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

Diversification: The Evolution of Strategy and Management Thinking PRIORITIES Quest for Growth Addressing under-performance of widely-diversified firms Creating shareholder value Competitive advantage through speed & flexibility Creating opportunities for future growth Emergence of conglomerates Diversification by established companies into related sectors Emphasis on “related’ & “concentric” diversification Refocusing on core businesses Divesting diversified businesses Joint ventures and alliances Creating growth options through focused diversification DEVELOPMENTS IN CORPORATE STRATEGY STRATEGY TOOLS & CONCEPTS 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 Dynamic capabilities Transaction cost analysis Real options 1960 1970 1980 1990 2000 2006 1

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

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

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 OUTLINE Structure of the Multidivisional Company Theory of the M-form The divisionalized firm in practice The Role of Corporate Management Managing the Corporate Portfolio Portfolio planning techniques Value-creation through corporate restructuring Managing Individual Businesses Managing Internal Linkages Recent Trends 37

The 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. 40

The 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 41

The Functions of Corporate Management —Decisions over diversification, acquisition, divestment —Resource allocation between businesses. Managing the Corporate Portfolio — Business strategy formulation —Monitoring and controlling business performance Managing the individual businesses —Sharing and transferring resources and capabilities Managing linkages between businesses 42

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 43

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. 46

Portfolio Planning Models: The BCG Growth-Share Matrix 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 Earnings: high stable, growing Cash flow: neutral Strategy: invest for growth ? HIGH Annual real rate of market growth (%) Earnings: high stable Cash flow: high stable Strategy: milk Earnings: low, unstable Cash flow: neutral or negative Strategy: divest LOW LOW HIGH Relative market share 44

Annual real rate of market growth (%) Applying the BCG Matrix to Time Warner Inc. Cable TV Networks Film production -8 -4 0 4 8 12 Cable Magazine Publishing Annual real rate of market growth (%) Bakery division Music AOL Relative market share Position in 2003 Position in 2000. (Area of circle proportional to $ sales) 47

Portfolio Planning Models: The GE/ McKinsey Matrix High B U I L D Industry Attractiveness H O L D Medium H A R V E S T Low Low Medium High Business Unit Position 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 45

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 48

Corporate Restructuring to Create Value: The McKinsey Pentagon Current market value 1 Current perceptions gap Maximum raider opportunity Optimal restructured value Company value as is 2 5 RESTRUCTURING FRAMEWORK Strategic and operating opportunities Total company opportunities 3 4 Potential value with internal improvements Disposal/acquisition opportunities Potential value with external improvements 50

Exxon’s Strategic Planning Process Economic Review Energy Review Discuss- -ion with contact director Approval by Mgmt. Committee Business Plans Stewardship Review Stewardship Basis Financial Forecast Corporate Plan Investment Reappraisals Annual Budget 18

Corporate Control over the Businesses 2 basic approaches Input control Output (or performance) control Monitoring & approving business level decisions 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 High Centralized Strategic planning CORPORATE INFLUENCE Strategic control Financial control Holding company Low Flexible strategic Tight strategic Tight financial CONTROL INFLUENCE 52

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 49

Managing 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” (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) —Sharing operational resources and functions (e.g. sales and distribution, manufacturing facilities). 51

Rethinking the Management of Multibusiness Corporations: Lessons from General Electric Jack Welch’s transformation of GE’s structure and management systems: 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”). 53

Rethinking the Management of Multibusiness Corporations: Lessons from ABB Key features of ABB’s corporate management system: 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. 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 54

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 RENEWAL PROCESS Shaping and embedding corporate purpose Developing and nurturing organizational values Establishing strategic mission & performance standards Creating and maintaining organizational trust Linking skills, knowledge, and resources Reviewing, developing, and supporting initiatives INTEGRATION PROCESS ENTREPRENEURIAL PROCESS Front-line Management Middle Management Top Management 55

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?