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Corporate Strategy: Diversification - PowerPoint PPT Presentation.

Corporate Strategy: Diversification. Learning Objectives: To identify types of diversification and when this strategy can create value to the firm and generate sustained competitive advantage Have any of you experienced corporate diversification with your employers ?.

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Corporate Strategy:Diversification.

To identify types of diversification and when this strategy can create value to the firm and generate sustained competitive advantage.

Have any of you experienced corporate diversification with your employers ?

… using a corporate diversification strategy, a firm operates in multiple industries or markets simultaneously …

Types of corporate diversification.

How are these types different ?

Why are these differences important ?

Analyze corporate diversification from VRIO perspective.

Two conditions must hold for this strategy to produce value:

Valuable economies of scope.

Stockholders cannot achieve these economies at a lesser-cost by themselves.

What do we mean by economies of scope ?

Financial economies of scope.

Internal capital allocation.

Anticompetitive economies of scope.

Exploiting market power.

Common Types of Economies of Scope(motivations for corporate diversification)

… operational economies come from shared activities or core competencies …

Shared activities Examples of shared activities ?

Definition of core competencies ?

Are these the same as ‘synergies’, the most abused word in corporate diversification lingo ?

… financial economies come from internal capital allocation, risk reduction and possible tax advantages …

Internal capital allocation.

Do firms get better information ?

Are decision makers subject to.

escalation of commitment ?

How well can shareholders do this themselves ?

Tax advantages – use losses to offset other gains.

Are these powerful arguments for corporate diversification ?

… anticompetitive tactics are most often noticed when a firm experiences multipoint competition with another firm, or seeks to exploit market power …

Examples of multipoint competition ?

Exploiting market power.

Examples of exploiting market power ?

Legality and ethics of tacit collusion and predatory pricing ?

Management compensation is more likely related to firm size (sales revenue) than to economic performance.

Implications: build sales quickly, M & A activity.

Is this a fair criticism of CEOs in corporate America ?

… if these economies of scope provide value, they must still pass other hurdles in the VRIO framework …

Rarity of diversification is based on the resulting economies of scope, not diversification per se.

Imitability of diversification is also based on the resulting economies of scope.

Economies that are.

Internal capital allocation.

Exploiting market power.

Imitability of Diversification.

What criteria makes these more or less costly to duplicate ?

Substitutes for diversification ?

Apple Computer introduces an I-Pod MD3 Player with a larger memory.

General Electric borrows money from BankAmerica at 3% interest and then makes capital available to its jet engine subsidiary at 8% interest.

A venture capital firm invests in a firm in the bio-technology industry and a firm in the entertainment industry.

Another venture capital firm invests in two firms in the bio-technology industry.

For each example, Identify the type of economy of scope.

Diversification Strategy - PowerPoint PPT Presentation.

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.

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Introduction: The Basic Issues.

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.

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 performance.

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.

To more fully utilize existing resources and capabilities.

To escape from undesirable or unattractive industry environments.

To make use of surplus cash flows.

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.

Horizontal or related diversification.

Opportunities to achieve economies of scale and scope.

Opportunities to expand product offerings or expand into new geographical areas.

Disadvantages of related diversification.

Complexity and difficulty of coordinating different but related businesses.

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.

Managers often lack expertise or knowledge about their firms’ businesses.

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 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.

Exploiting economies of scale.

Unit costs decline with increases in production.

Exploiting economies of scope.

Using the same resource to do different things.

Many assets in acquired firms are undervalued -- managers seek to exploit these opportunities and improve their operations and add value to their businesses.

Synergy in diversification derives from two main 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.

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 negative features.

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 businesses?

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 income.

70.2 63.5 53.7 53.9 39.9 37.0.

29.8 36.5 46.3 46.1 60.1 63.0.

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.

1949 1954 1959 1964 1969 1974.

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 performance.

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.

on average, destroy share-

holder value for acquirers.

positive shareholder returns.

return on net assets (%)

index of product diversity.

Exhibit summarizes findings of study that sought to determine how much various factors, including industry attractiveness, business strategy, and corporate strategy contribute to performance.

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!

Additional studies conclude that corporate strategy rarely makes significant contribution to shareholder value.

Recent study is shown in Exhibit below:

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.

Though diversification has been disastrous for many firms, diversified firms can also be successful.

Studies have found no obvious differences between high - and low-performing diversified firms along several important strategic dimensions.

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.

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)

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.

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.

Successful diversification strategies result from the ability of managers to develop skill and competency at MANAGING diversification.

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.

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.

How to coordinate the activities of businesses in order to achieve synergies.

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.

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.

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).

Size alone does not guarantee firms an advantage.

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.

Critical factor in determining success is the level of management expertise in formulating and implementing corporate strategy.

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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Diversification.

'Tis the part of a wiseman to keep himself today for . 'Put all your eggs in one basket and WATCH THAT BASKET.' - Mark Twain. 2002 John Wiley & Sons . – PowerPoint PPT presentation.

Tis the part of a wiseman to keep himself today.

for tomorrow, and not venture all his eggs in one.

basket. - Miguel de Cervantes.

Put all your eggs in one basket and WATCH THAT.

BASKET. - Mark Twain.

Leveraging Assets and Competencies.

Implement the Business Plans.

Assess Assets, Competencies, and Excess Capacity.

Identify Business Plans that will Leverage.

Assets and Competencies.

Related Diversification Exporting or Exchanging Assets and Competencies Brand Name Capacity in Sales or Distribution Manufacturing Skills RD Skills Achieving Economies of Scale.

The Mirage of Synergy Potential synergy does not exist Potential synergy exits, but implementation.

barriers make it unattainable Potential synergy is overvalued.

Unrelated Diversification Managing and Allocating Cash Flow Entering Business Areas with High ROI Prospects Obtaining a Bargain Price for a Business The Potential to Refocus a Firm Reducing Risk Tax Implications Obtaining Liquid Assets Vertical Integration Motivations Defending against a Takeover Providing Executive Interest Risks of Unrelated Diversification.

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Diversification Strategy.

Diversification and Shareholder Value: Porter's Three Essential Tests. . Explore the complex relationship between diversification and firm performance. . – PowerPoint PPT presentation.

Title: Diversification Strategy.

OUTLINE Introduction The Basic Issues The Trend over Time Motives for Diversification - Growth and risk spreading - Diversification and Shareholder Value.

Porters Three Essential Tests. Competitive Advantage from Diversification Diversification and Performance Empirical.

Objectives 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.

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 performance.

Introduction 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.

Introduction (cont.) Why Firms Diversify To grow To more fully utilize existing resources and.

capabilities. 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.

Introduction (cont.) Horizontal or related diversification Advantages Opportunities to achieve economies of scale and.

scope. 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.

diversification Managers often lack expertise or knowledge about.

their firms businesses.

Introduction The Basic Issues Diversification decisions involve two basic.

issues Is the industry to be entered more attractive.

than the firms 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.

Aim of Corporate Strategy Synergy 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.

Relatedness in Diversification Synergy in diversification derives from two main.

types of relatedness Operational Relatedness-- synergies from sharing.

resources across businesses (common distribution.

facilities, brands, joint RD) 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.

Problems in Exploring Potential Synergies 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 negative features.

Problems in Exploring Potential Synergies (cont.) Even after making an acquisition, managers must.

still integrate the new business into their.

companys 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 income. Difficult to assess the risks associated with new.

The Trend Over Time Diversified Companies among.

the Fortune 500.

53.9 39.9 37.0 Percentage of Specialized Companies.

(single-business, vertically-integrated and.

dominant-business) Percentage of Diversified Companies.

(related-business and unrelated business) BUT Since late 1970s, diversification has.

1949 1954 1959 1964.

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 performance.

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.

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 performance. 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.

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.

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.

successful. Studies have found no obvious differences between.

high - and low-performing diversified firms along.

several important strategic dimensions.

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.

Diversification and Shareholder Value Porters.

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-attracti.

ve 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.

Introduction The Tasks of Corporate Strategy In.

the Multibusiness Corporation Determining the companys business.

divestment Allocating resources between the different.

businesses Formulating strategy for the different businesses Controlling business performance Coordinating the businesses and creating overall.

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.

Crucial Role of Managers Successful diversification strategies result from.

the ability of managers to develop skill and.

competency at MANAGING diversification. Managers must develop two important types of.

mental models Must have well-developed understandings of their.

firms diversity and relatedness that define.

Crucial Role of Managers (cont.) Understandings of how their firms 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.

organizations 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.

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 firms stock market.

performance is directly related to.

diversification experience (see exhibit on.

Exhibit Five-Year Stock Market Performance of.

Four Bank Holding Companies that Are Active.

Conclusions Size alone does not guarantee firms an advantage. 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.

Conclusions (cont.) Critical factor in determining success is the.

level of management expertise in formulating and.

implementing corporate strategy. More difficult for diversified firms. Managers of large diversified firms possess a.