Diversification Strategy

1
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

2
The Basic Issues in Diversification Decisions
Superior profit derives from two sources
INDUSTRY ATTRACTIVENESS
RATE OF PROFIT gt 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?

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Diversification among the US Fortune 500, 1949-74
70.2 63.5 53.7
53.9 39.9 37.0

• Percentage of Specialized Companies
  (single-business,
• vertically-integrated and dominant-business)
• Percentage of Diversified Companies
  (related-business
• and unrelated business)
• Note During the 1980s and 1990s the trend
  reversed as large
• companies refocused upon their core businesses

29.8 36.5 46.3
46.1 60.1 63.0
1949 1954 1959 1964
1969 1974
4
Diversification among Large UK Corporations,
1950-93
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Diversification The Evolution of Strategy and
Management Thinking
MANAGEMENT PRIORITIES
Quest for Growth
Addressing under-performance of
widely-diversified firms
Creating shareholder value

• Competitive advantage through speed flexibility
• Creating opportunities for future growth

• Emergence of conglomerates
• Diversification by established companies into
  related sectors

Emphasis on related concentric
diversification

• Refocusing on core businesses
• Divesting diversified businesses

• Joint ventures and alliances
• Creating growth options
• through focused
• diversification

DEVELOPMENTS IN CORPORATE STRATEGY
STRATEGY TOOLS CONCEPTS

• Financial analysis
• Diffusion of M form structures
• Creation of corporate planning depts.

• Economies of scope synergy
• Portfolio planning models
• Capital asset pricing model

• Maximization of shareholder wealth
• Core competences
• Dominant logic

• Dynamic capabilities
• Transaction cost analysis
• Real options

1960 1970 1980 1990 2000
2006
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Motives for Diversification

• GROWTH --The desire to escape stagnant or
  declining industries a powerful motives for
  diversification (e.g. tobacco,
• oil, newspapers).
• --But, growth satisfies managers not
  shareholders.
• --Growth strategies (esp. by acquisition),
  tend to
• destroy shareholder value

RISK --Diversification reduces variance
of profit flows SPREADING --But, doesnt
create value for shareholdersthey can hold
diversified portfolios of securities. --Capital
Asset Pricing Model shows that
diversification lowers unsystematic risk not
systematic risk.
PROFIT --For diversification to create
shareholder value, then bringing together of
different businesses under common ownership
must somehow increase their profitability.
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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)

Additional source of value from diversification
Option value
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Competitive Advantage from Diversification

• Predatory pricing/tie-in sales Evidence
• Reciprocal buying of these
• Mutual forbearance is sparse

MARKET POWER

• Sharing tangible resources (research labs,
  distribution systems) across multiple businesses
• Sharing intangible resources (brands,
  technology) across multiple businesses
• Transferring functional capabilities (marketing,
  product development) across businesses
• Applying general management capabilities to
  multiple businesses

ECONOMIES OF SCOPE

• Economies of scope not a sufficient basis for
  diversification ----must 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

ECONOMIES FROM INTERNALIZING TRANSACTIONS
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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 RD)
• 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.

10
Diversification Performance

• No consistent systematic relationships between
  performance and degree of diversification
• Perhaps an Inverse U shape why?
• Stock market returns to acquiring firms negative
  on average
• Related vs. unrelated diversification
• Conglomerate discount stick to the knitting
• But GE, LVMH, Virgin Group are anomalies

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Managing the Multibusiness Corporation
OUTLINE

• Structure of the Multidivisional Company
• Theory of the M-form
• The divisionalized firm in practice
• The Role of Corporate Management
• Managing the Corporate Portfolio
• Portfolio planning techniques
• Value-creation through corporate restructuring
• Managing Individual Businesses
• Managing Internal Linkages
• Recent Trends

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The Multidivisional Structure Theory of the
M-Form

• Efficiency advantages of the multidivisional
  firm
• Recognizes bounded rationalitytop management has
  limited decision-making capacity
• Divides decision-making according to frequency
• high-frequency operating decisions at
  divisional level
• low-frequency strategic decisions at corporate
  level
• Reduces costs of communication and coordination
  business level decisions confined to divisional
  level (reduces decision making at the top)
• Global, rather than local optimization-
  functional organizations encourage functional
  goals. M-form structure encourages focus on
  profitability.
• Efficient allocation of resources through
  internal capital and labor markets
• Resolves agency problem-- corporate management an
  interface between shareholders and business-level
  managers.

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The Divisionalized Firm in Practice

• Constraints upon decentralization.
• Difficult to achieve clear division of decision
  making between corporate and divisional levels.
• On-going dialogue and conflict between corporate
  and divisional managers over both strategic and
  operational issues.
• Standardization of divisional management
• Despite potential for divisions to develop
  distinctive strategies and structurescorporate
  systems may impose uniformity.
• Managing divisional inter-relationships
• Requires more complex structures, e.g. matrix
  structures where functional and/or geographical
  structure is imposed on top of a product/market
  structure.
• Added complexity undermines the efficiency
  advantages of the M-form

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The Functions of Corporate Management
Decisions over diversification,
acquisition, divestment Resource
allocation between businesses.
Managing the Corporate Portfolio
Business strategy formulation Monitoring
and controlling business performance
Managing the individual businesses
Sharing and transferring resources
and capabilities
Managing linkages between businesses
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The Development of Strategic Planning Techniques
General Electric in the 1970s

• Late 1960s GE encounters problems of
  direction, coordination, control, and
  profitability
• Corporate planning responses
• Portfolio Planning Models matrix-based
  frameworks for evaluating business unit
  performance, formulating business strategies, and
  allocating resources
• Strategic Business Units GE reorganized around
  SBUs (business comprising a strategically-distinct
  group of closely-related products
• PIMS a database which quantifies the impact of
  strategy on performance. Used to appraise SBU
  performance and guide business strategy
  formulation

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Portfolio Planning Models Their Uses in
Strategy Formulation

• Allocating resources-- the analysis indicates
  both the investment requirements of different
  businesses and their likely returns
• Formulating business-unit strategy-- the analysis
  yields simple strategy recommendations (e.g..
  build, hold, or harvest)
• Setting performance targets-- the analysis
  indicates likely performance outcomes in terms of
  cash flow and ROI
• Portfolios balance-- the analysis can assist in
  corporate goals such as a balanced cash flow and
  balance of growing and declining businesses.

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Portfolio Planning Models The BCG Growth-Share
Matrix
Earnings low, unstable, growing Cash flow
negative Strategy analyze to determine
whether business can be grown into a
star, or will
degenerate into a dog
Earnings high stable, growing Cash flow
neutral Strategy invest for growth
?
HIGH
Annual real rate of market growth ()
Earnings high stable Cash flow high
stable Strategy milk
Earnings low, unstable Cash flow
neutral or negative Strategy divest
LOW
HIGH
LOW
Relative market share
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Applying the BCG Matrix to Time Warner Inc.
Cable TV Networks
Film production
-8 -4 0 4 8 12
Cable
Magazine Publishing
Annual real rate of market growth ()
Bakery division
Music
AOL
Relative market share
Position in 2003 Position in 2000. (Area of
circle proportional to sales)
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Portfolio Planning Models The GE/ McKinsey
Matrix

High
B U I L D
Industry Attractiveness
H O L D
Medium
H A R V E S T
Low
Low
Medium
High
Business Unit Position
Industry Attractiveness Criteria Business
Unit Position - Market size - Market
share (domestic, - Market growth global,
and relative) - Industry profitability -
Competitive position - Inflation recovery -
Relative profitability - Overseas sales ratio
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Do Portfolio Planning Models Help or Hinder
Corporate Strategy Formulation?

• ADVANTAGES
• Simplicity Can be quickly
• prepaired
• Big picture Permits one page
• representation of the corporate
• portfolio the strategic
• positioning of each business
• Analytically versatile
• Applicable to businesses,
• products, countries,
• distribution channels.
• Can be augmented A useful
• point of departure for more
• sophisticated analysis

• DISADVANTAGES
• Simplicity Oversimplifies the
• factors determining industry
• attractiveness and competitive
• advantage
• AmbiguousThe positioning
• of a business depends
• critically upon how a market is
• defined
• Ignores synergy the analysis
• takes no account of any
• interdependencies between
• businesses

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Corporate Restructuring to Create Value The
McKinsey Pentagon
Current market value
1
Maximum raider opportunity
Current perceptions gap
Optimal restructured value
Company value as is
2
5
RESTRUCTURING FRAMEWORK
Strategic and operating opportunities
Total company opportunities
3
4
Potential value with internal improvements
Potential value with external improvements
Disposal/acquisition opportunities
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Exxons Strategic Planning Process
Economic Review Energy Review
Discuss- -ion with contact director
Approval by Mgmt. Committee
Business Plans
Stewardship Review
Stewardship Basis
Financial Forecast
Corporate Plan
Investment Reappraisals
Annual Budget
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Corporate Control over the Businesses
2 basic approaches
Input control
Output (or performance) control
Monitoring approving business level decisions
Setting monitoring the achievement
of performance targets
Primarily through strategic planning system
capital expenditure approval system
Primarily through performance management
system, including operating budgets and HR
appraisals
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Goold Campbells Corporate Management Styles
Financial and Strategic Control
High
Centralized
Strategic planning
CORPORATE INFLUENCE
Strategic control
Financial control
Holding company
Low
Flexible strategic
Tight strategic
Tight financial
CONTROL INFLUENCE
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Corporate Management Applications of PIMS Analysis

• Setting performance targets
• feeding business unit strategic and industry
  data into the PIMS
• regression model gives performance norms for
  the business
• (PAR ROI).
• Formulating business unit strategy
• PIMS model can simulate the impact of changing
  strategic
• variables.
• Allocating investment funds between businesses
• PIMS Strategic Attractiveness Scan comparison
  different
• business units strategic attractiveness and
  their cash flow
• characteristics

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Managing Linkages between Businesses
KEY ISSUEHow does the corporate center add value
to the business?

• BASIS OF BUSINESS LINKAGESSharing of resources
  and capabilities.
• SHARING OCCURS AT TWO LEVELS
• Corporate levelcommon corporate services
• Business levelsharing resources, transferring
  capabilities

• PORTERS ANALYSIS OF BUSINESS LINKAGES AND
  CORPORATE
• STRATEGY TYPES
• Portfolio management Parent creates value by
  operating an internal
• capital market
• RestructuringParent create value by acquiring
  and restructuring
• Inefficiently-managed businesses
• Transferring skillsParent creates value by
  transferring capabilities
• between businesses
• Sharing activitiesParent creates value by
  sharing resources between
• businesses

ROLE OF DOMINANT LOGICimportance of corporate
managers perception of linkages
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What Corporate Management Activities are Implied
by Porters Concepts of Corporate Strategy

• (1) Portfolio Management
• Using superior information and analysis to
  acquire attractive companies at
• favorable prices (e.g. Berkshire Hathaway).
• Minimizing cost of capital (e.g. GE)
• Create efficientt internal system for capital
  allocation (e.g. Exxon-Mobil)
• Efficient monitoring of business unit
  performance (e.g BP-Amoco).

(2) Restructuring Intervening to cut costs and
divest under performing assets (e.g. Hanson
during 1980s early 1990s) (3) Transferring
skills Transferring best practices (e.g.
Hewlett-Packard) Transferring innovations (e.g.
Sharp) Transferring key personnel between
businesses (e.g. Sony) (4) Sharing
activities Common corporate services (e.g.
3M) Sharing operational resources and functions
(e.g. sales and distribution, manufacturing
facilities).
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Rethinking the Management of Multibusiness
Corporations Lessons from General Electric
Jack Welchs transformation of GEs structure and
management systems

• Delayering --- from 9 or 10 layers of hierarchy
  to 4 or 5
• Decentralizing decisions.
• Reformulating strategic planningfrom formal,
  document-intensive analysis to direct
  face-to-face discussion of key issues.
• Redefining the role of HQfrom checker,
  inquisitor, and authority to facilitator, helper,
  and supporter.
• Coordinating role of HQ corporate HQ to lead in
  creating the boundaryless corporation where
  innovations and ideas flow and where horizontal
  coordination occurs to respond to new
  opportunities.
• HQ as change agent corporate HQ driving force
  for continual organizational change (e.g.
  workout, six-sigma).

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Rethinking the Management of Multibusiness
Corporations Lessons from ABB
Key features of ABBs corporate management system

• Matrix organizationboth product and country /
  regional coordination flexible reporting
  requirements
• Radical decentralizationABBs corporate HQ was
  tiny (lt100 staff). Decision making authority lay
  with individual national subsidiaries (mostly
  small or medium-sized businesses).
• Bottom-up management. Each business had its own
  balance sheet and could retain 1/3 of net income.
• Informal collaboration and integration.

Yet, for all of ABBs apparent success at
reconciling coordination with decentralization,
by 2002-03, deteriorating profitability and
complexity of matrix structure caused ABB to
dismantle its matrix and adopt simpler line of
business structure
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Rethinking the Management of Multibusiness
Corporations Bartlett Ghoshals Analysis of
Key Management Processes
Managing the tension between short-term
ambition Managing operational interdependencies
and personal networks Creating and pursuing
opportunities
RENEWAL PROCESS
Shaping and embedding corporate
purpose Developing and nurturing organizational
values Establishing strategic mission
performance standards
Creating and maintaining organizational
trust Linking skills, knowledge, and
resources Reviewing, developing, and supporting
initiatives
INTEGRATION PROCESS
ENTREPRENEURIAL PROCESS
Front-line Management Middle Management
Top Management
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Case Virgin

• What common resources and capabilities link the
  separate Virgin companies?
• Which businesses, if any, should Branson consider
  divesting?
• What criteria should Branson apply in deciding
  what new diversification to pursue?
• What is the Virgin business model?
• What changes in the financial structure,
  organizational structure, and management systems
  of the Virgin groupwould you recommend?