Diversification 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 27

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 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?) 28

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. 35

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 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. 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 29

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 3 return on net assets (%) 2 1 1 2 3 4 5 6 index of product diversity 33

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:

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. 31

Diversification and Shareholder Value: Porter’s 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) 32

Introduction: The Tasks of Corporate Strategy In the Multibusiness 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 38

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. 41

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

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.