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Diversification Strategy. OUTLINE. Introduction: The Basic Issues The Trend over Time Motives for Diversification - Growth and R isk Reduction - Shareholder Value: Porter’s Essential Tests Competitive Advantage from Diversification Diversification and Performance: Empirical Evidence

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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


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

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)

Note:During the 1980s and 1990s the trend reversed as large

companies refocused upon their core businesses

1949 1954 1959 1964 1969 1974


Diversification among Large UK Corporations, 1950-93


Diversification: The Evolution of Strategy and Management Thinking

MANAGEMENT

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


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 forshareholders—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.


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


Competitive Advantage from Diversification

  • Predatory pricing/tie-in salesEvidence

  • Reciprocal buyingof these

  • Mutual forbearanceis 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 inDiversification

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.


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


  • 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.


    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


    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


    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


    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.


    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


    Applying the BCG Matrix to Time Warner Inc.

    Cable TV

    Networks

    Film

    production

    Cable

    -8 -404 8 12

    Magazine

    Publishing

    Annual real rate of market growth (%)

    Bakery division

    Music

    AOL

    Relative market share

    Position in 2003Position in 2000. (Area of circle proportional to $ sales)


    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


    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


    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

    Potential value

    with external

    improvements

    Disposal/acquisition

    opportunities


    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


    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,

    includingoperating budgets

    and HR appraisals


    Goold & Campbell’s Corporate Management Styles: Financial and Strategic Control

    High

    Centralized

    Strategic

    planning

    CORPORATEINFLUENCE

    Strategic

    control

    Financial

    control

    Holding

    company

    Low

    Flexible strategic

    Tight strategic

    Tight financial

    CONTROL INFLUENCE


    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 theimpact of changing strategic

      • variables.

    • Allocating investment funds between businesses

      • — PIMS Strategic Attractiveness Scan comparison different

      • business units’strategic attractiveness and their cash flow

      • characteristics


    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 createsvalue by transferringcapabilities

    • between businesses

    • Sharing activities—Parent createsvalue 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).


    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”).


    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


    Rethinking the Management of Multibusiness Corporations: Bartlett & Ghoshal’s Analysis of Key Management Processes

    RENEWAL PROCESS

    Managing the tension between short-term ambition

    Managing operational interdependencies and personal networks

    Creating and pursuing opportunities

    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


    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?


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