Diversification Strategy

1. 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

2. 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?

3. 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

4. Diversification among Large UK Corporations, 1950-93

5. 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

6. 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.

7. 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

8. Competitive Advantage from Diversification • Predatory pricing/tie-in sales Evidence • Reciprocal buying of these • Mutual forbearance is 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

9. 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.

10. Branson & the Virgin Companies: Making strategic sense of apparent entrepreneurial chaos • KEY RESOURCES • Virgin brand • Branson • -charisma/image • --PR skills • -networking skills • -entrepreneurial flair • DOMINANT LOGIC • Seek competitive advantage by start-up cos. • pursuing innovative differentiation in • underserved market with sleepy incumbents • CHARACTERISTICS OF • MARKETSTHAT CONFORM • TO THIS LOGIC • Consumer businesses • dominant incumbent • scope for new approaches • to customer service • high entry barriers to other • start-ups • Branson/Virgin image • appeals to customers • DESIGNING A CORPORATE STRATEGY • & STRUCTURE • What’s the business model? • (Does Virgin create value by • being an entrepreneurial incubator, • a venture capital fund, a • diversified corporation, or what?) • Which businesses to divest? • Criteria for future diversification • What type of structure?—Is there • a need for greater formalization?