Diversification Diversification Strategy Strategy OUTLINE • Introduction: The Basic Issues • The Trend over Time • Motives for Diversification - Growth and Risk Reduction - Shareholder Value: Porter’s Essential Tests • Competitive Advantage from Diversification • Diversification and Performance: Empirical Evidence • Relatedness in Diversification The The Basic Basic Issues Issues in in Diversification Diversification Decisions Decisions Superior profit derives from two sources: INDUSTRY ATTRACTIVENESS RATE OF PROFIT > 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? Diversification Diversificationamong among the the US US Fortune Fortune 500, 500,1949-74 1949-74 70.2 29.8 63.5 53.7 1949 1954 36.5 53.9 46.3 1959 39.9 46.1 1964 Percentage of Specialized Companies (single-business, vertically-integrated and dominant-business) Percentage of Diversified Companies (related-business and unrelated business) Note: 37.0 60.1 1969 63.0 1974 During the 1980s and 1990s the trend reversed as large companies refocused upon their core businesses Diversification Diversificationamong amongLarge Large UK UK Corporations, Corporations,1950-93 1950-93 70 60 Single business 50 Dominant business Related business 40 30 20 Unrelated business 10 1950 1960 1970 1983 1993 Diversification: Diversification: The TheEvolution Evolutionof of Management Management Thinking Thinking and and Management ManagementPractice Practice MANAGEMENT GOALS COMPANY DEVELOPMENTS Quest for Growth Refocusing on shareholder value Rise of conglomerates Refocusing on Emphasis on“related’ Related diversification core businesses & “concentric” by industrial firms Divestment diversification Financial Analysis STRATEGY TOOLS & CONCEPTS Financial problems of conglomerates Diffusion of M form structures Analysis of economies of scope & “synergy” Portfolio planning models Capital asset Development of corporate planning systems pricing model 1950 1990 1960 1970 Competitive advantage through Speed, flexibility, and capability Joint ventures, Alliance, corporate venturing Value based Transaction management cost analysis Core competences Dominant logic 1980 Dynamic capability Motives Motives for for Diversification 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 SPREADING Diversification reduces variance of profit flows But, doesn’t create value for shareholders—they 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 Diversification Diversification and and Shareholder Shareholder Value: Value: Porter’s Porter’s Three Three Essential Essential Tests Tests If diversification is to create shareholder value, it must meet three tests: The Attractiveness Test: diversification must be directed towards attractive industries (or have the potential to become attractive) The Cost of Entry Test : the cost of entry must not capitalize all future profits 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 Competitive CompetitiveAdvantage Advantage from from Diversification Diversification MARKET POWER ECONOMIES OF SCOPE • Predatory pricing/tie-in sales • Reciprocal buying • Mutual forbearance Evidence of these is sparse • 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 not a sufficient basis for ECONOMIES diversification must be supported by transaction costs FROM • Diversification firm can avoid transaction costs by INTERNALIZING operating internal capital and labor markets TRANSACTIONS • Key advantage of diversified firm over external markets superior access to information Competitive CompetitiveAdvantage Advantage from from Diversification Diversification MARKET POWER ECONOMIES OF SCOPE • Predatory pricing • Reciprocal buying • Mutual forbearance Evidence of these is sparse • 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 not a sufficient basis for ECONOMIES diversification—must be supported by transaction costs FROM • Diversification firm can avoid transaction costs by INTERNALIZING operating internal capital and labor markets TRANSACTIONS • Key advantage of diversified firm over external markets superior access to information Relatedness Relatedness in in Diversification 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 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 Branson Branson&&the theVirgin VirginCompanies: Companies:Making Makingstrategic strategic sense senseof ofapparent apparententrepreneurial entrepreneurialchaos 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 DESIGNING A CORPORATE STRATEGY & STRUCTURE • What’s 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? CHARACTERISTICS OF MARKETSTHAT CONFORM TO THIS LOGIC •consumer •dominant incumbent •scope for new approaches to customer service •high entry barriers to other start-ups •Branson/Virgin image appeals to customers ... industrial firms Divestment diversification Financial Analysis STRATEGY TOOLS & CONCEPTS Financial problems of conglomerates Diffusion of M form structures Analysis of economies of scope & “synergy” Portfolio... •consumer •dominant incumbent •scope for new approaches to customer service •high entry barriers to other start-ups •Branson/Virgin image appeals to customers ... diversification is to create shareholder value, it must meet three tests: The Attractiveness Test: diversification must be directed towards attractive industries (or have the potential to become attractive)