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Logic of Corporate Level Strategy

The Strategic Management Process
Corporate level strategy should create value:
External
Analysis
1) such that businesses forming the corporate whole
are worth more than they would be under
Strategic Strategy Competitive
Mission Objectives independent ownership
Choice Implementation Advantage

Which Businesses 2) that equity holders cannot create through

Internal to Enter? portfolio investing
Analysis
Corporate Level • Vertical Integration
Strategy • Diversification Therefore,
• a corporate level strategy must create
synergies
• economies of scope—diversification

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INTRODUCTION: THE BASIC ISSUES

Core Issues in Diversification Decisions

Superior profit derives from two sources:

INDUSTRY
ATTRACTIVENESS
RETURN ON CAPITAL

> COST OF CAPITAL

COMPETITIVE
ADVANTAGE

Diversification decisions involve these same two issues: MANAGING PORTFOLIO

• How attractive is the industry to be entered?
• Can the firm achieve a competitive advantage?

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INTRODUCTION: THE BASIC ISSUES

Trends in Diversification Diversification Strategies of US and UK

Corporations during the 20th Century
%
70
• Urge to Diversify: 1950 – 1980 United States United Kingdom
– Diversification major source of corporate growth 60
– 1970s saw the emergence of conglomerate – from multiple,
unrelated acquisitions 50

40 Single business
• Refocusing: 1980 – 2009 Dominant business
– Noncore businesses divested, only related diversification 30 Related business
– Emphasis on shareholder value Unrelated business
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0
1949 1964 1974 1950 1970 1993

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INTRODUCTION: THE BASIC ISSUES

The Evolution of Diversification Strategies, 1960-2018 Directional Policy Matrix

Making Creating Corporate
MANAGEMENT Growth diversification shareholder
GOALS advantage
profitable value

•Diversification • Emphasis on • Core business • Product

IMPLICATIONS by established related focus bundling and
FOR firms • Divestments, customer
diversification
DIVERSIFICATION • Emergence of and spin-offs solutions
STRATEGY • Quest for
conglomerates • Leveraged • Alliances
synergy
• Boom in M&A buyouts • Growth options

• Financial • Economies of •Shareholder • Parenting

analysis scope value advantage
STRATEGY • Portfolio •Transaction cost • Real options
• M-form
TOOLS AND structures planning models analysis • Demand-side
CONCEPTS economies of
• Corporate • Modern •Core competence
financial theory scope
planning •Dominant logic
• Tech platforms

1960 1970 1980 1990 2000 2018

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BCG Matrix BCG Matrix

Question marks. Question marks Stars. Stars are the primary units in
have potential to gain market which the company should invest
share and become a star, which its money, because stars are
would later become cash cow. expected to become cash cows
and generate positive cash flows.
Strategic choices: Market
penetration, market development,
Strategic choices: Vertical
product development, divestiture
integration, horizontal integration,
market penetration, market
development, product development

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BCG Matrix BCG Matrix

Cash cows. Cash cows are the most
Dogs. Not worth investing in
profitable brands and should be
unless, they provide synergies for
“milked” to provide as much cash as
other brands or SBUs or simple act
possible. The cash gained from
as a defense to counter
“cows” should be invested into stars
competitors moves.
to support their further growth.

Strategic choices: Retrenchment,

Strategic choices: Product
divestiture, liquidation
development, diversification,
divestiture, retrenchment

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Strategies of Danaher Corporation

• Business Level Strategies:
• Cost leadership: lowest cost manufacturer, scale economies (12 of 14 subsidiaries mkt leaders)
• Product Differentiation: innovation, new product development

• Corporate strategies:
• Diversification: related and unrelated, debt driven growth, manufacturing sector
• Merger & Acquisitions: 50 M&A in 5 years
• Global Strategies: New market entry Types of

• M&A strategies: DIVERSIFICATION

• Attractive industry: growth (5-7%), size ($1 bn), cyclicity, fragmentation, competition
• Attractive firm: market leader, weak leadership, missing infra, inefficiency
• New platforms, Bolt-ons, Adjacencies

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RELATEDNESS IN DIVERSIFICATION

The Sources of Strategic Relatedness

Diversification Between Businesses
Corporate
Determinants of Strategic Similarity
Management Tasks
• Similar sizes of capital investment projects
• Similar time spans of investment projects
Diversification Resource allocation • Similar sources of risk

Other Other • Similar general management skills required for

Current
business unit managers
Businesses Businesses Businesses
• Similar key success factors
No Unrelated Related Many • Similar stages of the industry life cycle
Links Links Strategy formulation • Similar competitive positions occupied by each
business within its industry

Performance • Targets defined in terms of similar performance

management and variables
control • Similar time horizons for performance targets

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Types of Corporate Diversification Product and Geographic Diversification

At a general level… Possibilities:
Product Diversification: • single-business in one geographic area
• single-business in multiple geographic areas
• operating in multiple industries
• related-constrained in one or multiple geographic areas
Geographic Market Diversification: • related-linked in one or multiple geographic areas

• operating in multiple geographic markets • unrelated in one or multiple geographic areas

Note:
Product-Market Diversification • Relatedness usually refers to products.
• operating in multiple industries in multiple • Seemingly unrelated products may be related on
geographic markets other dimensions.

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Types of Corporate Diversification Types of Corporate Diversification

At a more specific level…
Limited Diversification Product Product-Market
Multiple Diversified Diversified
• single business: > 95% of sales in single business
Market
• dominant business: 70% to 95% in single business
Market
Single Single Business
Related Diversification (<70% of sales from single business) Diversified

• related-constrained: all businesses related on most

dimensions Single Multiple

• related-linked: some businesses related on some

Geography
dimensions

Unrelated Diversification
• businesses are not related

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Diversification Conglomerates

• Diversification through the development of new products delivered in new • A unique category of firms that are affiliated with a group of firms tied
markets (Ansoff, 1957) together by a common ownership network

• Known by different names in different countries

– Chaebol in South Korea
– Grupos in Latin America
– Business Groups in India

• The control and coordination in affiliated firms is through a complex web of

multiple and reciprocated equity, debt and commercial ties in its network.

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MOTIVES FOR DIVERSIFICATION

Motives for Diversification

• The desire to escape stagnant or declining industries a
powerful motives for diversification (e.g. tobacco, oil,
GROWTH newspapers).
• But, growth in the interests of managers not
shareholders
• Growth-seeking diversification (esp. by acquisition)
tends to destroy shareholder value

• Diversification reduces the variance of profit flows

RISK • But, doesn’t create value for shareholders—they can
Why SPREADING hold diversified portfolios of securities. [Capital Asset
Pricing Model shows that diversification only lowers
DIVERSIFY? unsystematic risk not systematic risk]

• For diversification to create shareholder value, then

VALUE bringing putting different businesses under common
CREATION ownership must increase their total profitability

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Why firms diversify? Why firms diversify?

Diversification allows the firm to grow rapidly by expanding operations into new Related Unrelated
business fields Transfer of skills In search of new investments
Knowledge, and other competences across
businesses
Why is (rapid) growth beneficial? Attractive profitability/risk and growth
Economies of scale prospects
Learning and experience curve effects Economies of scope
Advantages arising from
Lower average unit costs (running at full capacity) Attractive speculative prospects
'umbrella branding'
More bargaining power with suppliers and customers
Exploiting differences between diverse geographical areas Developing innovative products and/or
processes

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Value of Diversification Value of Diversification

Two Criteria Business X + Business Y + Business Z Value

1) There must be some economy of scope. Independent: equity holder could buy shares of each firm

Focal Firm
2) The focal firm must have a cost advantage over
outside equity holders in exploiting any Business X
economies of scope. Economies
of Business Y Value
Scope
Business Z

Combined: equity holder buys shares in one firm

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MOTIVES FOR DIVERSIFICATION

Diversification and Shareholder Value: Economies of Scope

Porter’s Three Essential Tests Four Types
For diversification to create shareholder value, it must meet
three tests: Operational Economies of scale relate to
cost economies from
1. The Attractiveness Test: diversification must be directed increasing output of a single
towards attractive industries (or those with e the potential to Financial product.
become attractive).
Economies of scope relate to
2. The Cost of Entry Test : the cost of entry must not capitalize cost economies from
Anticompetitive increasing the output of
all future profits.
multiple products.
3. The Better-Off Test: either the new unit must gain competitive
advantage from its link with the company, or vice-versa. (i.e. Managerialism
some form of “synergy” must be present)

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Economies of Scope Economies of Scope

Operational Economies of Scope Operational Economies of Scope

Sharing Activities • Sharing tangible resources (e.g. research labs, distribution systems)
across multiple businesses
• exploiting efficiencies of sharing business
activities & avoiding duplication • Sharing intangible resources (e.g. brands, technology) across multiple
businesses

Spreading Core Competencies • Transferring functional capabilities (e.g. marketing, product development)
across businesses
• exploiting core competencies in other businesses
• Applying common general management capabilities to different businesses
• competency must be strategically relevant

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Economies of Scope Economies of Scope

Operational Economies of Scope Financial Economies of Scope
Economies of scope in diversification derive from two types of
relatedness: Internal Capital Market
• Operational Relatedness—synergies from sharing resources across • Premise: insiders can allocate capital across
businesses (common distribution facilities, brands, joint R&D) divisions more efficiently than the external capital
• Strategic Relatedness—synergies at the corporate level deriving market.
from the ability to apply common management capabilities to different
businesses. • works only if managers have better information
• may protect proprietary information
Problem of operational relatedness:
• may suffer from escalating commitment
The benefits from economies of scope may be dwarfed by the
administrative costs involved in their exploitation.

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Economies of Scope Economies of Scope

Financial Economies of Scope Financial Economies of Scope
Internal Capital Market Risk Reduction
• Economies of scope not a sufficient basis for diversification—must be
• counter cyclical businesses may provide
supported by transaction costs in markets for resources
decreased overall risk
• Diversified firm can avoid external transactions by operating internal however,
capital and labor markets
• individual investors can usually do this more
efficiently than a firm
• Diversified firm has better information on resource characteristics than
external markets

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Economies of Scope Economies of Scope

Anticompetitive Economies of Scope
Financial Economies of Scope
Multipoint Competition
Tax Advantages
• mutual forbearance
• transfer pricing policy allows profits in one • a firm chooses not to compete aggressively
division to be offset by losses in another division in one market to avoid competition in another
• this is especially true internationally market

• can be used to “smooth” income Market Power

• using profits from one business to compete in
another business
• using buying power in one business
to obtain advantage in another business

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Economies of Scope Equity Holders and Economies of Scope

Managerialism Most economies of scope cannot be captured
by equity holders.
• An economy of scope that accrues to managers
at the expense of equity holders. • Risk reduction can be captured by equity holders.
• Managers of larger firms receive more compensation
(larger scope = more compensation).
Managers should consider whether corporate
• Therefore, managers have an incentive to diversification will generate economies of scope
acquire other firms and become ever larger. that equity holders can capture.
• Even though the incentive is there, it is difficult • If a corporate diversification move is unlikely
to know if managerialism is the reason for an to generate valuable economies of scope,
acquisition. managers should avoid it.

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Measure of Diversification

Measuring

DIVERSIFICATION

CSP001: SECTION B SESSION 10 42

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Measure of Diversification Measure of Diversification

CSP001: SECTION B SESSION 10 43 CSP001: SECTION B SESSION 10 44

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DIVERSIFICATION AND PERFORMANCE

The Findings of Empirical Research Trends in Diversification

• No consistent relationship
• Evidence of a ∩-shaped relationship: dn. first
Do diversified increases profitability, then further dn.
reduces profitability (increased complexity?)
firms outperform
specialized firms? • McKinsey & Co. identify benefits from
moderate dn.—especially for firms that have
run out of growth opportunities
• Question of direction of causation: does dn.
drive profitability, or vice-versa?
• Most studies show related dn. outperforms
What type of unrelated dn.
diversification is • Related dn. offers greater synergies—but
most profitable? - also imposes higher management costs
--Related dn. vs. • But what is “related dn.”? Businesses can
Diversification into related industries may be more profitable than into unrelated
unrelated dn. be related in many different ways (e.g. industries (Rumelt, 1974)
LMVH, GE, Virgin group)

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Summary Summary
Corporate Strategy: In what businesses should Economies of Scope
the firm operate?
• Operational; Functional; Anticompetitive; Managerial;
• An understanding of diversification helps managers
answer that question.
Porters Three Criteria:
Two Criteria: 1) Attractiveness Test
1) economies of scope must exist
2) Cost of Entry Test
2) must create value that outside equity holders
cannot create on their own 2) Better-off Test

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