Diversification 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 27

The Basic Issues in Diversification 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 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 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 among Large UK Corporations, 1950-93

Related diversification Development of corporate planning systems Diversification: The Evolution of Management Thinking and Management Practice MANAGEMENT GOALS Quest for Growth Financial problems of conglomerates Refocusing on shareholder value Competitive advantage through Speed, flexibility, and capability Rise of conglomerates Related diversification by industrial firms Emphasis on“related’ & “concentric” diversification Refocusing on core businesses Divestment Joint ventures, Alliance, corporate venturing COMPANY DEVELOPMENTS Value based management Transaction cost analysis Portfolio planning models Analysis of economies of scope & “synergy” Financial Analysis STRATEGY TOOLS & CONCEPTS Diffusion of M form structures Core competences Dynamic capability Capital asset pricing model Development of corporate planning systems Dominant logic 1950 1960 1970 1980 1990

Motives 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 flows SPREADING --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. 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 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 32

Competitive Advantage from Diversification Predatory pricing/tie-in sales Evidence Reciprocal buying of these Mutual forbearance is sparse MARKET POWER 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 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 FROM INTERNALIZING TRANSACTIONS

Competitive Advantage from Diversification Predatory pricing Evidence Reciprocal buying of these Mutual forbearance is sparse MARKET POWER 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 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 FROM INTERNALIZING TRANSACTIONS 34

Relatedness 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. 35

Branson & the Virgin Companies: Making strategic sense of apparent entrepreneurial 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 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 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?