1. Session 03 © Furrer 2002-20081 Corporate Strategy Fall 2007 Session 3 - Lecture 2 Diversification and Performance Dr. Olivier Furrer Office: TvA 1-1-11, Phone: 361 30 79 e-mail: o.furrer@fm.ru.nl Office Hours: only by appointment

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3. 3 Firms Vary by Degree of Diversification Single-business > 95% of revenues from a single business unit Low Levels of Diversification Dominant-business Between 70% and 95% of revenues from a single business unit Related-Diversified <70% of revenues from a single business unit Moderate to High Levels of Diversification Businesses share product, techno-logical or distribution linkages Unrelated-Diversified Business units not closely related High Levels of Diversification Ref.: Rumelt, 1974

4. Session 03 © Furrer 2002-20084 Firms Vary by Degree of Diversification Ref.: Rumelt, 1974 Unrelated Business Related Business Dominant- Unrelated Dominant Business Single Business 1.0 0.95 0.7 0.0 1.0 0.7 0.0 Specialization Ratio Related Ratio Specialization Ratio: Proportion of a firm’s revenues derived from its largest single business. Related Ratio: Proportion of a firm’s revenues derived from its largest single group of related businesses.

5. Session 03 © Furrer 2002-20085 Types of Diversification Strategies Ref.: adapted from Rumelt, 1974 Low Levels of Diversification Moderate to High Levels of Diversification Very High Levels of Diversification A A B A B C A B C A B C Single Business Dominant Business Related constrained Related linked Unrelated

6. Session 03 © Furrer 2002-20086 Reasons for Diversification Motives to Enhance Strategic Competitiveness Economies of Scope Market Power Financial Economies Resources Managerial Motives Incentives Incentives and Resources with Neutral Effects of Strategic Competitiveness Anti-Trust Regulation Tax Laws Low Performance Uncertain Future Cash Flows Firm Risk Reduction Tangible Resources Intangible Resources Managerial Motives Causing Value Reduction Diversifying Managerial Employment Risk Increasing Managerial Compensation Ref.: Hoskisson and Hitt, 1990

7. Session 03 © Furrer 2002-20087 Summary Model of the Relationship between Firm Performance and Diversification Resources Capital Market Intervention and Market for Managerial Talent Diversification Strategy Firm Performance Internal Governance Strategy Implementation Incentives Managerial Motives Ref.: Hoskisson and Hitt, 1990

8. Session 03 © Furrer 2002-20088 Adding Value by Diversification By developing economies of scope between business units in the firms which leads to synergistic benefits By developing market power which lead to greater returns Diversification most effectively adds value by either of two mechanisms

9. Session 03 © Furrer 2002-20089 Alternative Diversification Strategies Efficient Internal Capital Market Allocation Transferring Core Competencies Sharing Activities Restructuring Related Diversification Strategies Unrelated Diversification Strategies 1 2 3 4 Efficient Internal Capital Market Allocation

10. Session 03 © Furrer 2002-200810 Sharing Activities Key Characteristics Sharing Activities often lowers costs or raises differentiation Sharing Activities can lower costs if it: Example: Using a common physical distribution system and sales force such as Procter & Gamble’s disposable diaper and paper towel divisions * Achieves economies of scale * Boosts efficiency of utilization * Helps move more rapidly down Learning Curve Example: General Electric’s costs to advertise, sell and service major appliances are spread over many different products

11. Session 03 © Furrer 2002-200811 Sharing Activities Key Characteristics Sharing Activities can enhance potential for or reduce the cost of differentiation Example: Shared order processing system may allow new features customers value or make more advance remote sensing technology available Must involve activities that are crucial to competitive advantage Example: Procter & Gamble’s sharing of sales and physical distribution for disposable diapers and paper towels is effective because these items are so bulky and costly to ship

12. Session 03 © Furrer 2002-200812 Sharing Activities Assumptions Strong sense of corporate identity Clear corporate mission that emphasizes the importance of integrating business units Incentive system that rewards more than just business unit performance   

13. Session 03 © Furrer 2002-200813 Transferring Core Competencies Key Characteristics  Exploits Interrelationships among divisions  Start with Value Chain analysis Identify ability to transfer skills or expertise among similar value chains Exploit ability to share activities Two firms can share the same sales force, logistics network or distribution channels

14. Session 03 © Furrer 2002-200814 Assumptions Activities involved in the businesses are similar enough that sharing expertise is meaningful Transfer of skills involves activities which are important to competitive advantage The skills transferred represent significant sources of cooperative advantage for the receiving unit    Transferring Core Competencies Transferring Core Competencies leads to competitive advantage only if the similarities among business units meet the following conditions:

15. Session 03 © Furrer 2002-200815 Key Characteristics Firms pursuing this strategy frequently diversify by acquisition: Acquire sound, attractive companies Acquired units are autonomous Acquiring corporation supplies needed capital Portfolio managers transfer resources from units that generate cash to those with high growth potential and substantial cash needs Add professional management & control to sub-units Sub-unit managers compensation based on unit results Efficient Internal Capital Market Allocation

16. Session 03 © Furrer 2002-200816 Assumptions Managers have more detailed knowledge of firm relative to outside investors Firm need not risk competitive edge by disclosing sensitive competitive information to investors Firm can reduce risk by allocating resources among diversified businesses, although shareholders can generally diversify more economically on their own    Efficient Internal Capital Market Allocation

17. Session 03 © Furrer 2002-200817 Portfolio Planning under the Boston Consulting Group (BCG) matrix: –Identifying the Strategic Business Units (SBUs) by business area or product market –Assessing each SBU’s prospects (using relative market share and industry growth rate) relative to other SBUs in the portfolio. –Developing strategic objectives for each SBU. Portfolio Planning

18. Session 03 © Furrer 2002-200818 The BCG Matrix Ref: Adapted from The Boston Consulting Group, Inc., Perspectives, No. 66, “The Product Portfolio.” 1970.

19. Session 03 © Furrer 2002-200819 The Strategic Implications of the BCG Matrix Stars –Aggressive investments to support continued growth and consolidate competitive position of firms. Question marks –Selective investments; divestiture for weak firms or those with uncertain prospects and lack of strategic fit. Cash cows –Investments sufficient to maintain competitive position. Cash surpluses used in developing and nurturing stars and selected question mark firms. Dogs –Divestiture, harvesting, or liquidation and industry exit.

20. Session 03 © Furrer 2002-200820 Limitations on Portfolio Planning Flaws in portfolio planning: –The BCG model is simplistic; considers only two competitive environment factors– relative market share and industry growth rate. –High relative market share is no guarantee of a cost savings or competitive advantage. –Low relative market share is not always an indicator of competitive failure or lack of profitability. –Multifactor models (e.g., the McKinsey matrix) are better though imperfect.

21. Session 03 © Furrer 2002-200821 The McKinsey Matrix

22. Session 03 © Furrer 2002-200822 Restructuring Key Characteristics Seek out undeveloped, sick or threatened organizations or industries Frequently sell unit after making one-time changes since parent no longer adds value to ongoing operations Parent company (acquirer) intervenes and frequently: - Changes sub-unit management team - Shifts strategy - Infuses firm with new technology - Divests part of firm - Makes additional acquisitions to achieve critical mass - Enhances discipline by changing control systems

23. Session 03 © Furrer 2002-200823 Assumptions Requires keen management insight in selecting firms with depressed values or unforeseen potential Must do more than restructure companies Need to initiate restructuring of industries to create a more attractive environment    Restructuring

24. Session 03 © Furrer 2002-200824 External Incentives Relaxation of Anti-Trust regulation allows more related acquisitions than in the past Before 1986, higher taxes on dividends favored spending retained earnings on acquisitions Incentives to Diversify After 1986, firms made fewer acquisitions with retained earnings, shifting to the use of debt to take advantage of tax deductible interest payments

25. Session 03 © Furrer 2002-200825 Diversification and Firm Performance Performance Level of Diversification Dominant Business Unrelated Business Related Constrained Ref.: Palich, Cardinal and Miller, 2000

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27. Session 03 © Furrer 2002-200827 Incentives to Diversify Poor performance may lead some firms to diversify to attempt to achieve better returns Firm may diversify into different businesses in order to reduce risk Internal Incentives Firms may diversify to balance uncertain future cash flows Managers often have incentives to diversify in order to increase their compensation and reduce employment risk, although effective governance mechanisms may restrict such abuses

28. Session 03 © Furrer 2002-200828 What Resources, Capabilities and Core Competencies do we possess that would allow us to outperform competitors? Is it possible to leapfrog competitors? What Core Competencies must we possess to succeed in a new product or geographic market? Will diversification break up capabilities and competencies that should be kept together? Will we only be a player in the new product or geographic market or will we emerge as a winner? What can the firm learn through its diversification? Is it organized properly to acquire such knowledge? Issues to Consider Prior to Diversification

29. Session 03 © Furrer 2002-200829 Alternative Diversification Strategies Efficient Internal Capital Market Allocation Transferring Core Competencies Sharing Activities Restructuring Related Diversification Strategies Unrelated Diversification Strategies 1 2 3 4 Efficient Internal Capital Market Allocation

30. Session 03 © Furrer 2002-200830 M&A Wave Era Portfolio Management (1960s, 1970s) Restructuring (1980s) Transfer of Skills / Sharing Activities (1990s) Corporate RolePassive: Banker/Investor; Antitrust law Active: Surgeon; Asset striping Active: Coach & Architect Focus of StrategyBusiness Portfolio; Conglomerates Coordination of businesses; Divestitures Sharing of knowledge; Relatedness hypothesis Operational Approach Lowering costs of capital, increasing financial cash flows; managerial synergies Higher operating cash flows Coordination of resources; Economies of scale and scope Corporate Strategy and Shareholder Value Creation Source: Business Horizons, January-February 1997, p. 34.

31. Session 03 © Furrer 2002-200831 M&A Wave Era Portfolio Management (1960s, 1970s) Restructuring (1980s) Transfer of Skills / Sharing Activities (1990s) ResultsEfficient markets; Conglomerate discounts: the whole less valuable than the sum of its parts Many distressed businesses result in widespread divesture Dept financed M&A by raiders beneficial, full-blown M&A less beneficial Partly beneficial, but “deptism” occurs, limiting ultimate success Potential for creation of value high, post- M&A management crucial (implementation failures, excess bidding) The brave new world of corporate synergy? Corporate Strategy and Shareholder Value Creation Source: Business Horizons, January-February 1997, p. 34.

32. Session 03 © Furrer 2002-200832 198019902000 Focused = 95% or more of sales within main industry. Dominant Business = Between 80% and 95% of sales within main industry. Diversified = Between 20% and 40% of sales outside main industry. Highly Diversified = More than 40% of sales outside main industry. Reference: Franko, 2004 Level of Diversification

33. Session 03 © Furrer 2002-200833 How Parents Create Value Stand-alone influence Linkage influence Central functions and services Corporate development Source: Goold, Campbell and Alexander, 1994

34. Session 03 © Furrer 2002-200834 Summary Model of the Relationship between Firm Performance and Diversification Resources Capital Market Intervention and Market for Managerial Talent Diversification Strategy Firm Performance Internal Governance Strategy Implementation Incentives Managerial Motives Ref.: Hoskisson and Hitt, 1990

35. Session 03 © Furrer 2002-200835 Rumelt’s Strategy, Structure and Economic Performance (1974) represents a landmark in the study of corporate strategy. His key finding was the superiority of related over unrelated diversification. Empirical studies of the relationship between diversification strategy and performance initially confirmed the superiority of related diversification over unrelated diversification (Bettis, 1981; Christensen and Montgomery, 1981; Rumelt, 1982: Lecraw, 1984). Summary

36. Session 03 © Furrer 2002-200836 However, as the volume of empirical work on the relationship between diversification strategy and performance grew, the findings became more inconsistent. Some studies found no significant relationship between relatedness in diversification and profitability (Grant et al., 1988) While other studies found unrelated diversification to be more profitable than related diversification (Michel and Shaked, 1984; Luffman and Reed, 1984; Lubatkin, 1987). Some other studies observed a curvilinear relationship (Grant et al, 1988; Lubatkin and Chatterjee, 1994; Palich et al. 2000). Summary

37. Session 03 © Furrer 2002-200837 Recent investigations of the relationship between corporate strategy and performance have featured more refined methodologies. These have deployed more sophisticated measures of diversification (Hoskisson et al. 1993; Nayyar, 1992; Robins and Wiersema, 1997) and the use of a wider range of control variables. Particular attention has been devoted to the interactions between corporate strategy and industry characteristics (Montgomery and Wernerfelt, 1991; Stimpert and Duhaime, 1997) in addition to the links between resources and diversification (Chatterjee and Wernerfelt, 1991). Summary

38. Session 03 © Furrer 2002-200838 In other areas of corporate strategy, the picture is less confusing. Greater consistency found in relation to vertical integration and international diversification. In relation to vertical integration, Rumelt’s (1974) fining hat vertically integrated firms underperform both specialized and diversified firms has been supported by subsequent evidence. In relation to international diversification, multinationals have tended to outperform nationally focused firms (Grant, 1987; Grant et al., 1988; Hitt et al., 1997) Summary

39. Session 03 © Furrer 2002-200839 Recent evidence concerning the relationship between diversification and performance includes the consequences of refocusing initiatives. The results of the divestments of diversified businesses by conglomerates suggest that narrowing business scope leads to increased profitability and increased stock market valuation. The stock market’s verdict on diversification is unambiguous. The high price-earning ratios attached to conglomerates during the 1960s have been replaced by a ‘conglomerate discount’. The result was that diversified companies came under attack from leveraged-buyout specialists seeking to add value by dismembering these companies. Summary

40. Session 03 © Furrer 2002-200840 The main conclusion that arises from the empirical literature is that there is no simple and consistent relationship between diversification and firm performance. In answering the question: ‘Does diversification enhance firm performance?’ the most we can say is: ‘It all depends’. Conclusion

41. Session 03 © Furrer 2002-200841 Next Session: Case Study 1 Microsoft’s Diversification Strategy 1.What opportunities and challenges await Microsoft in markets in which it did not have proprietary advantage? 2.What specific strategies did it have to adopt to capitalize on the opportunities and counter the challenges? 3.How best could Microsoft execute its diversification strategy?