Diversification StrategyDiversification Strategy

• 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

OUTLINEOUTLINE

RATE OF PROFIT

> COST OF CAPITAL

INDUSTRY

ATTRACTIVENESS

COMPETITIVE

ADVANTAGE

The Basic Issues in Diversification DecisionsThe Basic Issues in Diversification Decisions

Superior profit derives from two sources:

Diversification decisions involve these same two issues:• How attractive is the sector to be entered?•Can the firm achieve a competitive advantage?

Diversification among the US Fortune 500, 1949-74Diversification among the US Fortune 500, 1949-74

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

1949 1954 1959 1964 1969 1974

70.2 63.5 53.7 53.9 39.9 37.029.8 36.5 46.3 46.1 60.1 63.0

0

10

20

30

40

50

60

70

1950 1960 1970 1983 1993

Single business

DominantbusinessRelated business

Unrelatedbusiness

Diversification among Large UK Corporations, 1950-93

Diversification among Large UK Corporations, 1950-93

DEVELOPMENTSIN CORPORATE

STRATEGY

MANAGEMENT PRIORITIES

STRATEGY TOOLS & CONCEPTS

Quest for GrowthAddressing under-performance of widely-diversified firms

Creating shareholder value

1960 1970 1980 1990 2000 2006

•Emergence of conglomerates

•Diversification by established companies into related sectors

Emphasis on “related’ & “concentric” diversification

•Refocusing on core businesses •Divesting diversified businesses

•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

Diversification: The Evolution of Strategy and Management Thinking

•Competitive advantage through speed & flexibility•Creating opportunities for future growth

•Joint ventures and alliances•Creating growth options through focused diversification

•Dynamic capabilities•Transaction cost analysis•Real options

Motives for DiversificationMotives 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 flowsSPREADING --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 and Shareholder Value: Porter’s Three Essential Tests

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 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

Competitive Advantage from DiversificationCompetitive Advantage from Diversification

• Predatory pricing/tie-in sales Evidence• Reciprocal buying of these• Mutual forbearance is sparse

MARKETPOWER

• 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 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 OF

SCOPE

ECONOMIESFROM

INTERNALIZINGTRANSACTIONS

Relatedness in DiversificationRelatedness 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 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.

Diversification & Performance

• No consistent systematic relationships between performance and degree of diversification– Perhaps an Inverse U shape – why?

• Stock market returns to acquiring firms negative on average

• Related vs. unrelated diversification– Conglomerate discount & “ stick to the knitting”– But GE, LVMH, Virgin Group are anomalies

Managing the Multibusiness Corporation

Managing the Multibusiness Corporation

• Structure of the Multidivisional Companyo Theory of the M-formo The divisionalized firm in practice

• The Role of Corporate Management• Managing the Corporate Portfolio

o Portfolio planning techniqueso Value-creation through corporate

restructuring• Managing Individual Businesses• Managing Internal Linkages• Recent Trends

OUTLINE

The Multidivisional Structure: Theory of the M-FormThe Multidivisional Structure: Theory of the M-Form

Efficiency advantages of the multidivisional firm:

• Recognizes bounded rationality—top management has limited decision-making capacity

• Divides decision-making according to frequency:

—high-frequency operating decisions at divisional level

—low-frequency strategic decisions at corporate level

• Reduces costs of communication and coordination: business level decisions confined to divisional level (reduces decision making at the top)

• Global, rather than local optimization:- functional organizations encourage functional goals. M-form structure encourages focus on profitability.

• Efficient allocation of resources through internal capital and labor markets

• Resolves agency problem-- corporate management an interface between shareholders and business-level managers.

The Divisionalized Firm in PracticeThe Divisionalized Firm in Practice

• Constraints upon decentralization. – Difficult to achieve clear division of decision making between

corporate and divisional levels.

– On-going dialogue and conflict between corporate and divisional managers over both strategic and operational issues.

• Standardization of divisional management– Despite potential for divisions to develop distinctive strategies and

structures—corporate systems may impose uniformity.

• Managing divisional inter-relationships

– Requires more complex structures, e.g. matrix structures where functional and/or geographical structure is imposed on top of a product/market structure.

– Added complexity undermines the efficiency advantages of the M-form

The Functions of Corporate ManagementThe Functions of Corporate Management

—Decisions over diversification, acquisition, divestment

—Resource allocation between businesses.

— Business strategy formulation

—Monitoring and controlling business

performance

—Sharing and transferring resources and capabilities

Managing linkagesbetween

businesses

Managing theindividual businesses

Managing the Corporate Portfolio

The Development of Strategic Planning Techniques: General Electric in the 1970’s

The Development of Strategic Planning Techniques: General Electric in the 1970’s

Late 1960’s: GE encounters problems of direction, coordination, control, and profitability

Corporate planning responses:

Portfolio Planning Models —matrix-based frameworks for evaluating business unit performance, formulating business strategies, and allocating resources

Strategic Business Units —GE reorganized around SBUs (business comprising a strategically-distinct group of closely-related products

PIMS —a database which quantifies the impact of strategy on performance. Used to appraise SBU performance and guide business strategy formulation

Portfolio Planning Models: Their Uses in Strategy Formulation

Portfolio Planning Models: Their Uses in Strategy Formulation

• Allocating resources-- the analysis indicates both the investment requirements of different businesses and their likely returns

• Formulating business-unit strategy-- the analysis yields simple strategy recommendations (e.g..: “build”, “hold”, or “harvest”)

• Setting performance targets-- the analysis indicates likely performance outcomes in terms of cash flow and ROI

• Portfolios balance-- the analysis can assist in corporate goals such as a balanced cash flow and balance of growing and declining businesses.

HIGH

LO

W

LOW

An

nu

al r

eal r

ate

of

mar

ket

gro

wth

(%

)

Relative market share

Earnings: high stable

Cash flow: high stable

Strategy: milk

Earnings: low, unstable

Cash flow: neutral or negative

Strategy: divest

Earnings: high stable, growing

Cash flow: neutral

Strategy: invest for growth

Earnings: low, unstable, growing

Cash flow: negative

Strategy: analyze to determine whether business can be grown into a

star, or will degenerate into a dog

HIG

H

?

Portfolio Planning Models: The BCG Growth-Share Matrix

Portfolio Planning Models: The BCG Growth-Share Matrix

Annual re

al ra

te o

f m

ark

et

gro

wth

(%

)

Relative market share

-8 -

4 0

4

8

1

2

Bakery division

Position in 2003 Position in 2000. (Area of circle proportional to $ sales)

Applying the BCG Matrix to Time Warner Inc.

AOL

Filmproduction

Cable

Cable TVNetworks

Music

MagazinePublishing

H A R V E S T

H O L D

B U I L D

Low

Medium

High

Low Medium High

Ind

ust

ry A

ttra

ctiv

enes

s

Portfolio Planning Models: The GE/ McKinsey Matrix

Portfolio Planning Models: The GE/ McKinsey Matrix

Industry Attractiveness Criteria Business Unit Position - Market size - Market share (domestic,- Market growth global, and relative)- Industry profitability - Competitive position- Inflation recovery - Relative profitability- Overseas sales ratio

Business Unit Position

Do Portfolio Planning Models Help or Hinder Corporate Strategy Formulation?

Do Portfolio Planning Models Help or Hinder Corporate Strategy Formulation?

ADVANTAGES• Simplicity: Can be quickly prepaired• Big picture: Permits one page representation of the corporate portfolio & the strategic positioning of each business• Analytically versatile: Applicable to businesses, products, countries, distribution channels.• Can be augmented: A useful point of departure for more sophisticated analysis

DISADVANTAGES• Simplicity: Oversimplifies the factors determining industry attractiveness and competitive advantage• Ambiguous:The positioning of a business depends critically upon how a market is defined• Ignores synergy: the analysis takes no account of any interdependencies between businesses

Corporate Restructuring to Create Value: The McKinsey Pentagon

Corporate Restructuring to Create Value: The McKinsey Pentagon

Currentmarketvalue

Maximum raideropportunity

Current perceptions gap

Companyvalue as is

Optimalrestructured

value

Strategic andoperating

opportunities

Potential valuewith internal

improvements

Disposal/acquisitionopportunities

Total companyopportunities

1

2 5RESTRUCTURING

FRAMEWORK

3 4 Potential valuewith externalimprovements

Exxon’s Strategic Planning ProcessExxon’s Strategic Planning Process

Economic Review

Energy Review

Business Plans

Discuss- -ion with contact director

Approval by

Mgmt. Committee

Stewardship Review

Stewardship Basis

Financial Forecast

Corporate Plan

Investment Reappraisals

Annual Budget

Corporate Control over the BusinessesCorporate Control over the Businesses

2 basic approaches

Inputcontrol

Monitoring & approving business level decisions

Output (or performance) control

Setting & monitoring the achievement of

performance targets

Primarily through strategic planning system & capital

expenditure approval system

Primarily through performance management system,

including operating budgets and HR appraisals

Goold & Campbell’s Corporate Management Styles: Financial and Strategic Control

Goold & Campbell’s Corporate Management Styles: Financial and Strategic Control

High

Low

CONTROL INFLUENCE

Strategicplanning

Centralized

Strategiccontrol

Holdingcompany

Financialcontrol

CO

RP

OR

AT

E IN

FL

UE

NC

E

Flexible strategic Tight strategic Tight financial

Corporate Management Applications of PIMS Analysis

Corporate Management Applications of PIMS Analysis

• Setting performance targets—feeding business unit strategic and industry data into the PIMS

regression model gives performance norms for the business (PAR ROI).

• Formulating business unit strategy— PIMS model can simulate the impact of changing strategic variables.

• Allocating investment funds between businesses— PIMS Strategic Attractiveness Scan comparison different business units’ strategic attractiveness and their cash flow characteristics

Managing Linkages between BusinessesManaging Linkages between Businesses

KEY ISSUE—How does the corporate center add value to the business?

BASIS OF BUSINESS LINKAGES—Sharing of resources and capabilities.

SHARING OCCURS AT TWO LEVELS:• Corporate level—common corporate services• Business level—sharing resources, transferring capabilities

PORTER’S ANALYSIS OF BUSINESS LINKAGES AND CORPORATE STRATEGY TYPES• Portfolio management— Parent creates value by operating an internal capital market• Restructuring—Parent create value by acquiring and restructuring Inefficiently-managed businesses• Transferring skills—Parent creates value by transferring capabilities between businesses• Sharing activities—Parent creates value by sharing resources between businesses

ROLE OF DOMINANT LOGIC—importance of corporate managers’ perception of linkages

What Corporate Management Activities are Implied by Porter’s “Concepts of Corporate Strategy”

What Corporate Management Activities are Implied by Porter’s “Concepts of Corporate Strategy”

(1) Portfolio Management• Using superior information and analysis to acquire attractive companies at

favorable prices (e.g. Berkshire Hathaway).• Minimizing cost of capital (e.g. GE)• Create efficientt internal system for capital allocation (e.g. Exxon-Mobil)• Efficient monitoring of business unit performance (e.g BP-Amoco).

(2) Restructuring: Intervening to cut costs and divest under performing assets (e.g. Hanson during 1980s & early 1990s)

(3) Transferring skills: —Transferring best practices (e.g. Hewlett-Packard)—Transferring innovations (e.g. Sharp)—Transferring key personnel between businesses (e.g. Sony)

(4) Sharing activities:——Common corporate services (e.g. 3M)Common corporate services (e.g. 3M)——Sharing Sharing operational resources and functions (e.g. sales and distribution, manufacturing facilities).

Rethinking the Management of Multibusiness

Corporations: Lessons from General Electric Rethinking the Management of Multibusiness

Corporations: Lessons from General Electric

•Delayering --- from 9 or 10 layers of hierarchy to 4 or 5

•Decentralizing decisions.

•Reformulating strategic planning—from formal, document-intensive analysis to direct face-to-face discussion of key issues.

•Redefining the role of HQ—from checker, inquisitor, and authority to facilitator, helper, and supporter.

•Coordinating role of HQ— corporate HQ to lead in creating the “boundaryless corporation” where innovations and ideas flow and where horizontal coordination occurs to respond to new opportunities.

•HQ as change agent— corporate HQ driving force for continual organizational change (e.g. “workout”, “six-sigma”).

Jack Welch’s transformation of GE’s structure and management systems:

Rethinking the Management of Multibusiness Corporations: Lessons from ABB

Rethinking the Management of Multibusiness Corporations: Lessons from ABB

Matrix organization—both product and country / regional coordination; flexible reporting requirements

•Radical decentralization—ABB’s corporate HQ was tiny (<100 staff). Decision making authority lay with individual national subsidiaries (mostly small or medium-sized businesses).

•Bottom-up management. Each business had its own balance sheet and could retain 1/3 of net income.

•Informal collaboration and integration.

Key features of ABB’s corporate management system:

Yet, for all of ABB’s apparent success at reconciling coordination with decentralization, by 2002-03, deteriorating profitability and complexity of matrix structure caused ABB to dismantle its matrix and adopt simpler line of business structure

Rethinking the Management of Multibusiness Corporations: Bartlett & Ghoshal’s Analysis

of Key Management Processes

Rethinking the Management of Multibusiness Corporations: Bartlett & Ghoshal’s Analysis

of Key Management Processes

Managing the tension between short-term

ambition

Managing operational interdependencies and

personal networks

Creating and pursuing opportunities

Creating and maintaining organizational trust

Linking skills, knowledge, and resources

Reviewing, developing, and supporting initiatives

Shaping and embedding corporate purpose

Developing and nurturing organizational

values

Establishing strategic mission & performance standards

Front-line Management Middle Management Top Management

RENEWAL PROCESS

INTEGRATION PROCESS

ENTREPRENEURIAL PROCESS

Case: Virgin

• What common resources and capabilities link the separate Virgin companies?

• Which businesses, if any, should Branson consider divesting?

• What criteria should Branson apply in deciding what new diversification to pursue?

• What is the Virgin business model?• What changes in the financial structure,

organizational structure, and management systems of the Virgin groupwould you recommend?