07 Diversification

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2006 Dr. Bernd Venohr

Corporate Strategy

Diversification

Prof. Dr. Bernd Venohr

Berlin, June 2007

7


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2 2006 Dr. Bernd Venohr

Agenda (NEU)

Introduction to StrategyCourse Overview and Strategy ConceptCommunication and Problem SolvingEconomics of StrategyShareholder Value

Business StrategyExternal EnvironmentInternal EnvironmentCompetitive Positioning

Corporate StrategyDiversificationMergers & Acquisitions

Global Strategy

Strategy ProcessOrganizational Structure and ControlStrategic Leadership

123

5

67

8

9

10

1112

4


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Where are we today?

Introduction to Strategy

Business Strategy Corporate StrategyExternalEnvironment

InternalEnvironment

CompetitivePositioning

Diversification

Mergers &Acquisitions

GlobalStrategy

Strategy Concept Communication andProblem Solving

Shareholder Value

Strategy Process

1 2

3

OrganizationalStructure andControl

StrategicLeadership

11

12

5 6

7

8

9 10

Economics ofStrategy3 4


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Corporate vs. business level strategy: a diversified company,which is active in more than one business, has two levels ofstrategy (BITTE LOGOS DP HINEINKOPIEREN(

DPWN

MailFinancial

ServicesLogisticsExpress

Example: Deutsche Post World NetExample: Deutsche Post World Net

Source: Corey Phelps; Mgmt 430

CORPORATE

LEVEL

BUSINESS

LEVEL


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Key issues corporate versus business strategy

What businesses should we be in?

How should these be managed?

How to create value for the corporation as a whole?

CORPORATE STRATEGY: How to create a competitive advantage

for the whole company

BUSINESS STRATEGY: How to create a competitive advantage in

specific, individual product markets

Which customers to serve (who?) segmentation

Which customers needs to satisfy (what?) differentiation

Resources and value chain activities necessary to satisfying customer

needs (how?) core competencies


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Key Challenges for a value-creating corporate strategy

Direct competition occurs at the business unit level

Corporate Strategy adds costs and constraints to business

units

Shareholders can easily diversify themselves

Source: Porter, From competitive advantage to corporate strategy


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Goal of Corporate Strategy: create corporate advantage

Goal of corporate strategy

- to build corporate advantage

- earn above normal returns

Three tests on the existence ofcorporate advantage

- Does ownership of the business create benefitsomewhere in the corporation? (Does parentage matter?)

- Are those benefits greater than the cost of corporateoverhead?

- Does the corporation create more value with the business

than any other possible corporate parent or alternativegovernance structure?

Source: Collis and Montgomery, 1998


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P1 P2 P3 C1 C2 C3

Vertical Market - Geographical

Scope Scope Scope

V1V2

V3

P3P2P1 C3C2C1

V1

V2

V3

[A] Single

Integrated

Firm

[B] Several

Specialized

Firms linked

by Markets

In situation [A] the business units are integrated within a single firm.

In situation [B] the business units are independent firms linked by markets.

Are the administrative costs of the integrated firm less than the transaction

costs of markets?

Focus of corporate strategy: where a firm competes,i.e. the scope of its activities

Source: Robert M. Grant, Contemporary Strategy Analysis: Concepts, Techniques, Applications (5th edition, Blackwell, 2004)


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Corporate strategy: diversification into new areas byemploying one of the three levers

Markets: Products and Services and Customer segments

Vertical: Value Chain

Geography

1

2

3


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Low Levels of Diversification

Moderate to High Levels of Diversification

Very High Levels of Diversification

Related linked (mixed) < 70% of revenues from dominantbusiness, only limited links exist

A

B C

Single business > 95% of revenues from singlebusiness unit

A

Dominant business Between 70% and 95% ofrevenues from single business unit

B

A

Unrelated-

Diversified

Business units not closely related

A

B C

< 70% of revenues from dominantbusiness; all businesses shareactivities in value chain

Related constrainedA

B C

Levels and types of diversification: therelated ratio

Source: Robert M. Grant, Contemporary Strategy Analysis: Concepts, Techniques, Applications (5th edition, Blackwell,

2004)


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Two alternative diversification strategies:related versus unrelated

Related diversification strategies: firm moves from a core of activities

in a specific product market to other related activities and markets

Demand and/or cost linkages between lines of business

Sharing value chain activities and transferring core competencies

Unrelated diversification strategies

Replace external capital market with internal capital market allocation

No linkages between businesses



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Two directions of related diversification:vertical and horizontal

Horizontal diversification (HD) : different businesses in similar stage of

value chain

concentric diversification: businesses are highly related

conglomerate: businesses are unrelated

Vertical diversification (VD) : Number of stages a firm engages in the

value chain

Forward (into distribution channels) vs. backward integration (sources of

supply)

Make vs. buy



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Vertical Diversification:Number of stages a firm engages in the value chain

IT Consulting and

Outsourcing

Software

IT Hardware


Ve

rticalDimens

ion


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Horizontal Diversification: number of different productmarkets a company is active in

Power

Generation

I&C

Net-works

Medical

Solutions

Horizontal Diversification



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Degree of vertical diversification (integration)explained by transaction cost theory

Developed by Ronald Coase ( Nobel Memorial Prize inEconomics in 1991 ; The Nature of the Firm)

Why economy is populated by a number of business firms,instead of consisting exclusively of a many independent, self-employed people who contract with one another ?

Key driver: transaction costs of the market (= cost oflocating, negotiating, and enforcing a contract) . Firms will arisewhen they can arrange to produce what they need internallyand avoid these costs.

There is a natural limit to what can be produced internally :"decreasing returns to the entrepreneurial function ( overhead

costs and mistakes in resource allocation)

Source: Coase, Ronald. "The Nature of the Firm".; Wikepedia


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Vertical diversification: Owning and directing additionalactivities makes sense if external markets dont function well

Activity is more efficient within the firm (cost / benefit)

Lower transaction costs and improved coordination vs.

Sacrifice scale/scope economies

Protect leakage of technology

Create market power via creation of entry barriers

Integrate backwards: buy up key supplier

Integrate forward: lock up distribution

Undo effects of market power: eliminate market power of supplier or buyer

Acquire information about value chain steps



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Vertical diversification: Some Vertical Integration Fallacies

Firms should make (integrate) to keep for themselves profits earned

by market firms: profits represent returns necessary to attract investment

and would be required of any firm

Vertically integrated firms can produce an input at cost and will have

cost advantage over nonintegrated firms who have to buy inputs at

market prices

hidden opportunity costs for vertically integrated firm: no sales in open

market (less scale economies); less competitive pressures

increasing cost of coordinating vertical activities



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Vertical diversification:recent trends in vertical relationships

From competitive contractingto supplier partnerships, e.g. in autos

From vertical integration to outsourcing (not just components, also IT,

distribution, and administrative services)

Diffusion of franchising

Technology partnerships (e.g. IBM-Apple; Canon-HP)

Inter-firm networks

General conclusion:

Boundaries between firms and markets becoming increasingly blurred.



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Vertical diversification: Different Types of Vertical Relationships

Spot sales/

purchases

Long-term

contracts

Agencyagreements

Franchises

Vertical

integration

Joint

ventures

Informal

supplier/

customer

relationships

Supplier/

customer

partnerships

Low Degree of Commitment High

Low

Formalization

High



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Horizontal diversification benefits (synergies) arisebecause of shared resources that exist across productmarket boundaries

Cost-driven synergies: Sharing of activities lowers costs

Supply-based joint resources (Economies of scope):if a firm produces two

related products, the total costs of producing them jointly is lower than the sum of

the cost of producing them separately (share fixed costs between different

products) due to resource sharing.

Examples : common distribution facilities, brands, joint R&D

Demand-based synergies: raise differentiation

customers perceive linkages in products

risky, since quite often based on customers cognitive links betweeen products

(perceptions) which can change quickly



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Horizontal diversification: Identify cross-business sharedresources by comparing value chains across businesses

Business A

Value Chain ActivitiesInbound

LogisticsTechnology Operations

Sales and

MarketingDistribution Service

Business B

Business C

Business D

Business E

Opportunity to combine purchasing activities (gain more leverage with suppliers)

Opportunity to share technology, transfer technical skills, combine R&D

Opportunity to combine sales & marketing activities, use common distribution channels,leverage use of a common brand name, and/or combine after-sale service

No sharing



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Example horizontal diversification: Procter & Gambleusing a common physical distribution system andsales force

Source: Walker W. Lewis, The CEO and Corporate Strategy in the 80s: Back to Basics , 1984

Reprinted by permiss ion of The institute of Management Sciences, Providence, RI

Procter & Gamble Strategic Field


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Horizontal diversification:Transferring Core Competencies

Exploit intangible interrelationships among divisions

Identify ability to transfer skills and expertise among similar value chains(across divisions)

Activities must be sufficiently similar that sharing is possible

Transfer of skills involve activities which are important to competitive advantage The skills transferred represent significant sources of advantage for the receiving

business unit

Examples:

Deutsche Post logistics expertise

Toyotas core competence in engines

Apple`s core competence in design



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Horizontal diversification: Significant managementchallenges in actually achieving the potential benefits

Diversification alone will not produce superior performance: benefits

dont just happen

Management skills in capturing potential benefits of interrelationships

are a key success factor

Key levers are:

strong sense of corporate identity and mission that emphasizes the

importance of integrating business units

allocation of management attention

allocation of capital and shared resources to different business units

management hiring/training

incentive systems that reward more than just business unit performance


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Conglomerates/Holding Companies: to venture into any business in which we think wecan make a profit

Assumptions

Managers have superior information vs. outside investors

Top management can more precisely allocate resources to businesses than external

market

Key characteristics of unrelated diversification

Often pursued through acquisitions: sound companies in attractive markets

Acquired businesses will stay autonomous

Corporate headquarter acts as portfolio manager

Supplies needed capital to each business

Transfers resources from cash cows to businesses with high growth potential

Add professional management and strict financial controls

Unit managers compensated on unit results

Unrelated Diversification: diversifying into businesseswith nomeaningful value chain relationships or demandside synergies



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Example of unrelated diversification: Virgin Group

*Source: virgin.com Homepage


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Example of unrelated diversification: Virgin Group -Richard Branson as founder and CEO


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Unrelated diversification: benefits and risks

Potential benefits Business risk scattered over different industries Financial resources directed to those industries offering best profit

prospects Stability of profits : Hard times in one industry may be offset by good

times in another industry

If bargain-priced firms with big profit potential are bought, shareholderwealth can be enhanced

Potential risks Difficulties of competently managing many diverse businesses Lack of strategic fit which can be leveraged into competitive advantage Consolidated performance of unrelated businesses tends to be no better

than sum of individual businesses on their own (and it may be worse). 1+ 1 = 2, rather than 1 + 1 =3

Promise of greater sales-profit stability over business cycles seldomrealized


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Theory of unrelated diversification:Why an internal capital market can be more efficientthan the external capital market?

Create value by exploiting financial economies: large organizationscan fund projects more quickly and economically than external market

small projects are bundled

large projects can be taken on

key challenge :find products and markets that provide negativelycorrelated cash flows

Reduce funding costs through superior financial resource allocation:internal capital market is like a debt market with all the benefits ofequity ownership

resolve borrower-lender problem (moral hazard):

internal funding allows for information sharing and better control over theuse of funds by the lender

less likely that borrower and lender expropriate each other



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Theory of unrelated diversification:common diversification problems

Internal capital markets are less efficient than external ones

Higher quality information not guaranteed

Individual investors can generally diversify more effectively

Capital allocation can quickly stretch abilities of top managers

Managers personal interests drive diversification decision Top executives compensation often based on peer companies

(diversify to increase compensation) : empire building

When diversification buffers performance its harder for top execs to get

fired (Reduce employment risk)

Poor performance may lead firms to diversify to achieve better returns

(the grass is always greener)



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Underrated good reason for unrelated diversification:

business life cycles

All business go through life cycles no matter how good a business is today

, it will eventually mature and decline

Companies in growth industries should devote the majority of their

management time and attention to exploit the potential

Corporations in maturing industries with little diversification and low

expected long-term growth should introduce growth businesses into their

portfolio: here most of the benefits of moderate diversification can be

achieved.

Anecdotal evidence: the experience of very old and still very successfulcompanies like Haniel or Siemens (all active in several businesses; in most

cases original business has been shed)


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Moderate levels of diversification yield higher levelsof performance than either limited or extensivediversification (1)*

*Source: Palich/ Cardinal/ Chet Miller, 2000

Single/

Dominant

Business

Related Unrelated

Performan

ce

Level of Diversification


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Read slides on session 7 on ILIAS

Visit company web pages and prepare as team a brief description

of your companies corporate strategy (degree of relatedness; potential linkages

among businesses)

Topics of next session:

Brief page presentation on each company; send in advance per e-mail or bring

presentation on usb stick

Lecture: Corporate Strategy: M&A

New Assignment and Outlook next Session


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Appendix


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Remarks-Premises of Corporate Strategy

Direct competition occurs at the business unit level

- Corporations dont compete; only their business units do

- Value created at the business unit level, only added at the corporate level

- Successful corporate strategy must grow out of and reinforce business strategy

Corporate Strategy inevitably adds costs and constraints to business units

- Corporate overhead

- Costs of coordination and monitoring: communication between headquarter andbusiness units

Shareholders can easily diversify themselves

- Shareholders can diversify their own portfolios of stocks, and they can often do itmore cheaply with less risk than corporations

- Shareholders can buy shares at market prices and avoid paying large acquisitionpremiums

Source: Porter, From competitive advantage to corporate strategy


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Vertical diversification: Transactions cost exist,when there is market failure (market transactionsinappropriate or too costly), which in turn lead to firmsvertically integrating

A vertical market "fails" when transactions within it are too risky and the contracts designed toovercome these risks are too costly (or impossible) to write and administer. Where transaction costsare high , the firm is a more efficient means of organization

Examples (causes) ofmarket failures:

One Seller, One Buyer

Difficulty in Writing Contracts: Bounded Rationality; Opportunism; Pre Adverse Selection; Post - --Moral Hazard

Asset Specificity Frequency of Transaction: The more frequent a transaction, all else equal, the more likely integration will

occur

By vertically integrating a firm makes its resource decisions internally, using managementmechanisms, as opposed to using the market . The objective is to adopt the organizational mode thatbest economizes on transaction costs, minimizes the risk of market failure, while taking into account theexpense of governance costs. Firms must balance transaction costs with the cost of governance.

Rapid decline of vertical integration in the last few years: rise of outsourcing advances of computer technology allow for easy cooperation between companies (lowering transaction

costs and incentive and coordination poblems)

increased ability to write more complete and enforceable contracts

Source: Coase, Ronald. "The Nature of the Firm".; Wikepedia


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Vertical diversification:The Costs and Benefits of Vertical Integration

Benefits

Technical economies from integrating processes e.g. iron and steel production

Superior coordination

Avoids transactions costs of market contracts in situations where there are:

small numbers of firms

transaction-specific investments

opportunism and strategic misrepresentation

taxes and regulations on market transactions

Costs

Differences in optimal scale of operation between different stages prevents balanced verticalintegration

Strategic differences between different vertical stages creates management difficulties

Inhibits development of and exploitation of core competencies

Limits flexibility in responding to demand cycles

in responding to changes in technology, customer preferences, etc.

Compounding of risk



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Remarks-Theory of unrelated diversification:Why an internal capital market can be more efficientthan the external capital market?

Create value by exploiting financial economies: large organizations can fundprojects more quickly and economically than external market

small projects are bundled, large company can borrow more cheaply (company assecuritized bundle of projects)

large projects: diversified firm may take on projects whose risk is too great to betaken on by any one or a group of smaller companies

key challenge for related diversifiers: find products and markets that can takeadvantage of competitive strengths but at the same time provide negativelycorrelated cash flows

Reduce funding costs through superior financial resource allocation: internalcapital market is like a debt market with all the benefits of equity ownership

resolve borrower-lender problem (moral hazard): once lending contract is signedborrower has an incentive to increase risk of project financed increasing hisexpected return while decreasing that of a lender. Contracts can only imperfectlycontrol this risk

internal funding allows for information sharing and better control over the use offunds by the lender

less likely that borrower and lender expropriate each otherSource: Corey Phelps; Mgmt 430


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Remarks-Theory of unrelated diversification:common diversification problems

Internal capital markets are less efficient than external ones

Higher quality information not guaranteed

Individual investors can generally diversify more effectively: combined cash flows

may reduce unique risk (assuming not perfectly correlated) NOT considered a

benefit to outside equity holders; may be insurance for employees, customers,

suppliers, debt holders

Capital allocation can quickly stretch abilities of top managers; additional problem:

escalation of commitment more likely

Managers personal interests drive diversification decision

Top executives compensation often based on peer companies (diversify to

increase compensation) : empire building

When diversification buffers performance its harder for top execs to get fired(Reduce employment risk)

Poor performance may lead firms to diversify to achieve better returns (the grass

is always greener)Source: Corey Phelps; Mgmt 430


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Empirical results on diversification: Most large firmsare probably still remarkably diversified, but thereseems to be somewhat of a a trend to focus on oneor more core businesses

*Source: Szeless (2001): page 81-96; data taken from DATASTREAM

database (original sample of 250 companies reduced to 93

companies); own calculations

**Source: Prner (2003): data based on tel ephone interviews with Heads

of Strategic Planning/Corporate Development of 16 out of 30 Dax

companies

Current strategic priorities

of DAX 30 companies**

Degree of diversification of 250 largest publicly

listed companies in Germany/Switzerland/Austria*

EXAM

PLES

Dominant

1991

27%

Related 25%

Unrelated 32%

1994

30%

24%

29%

1997

27%

20%

34%

Single 16% 17% 19%

Konzentration aufKerngeschftsfelder

Wachstum

Realis ierung von Synergieeffekten

zwischen den Geschftsbereichen

Internationalisierung

Innovationsstrategie

Kooperationsstrategien

Risikoausgleich zwischen deneinzelnen Geschftsbereichen

Finanzielles Gleichgewichtzwischen den Geschftsbereichen

Kapazittsabbau/Schrumpfung

Diversifikation

Sonstige 4344

9101213131414


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Empirical results diversification and firm perfor-mance: moderate levels of diversification yieldhigher levels of performance than either limitedor extensive diversification (2)*

Key results

most profitable firms are those that have diversified around a set of resources thatare specialized enough to confer an advantage in an attractive industry, yetfungible enough to be applied in other industries

least profitable are those that are broadly diversified and whose strategies are

built around very general resources that are applied in a wide variety of industriesbut are rarely instrumental in competitive advantage in an attractive industry

Limits of diversification

Bureaucratic costs place a limit on the amount of diversification that can profitablybe pursued

Arise in large, complex organizations due to managerial inefficiencies (diversebusinesses in a companys portfolio; Information overload; coordination amongbusinesses)

*Source: Palich/ Cardinal/ Chet Miller, 2000


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Alternative strategy concept for internal analysis:Focus on companys competencies / capabilitiesand ressoures to explain the underlying factors fora competitive advantage (CCR-Framework)

Resources Tangible

Intangible

Capabilities

Teams of

Resources

Core Competencies

Sources ofCompetitive

Advantage

Above-average returns ()

Criteria ofSustainable

Advantages

ValueChain

Analysis

Robert M. Grant, Contemporary Strategy Analysis: Concepts, Techniques, Applications

(5th edition, Blackwell, 2004)


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Core Competencies:What a firm does that is strategically valuable

What a firm does that is strategically valuable

the essence of what makes an organization unique in its ability to provide value

to customers.

Criteria for resource to be a core competency and generate sustained

competitive advantage

Valuable: Capabilities that either help a firm to exploit opportunities in the

environment to create value or to neutralize threats in the environment

Rare: Capabilities possessed by few, if any, current or potential competitors

Costly to imitate: Capabilities that other firms cannot develop easily, usually due

to unique historical conditions, causal ambiguity or social complexity

Non substitutable: Capabilities that do not have strategic equivalents, such as

firm-specific knowledge or trust-based relationships

Source: Robert M. Grant, Contemporary Strategy Analysis: Concepts, Techniques, Applications



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Resources: What a firm has

Resources

What a firm has to work with

Its assets, including its people and the value of

its brand name

Represent inputs into a firms production process

and contribute to its ability to provide value

Such as capital equipment, employees skills

and knowledge, brand names, finances,

managerial talent

Are observable

Are tradeable

Contribute to the firms market position by

improving value, by lowering cost or both.

Have value if difficult to imitate or substitute

Tangible resources

Financial

Physical

Organizational

Technological

Intangible resources

Human

Innovation Reputation

Robert M. Grant, Contemporary Strategy Analysis: Concepts, Techniques, Applications



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Capabilities: What a firm does

Capabilities

Cannot be readily observed

Are not tradeable separately from the company.

Are developed by a company through coordinated action

Become important when they combine resources in unique combinations that

create economic value and can lead to competitive advantage (Can contribute tohigher value, lower cost or both.)

Firms compete on resources & capabilities as much as they do on products

Visible competition product market competition

Invisible competition resource & capability development and deployment




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Core Competencies: the roots of a business


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PrecisionMechanics

FineOptics

Micro-Electronics

35mm SLR camera

Compact fashion cameraEOS autofocus cameraDigital camera

Video still camera

Plain-paper copier

Color copierColor laser copier

Laser copierBasic fax

Laser fax

Mask alignersExcimer laser alignersStepper aligners

Inkjet printerLaser printer

Color video printer

CalculatorNotebook computer

Canon: Products and Core Technical Capabilities



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