizational capabilities or competencies that
allow firms to exploit potential economies/synergies that large size or
diversity can offer.
 Introduction (cont.)
• Why Firms Diversify
– To grow
– To more fully utilize existing resources and
capabilities.
– To escape from undesirable or unattractive
industry environments.
– To make use of surplus cash flows.
 Introduction (cont.)
• Horizontal or related diversification
– Strategy of adding related or similar product/service
lines to existing core business, either through
acquisition of competitors or through internal
development of new products/services.
 Introduction (cont.)
• Horizontal or related diversification
– Advantages
• Opportunities to achieve economies of scale and
scope.
• Opportunities to expand product offerings or expand
into new geographical areas.
Disadvantages of related diversification
• Complexity and difficulty of coordinating different
but related businesses.
 Introduction (cont.)
Conglomerate or unrelated diversification
– Firms pursue this strategy for several reasons:
• Continue to grow after a core business has matured or started to
decline.
• To reduce cyclical fluctuations in sales revenues and cash flows.
– Problems with conglomerate or unrelated diversification:
• Managers often lack expertise or knowledge about their firms’
businesses.
 Introduction:
Introduction: The
The Basic
Basic
Issues
Issues

Diversification decisions involve two basic issues:

• Is the industry to be entered more attractive than

the firm’s existing business?

• Can the firm establish a competitive advantage

within the industry to be entered? (i.e. what
synergies exist between the core business and
the new business?)
 Aim of Corporate Strategy:
Synergy
• Aim of diversification should be to create value or
wealth in excess of what firms would enjoy without
diversification.
• Synergy: the value of the combined firm after
acquisition should be greater than the value of the
two firms prior to acquisition.
– Obtained in three ways:
• Exploiting economies of scale.
– Unit costs decline with increases in production.
Aim of Corporate Strategy:
Synergy (cont.)
• Exploiting economies of scope.
– Using the same resource to do different things.
• Efficient allocation of capital.
– Many assets in acquired firms are undervalued --
managers seek to exploit these opportunities and improve
their operations and add value to their businesses.
 Relatedness
Relatedness inin
Diversification
Diversification

Synergy in diversification derives from two main 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.

Problem of operational relatedness:- the benefits in terms

of economies of scope may be dwarfed by the
administrative costs involved in their exploitation.
 Problems in Exploring Potential
Synergies
• Poor understanding of how diversification activities
will “fit” or be coordinated with existing businesses.
• Acquisition process is fraught with risks.
– Managers might fail to conduct an adequate strategic
analysis of acquisition candidate.
• Will often try to complete the deal too quickly before other potential
buyers begin a bidding war.
• Managers will often focus on the attractive features of a candidate,
while giving less attention to the negative features.
Problems in Exploring Potential
Synergies (cont.)
– Even after making an acquisition, managers
must still integrate the new business into their
company’s existing portfolio of businesses.
• Differences in organizational cultures.
• Should new business be standalone operation or
should it be merged into one of the existing
businesses?
 Problems in Exploring Potential
Synergies (cont.)
• Problems associated with internal
development of new businesses.
– Most problems due to considerable time and
investment required to launch new business.
• On average, most new product lines require 10 years
before generating positive cash flows and net income.
– Difficult to assess the risks associated with new
investment opportunity.
 The Trend Over Time: Diversified
Companies among the Fortune 500
70.2 63.5 53.7 53.9 39.9 37.0
29.8 36.5 46.3 46.1 60.1 63.0

1949 1954 1959 1964 1969 1974

Percentage of Specialized Companies (single-business, vertically-
integrated and dominant-business)
Percentage of Diversified Companies (related-business and
unrelated business)
BUT Since late 1970’s, diversification has declined.
 Diversification and Performance:
The Score
• What is relationship between diversification
and firm performance?
– Academics, consultants,and financial
community have dim view of diversification.
– Some studies suggest that diversification
beyond a core business leads to lower
performance.
 Diversification
Diversification and
and Performance:
Performance:
Empirical
Empirical Evidence
Evidence
• Diversification trends have been driven by beliefs rather
than evidence:- 1960s and 70s diversification believed to be
profitable; 1980s and 90s diversification seen as value
destroying.
• Empirical evidence inconclusive-- no consistent findings
on impact of diversification on profitability, or on related
vs. unrelated diversification.
• Some evidence that high levels of diversification
detrimental to profitability
return on net assets (%)
3
• Diversifying acquisitions,
on average, destroy share- 2
holder value for acquirers
1
• Refocusing generates 1 2 3 4 5 6
index of product diversity
positive shareholder returns
Diversification and Performance: The
Score (cont.)
– Exhibit summarizes findings of study that
sought to determine how much various factors,
including industry attractiveness, business
strategy, and corporate strategy contribute to
performance.
• Findings suggest that industry attractiveness and
business strategy together explain more than 99% of
variation of business unit performance.
– Corporate strategy has no apparent effect on performance!
Diversification and Performance: The
Score (cont.)
– Additional studies conclude that corporate
strategy rarely makes significant contribution to
shareholder value.
– Recent study is shown in Exhibit below:
Low- High-
Performing Performing
Firms Firms
Less
Diversified 47 46

46 47
Diversification and Performance: The
Score (cont.)
– Exhibit suggests:
• Categorization of firms into the 4 diversification-
performance groups is remarkably balanced.
– High-performing firms are just as likely to be more
diversified as they are to be less diversified.
– Low-performing firms are just as likely to be less
diversified as they are to be more diversified.
• No significant performance differences between
high-performing more or less diversified firms.
 Diversification and Performance: The
Score (cont.)
• Summary
– Though diversification has been disastrous for
many firms, diversified firms can also be
successful.
– Studies have found no obvious differences
between high- and low-performing diversified
firms along several important strategic
dimensions.
 Motives
Motives for
for
Diversification
Diversification
GROWTH --The desire to escape stagnant or declining industries
has been one of the most powerful motives for
diversification (tobacco, oil, defense).
--But, growth satisfies management not shareholder
goals.
--Growth strategies (esp. by acquisition), tend to
destroy shareholder value
RISK --Diversification reduces variance of profit flows
SPREADING --But, does not normally create value for
shareholders, since shareholders can hold diversified
portfolios.
--Capital Asset Pricing Model shows that
diversification lowers unsystematic risk not
systematic risk.

PROFIT --For diversification to create shareholder value, the act

of bringing different businesses under common owner-
ship must somehow increase their profitability.
Diversification
Diversification and
and Shareholder
Shareholder Value:
Value:
Porter’s
Porter’s Three
Three Essential
Essential Tests
Tests

If diversification is to create shareholder value, it must meet

three tests:

1. The Attractiveness Test: diversification must be directed

towards actual or potentially-attractive industries.

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 corporation, or
vice-versa. (i.e. synergy must be present)
 Introduction:
Introduction: The
The Tasks
Tasks of
of Corporate
Corporate
Strategy
Strategy In
In the
the Multibusiness
Multibusiness Corporation
Corporation

• Determining the company’s business portfolio--

diversification, acquisition, divestment

• Allocating resources between the different businesses

• Formulating strategy for the different businesses

• Controlling business performance

• Coordinating the businesses and creating overall

cohesiveness and direction for the company
 The
The Divisionalized
Divisionalized Firm
Firm in
in Practice
Practice

• Constraints upon decentralization. Few diversified companies

achieve clear division of decision making between corporate
and divisional levels. On-going dialogue and conflict exists
between corporate and divisional managers over both strategic
and operational issues.
• Standardization of divisional management. Despite potential
for divisions to differentiate strategies, structures and styles---
corporate systems may impose uniformity.
• Managing divisional inter-relationships. Managing
relationships between divisions requires more complex
structures e.g.. matrix structures where functional and/or
geographical structure is imposed on top of a product/market
structure.
 Crucial Role of Managers

• Successful diversification strategies result from

the ability of managers to develop skill and
competency at MANAGING diversification.
• Managers must develop two important types of
mental models:
– Must have well-developed understandings of their
firm’s diversity and relatedness that define their
companies.
Crucial Role of Managers (cont.)
• Understandings of how their firm’s businesses are
related are important for 2 reasons:
– They will influence how managers describe their organizations
to important stakeholders.
– Managers’ understandings also describe or suggest how their
businesses are related to each other.
– Must also have well-developed beliefs about how
diversification should be managed in order to
achieve synergies.
• How to coordinate the activities of businesses in order to
achieve synergies.
Crucial Role of Managers (cont.)
• How to allocate resources to the various businesses in a
diversified firm.
• Whether various functional activities such as
engineering, finance and accounting, marketing and
sales, production, and research and development should
be centralized at the corporate HQ or be decentralized
and operated by SBU managers.
• How to compensate and reward business unit managers
so that their goals and objectives are best aligned with
those of the organization.
 Crucial Role of Managers (cont.)
• The “Learning Hypothesis”
– Managers learn from trial and error.
• They evaluate success of past strategic decisions.
• These acquired beliefs become embedded in an
organization’s routine operating procedures.
– Usually difficult for rivals to imitate.
– By engaging in a number of acquisitions over time,
managers can come to develop an expertise about
how the acquisition process should be managed.
Crucial Role of Managers (cont.)
• Those firms with management teams that have more
experience at managing diversification will enjoy
higher performance than those firms that do not
have that experience.
– Evidence suggests that firm’s stock market performance is
directly related to diversification experience (see exhibit
on following slide).
 Exhibit: Five-Year Stock Market
Performance of Four Bank Holding
Companies that Are Active Acquirers
Banc One 44%

NationsBank 118%

Norwest 142%

First Bank 195%

Wells Fargo 234%

0% 50% 100% 150% 200% 250%

 Conclusions
• Size alone does not guarantee firms an advantage.
– Coordination required to exploit economies of scale and
scope is not without cost.
– Size creates additional challenges and difficulties,
including problems of communication and coordination.
• Higher levels of diversification are not
incompatible with high performance -- nor do they
necessarily imply that firms will suffer lower
performance levels.
 Conclusions (cont.)
• Critical factor in determining success is the
level of management expertise in formulating
and implementing corporate strategy.
– More difficult for diversified firms.
– Managers of large diversified firms possess a
variety of well-developed mental models that
provide them with powerful understandings of how
to manage their firms.