EVALUATING THE STRATEGIES OF DIVERSIFIED COMPANIES CHAPTER 10 EVALUATING THE STRATEGIES OF DIVERSIFIED COMPANIES Screen graphics created by: Jana F. Kuzmicki, PhD, Mississippi University for Women

“The corporate strategies of most companies have dissipated instead of created shareholder value.” Michael Porter “Achieving superior performance through diversification is largely based on relatedness. Philippe Very “Quote” McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 2

Chapter Outline Identify Present Corporate Strategy Evaluate Industry Attractiveness Evaluate Competitive Strength of Business Units Strategic Fit Analysis Resource Fit Analysis Rank Business Units Based on Performance Decide on Resource Allocation Priorities and General Strategic Direction Crafting a Corporate Strategy Guidelines for Managing the Corporate Strategy Process

Building Shareholder Value: Questions to Ask About a Diversified Company 1. How attractive is the group of businesses the company has diversified into? 2. How good is the firm’s overall performance outlook in the years ahead with these businesses? 3. If previous two answers aren’t satisfactory, what should the firm do to realign its business lineup? Divest unattractive businesses? Strengthen positions of remaining ones? Acquire new businesses?

How to Evaluate a Diversified Company’s Strategy Step 1: Identify present corporate strategy Step 2: Evaluate long-term attractiveness of each industry firm is in Step 3: Evaluate competitive strength of firm’s business units Step 4: Apply strategic fit test Step 5: Apply resource fit test

How to Evaluate a Diversified Company’s Strategy Step 6: Rank business units based on historical performance and future prospects Step 7: Rank business units in terms of priority for resource allocation and decide on general strategic posture Step 8: Craft new strategic moves to improve overall company performance

Figure 10.1: Identifying a Diversified Company’s Strategy Narrow or broad-based diversification Approach to allocating investment capital and resources Is diversification related, unrelated or a mix? Corporate Strategy Scope of geographic operations Efforts to capture cross-business strategic fits Moves to divest weak business units Moves to add new businesses Moves to build positions in new industries

Step 1: Identify Present Corporate Strategy Extent to which firm is diversified (broad versus narrow, % of sales contributed by each business) Is portfolio keyed to related or unrelated diversification or both? Is scope of operations mostly domestic, increasingly multinational, or global? Recent moves to add new businesses

Step 1: Identify Present Corporate Strategy (continued) Recent moves to divest weak businesses Actions to boost performance of key business units Efforts to capture cross-business strategic fit benefits and exploit value chain relationships to create competitive advantage Percentage of capital expenditures allocated to each business unit

Step 2: Evaluate Industry Attractiveness Attractiveness of each industry in portfolio Each industry’s attractiveness relative to the others Attractiveness of all industries as a group

Industry Attractiveness Factors Market size and projected growth Intensity of competition Emerging opportunities and threats Seasonal and cyclical factors Resource requirements Cross-industry strategic fits and resource fits with present businesses Industry profitability Social, political, regulatory, and environmental factors Degree of risk and uncertainty

Procedure: Rating the Relative Attractiveness of Each Industry Step 1: Select industry attractiveness factors Step 2: Assign weights to each factor (sum of weights = 1.0) Step 3: Rate each industry on each factor (use scale of 1 to 10) Step 4: Calculate weighted ratings; sum to get an overall industry attractiveness rating for each industry

Example: Rating Industry Attractiveness 4 2 5 0.20 0.50 5.80 0.05 0.10 1.00 7 6 0.75 1.05 0.60 0.15 Attractiveness Rating 8 Weighted Industry Rating 2.00 Weight 0.25 Industry Attractiveness Factor Market size and projected growth Intensity of competition Strategic fits and resource fits with other industries in portfolio Resource requirements Emerging industry opportunities and threats Seasonal and cyclical influences Social, political, regulatory, and environmental factors Industry uncertainty and business risk Sum of weights Industry attractiveness rating Rating Scale: 1 = Very unattractive; 5 = Average; 10 = Very attractive

Attractiveness of Mix of Industries as a Whole How appealing is the whole group of industries in which the company is invested? Is the company in too many relatively unattractive industries? Does the portfolio of industries hold promise for attractive growth and profitability? Should some form of portfolio restructuring be considered?

Step 3: Evaluate Each Business Unit’s Competitive Strength # 1 ! Objectives Determine how well each business is positioned in its industry relative to rivals Evaluate whether it is or can be competitively strong enough to contend for market leadership

Factors to Use in Evaluating Competitive Strength Relative market share Costs relative to competitors Ability to match/beat rivals on key product attributes Ability to exercise bargaining leverage with key suppliers or customers Caliber of alliances and collaborative partnerships Ability to benefit from strategic fits with sister businesses Technology and innovation capabilities How well business’s competencies match industry KSFs Brand name recognition and reputation Profitability relative to competitors

Procedure: Rating the Competitive Strength of Each Business Step 1: Select competitive strength factors Step 2: Assign weights to each factor (sum of weights = 1.0) Step 3: Rate each business on each factor (use scale of 1 to 10) Step 4: Calculate weighted ratings; sum to get an overall strength rating for each business

Example: Rating a Business Unit’s Competitive Strength Competitive Strength Measure Weight Strength Rating Weighted Strength Rating Relative market share 0.15 5 0.75 Costs relative to competitors 0.20 8 1.60 Ability to match rivals on key product attributes 0.10 7 0.70 Bargaining leverage 0.10 6 0.60 Strategic fit relationships 0.15 7 1.05 Technology and innovation capabilities 0.10 4 0.40 How well resources match KSFs 0.10 7 0.70 Degree of profit relative to rivals 0.10 5 0.50 Sum of weights 1.00 Competitive strength rating 6.30 Rating Scale: 1 = Very weak ; 5 = Average; 10 = Very strong

Using a Matrix to Display Industry Attractiveness and Competitive Strength Use quantitative measures of industry attractiveness and business strength to plot location of each business in matrix Each business unit appears as a circle Area of circle is proportional to size of business as a percent of company revenues Or area of circle can represent relative size of industry with pie slice showing the company’s market share

Figure 10.2: Industry Attractiveness-Competitive Strength Matrix Low High Medium Average Strong Weak 6.7 3.3 10.0 1.0 High priority for investment Medium priority for investment Low priority for investment Business Unit Competitive Strength Industry Attractiveness

Strategy Implications of Attractiveness/Strength Matrix Businesses in upper left corner Accorded top investment priority Strategic prescription - grow and build Businesses in three diagonal cells Given medium investment priority Invest to maintain position Businesses in lower right corner Candidates for harvesting or divestiture May, on occasion, be candidates for an overhaul and reposition strategy

Appeal of the Attractiveness/Strength Matrix Incorporates a wide variety of strategically relevant variables Stresses concentrating corporate resources in businesses that enjoy High degree of industry attractiveness and High degree of competitive strength The lesson here is emphasize businesses that are market leaders or that can contend for market leadership

Step 4: Strategic Fit Analysis Objective Determine competitive advantage potential of value chain relationships and strategic fits among sister businesses Examine strategic fit from two angles Whether one or more businesses have valuable strategic fits with other businesses in portfolio Whether each business meshes well with firm’s long-term strategic direction

Evaluate Portfolio for Competitively Valuable Cross-Business Strategic Fits Identify businesses which have value chain matchups offering opportunities to Reduce costs Purchasing E-commerce systems Manufacturing Distribution Transfer skills / technology / intellectual capital Leverage use of a well-known and competitively powerful brand name Create valuable new competitive capabilities or to leverage existing resources

Figure 10.3: Identify Cross-Business Strategic Fits Value Chain Activities Inbound Logistics Technology Operations Sales and Marketing Distribution Service Business A Business B Business C Business D Business E Opportunity to combine purchasing activities to gain more leverage with suppliers Opportunity to share technology, transfer technical skills, combine R&D Opportunity to combine sales & marketing activities, use common distribution channels, leverage use of a common brand name, and/or combine after-sale service No strategic fit opportunities

Step 5: Assess Resource Fit Objective Determine how well firm’s resources match business unit requirements Good resource fit exists when A business adds to a firm’s resource strengths, either financially or strategically Firm has resources to adequately support requirements of its businesses as a group

Checking for Financial Resource Fit Determine cash flow and investment requirements of the business units Which are cash hogs and which are cash cows? Assessing cash flow of each business Highlights opportunities to shift financial resources between businesses Explains why priorities for resource allocation can differ from business to business Provides rationalization for both invest-and-expand strategies and divestiture

Characteristics of Cash Hogs Internal cash flows are inadequate to fully fund needs for working capital and new capital investment Parent company has to continually pump in capital to “feed the hog” Strategic options Aggressively invest in attractive cash hogs Divest cash hogs lacking long-term potential

Characteristics of Cash Cows Generate cash surpluses over and above what is needed to sustain present market position Such businesses are valuable because surplus cash can be used to Pay corporate dividends Finance new acquisitions Invest in promising cash hogs Strategic objectives Fortify and defend present market position Keep the business healthy

Good vs. Poor Financial Fit Good financial fit exists when a business Contributes to achievement of corporate objectives Enhances shareholder value Poor financial fit exists when a business Soaks up disproportionate share of financial resources Is an inconsistent bottom-line contributor Is too small to make a sizable contribution to total corporate earnings Experiences a profit downturn that could jeopardize entire company

Checking for Competitive and Managerial Resource Fits Involves determining whether Resource strengths are well matched to KSFs of industries firm is in Ample resource depth exists to support resource requirements of all the businesses Ability exists to transfer competitive capabilities from one business to another Company must invest in upgrading its resources/capabilities to stay ahead of efforts of rivals

Notes of Caution: Why Diversification Efforts Can Fail Transferring resource capabilities to new businesses can be far more arduous and expensive than expected Trying to replicate a firm’s success in one business and hitting a second home run in a new business is easier said than done Management can misjudge difficulty of overcoming resource strengths of rivals it will face in a new business

Step 6: Rank Business Units Based on Financial Performance Yardsticks for comparing performance of different businesses Sales growth Profit growth Contribution to company earnings Return on capital employed in business Cash flow generation

Step 7: Decide Resource Allocation Priorities and Strategic Direction Objective “Get the biggest bang for the buck” in allocating corporate resources Procedure Rank each business from highest to lowest priority for corporate resource support and new investment Decide on general strategic direction for each business 2 3 5 6 4

Options: General Strategic Direction Invest and grow Aggressive expansion Fortify and defend Protect current position Overhaul and reposition Make major strategy changes Harvest or divest Gradual market retreat Spin off business as independent company Sell business Our direction will be. .

Options for Allocating Financial Resources Strategic purposes Invest in ways to strengthen or expand existing businesses Make acquisitions to establish positions in new industries Fund long-range R&D ventures Financial purposes Pay off existing long-term debt Increase dividends Repurchase company’s stock Stock certificate

Step 8: Crafting a Corporate Strategy -Key Issues Are enough businesses in attractive industries? Is the number of mature or declining businesses so great corporate growth will be sluggish? Are businesses overly vulnerable to seasonal influences or recession? Are there too many average-to-weak businesses in the company’s business make-up? Is there ample strategic fit among the businesses?

Step 8: Crafting a Corporate Strategy -Key Issues (continued) Is there ample resource fit among the businesses? Are there enough cash cows to finance those cash hogs with potential to be star performers? Do core businesses generate dependable profits and/or cash flow? Does makeup of business portfolio put firm in good future position?

The Performance Test Can the company’s performance targets be reached with the current businesses? If yes, no major corporate strategy changes are indicated If a performance gap is likely, actions can be taken to close the gap

Options for Addressing a Performance Shortfall Alter strategic plans for some, or all, of businesses Add new businesses Divest weak-performing businesses Form cooperative alliances Upgrade firm’s resource base Lower corporate performance objectives

Identifying Additional Diversification Opportunities Related Diversification Identify businesses whose value chains have fits with value chains of present businesses Identify businesses whose resource requirements are well-matched to firm’s corporate resource capabilities Unrelated Diversification Find firms offering attractive financial returns regardless of industry

How Do Corporate Strategies Form? In diversified companies corporate strategy tends to emerge incrementally As internal and external events unfold As managers Probe the future Experiment Gather more information Sense problems Build awareness of options Spot new opportunities Develop ad hoc responses to unexpected crises Acquire a feel for strategically relevant factors and their importance and interrelationships Develop consensus of how to proceed Our strategy will be . . .

Managing the Process of Crafting Corporate Strategy Not done all at once in comprehensive fashion Approached a step at a time, emerging gradually Begin with broad, intuitive concepts and then fine-tune and embellish them as More information is gathered Formal analysis confirms or modifies emerging judgments about situation Confidence and consensus build for the proposed strategic moves