What is Diversification?

A collection of businesses under one corporate umbrella

Prannoy K.K

Introduction
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 products/services.

Introduction
Advantages

(cont.)

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.

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.

Levels and Types of Diversification

Low Levels of Diversification
Single Business
> 95% of business from a single business unit

Dominant Business
Between 70 and 95% of business from a single business unit

Levels and Types of Diversification

Moderate to High Levels of Diversification
Related Constrained
<70% of revenues from dominant business; all businesses share product, technological and distribution linkages

Levels and Types of Diversification

Moderate to High Levels of Diversification
Related Linked (Mixed)
< 70% of revenues from dominant business, and only limited links exist

Levels and Types of Diversification

Very High Levels of Diversification
Unrelated
< 70% of revenue comes from the dominant business, and there are no common links between businesses

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?

Reasons for Diversification

Incentives

Reasons to Enhance Strategic Competitiveness

Economies of scope Market power Financial economics

Resources

Managerial Motives

Reasons for Diversification

Incentives

Resources with varying effects on value creation and strategic competitiveness

Tangible resources financial resources physical assets Intangible resources tacit knowledge customer relations image and reputation

Resources

Managerial Motives

Adding Value by Diversification

Diversification most effectively adds value by either of two mechanisms: Economies of scope: cost savings attributed to transferring the capabilities and competencies developed in one business to a new business Market power: when a firm is able to sell its products above the existing competitive level or reduce the costs of its primary and

support activities below the competitive level, or both

Reasons for Diversification

Incentives

Incentives with Neutral Effects on Strategic Competitiveness

Anti-trust regulation Tax laws Low performance Uncertain future cash flows Firm risk reduction

Resources

Managerial Motives

Incentives to Diversify
Internal Incentives:

Poor performance may lead some firms to diversify an attempt

to achieve better returns Firms may diversify to balance uncertain future cash flows Firms may diversify into different businesses in order to reduce risk

Reasons for Diversification

Incentives

Managerial Motives (Value Reduction)

Diversifying managerial employment risk

Resources

Increasing managerial compensation

Managerial Motives

Managerial Motives to Diversify

Managers have motives to diversify diversification increases size; size is associated with executive compensation diversification reduces employment risk

effective governance mechanisms may restrict such motives

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 SPREADING

--Diversification reduces variance of profit flows --But, doesn't create value for shareholdersthey 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.

WHEN DOES DIVERSIFICATION START TO MAKE SENSE?

Strong competitive position, rapid market growth -- Not a good time to diversify Weak competitive position, rapid market growth -- Not a good time to diversify

Strong competitive position, slow market growth -Diversification is top priority consideration

Weak competitive position, slow market growth -Diversification merits consideration

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-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.

Strategies for Diversification

1. Acquire existing firm in target

industry 2. Start new company internally 3. Form joint venture

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 performance levels.

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 variety of

well-developed mental models that provide them with powerful understandings of how to manage their firms.

When to Stop Diversifying

When you achieve acceptable levels of growth and profitability Before complexity outstrips management's ability to manage

Restructuring
A strategy through which a firm changes its set of businesses or financial structure Failure of an acquisition strategy often precedes a restructuring strategy Restructuring may occur because of changes in the external or internal environments Restructuring strategies: Downsizing Downscoping Leveraged buyouts