session 03 © furrer 2002-20081 corporate strategy fall 2007 session 3 - lecture 2 diversification...

Session 03 © Furrer 2002-2008 1

Corporate StrategyFall 2007

Session 3 - Lecture 2

Diversification and Performance

Dr. Olivier Furrer

Office: TvA 1-1-11, Phone: 361 30 79e-mail: [email protected]

Office Hours: only by appointment


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


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 0.01.0

0.7

0.0

Specialization Ratio

Rel

ated

Rat

io

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.


Types of Diversification Strategies

Ref.: adapted from Rumelt, 1974

Low Levels of Diversification Moderate to High Levels of Diversification

Very High Levels of Diversification

AAAA

BBAA

BB CC

AA

BB CC

AA

BB CC

Single Business Dominant Business Related constrained Related linked

Unrelated


Reasons for Diversification

Motives to Enhance Strategic Competitiveness

Economies of ScopeMarket Power

Financial Economies

Resources

ManagerialMotives

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 ManagerialEmployment Risk

Increasing Managerial Compensation Ref.: Hoskisson and Hitt, 1990


Summary Model of the Relationship between Firm Performance and Diversification

Resources

Capital Market Intervention and

Market for Managerial Talent

DiversificationStrategy

FirmPerformance

InternalGovernance

StrategyImplementation

Incentives

ManagerialMotives

Ref.: Hoskisson and Hitt, 1990


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


Alternative Diversification Strategies

Efficient Internal Capital Market Allocation

Transferring Core Competencies

Sharing Activities

Restructuring

Related Diversification Strategies

Unrelated Diversification Strategies

1

2

3

4



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


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


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



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


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 leads to competitive advantage only if the similarities among business units meet the following conditions:


Key CharacteristicsFirms 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



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



• 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


The BCG Matrix

Ref: Adapted from The Boston Consulting Group, Inc., Perspectives, No. 66, “The Product Portfolio.” 1970.


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.


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.


The McKinsey Matrix


Restructuring

Key CharacteristicsSeek 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


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


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


Diversification and Firm PerformanceP

erfo

rman

ce

Level of Diversification

DominantBusiness

UnrelatedBusiness

RelatedConstrained

Ref.: Palich, Cardinal and Miller, 2000


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


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


Alternative Diversification Strategies



Sharing Activities

Restructuring

Related Diversification Strategies

Unrelated Diversification Strategies

1

2

3

4



M&A Wave Era

PortfolioManagement(1960s, 1970s)

Restructuring

(1980s)

Transfer of Skills / Sharing Activities

(1990s)

Corporate Role Passive:

Banker/Investor; Antitrust law

Active:

Surgeon; Asset striping

Active:

Coach & Architect

Focus of Strategy Business 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.


M&A Wave Era

PortfolioManagement(1960s, 1970s)

Restructuring

(1980s)

Transfer of Skills / Sharing Activities

(1990s)

Results Efficient 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.


1980 1990 2000

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


How Parents Create Value

Stand-alone influence Linkage influence

Central functions and services Corporate development

Source: Goold, Campbell and Alexander, 1994


Summary Model of the Relationship between Firm Performance and Diversification

Resources

Capital Market Intervention and

Market for Managerial Talent

DiversificationStrategy

FirmPerformance

InternalGovernance

StrategyImplementation

Incentives

ManagerialMotives

Ref.: Hoskisson and Hitt, 1990


• 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


• 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


• 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


• 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


• 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


• 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


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?

session 03 © furrer 2002-20081 corporate strategy fall 2007 session 3 - lecture 2 diversification...

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