The procedure for evaluating the pluses and minuses of a diversified company's strategy includes

169Chapter 8 Diversification Strategies 169

Copyright © 2020 by Arthur A. Thompson. All rights reserved. Reproduction and distribution of the contents are expressly prohibited without the author’s written permission

Strategy: Core Concepts and Analytical Approaches

An e-book published by McGraw-Hill Education

Arthur A. Thompson, The University of Alabama 6th Edition, 2020-2021

169

chapter 8 Diversification Strategies

I think our biggest achievement to date has been bringing back to life an inherent Disney synergy that enables each part of our business to draw from, build upon, and bolster the others. —Michael Eisner, former CEO, Walt Disney Company

Fit between a parent and its businesses is a two-edged sword: A good fit can create value; a bad one can destroy it. —Andrew Campbell, Michael Gould, and Marcus Alexander

Make winners out of every business in your company. Don’t carry losers. —Jack Welch, former CEO, General Electric

In this chapter, we move up one level in the strategy-making hierarchy, from strategy making in a single-business enterprise to strategy making in a diversified enterprise. Because a diversified company is a collection of individual businesses, the strategy-making task is more complicated. In a one-business company, managers have to come up with a game plan for competing successfully in a single industry arena or a single line of business—the result is what was labeled as business strategy in Chapter 2. But in a diversified company, the strategy-making challenge involves assessing multiple industry environments and developing a set of business strategies, one for each industry arena (or line of business) in which the diversified company operates. And top executives at a diversified company must still go one step further and devise a companywide (or corporate) strategy for improving the attractiveness and performance of the company’s overall business lineup and for making a rational whole out of its diversified collection of individual businesses and individual business strategies.

In the first portion of this chapter, we describe what crafting a diversification strategy entails, when and why diversification makes good strategic sense, and the pros and cons of related versus unrelated diversification strategies. The second part of the chapter looks at how to evaluate the attractiveness of a diversified company’s business lineup, how to decide whether it has a good diversification strategy, and the strategic options for improving a diversified company’s future performance.

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What Does Crafting a Diversification Strategy Entail?

The task of crafting a diversified company’s overall or corporate strategy falls squarely in the lap of top-level executives and involves four distinct facets:

1 . Picking new industries to enter and deciding on the means of entry. Pursuing diversification requires top-level decisions about which industries to enter (and why these make good business sense) and then, for each industry, whether to enter by acquiring a company already in the target industry, internally developing its own new business in the target industry, or forming a joint venture or strategic alliance with another company.

2 . Pursuing opportunities to leverage cross-business value chain relationships and strategic fits into competitive advantage. The task here is to determine whether there are opportunities to strengthen a diversified company’s businesses by transferring competitively valuable resources and capabilities from one business to another, combining the related value chain activities of different businesses to achieve lower costs, sharing the use of a powerful and well-respected brand name across multiple businesses, and encouraging cross-business knowledge-sharing and collaboration to create competitively valuable new resources and capabilities.

3 . Evaluating the growth and profitability prospects of each of the company’s businesses, establishing investment priorities for each business, and then using these priorities to steer corporate resources to individual businesses. Typically, this translates into investing aggressively and pursuing rapid-growth strategies in attractive businesses with the best profit prospects, investing cautiously in businesses with just average prospects, initiating profit improvement or turnaround strategies in under-performing businesses that have potential, and divesting businesses with unacceptable prospects. A corporate parent’s actions to help strengthen the long-term competitive positions and profitability of its individual businesses can include providing managerial expertise, funding for desirable new operating improvements and capital investments, assorted kinds of administrative support from central headquarters, and other resources that may be useful (which may include acquiring similar businesses and merging their operations into an existing business).

4 . Initiating actions to boost the combined performance of the corporation’s collection of businesses. Strategic options for improving the corporation’s overall performance include (1) sticking closely with the existing business lineup and pursuing opportunities presented by these businesses, (2) broadening the scope of diversification by entering additional industries, (3) retrenching to a narrower scope of diversification by divesting poorly performing businesses that are no longer attractive or that don’t fit into management’s long-range plans, and (4) broadly restructuring the entire company by divesting some businesses and acquiring others so as to put a whole new face on the company’s business lineup.

The demanding and time-consuming nature of these four tasks explains why top executives in diversified companies generally refrain from becoming immersed in the details of crafting and executing business-level strategies. Rather, the normal procedure is to delegate lead responsibility for business strategy to the heads of each business, giving them the latitude to develop strategies suited to the particular industry and competitive circumstances in which their business operates, and holding them accountable for producing good financial and strategic results.

Figure 8.1 shows the things to look for in identifying a company’s diversification strategy. Having a clear fix on the main elements of a company’s diversification strategy sets the stage for evaluating how good the strategy is and proposing strategic moves to boost the company’s performance.

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Figure 8.1 Identifying a Diversified Company’s Strategy

Is the company’s

diversification based narrowly in a few

industries or broadly in many industries?

A Diversified Company’s

Strategy

Are the businesses the

company has diversified into related, unrelated

or a mixture of both?

Is the scope of company

operations mostly domestic, increasingly

multinational, or global?

Any recent moves to strengthen

the company’s positions in existing

businessses? Any recent moves to

build positions in new

industries?

Any recent moves to divest weak business

units?

Any effort to capture the benefits

of cross-business value chain

relationships?

What is the company’s approach to allocating investment capital and resources

across its present businesses?

When to Consider Diversifying So long as a company has its hands full trying to capitalize on profitable growth opportunities in its present industry, there is no urgency to diversify into other businesses. But it is risky for a single-business company to continue to keep all of its eggs in one industry basket when, for whatever reasons, its long-term prospects for continued good performance start to dim. Changing industry conditions—new technologies, product innovation that stimulates the introduction of substitute products, fast-shifting buyer preferences, or intensifying competition—can undermine a company’s ability to deliver ongoing gains in revenues and profits. Profitable growth opportunities are typically limited in mature industries and markets where buyer demand is flat or declining. Thus, diversification always merits strong consideration at single-business companies when industry conditions take a turn for the worse and are expected to be long-lasting.

However, there are four other instances in which a company becomes a prime candidate for diversifying:1

n When it spots opportunities for expanding into industries whose technologies and/or products complement its present business.

n When it can leverage existing resources and capabilities by expanding into businesses where these same resources and capabilities are key success factors and valuable competitive assets.

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n When diversifying into closely related businesses opens new avenues for reducing costs.

n When it has a powerful and well-known brand name that can be transferred to the products of other businesses and help drive the sales and profits of such businesses to higher levels.

The decision to diversify presents wide-open possibilities. A company can diversify into closely related businesses or into totally unrelated businesses. It can diversify its present revenue and earning base to a small extent (so that new businesses account for less than 15 percent of companywide revenues and profits) or to a major extent (so that new businesses produce 30 percent or more of revenues and profits). It can move into one or two large new businesses or a greater number of small ones. It can achieve multibusiness/multi-industry status by acquiring an existing company already in a business/industry it wants to enter, forming its own new business subsidiary to enter a promising industry, and/or forming a joint venture with one or more companies to enter new businesses. But in every case, a decision to diversify must start with good economic and business justification for doing so.

Moves to Diversify into a New Business Should Pass Three Tests Diversification must do more for a company than just spread its business risk across more industries. In principle, diversification into a new business cannot be considered wise or justifiable unless it offers good prospects of added long-term economic value for shareholders—value that shareholders cannot capture on their own by purchasing stock in companies in different industries or investing in mutual funds or exchange-traded funds (ETFs) to spread their investments across several industries. A move to diversify into a new business stands little chance of producing added long-term shareholder value unless it can pass three tests:2

1 . The industry attractiveness test. Whether an industry is attractive depends chiefly on the presence of industry and competitive conditions conducive to earning as good or better profits and return on investment than the company is earning in its present business(es). It is hard to justify diversifying into an industry where profit expectations are lower than in the company’s present businesses. Good industry attractiveness also requires good opportunities for long-term growth.

2 . The cost-of-entry test. The cost to enter the target industry must not be so high it erodes the potential for good profitability. A Catch-22 can prevail here, however. The more attractive an industry’s prospects are for growth and good long-term profitability, the more expensive it can be to get into. Entry barriers for startup companies are likely to be high in attractive industries—if barriers were low, a rush of new entrants would soon erode the potential for high profitability. And buying a well-positioned company in an appealing industry often entails a high acquisition cost that makes passing the cost-of-entry test less likely. For instance, suppose the price to purchase a company is $3 million and the company to be acquired is earning after-tax profits of $200,000 on an equity investment of $1 million (a 20 percent annual return). Simple arithmetic requires that the profits be tripled if the purchaser (paying $3 million) is to earn the same 20 percent return. Building the acquired firm’s earnings from $200,000 to $600,000 annually could take several years—and require additional investment on which the purchaser would also have to earn a 20 percent return. Since the owners of a successful and growing company usually demand a price that reflects their business’s profit prospects, it’s easy for the acquisitions of well positioned and/ or attractively profitable companies to fail the cost-of-entry test.

3 . The better-off test. Diversifying into a new business must offer potential for the company’s existing businesses and the new business to perform better together under a single corporate umbrella than they would perform operating as independent stand-alone businesses—an outcome known as synergy. For example, let’s say Company A diversifies by purchasing Company B in another

CORE CONCEPT Creating added long­term value for shareholders via diversification requires building a multi­ business company where the whole is greater than the sum of its parts—such 1 + 1 = 3 effects are called synergy.

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industry. If A and B’s consolidated profits in the years to come prove no greater than what each could have earned on its own, then A’s diversification won’t provide its shareholders with added value. Company A’s shareholders could have achieved the same 1 + 1 = 2 result by merely purchasing stock in Company B. Diversification does not result in added long-term value for shareholders unless it produces a 1 + 1 = 3 effect where sister businesses perform better together as part of the same firm than they could have performed as independent companies.

Diversification moves that satisfy all three tests have the greatest potential to grow shareholder value over the long term. Diversification moves that can pass only one or two tests are suspect.

Choosing the Diversification Path: Related vs. Unrelated Businesses

Once a company decides to diversify, its first big strategy decision is whether to diversify into related businesses, unrelated businesses, or some mix of both (see Figure 8.2). Businesses are said to be related when their value chains possess competitively valuable cross-business relationships that present opportunities for the businesses to perform better under the same corporate umbrella than they could by operating as stand-alone entities. The big appeal of related diversification is to build shareholder value by leveraging these cross-business relationships into competitive advantage, thus allowing the company as a whole to perform better than just the sum of its individual businesses. Businesses are said to be unrelated when the activities that compose their respective value chains are so dissimilar that no competitively valuable cross-business relationships are present. One must be careful about assuming different businesses are unrelated just because their products are quite different. For example, Citizen Watch Company is engaged in three businesses—watches, machine tools, and flat panel displays—that seem on the surface to be unrelated, but hidden from view one discovers that these businesses are indeed related because the value chains of all three products involve production activities that rely heavily on common miniaturization know-how and advanced precision technologies.

The next two sections explore the ins and outs of related and unrelated diversification.

Figure 8.2 The Three Fundamental Strategy Alternatives for Pursuing Diversification

Diversify into Related Businesses

Diversify into Unrelated Businesses

Diversify into Both Related and Unrelated Businesses

Diversification Strategy Options

CORE CONCEPT Related businesses possess competitively valuable cross­business value chain matchups. Unrelated businesses have dissimilar value chains containing no competitively useful cross­ business relationships.

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The Case for Diversifying into Related Businesses A related diversification strategy involves building the company around businesses whose value chains possess competitively valuable strategic fits, as shown in Figure 8.3. Strategic fit exists whenever one or more activities in the value chains of different businesses are sufficiently similar to present opportunities for one or more of the following:3

n Transferring competitively valuable resources and capabilities from one business to enhance the competitiveness and performance of a sister business. Frequently, a company pursuing related diversification has one or more businesses with competitively valuable resources, expertise, and know-how in performing certain value chain activities that are well-suited to performing closely related value chain activities in a sister business (especially a newly acquired business). In such instances, prompt and aggressive actions to transfer a portion of these competitively potent resources and capabilities from one or more of a diversified company’s businesses and redeploy them to resource and/or capability-deficient businesses can significantly enhance the latter’s performance of key value chain activities, boost the value it delivers to customers, and significantly improve its competitiveness and profitability. Sometimes, however, the transfer of competitively valuable resources and capabilities is reversed, proceeding from a newly acquired business to existing businesses. For example, when Disney acquired Marvel Comics, Disney executives immediately made Marvel’s iconic Spiderman character available for use at Disney theme parks, in Disney retail stores, and in Disney video games. Cross-business resource transfers can be accomplished by shifting personnel with the requisite expertise and technological know-how from one business to another, instituting in-depth training to boost the capabilities of personnel at resource- deficient businesses, increasing cross-business knowledge sharing via online systems, enforcing cross- business adoption of best practices and other desirable operating procedures, and making competitive assets controlled by one business available to other businesses when appropriate.

n Combining the related value chain activities of separate businesses into a single operation to achieve lower costs. In companies pursuing related diversification, it is sometimes feasible to manufacture the products of different businesses in a single plant or use the same warehouses for shipping and distribution, or have a single sales force (or network of dealers/retailers) for the products of different businesses when they are marketed to the same types of customers, or have different businesses use the same administrative infrastructure (for finance and accounting, human resources, information technology, and so on). Such cost-saving benefits along the value chains of related businesses are called economies of scope—a concept distinct from economies of scale. Economies of scale are cost savings that accrue directly from a larger operation—for example, unit costs may be lower in a large plant than in a small plant, lower in a large distribution center than in a small one, and lower for large-volume purchases of components than for small-volume purchases. Economies of scope, however, stem directly from cost-saving strategic fits along the value chains of related businesses that allow sister businesses to operate more cost efficiently as part of the same company than they can operate as stand-alone businesses. The greater the cross- business economies associated with cost-saving strategic fits, the greater the potential for a related diversification strategy to yield a competitive advantage based on lower costs than rivals.

CORE CONCEPT Strategic fit exists when the value chains of different businesses present opportunities for cross­business resource transfer, lower costs through combining the performance of related value chain activities, cross­business use of a potent brand name, and/or cross­business collaboration to build new or stronger resources and capabilities that can enhance the competitive­ ness of one or more of the company’s businesses.

CORE CONCEPT Economies of scope are cost reductions that flow from operating in multiple businesses. Such economies stem directly from strategic fit efficiencies along the value chains of related businesses.

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n Exploiting use of a well-known and potent brand name. For example, Honda’s name in motorcycles and automobiles gave it instant credibility and recognition in entering the lawn mower business, allowing it to achieve a significant market share without spending large sums on advertising to establish a brand identity. Likewise, Apple’s reputation in PCs made it easier and cheaper to enter the market for digital music players, smart phones, and connected watches.

n Cross-business collaboration to create competitively valuable resources and capabilities. Sister businesses performing closely related value chain activities may seize opportunities to join forces, share knowledge and talents, and collaborate to create altogether new capabilities (such as virtually defect- free assembly methods or increased ability to speed new and improved products to market) that will be mutually beneficial in improving their competitiveness and business performance.

All four types of actions to capture strategic fit opportunities along the value chains of related businesses tend to produce synergistic outcomes: improved competitiveness of one or more businesses and greater ability to perform better as sister businesses than as stand-alone businesses.