Diversification Strategy

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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

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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
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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.

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

• 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?