Diversification Strategy OUTLINE 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 27

Introduction: The Basic Issues 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 synergy's exist between the core business and the new business?) 28

The Trend Over Time: Diversified Companies among the Fortune 500 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. 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

Corporate Strategy & Diversification: A Time-Line of Management Thought & Practice ISSUES Quest for Growth Financial problems of conglomerates Shareholder activism Leveraged Buyouts Rise of conglomerates Related diversification by industrial firms Emphasis on “related’ & “concen-tric” diversification Refocusing on core businesses Divestment Licensing, JVs, & strategic alliances COMPANY DEVELOPMENTS Development of corporate planning systems Transaction cost analysis Value based management Financial Analysis Portfolio planning STRATEGIC MANAGEMENT ANALYSIS Analysis of economies of scope & “synergy” Diffusion of M form structures Core competences Capital asset pricing model Planning concepts Dominant logic 1950 1960 1970 1980 1990 1

Why diversify?

Motives for Diversification 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 goals. --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 portfolios. --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. 31

How should we evaluate proposed diversification moves?

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) 32

More on the better off test - 1 What can our company do better than any of its competitors I its current market? What are our company’s strategic assets and how can we make the best use of them? What strategic assets do we need to succeed in the new market? Some vs. all (e.g. Coke in wine)

More on the better off test - 2 Can we catch up to or leapfrog competitors at their own game? Will diversification break up strategic assets that need to be kept together? (McDonald’s example)

More on the better off test - 3 Will we be simply a player in the new market or will we emerge a winner? (VRIO) What can our company learn by diversifying and are we sufficiently organized to learn it? Absorptive capacity GM

Potential access to a wide variety of markets Core Competence Tests Potential access to a wide variety of markets Makes a significant contribution to the perceived customer benefits Difficult to imitate 35

But, what is a core competence But, what is a core competence? For example, what is your firm’s core competence?

Core Competences are. . . Usually defined by describing successes and failures Often confused with non-core competences Broad generalities (e.g. marketing excellence) Often not clear about limits “some companies think everything they do is a core competency”

McKinsey Approach to Core Competence Definition “a combination of complementary skills and knowledge bases embedded in a group or team that results in the ability to execute one or more critical processes to a world-class standard.”

Core competence: two categories Insight/Foresight Technical/Scientific knowledge (Canon optics) Proprietary data Creative flair (e.g. Disney Superior analysis (e.g. Berkshire-Hathaway) Frontline Execution e.g. Southwest, Nordstrom, McDonalds

Evaluating Core Competences Are our skills truly superior? (What independent tests show that we are better at this skill than leading competitors in technical terms or customer opinion [or both]). How sustainable is the superiority? (R-I) How much value can the competence generate?

How does a company develop a core competence?

Creating Core Competences Evolution Incubation Acquisition

What does the evidence on diversification show?

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 destroying. 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 detrimental to profitability Diversifying acquisitions, on average, destroy share- holder value for acquirers Refocusing generates positive shareholder returns 3 return on net assets (%) 2 1 1 2 3 4 5 6 index of product diversity 33

Type of Diversification May Matter Conglomerate Concentric-related Related-linked

Summary