A strategy of diversifying into unrelated businesses

CHAPTER 8 Corporate Strategy: Diversification and the Multibusiness Company

LEARNING OBJECTIVES

THIS CHAPTER WILL HELP YOU UNDERSTAND:

When and how business diversification can enhance shareholder value

How related diversification strategies can produce cross-business strategic fit capable of delivering competitive advantage

The merits and risks of unrelated diversification strategies

The analytic tools for evaluating a company’s diversification strategy

What four main corporate strategy options a diversified company can employ for solidifying its strategy and improving company performance

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WHAT DOES CRAFTING A DIVERSIFICATION STRATEGY ENTAIL?

Step 1 Picking new industries to enter and deciding on the means of entry
Step 2 Pursuing opportunities to leverage cross-business value chain relationships and strategic fit into competitive advantage
Step 3 Establishing investment priorities and steering corporate resources into the most attractive business units
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STRATEGIC DIVERSIFICATION OPTIONS

Sticking closely with the existing business lineup and pursuing opportunities presented by these businesses

Broadening the current scope of diversification by entering additional industries

Retrenching to a narrower scope of diversification by divesting poorly performing businesses

Broadly restructuring the entire firm by divesting some businesses and acquiring others to put a whole new face on the firm’s business lineup

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WHEN TO CONSIDER DIVERSIFYING

A firm should consider diversifying when:

Growth opportunities are limited as its principal markets reach their maturity and buyer demand is either stagnating or set to decline.

Changing industry conditions—new technologies, inroads being made by substitute products, fast-shifting buyer preferences, or intensifying competition—are undermining the firm’s competitive position.

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HOW MUCH DIVERSIFICATION?

Deciding how wide-ranging diversification should be

Diversify into closely related businesses or into totally unrelated businesses?

Diversify present revenue and earnings base to a small or major extent?

Move into one or two large new businesses or a greater number of small ones?

Acquire an existing company?

Start up a new business from scratch?

Form a joint venture with one or more companies to enter new businesses?

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OPPORTUNITY FOR DIVERSIFYING

Strategic diversification possibilities

Expand into businesses whose technologies and products complement present business(es).

Employ current resources and capabilities as valuable competitive assets in other businesses.

Reduce overall internal costs by cross-business sharing or transfers of resources and capabilities.

Extend a strong brand name to the products of other acquired businesses to help drive up sales and profits of those businesses.

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BUILDING SHAREHOLDER VALUE: THE ULTIMATE JUSTIFICATION FOR DIVERSIFYING

The industry attractiveness test

The cost-of-entry test

The better-off test

Testing Whether Diversification Will Add Long-Term Value for Shareholders

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THREE TESTS FOR BUILDING SHAREHOLDER VALUE THROUGH DIVERSIFICATION

The attractiveness test

Are the industry’s profits and return on investment as good or better than present business(es)?

The cost of entry test

Is the cost of overcoming entry barriers so great as to long delay or reduce the potential for profitability?

The better-off test

How much synergy (stronger overall performance) will be gained by diversifying into the industry?

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Strategic Management Principle (1 of 9)

To add shareholder value, diversification into a new business must pass the three tests of corporate advantage

The industry attractiveness test

The cost of entry test

The better-off test

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Core Concept (1 of 15)

Creating added value for shareholders via diversification requires building a multibusiness company in which the whole is greater than the sum of its parts; such 1 + 1= 3 effects are called synergy.

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BETTER PERFORMANCE THROUGH SYNERGY

Evaluating the Potential for Synergy through Diversification

Firm A purchases Firm B in another industry. A and B’s profits are no greater than what each firm could have earned on its own.

Firm A purchases Firm C in another industry. A and C’s profits are greater than what each firm could have earned on its own.

No Synergy (1+1=2)

Synergy (1+1=3)

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APPROACHES TO DIVERSIFYING THE BUSINESS LINEUP

Existing business acquisition

Internal new venture (start-up)

Joint venture

Diversifying into New Businesses

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DIVERSIFICATION BY ACQUISITION OF AN EXISTING BUSINESS

Advantages:

Quick entry into an industry

Barriers to entry avoided

Access to complementary resources and capabilities

Disadvantages:

Cost of acquisition—whether to pay a premium for a successful firm or seek a bargain in a struggling firm

Underestimating costs for integrating acquired firm

Overestimating the acquisition’s potential to deliver added shareholder value

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Core Concept (2 of 15)

An acquisition premium, or control premium, is the amount by which the price offered exceeds the preacquisition market value of the target company.

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ENTERING A NEW LINE OF BUSINESS THROUGH INTERNAL DEVELOPMENT

Advantages of new venture development

Avoids pitfalls and uncertain costs of acquisition

Allows entry into a new or emerging industry where there are no available acquisition candidates

Disadvantages of intrapreneurship

Must overcome industry entry barriers

Requires extensive investments in developing production capacities and competitive capabilities

May fail due to internal organizational resistance to change and innovation

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Core Concept (3 of 15)

Corporate venturing, or new venture development, is the process of developing new businesses as an outgrowth of a firm’s established business operations. It is also referred to as corporate entrepreneurship or intrapreneurship since it requires entrepreneurial-like qualities within a larger enterprise.

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WHEN TO ENGAGE IN INTERNAL DEVELOPMENT

Availability of in-house skills and resources

Ample time to develop and launch business

Cost of acquisition higher than internal entry

Added capacity affects supply and demand balance

Low resistance of incumbent firms to market entry

Factors Favoring Internal Development

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WHEN TO ENGAGE IN A JOINT VENTURE

Evaluating the Potential for a Joint Venture

Is the opportunity too complex, uneconomical, or risky for one firm to pursue alone?

Does the opportunity require a broader range of competencies and know-how than the firm now possesses?

Will the opportunity involve operations in a country that requires foreign firms to have a local minority or majority ownership partner?

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USING JOINT VENTURES TO ACHIEVE DIVERSIFICATION

Joint ventures are advantageous when diversification opportunities:

Are too large, complex, uneconomical, or risky for one firm to pursue alone

Require a broader range of competencies and know-how than a firm possesses or can develop quickly

Are located in a foreign country that requires local partner participation or ownership

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DIVERSIFICATION BY JOINT VENTURE

Joint ventures have the potential for developing serious drawbacks due to:

Conflicting objectives and expectations of venture partners

Disagreements among or between venture partners over how best to operate the venture

Cultural clashes among and between the partners

Dissolution of the venture when one of the venture partners decides to go their own way

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CHOOSING A MODE OF MARKET ENTRY

The Question of Critical Resources and Capabilities Does the firm have the resources and capabilities for internal development?
The Question of Entry Barriers Are there entry barriers to overcome?
The Question of Speed Is speed of the essence in the firm’s chances for successful entry?
The Question of Comparative Cost Which is the least costly mode of entry, given the firm’s objectives?
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Core concept (4 of 15)

Transaction costs are the costs of completing a business agreement or deal of some sort, over and above the price of the deal. They can include the costs of searching for an attractive target, the costs of evaluating its worth, bargaining costs, and the costs of completing the transaction.

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CHOOSING THE DIVERSIFICATION PATH: RELATED VERSUS UNRELATED BUSINESSES

Related Businesses

Unrelated Businesses

Both Related and Unrelated Businesses

Which Diversification Path to Pursue?

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Core Concepts (5 of 15)

Related businesses possess competitively valuable cross-business value chain and resource matchups.

Unrelated businesses have dissimilar value chains and resource requirements, with no competitively important cross-business relationships at the value chain level.

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Core Concept (6 of 15)

Strategic fit exists whenever one or more activities constituting the value chains of different businesses are sufficiently similar in present opportunities for cross-business sharing or transferring of the resources and capabilities that enable these activities.

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DIVERSIFICATION INTO RELATED BUSINESSES

Strategic fit opportunities

Transferring specialized expertise, technological know-how, or other resources and capabilities from one business’s value chain to another’s

Sharing costs by combining related value chain activities into a single operation

Exploiting common use of a well-known brand name

Sharing other resources (besides brands) that support corresponding value chain activities across businesses

Engaging in cross-business collaboration and knowledge sharing to create new competitively valuable resources and capabilities

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PURSUING RELATED DIVERSIFICATION

Generalized resources and capabilities:

Can be deployed widely across a broad range of industry and business types

Can be leveraged in both unrelated and related diversification situations

Specialized resources and capabilities:

Have very specific applications which restrict their use to a narrow range of industry and business types

Can typically be leveraged only in related diversification situations

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FIGURE 8.1 Related Businesses Provide Opportunities to Benefit from Competitively Valuable Strategic Fit

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IDENTIFYING CROSS-BUSINESS STRATEGIC FITS ALONG THE VALUE CHAIN

R&D and technology activities

Supply chain activities

Manufacturing-related activities

Distribution-related activities

Customer service activities

Sales and marketing activities

Potential Cross-Business Fits

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STRATEGIC FIT, ECONOMIES OF SCOPE, AND COMPETITIVE ADVANTAGE

Transferring specialized and generalized skills or knowledge

Combining related value chain activities to achieve lower costs

Leveraging brand names and other differentiation resources

Using cross-business collaboration and knowledge sharing

Using Economies of Scope to Convert Strategic Fit into Competitive Advantage

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Core Concepts (7 of 15)

Economies of scope are cost reductions that flow from operating in multiple businesses (a larger scope of operation).

Economies of scale accrue from a larger-size operation.

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ECONOMIES OF SCOPE DIFFER FROM ECONOMIES OF SCALE

Economies of scope

Are cost reductions that flow from cross-business resource sharing in the activities of the multiple businesses of a firm

Economies of scale

Accrue when unit costs are reduced due to the increased output of larger-size operations of a firm

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FROM STRATEGIC FIT TO COMPETITIVE ADVANTAGE, ADDED PROFITABILITY AND GAINS IN SHAREHOLDER VALUE

Builds more shareholder value than owning a stock portfolio

Only possible via a strategy of related diversification

Yields value in the application of specialized resources and capabilities

Requires that management take internal actions to realize them

Capturing the Cross-Business Strategic-Fit Benefits of Related Diversification

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Strategic Management Principle (3 of 9)

Diversifying into related businesses where competitively valuable strategic-fit benefits can be captured puts a firm’s businesses in position to perform better financially as part of the firm than they could have performed as independent enterprises, thus providing a clear avenue for boosting shareholder value and satisfying the better-off test.

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THE EFFECTS OF CROSS-BUSINESS FIT

Fit builds more value than owning a stock portfolio of firms in different industries

Strategic-fit benefits are possible only via related diversification

The stronger the fit, the greater its effect on the firm’s competitive advantages

Fit fosters the spreading of competitively valuable resources and capabilities specialized to certain applications and that have value only in specific types of industries and businesses

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The Kraft-Heinz Merger: Pursuing the Benefits of Cross-Business Strategic Fit

Why did Kraft choose to seek a merger with Heinz rather than starting its own food products subsidiary?

What are the anticipated results of the merger?

To what extent is decentralization required when seeking cross-business strategic fit?

What should Kraft-Heinz do to ensure the continued success of its related diversification strategy?

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DIVERSIFICATION INTO UNRELATED BUSINESSES

Evaluating the acquisition of a new business or the divestiture of an existing business

Can it meet corporate targets for profitability and return on investment?

Is it in an industry with attractive profit and growth potentials?

Is it is big enough to contribute significantly to the parent firm’s bottom line?

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BUILDING SHAREHOLDER VALUE VIA UNRELATED DIVERSIFICATION

Astute corporate parenting by management

Cross-business allocation of financial resources

Acquiring and restructuring undervalued companies

Using an Unrelated Diversification Strategy to Pursue Value

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BUILDING SHAREHOLDER VALUE VIA UNRELATED DIVERSIFICATION

Astute corporate parenting by management Provide leadership, oversight, expertise, and guidance Provide generalized or parenting resources that lower operating costs and increase SBU efficiencies
Cross-business allocation of financial resources Serve as an internal capital market Allocate surplus cash flows from businesses to fund the capital requirements of other businesses
Acquiring and restructuring undervalued companies Acquire weakly performing firms at bargain prices Use turnaround capabilities to restructure them to increase their performance and profitability
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Core Concept (8 of 15)

Corporate parenting is the role that a diversified corporation plays in nurturing its component businesses through the provision of:

Top management expertise

Disciplined control

Financial resources

Other types of generalized resources and capabilities such as long-term planning systems, business development skills, management development processes, and incentive systems

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Core Concept (9 of 15)

A diversified firm has a parenting advantage when it is more able than other firms to boost the combined performance of its individual businesses through high-level guidance, general oversight, and other corporate-level contributions.

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Strategic Management Principle (4 of 9)

An umbrella brand is a corporate brand name that can be applied to a wide assortment of business types. As such, it is a generalized resource that can be leveraged in unrelated diversification.

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Core Concept (10 of 15)

Restructuring refers to overhauling and streamlining the activities of a business: combining plants with excess capacity, selling off underutilized assets, reducing unnecessary expenses, and otherwise improving the productivity and profitability of the firm.

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THE PATH TO GREATER SHAREHOLDER VALUE THROUGH UNRELATED DIVERSIFICATION

Diversify into businesses that can produce consistently good earnings and returns on investment

Negotiate favorable acquisition prices

Provide managerial oversight and resource sharing, financial resource allocation and portfolio management, and restructure underperforming businesses

The attractiveness test

The cost-of-entry test

Actions taken by upper management to create value and gain a parenting advantage

The better-off test

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THE DRAWBACKS OF UNRELATED DIVERSIFICATION

Limited Competitive Advantage Potential

Demanding Managerial Requirements

Monitoring and maintaining the parenting advantage

Potential lack of cross-business strategic-fit benefits

Pursuing an Unrelated Diversification Strategy

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MISGUIDED REASONS FOR PURSUING UNRELATED DIVERSIFICATION

Seeking a reduction of business investment risk

Pursuing rapid or continuous growth for its own sake

Seeking stabilization to avoid cyclical swings in businesses

Pursuing personal managerial motives

Poor Rationales for Unrelated Diversification

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STRATEGIC MANAGEMENT PRINCIPLE (5 of 9)

Relying solely on leveraging general resources and the expertise of corporate executives to wisely manage a set of unrelated businesses is a much weaker foundation for enhancing shareholder value than is a strategy of related diversification.

Only profitable growth—the kind that comes from creating added value for shareholders—can justify a strategy of unrelated diversification.

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COMBINATION RELATED-UNRELATED DIVERSIFICATION STRATEGIES

Dominant-business enterprises

Narrowly diversified firms

Broadly diversified firms

Multi-business enterprises

Related-Unrelated Business Portfolio Combinations

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FIGURE 8.2 Three Strategy Options for Pursuing Diversification

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STRUCTURES OF COMBINATION RELATED-UNRELATED DIVERSIFIED FIRMS

Dominant-business enterprises:

Have a major “core” firm that accounts for 50 to 80% of total revenues and a collection of small related or unrelated firms that accounts for the remainder

Narrowly diversified firms:

Are comprised of a few related or unrelated businesses

Broadly diversified firms:

Have a wide-ranging collection of related businesses, unrelated businesses, or a mixture of both

Multibusiness enterprises:

Have a business portfolio consisting of several unrelated groups of related businesses

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EVALUATING THE STRATEGY OF A DIVERSIFIED COMPANY

Diversified Strategy

Attractiveness of industries

Strength of business units

Cross-business strategic fit

Fit of firm’s resources

Allocation of resources

New strategic moves

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STEPS IN EVALUATING THE STRATEGY OF A DIVERSIFIED FIRM

Assess the attractiveness of the industries the firm has diversified into, both individually and as a group

Assess the competitive strength of the firm’s business units within their respective industries

Evaluate the extent of cross-business strategic fit along the value chains of the firm’s various business units

Check whether the firm’s resources fit the requirements of its present business lineup

Rank the performance prospects of the businesses from best to worst and determine resource allocation priorities

Craft strategic moves to improve corporate performance

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STEP 1: EVALUATING INDUSTRY ATTRACTIVENESS

1. Does each industry represent a good market for the firm to be in?

2. Which industries are most attractive, and which are least attractive?

3. How appealing is the whole group of industries?

How attractive are the industries in which the firm has business operations?

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CALCULATING INDUSTRY-ATTRACTIVENESS SCORES: KEY MEASURES

Market size and projected growth rate

The intensity of competition among market rivals

Emerging opportunities and threats

The presence of cross-industry strategic fit

Resource requirements

Social, political, regulatory, environmental factors

Industry profitability

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CALCULATING INDUSTRY ATTRACTIVENESS FROM THE MULTI-BUSINESS PERSPECTIVE

The question of cross-industry strategic fit How well do the industry’s value chain and resource requirements match up with the value chain activities of other industries in which the firm has operations?
The question of resource requirements Do the resource requirements for an industry match those of the parent firm or are they otherwise within the company’s reach?
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CALCULATING INDUSTRY ATTRACTIVENESS SCORES

Evaluating Industry Attractiveness

Deciding on appropriate weights for industry attractiveness measures

Gaining sufficient knowledge of the industry to assign accurate and objective ratings

Whether to use different weights for different business units whenever the importance of strength measures differs significantly from business to business

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TABLE 8.1 Calculating Weighted Industry-Attractiveness Scores

Remember: The more intensely competitive an industry is, the lower the attractiveness rating for that industry!

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STEP 2: EVALUATING BUSINESS-UNIT COMPETITIVE STRENGTH

Relative market share

Costs relative to competitors’ costs

Ability to match or beat rivals on key product attributes

Brand image and reputation

Other competitively valuable resources and capabilities

Benefits from strategic fit with firm’s other businesses

Bargaining leverage with key suppliers or customers

Profitability relative to competitors

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Strategic Management Principle (6 of 9)

Using relative market share to measure competitive strength is analytically superior to using straight-percentage market share.

Relative market share is the ratio of a business unit’s market share to the market share of its largest industry rival as measured in unit volumes, not dollars.

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TABLE 8.2 Calculating Weighted Competitive-Strength Scores for a Diversified Company’s Business Units

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FIGURE 8.3 A Nine-Cell Industry Attractiveness–Competitive Strength Matrix

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STEP 3: DETERMINING THE COMPETITIVE VALUE OF STRATEGIC FIT IN DIVERSIFIED COMPANIES

Assessing the degree of strategic fit across its businesses is central to evaluating a company’s related diversification strategy.

The real test of a diversification strategy is what degree of competitive value can be generated from strategic fit.

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STRATEGIC MANAGEMENT PRINCIPLE (7 of 9)

The greater the value of cross-business strategic fit in enhancing a firm’s performance in the marketplace or on the bottom line, the more competitively powerful is its strategy of related diversification.

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FIGURE 8.4 Identifying the Competitive Advantage Potential of Cross-Business Strategic Fit

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Core Concepts (11 of 15)

A company pursuing related diversification exhibits resource fit when its businesses have matching specialized resource requirements along their value chains.

A company pursuing unrelated diversification has resource fit when the parent company has adequate corporate resources (parenting and general resources) to support its businesses’ needs and to add value.

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STEP 4: CHECKING FOR RESOURCE FIT

Financial resource fit

State of the internal capital market

Using the portfolio approach:

Cash hogs need cash to develop.

Cash cows generate excess cash.

Star businesses are self-supporting.

Success sequence:

Cash hog  Star  Cash cow

Nonfinancial resource fit

Does the firm have (or can it develop) the specific resources and capabilities needed to be successful in each of its businesses?

Are the firm’s resources being stretched too thin by the resource requirements of one or more of its businesses?

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Core Concept (12 of 15)

A strong internal capital market allows a diversified firm to add value by shifting capital from business units generating free cash flow to those needing additional capital to expand and realize their growth potential.

A portfolio approach to ensuring financial fit among a firm’s businesses is based on the fact that different businesses have different cash flow and investment characteristics.

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Core Concepts (13 of 15)

A cash cow business generates cash flows over and above its internal requirements, thus providing a corporate parent with funds for investing in cash hog businesses, financing new acquisitions, or paying dividends.

A cash hog business generates cash flows that are too small to fully fund its operations and growth and requires cash infusions to provide additional working capital and finance new capital investment.

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STEP 5: RANKING BUSINESS UNITS AND ASSIGNING A PRIORITY FOR RESOURCE ALLOCATION

Ranking factors

Sales growth

Profit growth

Contribution to company earnings

Return on capital invested in the business

Cash flow

Steer resources to business units with the brightest profit and growth prospects and solid strategic and resource fit

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The Chief Strategic and Financial Options for Allocating a Diversified Company’s Financial Resources

Strategic options

Invest in ways to strengthen or grow existing business

Make acquisitions to establish positions in new industries or to complement existing businesses

Fund long-range R&D ventures aimed at opening market opportunities in new or existing businesses

Financial options

Pay off existing long-term or short-term debt

Increase dividend payments to shareholders

Repurchase shares of the company’s common stock

Build cash reserves; invest in short-term securities

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STEP 6: CRAFTING NEW STRATEGIC MOVES TO IMPROVE OVERALL CORPORATE PERFORMANCE

Stick with the existing business lineup

Broaden the diversification base with new acquisitions

Divest and retrench to a narrower diversification base

Restructure through divestitures and acquisitions

Strategy Options for a Firm That Is Already Diversified

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A Firm’s Strategic Alternatives After It Diversifies

Undiversified firm

Maintain existing business lineup

Makes sense when the current business lineup offers attractive growth opportunities and can generate added economic value for shareholders

Broaden diversification base

Acquire more businesses and build positions in new related or unrelated industries

Add businesses that will complement and strengthen the market position and competitive capabilities of businesses in industries where the firm already has a stake

Diversified firm

Narrow diversification base

Get out of businesses that are competitively weak or in unattractive industries, or lack adequate strategic and resource fit

Focus resources on businesses in a few select industry arenas

Restructure the firm’s business lineup through a mix of divestitures and new acquisitions

Use debt capacity and cash from divesting businesses that are in unattractive industries, or that lack strategic or resource fit and are noncore businesses to make acquisitions in more promising industries

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BROADENING A DIVERSIFIED FIRM’S BUSINESS BASE

Factors motivating the addition of businesses

The transfer of resources and capabilities to related or complementary businesses

Rapidly changing technology, legislation, or new product innovations in core businesses

Shoring up the market position and competitive capabilities of the firm’s present businesses

Extension of the scope of the firm’s operations into additional country markets

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DIVESTING BUSINESSES AND RETRENCHING TO A NARROWER DIVERSIFICATION BASE

Factors motivating business divestitures

Long-term performance can be improved by concentrating on stronger positions in fewer core businesses and industries.

Business is in a once-attractive industry where market conditions have badly deteriorated

Business has either failed to perform as expected or is lacking in cultural, strategic, or resource fit.

Business has become more valuable if sold to another firm or as an independent spin-off firm.

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Core Concept (14 of 15)

A spinoff is an independent company created when a corporate parent divests a business either by selling shares to the public via an initial public offering or by distributing shares in the new company to shareholders of the corporate parent.

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STRATEGIC MANAGEMENT PRINCIPLE (8 of 9)

Diversified companies need to divest low-performing businesses or businesses that do not fit in order to concentrate on expanding existing businesses and entering new ones where opportunities are more promising.

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RESTRUCTURING A DIVERSIFIED COMPANY’S BUSINESS LINEUP

Factors leading to corporate restructuring

A serious mismatch between the firm’s resources and capabilities and the type of diversification that it has pursued

Too many businesses in slow-growth, declining, low-margin, or otherwise unattractive industries

Too many competitively weak businesses

Ongoing declines in the market shares of major business units that are falling prey to more market-savvy competitors

An excessive debt burden with interest costs that eat deeply into profitability

Ill-chosen acquisitions that haven’t lived up to expectations

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Core Concept (15 of 15)

Companywide restructuring (corporate restructuring) involves making major changes in a diversified company by divesting some businesses or acquiring others, so as to put a whole new face on the company’s business lineup.

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STRATEGIC MANAGEMENT PRINCIPLE (9 of 9)

Diversified firms should divest low-performing businesses or businesses that do not fit in order to concentrate on expanding existing businesses and entering new ones where opportunities are more promising.

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Restructuring for Better Performance at Hewlett-Packard (HP)

What are the expected benefits of splitting HP into two separate and independent companies?

Why did HP take so long to recognize changes in the industry and the necessity for changing itself?

How can internal growth create a lack of strategic fit where none existed before?

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Appendix 1 Building Shareholder Value: The Ultimate Justification for Diversifying

In order to determine whether diversification will add long-term value for shareholders, the following three tests should be performed: