Diversification Strategy

Introduction: The Basic Issues

The Trend over Time
Motives for Diversification
- Growth and risk spreading
- Diversification and Shareholder Value: Porters
Three Essential Tests.
Competitive Advantage from Diversification
Diversification and Performance: Empirical Evidence
Relatedness in Diversification
OUTLINE
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: The Basic
Issues
Diversification decisions involve two basic issues:

Is the industry to be entered more attractive than
the firms 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 in
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
companys 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









Percentage of Specialized Companies (single-business,
vertically-integrated and dominant-business)
Percentage of Diversified Companies (related-business
and unrelated business)
BUT Since late 1970s, diversification has declined.

1949 1954 1959 1964 1969 1974
70.2 63.5 53.7 53.9 39.9 37.0
29.8 36.5 46.3 46.1 60.1 63.0
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 and Performance:
Empirical 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
Diversifying acquisitions,
on average, destroy share-
holder value for acquirers
Refocusing generates
positive shareholder returns
1 2 3 4 5 6
index of product diversity
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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:
46
47
47
46
Low-
Pe rformi ng
Fi rms
Le ss
Di ve rsi fi e d
Hi gh-
Pe rformi ng
Fi rms
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 for
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 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 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: The Tasks of Corporate
Strategy In the Multibusiness Corporation
Determining the companys 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 Divisionalized Firm in 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 firms diversity and relatedness that define
their companies.
Crucial Role of Managers (cont.)
Understandings of how their firms 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
organizations 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 firms 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
234%
195%
142%
118%
44%
0% 50% 100% 150% 200% 250%
Wells Fargo
First Bank
Norwest
NationsBank
Banc One
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.