final week 6 lecture 6 - diversification
TRANSCRIPT
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 1/98
DiversificationBesanko Chapter
5http://www.icmrindia.org/casestud
ies/catalogue/Business%20Strategy1/ITC%20Diversification%20Strategy.h
tm
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 2/98
Lecture overview
This lecture will cover the following points:
The rationale for diversification"
Economics based reasons"
Economies of scale/ scope" Transaction costs"
Incentives and agency costs"
Efficiency arguments"
Evidence on diversification"
Summarise key points
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 3/98
3
Lecture overview
This lecture will cover the following points: The rationale for diversification
Economics based reasons
± Economies of scale/ scope
± Transaction costs ± Incentives and agency costs
Efficiency arguments
Evidence on diversification
Summarise key points
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 4/98
Why are these topics relevant?
4
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 5/98
Krugmans New Trade Theory - Why does Toyota sell cars
in Germany and Mercedes sell cars in Japan?
International Trade and Economic Geography
What are the effects of free trade and globalization?
What are the driving forces behind worldwide urbanisation?
many goods and services can be produced more cheaply in long series,
a concept generally known as economies of scale. As a result, small-scale production for a local market is replaced bylarge-scale production for the world market, where firms with similarproducts compete with one another.Economies of scale combined with reduced transport costs also help to
explain why an increasingly larger share of the world population lives incities and why similar economic activities are concentrated in the samelocations.
- Royal Swedish Academy of Sciences
5
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 6/98
6
diversify?
Most well known firms serve multiple product
markets
± Apple: Music/ computers/ software/ operating systems
± Virgin: Transport/ communications/ media
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 7/98
DIFFERENT TYPES OF DIVERSIFICATION
Vertical Integration - Firm decides to enter one or more parts of its value chain that it has hitherto not entered.
An automobile firm that has only been assembling cars might decide
to produce some critical sub assemblies or components.
E.g. Maruti used to initially only assemble cars. It progressivelyintroduced engine and transmission manufacture into its operations.
On the other hand a firm might decide to move up the value chain.
Reliance, in its textile operation only manufactured the cloth. Later
on it opened exclusive retail outlets which addressed not only the
sales and distribution aspects of its business, but also contributed to
brand building.
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 8/98
DIFFERENT TYPES OF DIVERSIFICATION
Horizontal Integration or Related Diversification - Firmenters businesses that are related to its existing businesses.
Hindustan Lever, the FMCG major, used to be largely in the soaps anddetergents business. In the last ten years, it has diversified into the
foods and beverages business largely through the acquisition of firstLipton the tea company and later the acquisition of Brooke Bond.
Larsen & Toubro a leading engineering firm who has been dominantin the construction equipment industry entered the cement industrywhich is a related business.
IBM has entered the Infotech consultancy business another exampleof related diversification. Looking at the factors that have beencompelling for these firms it would be obvious that
The growth compulsion was stronger here than the capacityutilisation imperative that drives other firms to go in for VI
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 9/98
DIFFERENT TYPES OF DIVERSIFICATION
Unrelated or Conglomerate Diversification. This at times takesplace when a firm wishes to or is forced to exit from anunattractive or undesirable industry.
The tobacco firms who have diversified out of tobacco are the
obvious examples. American firms Phillip Morris and R.J. Reynolds entered the
FMCG arena specifically in Food and Beverages,
General Electric is the ultimate example of a firm which has
pursued unrelated diversification with dizzying success forseveral years.
Kingfisher
ITC
Reliance 9
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 10/98
ITC
10
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 11/98
ITC
11
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 12/98
Nestle
Wants to operate only those businesses aboutwhich it has some special knowledge andexpertise
Instant coffee, infant foods, milk products UHT Milk, butter and curd and noodles,chocolates, confectioneries and other semiprocessed food products, mineral water
Leading brands Cerelac, Nestum, Nescafe,Maggie, Kitkat, Munch, Pure Life
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 13/98
DIFFERENT TYPES OF DIVERSIFICATION
Global Diversification - Firms that have successfully dominated their homemarkets are attracted by the prospect of growth in the markets of other
nations.
Enter markets in emerging economies.
The diversifying firm adjusts its strategies to comply with the cultural
requirements and preferences of the countries that it enters.
Kellogg the giant breakfast food cereal marketer made the cardinal error of
assuming that Indian families would accept and adopt the concept of cold
breakfasts. Indians have a unanimous preference for hot meals especially
the morning repast. As a result of this critical oversight, Kellogg has failed to
make a major impact in India.
McDonalds on the other hand has with great marketing sagacity exploited
the Indian preference for vegetarian food, and spiciness of a high order,
understood that Chicken is the favoured meat, appealed to the Indian
orientation towards family and scored significant successes in its foray into
the fast food industry in our country.
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 14/98
Measuring/levels of Diversification:
relatedness
To identify economies of scale in multi
business firms, the relatedness concept was
developed by Richard Rumelt.
Two businesses are related if they share
technological characteristics, production
characteristics and/ or distribution channels.
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 15/98
15
Levels and Types of Diversification
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 16/98
Classification by relatedness
Type Proportion of revenue fromprimaryactivity
Example
Single >95% D
aimler Benz,D
eBeers,KLM-airlines,Wrigley-chewing gum
Dominant 70 to 95% Nestle
Related <70% Abbott Labs, Daewoo,Phillip Morris
Conglomerate <70% 3M, General Electric,Tata
16
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 17/98
Examples
Most well known firms serve multiple product markets
Apple: Music/ computers/ software/ operatingsystems
Virgin: Transport/ communications/ media Diversification across products and across markets can
be due to economies of scale and scope
Diversification that occur for other reasons tend to be
less successful Nokia - wood pulp and paper/ footwear/ televisions/capacitors
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 18/98
Relatedness in Indian Industry
Kaura (1987) took a sample of 251 private sector firms in India.He divided the firms into three categories as Single business,related business and unrelated diversified.
He found that out of the total sample only 63% of the firmsfollowed diversification strategy, with unrelated diversification as
the most popular strategy among Indian companies. Diversification was followed more intensively in Indian
subsidiaries of MNCs rather than whole Indian companies,
36.7% of the Indian companies followed SB* strategy as againstonly 25% of MNCs in SB strategy.
RB* strategy was followed only by 25.8% Indian companies andby 37.5% MNCs.
However, 37.5% of the companies both for Indian companies andIndian subsidiaries of MNCs favored UB* strategy equally.
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 19/98
Raman (1991) has measured the pattern of diversification of 67 Indiancompanies from the private sector. The pattern was studied over 1 1 -yearperiod from 1979-89 at three points of time, that is, 1979, 1984 and 1989.
Using Rumelt's classification the firms were divided into nine categories.It was observed that companies preferred going in for Unrelated Business
rather than Single Business. Among the Dominant Business, DominantVertical was the same for each year while Dominant Linked was larger in1989 as compared to 1979. The number of companies in related linkedalso increased as compared to related constrained.
However, between 1980-90, studies also show that companies startedfavoring refocusing rather than diversification.
Lichtenberg (1992) showed that the level of diversification declined
between 1985 and 1989 in a sample of 6,505 firms. Spender and Grant (1996) also reported that the average index of
diversification for Fortune 500 companies declined from 1.00 to 0.67.
Relatedness in Indian Industry
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 20/98
Entropy measures of classification
Entropy measures diversification as
information content.
If a firm is exclusively in one line of business(pure play), its entropy is zero.
For a firm spread out into 20 different lines
equally, the entropy is about 3.
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 21/98
Entropy Decline in 1980s
Study by Davis, Dieckman, Tinsley (1994):During the 80s, the average entropy of Fortune 500 firms dropped form 1.0 to 0.67
Study by Comment and Jarrell (1995):Fraction of U.S. businesses in singlebusiness segments increased from 36.2% in1978 to 63.9% in 1989
Firms have become more focused in their corebusinesses
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 22/98
22
EntropyIn Management Strategy I
Managers are interested in knowing how
diversified are the firms lines of business
It has been considered (and aptly discussedand hotly debated) that more diverse
businesses are more profitable
± May not always be the case though
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 23/98
23
EntropyIn Management Strategy II
In diversification we need to consider related (similar to thefirms core business) versus unrelated (dissimilar)diversification
In related diversification the firms several lines of business, even though distinct, still possess some kind of fit shared technology, common labor skills andrequirements, common suppliers and raw materialsources, similar operating methods, kinds of managerial
know-how, ), complementary channels or customeroverlap
In unrelated diversification there is no common linkage orelement of fit among the firms lines of business - pure
diversification
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 24/98
24
DiversityAn Example
If we take a beaker of water (H2O) and a very
concentrated solution of red food coloring and we
then add a drop of the coloring to the water we will
see the red color diffusing throughout the water andthus, we go from concentration to diversification
Economists, as well as chemists and physicists, want
to define concentration vs. diversification
Concentration and diversification are two ends of the
spectrum
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 25/98
Ways to diversify
Firms can diversify in different ways
They can develop new lines of business
internally. They can form joint ventures in new areas of
business.
They can acquire firms in unrelated lines of business.(M&A)
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 26/98
Why do Firms Diversify?
Efficiency based reasons
a) Economies of scale and scope
b) Economizing on transactions costsc) Financial Synergies
± Internal capital markets
±Shareholder diversification
± Identifying undervalued firms
Managerial Reasons for Diversification
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 27/98
Reasons for diversification
a) Economies of Scale and Scope
The idea is that it is less costly or more
valuable to producers for two activities to be
pursued jointly than separately
Economies of scope might arise because of
relatedness among products in terms of: raw
materials and/or technology and/or output
markets
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 28/98
If a merger is motivated by scale economies,
the market share of the merged firm should
increase immediately following the merger
(scale).
Data from manufacturing industries show that
changes in market share were in line with
expectations (scale).
Reasons for diversification - Evidenceof a) Economies of Scale and Scope
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 29/98
If firms pursue economies of scope through
diversification, large firms should be expected
to sell related set of products in different
markets (scope).
Evidence indicates that this happens only
occasionally (scope).
Reasons for diversification - Evidenceof a) Economies of Scale and Scope
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 30/98
Reasons for diversification a) -Scope
Economies outside technology and markets -
: Unrelated activities Several firms produce unrelated products and
serve unrelated consumer groups (scope).
Firms that produce unrelated products and serveunrelated markets could be pursuing scope
economies in other dimensions.
Two explanations that take this approach are
Resource based view of the firm (Edith Penrose).
Dominant general management logic (C K
Prahlad).
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 31/98
Resource based view of the firm (Edith Penrose)utilize managerial and organizationalunderutilzed resources in new areas when
growth in existing market is constrained Dominant general management logic (Prahalad
and Bettis): Managers of diversified firms mayspread their own managerial talent acrossnominally unrelated business areas.Management has specific skills that can beapplied in different areas of activity e.g.
information systems, finance, advertising etc.
Reasons for diversification a) Scope
Economies outside technology and markets
Unrelated activities
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 32/98
Reasons for diversification
b) Economizing on Transactions Costs
If transactions costs complicate coordinationamong independent firms, merger may be theanswer
Transactions costs arises in relationships withindependent firms when production processinvolves specialized assets such as humancapital, organizational routines or other forms of proprietary knowledge.
Transaction costs are not likely to be a problemMarket coordination may be superior in theabsence of specialized assets
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 33/98
Example:The University as a
Conglomerate
An undergraduate university is a conglomerate of
different departments
Economies of scale (common library, dormitories,athletic facilities) dictate common ownership and
location
Value of one departments investments depends on
the actions of the other departments (relationship
specific assets)
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 34/98
Reasons for diversification
3. Financial synergies
a) Internal capital markets
b) Diversifying Shareholders diversification
c) Identifying undervalued firms
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 35/98
Reasons for diversification
3. Financial synergies :
a)Internal Capital Markets In a diversified firm, some units generate
surplus funds that can be channeled to units
that need the funds (Internal capital market)
The key issue is whether the firm can do a
better job of evaluating its investment
opportunities than an outside banker can do
Internal capital market also engenders
influence costs
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 36/98
Reasons for diversification - 3.
Financial synergies :
b)Diversifying Shareholders Portfolios Individual shareholders benefit from investing indiversified portfolios and smoothens the earningsstream
A broadly diversified firm may receive only a small % of
its revenues from any one line of business. Soshareholder can invest in a single diversified firm andachieve the benefits of portfolio diversification.
But the shareholders do not benefit from this sincethey can diversify their portfolio themselves.
Only when shareholders are unable to diversify do theybenefit from firm diversifying into different products.
easons or ers ca on
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 37/98
easons or vers ca on
3. Financial synergies :
c) Identifying Undervalued Firms Firms shareholders may benefit from diversification if its managers are able to identify other firms that areundervalued by the stock market.
W
hen the acquired firm is in an unrelated business, theacquiring firm is more likely to have overvalued thetarget
The key question is: Why did other potential acquirersnot bid as high as the successful acquirer?
Winners curse could wipe out any gains from financialsynergies ( paying the highest price as compare toother bidders)
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 38/98
Managerial Reasons for Diversification
Growth may benefit managers even when it
does not add value for the shareholders
When growth cannot be achieved throughinternal development, diversification may be
an attractive route to growth
When related mergers were made difficult by
law (anti trust law) conglomerate mergers
became popular
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 39/98
Managerial Reasons for Diversification
Managers may feel secure if the firm
performance mirrors the performance of the
economy (which will happen with diversification)
Diversification will offer managers room for
lateral movement and allow them to invest in
firm specific skills
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 40/98
Potential Costs of diversification
Diversified firms may incur substantial influence costsand may need elaborate control systems to rewardand punish managers.
Internal capital markets may not function well. Growth may benefit managers even when it does notadd value for the shareholders.
Managers could be engaged in empire building andenhancing their status in their network at the expenseof the shareholders.
If managers undertake unwise acquisitions, the stockprice drops, reflecting overpayment for the acquisition
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 41/98
Corporate governance issues
Shareholders are knowledgeable regarding the
value of an acquisition to the firm.
Shareholders have weak incentive to monitor
the management.
Acquiring firms tend to experience loss of
value.
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 42/98
Market for corporate control: Evidence
Hostile takeovers tend to occur in decliningindustries and industries experiencing drasticchanges where managers have failed to
readjust scale and scope of operations.Corporate raiders have profited handsomely
for taking over and busting up firms thatpursued unprofitable diversification.
Such redistribution of wealth may adverselyaffect economic efficiency.
E id Di ifi i d
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 43/98
Evidence: Diversification and
Operating Performance
Operating Performance is usually measured as
accounting profits or as productivity.
Major results are:
Unrelated diversification harms productivity
Diversification into narrow markets does
better than diversification into broad markets
E id Di ifi i d
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 44/98
Improvements in newly acquired plants may
come at the expense of performance at the
existing plants.
Gains from diversification depends onspecialised resources of the firm.
Evidence: Diversification and
Operating Performance
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 45/98
Evidence : Diversification and long term
performance
Long term performance of diversified firms appear tobe poor.
One third to one half of all acquisitions and over half of all new business acquisitions are eventually divested.
Corporate refocusing of the 1980s (and later) could beviewed as a correction to the conglomerate mergerwave of the 1960s.
Past conditions could have favoured unrelateddiversification and these conditions could since havechanged (example: anti-monopoly behaviour basedregulations).
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 46/98
Evidence: Valuation and Event Studies
Compare stock market valuations of
diversified to those of undiversified firms
shares of diversified firms trade at a discount
relative to those of their undiversified
counterparts (up to 15%): diversification
discount
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 47/98
Evidence: Valuation and Event Studies
Why?
a) Combining two unrelated businesses reduces
value in some way or
b) Unrelated businesses elected to combine
had low market values even before the
combination
Recent empirical evidence shows that b) might
be motivation, at least partly
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 48/98
Evidence: Summary
Diversification can create value, although its
benefits relative to non-diversification are
unclear Diversifications in related activities
outperform those in unrelated activities
h i i i di f
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 49/98
The Transition Process in India from
Diversified to Focused
Conglomerates are leveraging their existing setups (internalfunds, brand equity, trust and relationships) into venturingand streamlining their processes.
There is a transition happening with a move towards
focusing on core competencies and outsourcing all thesecondary domains.
Focused approaches would reduce gross inefficiencies,accelerate the decision making process and also enhanceentrepreneurship.
When the conglomerates would become successful inestablishing themselves as global players in their coreareas, they might hive off or sell off their peripheral areasof business.
49
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 50/98
Indian Business
Bui ld ing on Core Competenci es
Outsour cing Secondary Ac t ivi t i es: The
contender i s most comfortable in bui ld ing on
i ts core abi l i t i es and competes in pr ov en
gr ounds. H enc e many emer ging Ind i an
compani es hav e deci ded t o re focus on core
competenci es, whi le outsour cing or shedd ingoff secondary operat ions.
50
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 51/98
Lecture summary
We have considered the rationale for
diversification.
We have assessed some examples and some
trends related to diversification.
We have employed ideas such as:
Economies of scale and scope
Transaction costs.
Efficiency factors.
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 52/98
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 53/98
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 54/98
54
The Extent of Diversification
What factors determine the extent to which a firmdiversifies across different industries?
Diversification will be efficient if there is SYNERGY
SYNERGY can come from ± economies of scope
± exploitation of specific assets
± reduction of risk and uncertainty
BUT DOES IT REALLY EXIST IN PRACTICE?
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 55/98
55
The history of diversification is not good
In the 1960s and 1970s the conglomerate was a
favourite form of business
Although the purchased firms were usually good
performers, the merged firm tended to have poorperformance
It became clear in the 1980s and 90s that there is a
diversification discount of about 15% on average
WHY?
± Firms seemed to not understand the sectors they
entered
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 56/98
56
Alternative forms of of merger Horizontal:
with competitors
Vertical:
with suppliers or customers
Conglomerate:
with unrelated firms
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 57/98
57
Mergers in a perfect world
All managers are efficient;they work in the interests of
shareholders; stock markets price shared efficiently;no
uncertainty; everyone uses the same discount rate
In that situation there are only two reasons for mergers to
take place:
± SYNERGY: 2+2>4; economies of scope or scale, joint
use of key resources or capabilities
± MARKET POWER: merger gives some degree of
monopoly power
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 58/98
58
The performance consequences of
mergers
Shareholders of the acquired firms gain -
because the acquiring firm pays a premium
The pattern of results for the acquiring firm is
very mixed with values tending to fall, not
rise!
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 59/98
59
Are mergers really for managers?
CEOs and senior managers like mergers
± larger firms involve more prestige and often more
pay
± larger and more diverse firms reduce risk for
managers (but not for shareholders who could do
it another way)
±publicity is welcomed by many CEOs
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 60/98
60
Partnerships and Value Constellations
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 61/98
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 62/98
0
10
20
30
40
50
60
70
1950 1960 1970 1983 1993
Single business
Dominant
business
Related business
Unrelatedbusiness
Diversification among Large UK
Corporations, 1950-93
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 63/98
COMPANY
DEVELOPMENTS
MANAGEMENT
GOALS
STRATEGY TOOLS
& CONCEPTS
1950 1960 1970 1980
1990
Financial
problems of
conglomerates
Refocusing on
shareholder value
Rise of conglomerates
Related diversification
by industrial firms
Emphasis on³related¶
& ³concentric´
diversification
Refocusing on
core businesses
Divestment
Diffusion of
M form structures
Analysis of economies of
scope &
³synergy´
Value based
management
Capital asset
pricing model
Portfolioplanning
models
Core
competences
Transactioncost analysis
Development of corporate planning systems
Diversification: The Evolution of Management
Thinking and Management Practice
Joint ventures,
Alliance, corporate
venturing
Competitive
advantage through
Speed, flexibility,
and capability
Dynamic
capability
Quest for Growth
Financial Analysis
Dominant logic
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 64/98
Motives for Diversification
GROWTH --The desire to escape stagnant or declining industriesa powerful motives for diversification (e.g. tobacco,oil, newspapers).
--But , growth satisfies managers not shareholders.
--Growth strategies (esp. by acquisition), tend todestroy shareholder value
RISK --Diversification reduces variance of profit flows
SPREADING --But , doesn¶t create value for shareholders²they 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 increasetheir profitability.
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 65/98
Diversification and Shareholder Value: Porter¶s
Three Essential Tests
If diversification is to create shareholder value, it must meetthree tests:
1. T he Attractiveness T est : diversification must be directedtowards attractive industries (or have the potential tobecome attractive).
2. T he Cost of Entry T est : the cost of entry must not capitalizeall future profits.
3. T he Better-Off T est : either the new unit must gaincompetitive advantage from its link with the company, or vice-versa. (i.e. some form of ³synergy´ must be present)
Additional source of value from diversification: Option value
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 66/98
Competitive Advantage from Diversification
Predatory pricing/tie-in sales Evidence
Reciprocal buying of these
Mutual forbearance is sparse
MARKETPOWER
Sharing tangible resources (research labs, distribution
systems) across multiple businesses
Sharing intangible resources (brands, technology) acrossmultiple businesses
Transferring functional capabilities (marketing, product
development) across businesses
Applying general management capabilities to multiple
businesses
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
OF
SCOPE
ECONOMIES
FROM
INTERNALIZING
TRANSACTION
S
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 67/98
Relatedness in Diversification
Economies of scope in diversification derive from two
types of relatedness:
Operational Relatedness-- synergies from sharing
resources across businesses (common distributionfacilities, brands, joint R&D)
S trategic Relatedness-- synergies at the corporate level
deriving from the ability to apply common management
capabilities to different businesses.
P roblem of operational relatedness:- the benefits in terms
of economies of scope may be dwarfed by the
administrative costs involved in their exploitation.
B & th Vi i C i M ki t t i
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 68/98
Branson & the Virgin Companies: Making strategic
sense of apparent entrepreneurial chaos
KEY RESOURCES
Virgin brandBranson
-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
MARKETS THAT CONFORM
TO THIS LOGIC
consumer
dominant incumbent
scope for new approachesto 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?²Is there
a need for greater formalization?
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 69/98
Virgin Conglomorate
Business opport uni t i es are l ik e buses, t heres al w ays anot her one coming Richard Branson
Virgin Group is a diversified group of more than 200 privately heldcompanies. The largest of these are Virgin Atlantic Airways, the numbertwo airline in the United Kingdom; Virgin Holidays, a vacation touroperator; the Virgin Retail Group, which operates numerous Virgin
Megastores, a retail concept featuring videos, music CDs, and computergames; and Virgin Direct, which offers financial services. Other Virginbusinesses include beverage maker Virgin Cola, a record label, book andmusic publishing operations, hotels, an Internet service provider, movietheaters, a radio station, cosmetics and bridal retailing concepts, and aline of clothing. Holding this disparate group of companies together is thecombination of Richard Branson and the Virgin brand name. Britishentrepreneur Branson dropped out of boarding school at the age of 17, in1967, to start his own magazine. That venture called Student was animmediate success, establishing the foundation for what would become amultibillion-dollar conglomerate.
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 70/98
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 71/98
STRATEGY AND COMPETITIVESTRATEGY AND COMPETITIVE
ADVANTAGE IN DIVERSIFIEDADVANTAGE IN DIVERSIFIEDCOMPANIESCOMPANIES
Diversification
f d
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 72/98
Diversification and Corporate
Strategy
A company i s d iv ersifi ed when i t i s in t wo or more l ines of business
Strategy-making in a d iv ersifi ed company is abigger picture exercise than crafting a strategy for asingle line-of-business
± A diversified company needs a mult i -ind ustry, mult i -business strategy
±
A strategic ac t ion plan must be developed forsev eral different businesses competing in d iv erseind ustry environments
When Does Diversification
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 73/98
When Does Diversification
Start to Make Sense?
Strong competitiveposition, rapid market
growth -- N ot a good
time to diversify
Strong competitive
position, slow market
growth -- Diversification
is t op pr ior i ty
consideration
Weak competitiveposition, rapid market
growth -- N ot a good
time to diversify
Weak competitive
position, slow market
growth -- Diversification
merits consi derat ion
S i f i
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 74/98
Strategies for Entering
New Businesses
Acquire existing company
Start-up new business internally
Joint venture with another company
A i C Al d i h
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 75/98
Acquire a Company Already in the
Target Industry
Most popular approach to diversification
Advantages
± Quicker entry into target market
± Easier to hurdle certain entry barriers
Technological inexperience
Gaining access to reliable suppliers
Being of a size to match rivals in terms of efficiency and costs
Getting adequate distribution access
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 76/98
Diversification via Internal Startup
More attrac t iv e whenMore attrac t iv e when Ample time exists to create a new business from
ground up
Incumbents slow in responding to new entry
Less expensive than acquiring an existing firm
Company already has most of needed skills
Additional capacity will not adversely impact
supply-demand balance in industry New start-up does not have to go head-to-head
against powerful rivals
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 77/98
Diversification via Joint VenturesG
ood w ay t o d iv ersif y whenG
ood w ay t o d iv ersif y when Uneconomical or risky to go it alone
Pooling competencies of two partners provides
more competitive strength
Foreign partners are needed to surmount
± Import quotas
± Tariffs
± Nationalistic political interests
± Cultural roadblocks
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 78/98
What Is Related Diversification?
Involves diversifying into businesses whosev al ue chains possess competitively valuable
strategic fi ts with the value chain(s) of the
present business(es)
Capturing the strategic fi ts makes related
diversification a 2 + 2 = 5 phenomenon
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 79/98
Benefits of Related Diversification
Preserves uni ty in its business activities Reap compet i t iv e ad v antage benefits of
± Skills transfer
± Lower costs
± Common brand name usage
Spread investor r i sk s over a broader base
Achieve consol i dated per for manc e greater than thesum of what individual businesses can earn
operating independently
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 80/98
Concept: Economies of Scope
Arise from ability to el iminate costs by operatingtwo or more businesses under same corporateumbrella
Exist when it is less costly for two or morebusinesses to operate under centralizedmanagement than to function independently
Cost saving opportunities can
stem from interrelationshipsanywhere along businessesv al ue chains
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 81/98
Capturing Benefits of Strategic FitBene fi ts d ont occur by t hemsel v es ! ± Businesses with sharing potential must be
reorganized to coordinate activities
± Means must be found to make skills transfer
effective
Benefits of some strategic coord inat ion must exist to
justify sacrificing business-unit autonomy
Compet i t iv e ad v antage potential exists ± To expand resources and strategic assets and
± To create new ones faster and cheaper than rivals
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 82/98
Involves diversifying into businesses with
± N o strategic fit
± N o meaningful value chain
relationships
± N o unifying strategic theme
Approach is to venture into any business
in which we think we can make a profit Firms pursuing unrelated diversification are often
referred to as congl omerates
What Is Unrelated Diversification?
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 83/98
Post-Diversification Strategies
Divestiture and liquidation
Corporate turnaround
Corporate retrenchment
Portfolio restructuring
Multinational diversification
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 84/98
Comment: Trend in Diversification
The present trend toward narrower
diversification has been driven by a
growing preference to gear
diversification around creating strong
competitive positions in a few, well-
selected industries as opposed to
scattering corporate investments across
many industries!
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 85/98
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 86/98
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 87/98
87
Procter & Gambles Diversification Strategy
Purpose of diversification: Use expertise andknowledge gained in one business by diversifyinginto a business where it can be used in a related
way ± Builds synergy: value added by corporate office adds up to morethan the value if different businesses in the portfolio wereseparate and independent
Procter & Gamble (P&G) ± Product mix: beauty products targeting women and baby care
products
± 2005: Acquired Gillette (consumer health care products)focused on masculine market
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 88/98
88
Procter & Gambles Diversification Strategy
Procter & Gamble (P&G) (Contd)
± Synergy created with combining toothbrush and toothpaste
businesses
Had to sell off product lines with Gillette acquisition, lost some
prospective market power
Good for retailers (shelf space)
Although strategy appeared to have potential, it was more difficult
to create actual operational relatedness between the products
±Comingle employees requiring actual physical re-location/talent exit
± Different ways to make business decisions
± Conflicting organizational cultures
l f f
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 89/98
89
Levels of Diversification
1. Low Levels
± Single Business Strategy
Corporate-level strategy in which the firm generates 95% or more of
its sales revenue from its core business area
E.g. Daimler Benz, DeBeers
± Dominant Business Diversification Strategy
Corporate-level strategy whereby firm generates 70-95% of total sales
revenue within a single business area
Nestle
l f f
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 90/98
90
Levels of Diversification
2. Moderate to High Levels
± Related Constrained Diversification Strategy
Less than 70% of revenue comes from the dominant business(fromprimary activity)
Di rect l i nks (I.e., share products, technology and distribution linkages)between the firm's businesses
E.gn Abott Labs
± Related Linked Diversification Strategy (Mixed related and
unrelated ) Less than 70% of revenue comes from the dominant business
Mixed: Linked firms sharing f ewer resources and assets among theirbusinesses (compared with related constrained, above), concentrating onthe transfer of knowledge and competencies among the businesses
L l f i ifi i
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 91/98
91
Levels of Diversification
3. Very High Levels: Unrelated (Conglomerate)
Less than 70% of revenue comes from (primary activity)dominant
business
No relationships between businesses E.g. 3M, General Motors
Cost of Diversification: Internal
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 92/98
Cost of Diversification: Internal
CapitalMarket in Oil Companies
If internal capital markets worked well, nonoil
investments should not be affected by the
price of oil. Lamont (1997) found on the
contrary that investments in non-oilsubsidiaries fell sharply after the drop in oil
prices.
Managerial reasons may dominate theinvestment decisions
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 93/98
Indian companies 1979-89
Raman (1991) has measured the pattern of diversification of 67 Indian companiesfrom the private sector. The pattern was studied over 1 1 -year period from 1979-89 at three points of time, that is, 1979, 1984 and 1989. Using Rumelt'sclassification the firms were divided into nine categories. It was observed that
companies preferred going in for Unrelated Business rather than Single Business.
Among the Dominant Business, Dominant Vertical was the same for each year
while Dominant Linked was larger in 1989 as compared to 1979. The number of companies in related linked also increased as compared to related
constrained.
However, between 1980-90, studies also show that companies started favoringrefocusing rather than diversification.
Lichtenberg (1992) showed that the level of diversification declined between 1985
and 1989 in a sample of 6,505 firms. Spender and Grant (1996) also reported that the average index of diversification
for Fortune 500 companies declined from 1.00 to 0.67.
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 94/98
94
Why do firms diversify
Diversification across productsand across markets can be due to
economies of scale and scope.
Diversification that occurs for
other reasons tends to be less
successful.Nokia - wood pulp and paper/
footwear/ televisions/ capacitors
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 95/98
E conomi es of sc ale and scope ± Operational synergies can be realized.
± Spreading the firm's unutilised organizational resources to other areas can create value.
± Leveraging skills across businesses can create value.
T ransac t ion costs
± Coordination among independent firms may involve higher transaction costs.
Inter nal c a pi tal mar k et ± Cash from some businesses can be used to make profitable investments.
± External finance may be more costly due to transaction costs, monitoring costs,etc.
Div ersif y ing shareholders port fol ios
± Individual shareholders may benefit from investing in a diversified portfolio.
I dent if y ing under v al ued fi r ms ± Shareholders may benefit from diversification if its managers are able to identify
firms that are undervalued by the stock market.
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 96/98
Why do firms diversify Growth is an implicit objective in nearly all organisations. Stock
markets tend to reward growing companies.
± Managers find growth extremely attractive because it hold out the
prospects of increased earnings for the firm leading to increased
compensations for themselves. They also see the acquisition of
new knowledge as instrumental in improving their self actualisation prospects.
Fuller utilisation of Resources and Capabilities - Firms find that they
have un utilised or under utilised capacities sometimes in
manufacturing some times in Alternatively a firm could find that it can perform a business
activity at a lower cost and with better timeliness than if it utilised its
internal capabilities.
96
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 97/98
Why do firms diversify To make use of surplus Cash flows. There are several examples of
this to be found in Indian Industry. Bajaj Auto and Bombay Dyeing
have consistently over the last few years invested surplus cash from
their core businesses in Two Wheelers and Textiles respectively into
treasury operations mostly short term lending to other cash strapped
Corporates. At times a firm might use surpluses from one of its cashrich businesses to cross fund other businesses.
Managerial Reasons - Managers find growth extremely attractive
because it hold out the prospects of increased earnings for the firm
leading to increased compensations for themselves. They also see the
acquisition of new knowledge as instrumental in improving their self
actualisation prospects.
97
Cons
5/12/2018 Final Week 6 Lecture 6 - Diversification - slidepdf.com
http://slidepdf.com/reader/full/final-week-6-lecture-6-diversification 98/98
Cons Combining two businesses in a single firm is likely to result
in substantial influence costs. Resource allocation can be influenced by lobbying.
Costly control systems may be needed that reward
managers based on division profits and discipline
managers by tying their careers to business unitobjectives.
Internal capital markets may not work well in practice.
Shareholders can diversify their own personal portfolios.Corporate managers are not really needed to do this.
Identifying undervalued firms may not be as easy as it
sounds