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Diversification Strategy - PowerPoint

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									       Diversification Strategy


• 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
• 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

• 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
  – 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
     • 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
   • Managers often lack expertise or knowledge about
     their firms’ businesses.
         Introduction: The Basic

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?)
   Aim of Corporate Strategy:
• 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

  Synergy in diversification derives from two main types of
• 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
• 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
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
   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
  – Difficult to assess the risks associated with new
    investment opportunity.
     The Trend Over Time: Diversified
    Companies among the Fortune 500
       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
               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.
       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
     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
• 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
                                  return on net assets (%)
  detrimental to profitability
• Diversifying acquisitions,      3

  on average, destroy share-      2
  holder value for acquirers
• Refocusing generates                 1    2    3    4     5    6
                                         index of product diversity
  positive shareholder returns
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
   • 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:
                      Low-          High-
                     Performing   Performing
                       Firms        Firms
       Diversified      47          46

                        46          47
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
  – Studies have found no obvious differences
    between high- and low-performing diversified
    firms along several important strategic
                   Motives for
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
            --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
            --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:
    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)
   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
      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
• 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

  Banc One          44%

NationsBank                     118%

    Norwest                        142%

  First Bank                              195%

Wells Fargo                                      234%

               0%         50%   100%   150%   200%      250%
• Size alone does not guarantee firms an
  – 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
  – 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.

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