The top-level executive task of crafting a diversified company's overall or corporate strategy

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.

Chapter 8 • Diversification Strategies 170

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.

Chapter 8 • Diversification Strategies 171

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.

Chapter 8 • Diversification Strategies 172

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.

Chapter 8 • Diversification Strategies 173

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.

Chapter 8 • Diversification Strategies 174

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.

Chapter 8 • Diversification Strategies 175

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.

Figure 8.3 Related Businesses Possess Related Value Chain Activities and Competitively Valuable Cross-Business Strategic Fits

Competitively valuable opportunities for technology or skills transfer, cost reduction, common brand-name usage, and cross-business collaboration exist at one or more points along the value chains of business A and business B.

Supply Chain

Activities Technology

Sales and

Marketing Distribution Customer

Service Operations

Supply Chain

Activities Technology

Sales and

Marketing Distribution Customer

Service Operations

Strategic Fit and Competitive Advantage: The Keys to Added Profitability and Gains in Shareholder Value What makes related diversification an attractive strategy is the opportunity to convert cross-business strategic fits into a competitive advantage over business rivals whose operations do not offer comparable strategic fit benefits.4 The greater the relatedness among a diversified company’s sister businesses, the bigger a company’s window for converting strategic fits into competitive advantage via (1) cross-business transfer of valuable skills, technology, competencies, capabilities, and other competitive assets, (2) the capture of cost-saving efficiencies along the value chains of related businesses via sharing use of the same resources

Chapter 8 • Diversification Strategies 176

(joint performance of new product or technology R&D, common use of plants and distribution centers, shared use of the same sales force or dealer network or customer service infrastructure, and the like), (3) cross-business use of a well-respected brand name, and/or (4) cross-business collaboration to create new resource strengths and capabilities.5

The competitive advantage potential that flows from the capture of strategic-fit benefits is what enables a company pursuing related diversification to achieve 1 + 1 = 3 financial performance and the hoped-for gains in shareholder value. The strategic and business logic is compelling: capturing strategic fits along the value chains of its related businesses gives a diversified company a clear path to achieving competitive advantage over undiversified competitors and competitors whose own diversification efforts do not offer equivalent strategic-fit benefits.6 Such competitive advantage potential provides a company with a dependable basis for earning profits and a return on investment that exceeds what the company’s businesses could earn as stand-alone enterprises. Converting the competitive advantage potential into greater profitability fuels 1 + 1 = 3 gains in shareholder value—the necessary outcome for satisfying the better-off test and proving the business merit of a company’s diversification effort.

Bear in mind three things here. One, capturing cross-business strategic fits via a strategy of related diversification builds long-term economic value for shareholders in ways they cannot undertake by simply owning a portfolio of stocks of companies in different industries. Two, the capture of cross-business strategic-fit benefits is possible only via a strategy of related diversification. Three, the benefits of cross-business strategic fits are not automatically realized when a company diversifies into related businesses—the benefits materialize only after management has successfully pursued internal actions to capture them.

The Case for Diversifying into Unrelated Businesses Whereas related diversification strategies seek to build shareholder value by diversifying only into businesses with important cross-business strategic fits, the hallmark of unrelated diversification strategies is managerial willingness to enter any industry and operate any business where company executives see opportunity to realize consistently good financial results. Companies pursuing unrelated diversification are often labeled conglomerates because the businesses they have diversified into range broadly across diverse industries with little or no discernible strategic fits in their value chains (as shown in Figure 8.4. Companies that pursue unrelated diversification nearly always enter new businesses by acquiring an established company rather than by forming a startup subsidiary within their own corporate structures or participating in joint ventures. With a strategy of unrelated diversification, an acquisition is deemed attractive if it passes the industry attractiveness and cost-of-entry tests and if it has good prospects for attractive financial performance— little, if any, consideration is given to whether the value chains of a conglomerate’s businesses have any strategic fits.

CORE CONCEPT Diversifying into related businesses where competitively valuable strategic fit benefits can be captured puts sister businesses in position to perform better financially as part of the same company than they could have performed as independent enterprises, thus providing a clear avenue for boosting shareholder value.

CORE CONCEPT The basic premise of unrelated diversification is that any company or business that can be acquired on good financial terms and has satis­ factory growth and earnings potential represents a good acquisition and a good business opportunity.

Chapter 8 • Diversification Strategies 177

In companies pursuing unrelated diversification, top executives spend much time and effort screening acquisition candidates and evaluating the pros and cons of keeping or divesting existing businesses, using such criteria as:

n Whether the business can meet corporate targets for profitability and return on investment.

n Whether the business is in an industry with attractive growth potential.

n Whether a distressed businesses can be acquired at a bargain price, turned around quickly (with astute managerial actions and initiatives on the part of the company) into a profitable enterprise with potential to realize a high return on investment.

n Whether the business is big enough to contribute significantly to the parent firm’s bottom line.

Unrelated diversification certainly merits consideration when a single-business firm is trapped in or overly dependent on an endangered or unattractive industry, especially if it has no competitively valuable resources or capabilities it can transfer to a closely related industry. Unrelated diversification may also be justified when a company strongly prefers to spread business risks widely, have the flexibility to deploy its capital resources to maximum advantage by (1) investing in whatever industries offer the best profit prospects (as opposed to considering only opportunities in industries with related value chain activities) and (2) diverting cash flows from company businesses with lower growth and profit prospects to acquiring and expanding businesses with higher growth and profit potentials, without regard to whether these businesses have value chain activities related to the value chains of any of its present businesses.

However, for an unrelated diversification strategy to be successful in building value for shareholders, it must grow the company’s profits above and beyond what could be achieved by the businesses operating independently as standalone enterprises. Unless a diversified company’s collection of unrelated businesses is more profitable operating under the company’s corporate umbrella than they would be operating as independent businesses, an unrelated diversification strategy can not create economic value for shareholders. And unless it does so, there is no real justifica tion for pursuing an unrelated diversification strategy, since top executives have a fiduciary responsibility to maximize long-term shareholder value for the company’s shareholders.

What Is Appealing about Unrelated Diversification? A strategy of unrelated diversification has appeal from several angles:

n Business risk is scattered over a set of truly diverse industries. In comparison to related diversification, unrelated diversification more closely approximates pure diversification of financial and business risk because the company’s investments are spread over businesses whose technologies and value chain activities bear no close relationship and whose markets are largely disconnected.7

n The company’s financial resources can be employed to maximum advantage by (1) investing in whatever industries offer the best profit prospects (as opposed to considering only opportunities in industries with related value chain activities) and (2) diverting cash flows from company businesses with lower growth and profit prospects to acquiring and expanding businesses with higher growth and profit potentials.

n To the extent that corporate managers are exceptionally astute at spotting bargain-priced companies with big upside profit potential, shareholder wealth can be enhanced by buying distressed businesses at a low price, turning their operations around fairly quickly with infusions of cash and managerial know- how supplied by the parent company, and then riding the crest of the profit increases generated by these businesses, or else enjoying the capital gains of selling rejuvenated businesses for amounts greater than above the purchase price.

n Company profitability may prove somewhat more stable over the course of economic upswings and downswings because market conditions in all industries don’t move upward or downward simultaneously. In a broadly diversified company, there’s a chance that market downtrends in some of the company’s

Chapter 8 • Diversification Strategies 178

businesses will be partially offset by cyclical upswings in its other businesses, thus producing somewhat less earnings volatility. (In actual practice, however, there’s no convincing evidence that the consolidated profits of firms with unrelated diversification strategies are more stable or less subject to reversal in periods of recession and economic stress than the profits of firms with related diversification strategies.)

Unrelated diversification certainly merits consideration when a firm is trapped in or overly dependent on an endangered or unattractive industry, especially when it has no competitively valuable resources or capabilities it can transfer to a closely related industry. Unrelated diversification may also be justified when a company strongly prefers to spread business risks widely and not restrict itself to only owning businesses with related value chain activities.

Figure 8.4 Unrelated Businesses Have Unrelated Value Chains and No Cross-Business Strategic Fits

Representative Value Chain Activities

Business A

Value Chain

Business B

Value Chain

Supply Chain

Activities Assembly Distribution Customer

Service

Product R&D,

Engineering and Design

Production Advertising

and Promotion

Sales to Dealer

Network

An absence of competitively valuable strategic fits between the value chains of business A and business B

Building Shareholder Value via Unrelated Diversification—The Essential Role of Astute Corporate Parenting Given the absence of cross-business strategic fits with which to capture added competitive advantage, the task of building long-term economic value for shareholders via unrelated diversification hinges on (1) the business acumen of corporate executives and (2) the parent company having valuable resources and high-caliber administrative expertise that can enhance the performance of the company’s individual businesses.

Chapter 8 • Diversification Strategies 179

In companies committed to a strategy of unrelated diversification, astute corporate parenting plays an essential role in achieving companywide financial results above and beyond what the individual businesses could achieve as stand-alone entities. Strong parenting capabilities can help build shareholder value in four important ways: n Utilize the business acumen of certain corporate executives in identifying undervalued or underperforming

companies and then further rely on the skills and expertise of these or other corporate executives in pinpointing achievable ways that the operations of such companies can be overhauled and streamlined to produce dramatic increases in profitability. Such restructuring can include pruning money-losing products, closing down or selling portions of the business that are losing money, selling underutilized assets, reducing unnecessary expenses, improving the appeal of product offerings, reducing administrative overhead, and the like. Usually, a number of the top executives of a newly-acquired underperforming business are quickly replaced with seasoned executives brought in specifically to lead the turnaround efforts, return the business to good profitability, and put it well on its way to becoming a strong market contender. Diversified companies with one or more corporate executives who have proven turnaround capabilities in rejuvenating weakly performing companies can often apply these capabilities in a relatively wide range of unrelated industries. Newell Rubbermaid (whose diverse product line includes Sharpie pens, Levolor window treatments, Goody hair accessories, Calphalon cookware, and Lenox power and hand tools—all businesses with different value chain activities) developed such a strong set of turnaround capabilities that the company was said to “Newellize” the businesses it acquired.

n Corporate managers advance the cause of adding shareholder value when they have the bargaining skills to successfully negotiate a low price and other favorable terms in acquiring any new business the corporate parent decides to enter (thereby helping satisfy the cost-of-entry test). Corporate managers have further value-adding potential if they are astute in discerning when a particular company business needs to be sold (because it is on the verge of confronting adverse industry and competitive conditions and probable declines in long-term profitability) and also in finding buyers who will pay a price higher than the company’s net investment in the business (so the sale of divested businesses will result in capital gains for shareholders rather than capital losses).

n Corporate managers definitely add shareholder value when they possess the skills and business acumen to do such a superior job of overseeing, guiding, and otherwise parenting the firm’s business subsidiaries that the subsidiaries perform at a higher level than they would otherwise be able to do as a stand-alone enterprise (thus satisfying the better-off test). Because the senior executives of a large diversified corporation have among them many years of experience in a variety of business settings, they are often able to provide first-rate advice and guidance to the heads of the various business subsidiaries on how to improve competitiveness and financial performance.8 The parenting activities of corporate executives often include identifying, recruiting, and hiring talented managers to run individual businesses and thereby squeeze out better business performance than otherwise might have occurred.

n Corporate executives of financially strong diversified companies can add shareholder value by astutely allocating financial resources across the company’s businesses. This can involve shifting funds from businesses with excess cash (more than needed to fund their operating requirements) to cash-short businesses with appealing growth opportunities. And there are occasions when corporate executives can add value by using the corporation’s strong credit rating to raise capital at acceptable interest rates from external sources and thus provide funds to individual business at lower interest rates than the businesses would otherwise have to pay as standalone enterprises. A parent company’s ability to function as its own internal capital market enhances overall corporate performance and increases shareholder value to the extent that its top executives (1) have access to better information about investment opportunities internal to the firm than do external financiers, (2) wisely engage in allocating internal cash flows and borrowed funds to either existing businesses or making new acquisitions, and (3) are able to use the corporation’s financial strength and credit rating to borrow monies to fund the capital requirements of individual businesses and do so at lower interest costs than the individual businesses would have had to pay as independent enterprises (assuming they could have obtained a loan on the strength of their own balance sheets).

Chapter 8 • Diversification Strategies 180

Other Benefits a Corporate Parent Can Provide to Boost the Performance of Its Business Subsidiaries There are two other commonly employed ways that corporate parents can enhance the financial performance of their unrelated businesses. One way is by providing them with administrative resources and expertise that lower the administrative costs of the indi vidual businesses and/or that enhance their operating effectiveness and/or that lower administrative and overhead costs companywide. The administrative resources and depth of expertise located at a company’s corporate headquarters are often considerable, enabling it to effectively and cost-efficiently handle such administrative functions for its subsidiaries as accounting and tax reporting, financial and risk management, human resource support and services, information systems and data processing, legal services, and so on. Providing individual businesses with administrative support services creates value by lowering companywide overhead costs and avoiding the inefficiencies of having each business handle its own administrative functions. (Of course, this benefit of utilizing a diversified company’s administrative resources and expertise to support the needs of its individual business is just as much available to corporations pursuing related diversification as to those pursuing unrelated diversification.)

A second way that a parent company can provide value to its unrelated business occurs when a corporate parent has a well-recognized or highly reputable name or brand that is not strongly attached to a certain product and thus can readily be shared by many or all of its individual businesses. General Electric, for example, has successfully applied its GE brand to such unrelated products and businesses as light bulbs (GE Lighting), medical products and health care (GE Healthcare), jet engines (GE Aviation), electric power generation and distribution equipment (GE Power), and locomotives (GE Transportation). Corporate brands that can be applied and shared in this fashion are sometimes called umbrella brands. Utilizing a well-known corporate name in a company’s individual businesses has the value-adding potential both to lower brand-building and reputational costs (by spreading them over many businesses) and to enhance each business’s customer value proposition by linking its products to a name that consumers trust.

To the extent that corporate parenting skills and other complementary parenting resources can actually deliver enough added value to individual businesses to yield a stream of dividends and capital gains for stockholders greater than a 1 + 1 = 2 outcome, a case can be made that unrelated diversification has truly enhanced shareholder value.

The Path to Enhancing Shareholder Value via Unrelated Diversification For a strategy of unrelated diversification to produce companywide financial results above and beyond what the businesses could generate operating as stand-alone entities, corporate executives should pursue five outcomes:

1 . Build a portfolio of businesses in unrelated industries by acquiring companies in any industry with growth and earnings prospects that can satisfy the industry attractiveness test and by acquiring undervalued or underperforming businesses that present appealing opportunities for being overhauled in ways that will result in big gains in profitability. Both types of acquisitions raise the chances that a corporation’s entry into new unrelated businesses can pass the better-off test.

2 . Acquire companies at prices sufficiently low to pass the cost of entry test.

3 . Develop and nurture outstanding corporate parenting capabilities. Successful deployment of such capabilities raises the chance that building a portfolio of unrelated businesses will yield 1 + 1 = 3 results and thus pass the better-off test.

4 . Provide individual businesses with administrative expertise and other corporate resources that lower companywide administrative and overhead costs and enhance the operating effectiveness of individual businesses.

5 . Become skilled in discerning when a particular company business should be sold (because of deteriorating industry and competitive conditions or other factors that make its long-term profit outlook unattractive) and also in finding buyers who will pay a price higher than the company’s net investment in the business (so the sale of divested businesses will result in capital gains for shareholders rather than capital losses).

Chapter 8 • Diversification Strategies 181

Astutely managed diversified companies understand the nature and value of corporate parenting resources and develop the skills to leverage them effectively across their businesses. The more adept corporate-level executives are at effectively building, nurturing, and deploying a rich collection of corporate parenting capabilities, the more able they are to create added value for shareholders in comparison to other enterprises pursuing unrelated diversification—diversified corporations with top-flight parenting capabilities have what is called a parenting advantage . When a corporation has a parenting advantage and when its executives are also uniquely skilled in identifying weak-performing companies where there are achievable opportunities to boost profits to appealingly high levels, then the corporation has credible prospects of pursuing an unrelated diversification strategy that can deliver 1 + 1 = 3 gains in long-term shareholder value.

The Two Big Drawbacks of Unrelated Diversification Unrelated diversification strategies have two important negatives:

1 . Demanding managerial requirements. Successfully managing a set of fundamentally different businesses operating in fundamentally different industry and competitive environments is a challenging and exceptionally difficult proposition.9 The more unrelated businesses that a company has diversified into, the harder it is for corporate executives to have in-depth knowledge about each business (consider, for example, that corporations like General Electric, Samsung, 3M, Honeywell, Johnson & Johnson, and Mitsubishi have dozens of business subsidiaries making hundreds and sometimes thousands of products). While headquarters executives can glean information about the industry from third-party sources, ask lots of questions when visiting different business operations, and do their best to learn about the company’s different businesses, they still remain heavily dependent on briefings from business unit managers for many of the details and on “managing by the numbers”—that is, keeping close track of the financial and operating results of each subsidiary and assuming that the heads of the various subsidiaries have most everything under control so long as the latest financial and operating measures look good. This can work provided the heads of the various business units are capable and favorable conditions allow a business to consistently meet its numbers. But the problem comes when things start to go awry in a business despite the best effort of business unit managers, and top-level corporate executives have to get deeply involved in helping turn around a business they do not know that much about. Because every business tends to encounter rough sledding at some juncture, unrelated diversification is a somewhat risky strategy from a managerial perspective.10 Hard-to-resolve problems in one or more businesses or big strategic mistakes (sloppy analysis of the industries a company is getting into, discovering that the problems of a newly acquired business will require considerably more time and money to correct than was expected, or being overly optimistic about a newly-acquired company’s future prospects) can cause a precipitous drop in corporate earnings and crash the parent company’s stock price.11 Thus, companies electing to pursue unrelated diversification strategies are usually well advised to avoid casting a wide net to build their business portfolios—a few unrelated businesses is often better than many unrelated businesses.

2 . No potential for competitive advantage beyond any benefits of corporate parenting and what each individual business can generate on its own. Unlike a related diversification strategy, there are no cross-business strategic fits to draw on for reducing costs, transferring beneficial skills and technology, leveraging use of a powerful brand name, or collaborating to build mutually beneficial competitive capabilities and thereby adding to any competitive advantage the individual businesses

CORE CONCEPT A diversified company has a parenting advantage when it has superior corporate parenting capabilities relative to other diversified companies and thus can boost the combined performance of its individual businesses through high­level oversight, timely advice, and contributions of needed resource support.

Without the added competitive advantage potential that cross­business strategic fit provides, it is hard for the consolidated performance of an unrelated group of businesses to be any better than the sum of what the individual business units could achieve if they were independent.

Chapter 8 • Diversification Strategies 182

possess. Yes, a cash-rich and/or managerially adept corporate parent pursuing unrelated diversification can provide its subsidiaries with much-needed capital, valuable top-management guidance and advice, and capable administrative know-how, but otherwise it has little to offer in enhancing the competitive strength of its individual business units. However, it must be noted that all the benefits accruing from first-rate corporate parenting capabilities are not exclusively attached to a strategy of unrelated diversification—these same benefits are equally available to companies pursuing a strategy of related diversification.

The drawbacks of demanding managerial requirements and limited competitive advantage potential greatly weaken the appeal of an unrelated diversification strategy. Relying on the shrewd acquisition skills of corporate- level executives and good-to-excellent corporate parenting capabilities to get 1 + 1 = 3 performance from a group of unrelated businesses is a weaker and less reliable basis for creating shareholder value than is a strategy of related diversification where competitively valuable cross-business strategic fits, astute acquisitions on the part of corporate-level executives, and valuable corporate parenting resources and expertise can all combine to drive 1 + 1 = 3 outcomes. Hence the likelihood that a strategy of related diversification can add more shareholder value than a strategy of unrelated diversification is indeed high. Real-world evidence supports this conclusion: There are far more companies pursuing unrelated diversification strategies whose financial results have been mediocre to poor than there are those whose financial performance over time has been good to excellent.12 Without exceptional corporate parenting skills and resources, the odds are that unrelated diversification will produce 1 + 1 = 2 or smaller gains for shareholders.

Combination Related–Unrelated Diversification Strategies There’s nothing to preclude a company from diversifying into both related and unrelated businesses. Indeed, in actual practice, the business make-up of diversified companies varies considerably. Some diversified companies are really dominant-business enterprises—one major “core” business accounts for 50 to 80 percent of total revenues and a collection of small related or unrelated businesses accounts for the remainder. Some diversified companies are narrowly diversified around a few (two to five) related or unrelated businesses. Others are broadly diversified around a wide-ranging collection of related businesses, unrelated businesses, or a mixture of both. Also, a number of multibusiness enterprises have diversified into unrelated areas but have a collection of related businesses within each area—thus giving them a business portfolio consisting of several unrelated groups of related businesses. There’s ample room for companies to customize their diversification strategies to incorporate elements of both related and unrelated diversification, as may suit their own collection of valuable competitive assets, corporate resources, and strategic vision.

Evaluating the Strategy of a Diversified Company

Assessing the strategies of diversified companies builds on the concepts and methods used for single-business companies. But there are some additional aspects to consider and a couple of new analytic tools to master. The procedure for evaluating the pluses and minuses of a diversified company’s strategy and deciding what actions to take to improve the company’s performance involves six steps:

1 . Assessing the attractiveness of the industries the company has diversified into, both individually and as a group.

2 . Assessing the competitive strength of the company’s business units and drawing a nine-cell matrix to simultaneously portray the industry attractiveness and competitive strength of each of the business

units.

3 . Evaluating the competitive value of cross-business strategic fits along the value chains of the company’s various business units.

Chapter 8 • Diversification Strategies 183

4 . Checking whether the firm’s resources fit the requirements of its present business lineup.

5 . Ranking the performance prospects of the businesses from best to worst and determining what the corporate parent’s priorities should be in allocating resources to its various businesses.

6 . Crafting new strategic moves to improve overall corporate performance.

The core concepts and analytical techniques underlying each of these steps merit further discussion.

Step 1: Assessing Industry Attractiveness A principal consideration in evaluating a diversified company’s business make-up and the caliber of its strategy is the attractiveness of the industries in which it has business operations. Answers to several questions are required:

n Does each industry the company has diversified into represent a good business for the company to be in—does it pass the industry attractiveness test?

n Which of the company’s industries are most attractive, and which are least attractive?

n How appealing is the whole group of industries in which the company has invested?

The more attractive the industries (both individually and as a group) a diversified company is in, the better its prospects for good long-term performance.

Calculating Industry Attractiveness Scores A simple and reliable analytical tool for gauging industry attractiveness involves calculating quantitative industry attractiveness scores based on the following measures:

n Market size and projected growth rate. Big industries are more attractive than small industries, and fast- growing industries tend to be more attractive than slow-growing industries, other things being equal.

n The intensity of competition. Industries where competitive pressures are relatively weak are more attractive than industries where competitive pressures are strong.

n Emerging opportunities and threats. Industries with promising opportunities and minimal threats on the near horizon are more attractive than industries with modest opportunities and imposing threats.

n The presence of cross-industry strategic fits. The more one industry’s value chain and resource requirements match up well with the value chain activities of other industries in which the company has operations, the more attractive the industry is to a firm pursuing related diversification. However, cross-industry strategic fits are not something that a company committed to a strategy of unrelated diversification considers when it is evaluating industry attractiveness.

n Resource and capability requirements. Industries having resource/capability requirements within the company’s reach are more attractive than industries where the requirements could strain corporate financial resources and/or capabilities.

n Seasonal and cyclical factors. Industries where buyer demand is relatively steady year-round and not unduly vulnerable to economic ups and downs tend to be more attractive than industries where there are wide swings in buyer demand within or across years. However, seasonality may be a plus for a company that is in several seasonal industries if the seasonal highs in one industry correspond to the lows in another industry, thus helping even out monthly sales levels. Likewise, cyclical market demand in one industry can be attractive if its up-cycle runs counter to the market down-cycles in another industry where the company operates, thus helping reduce revenue and earnings volatility.

n Social, political, regulatory, and environmental factors. Industries with significant problems in such areas as consumer health, safety, or environmental pollution or those subject to intense regulation are less attractive than industries where such problems are not burning issues.

Chapter 8 • Diversification Strategies 184

n Industry profitability. Industries with healthy profit margins and high rates of return on investment are generally more attractive than industries with historically low or unstable profitability.

n Industry uncertainty and business risk. Industries with less uncertainty on the horizon and lower overall business risk are more attractive than industries whose prospects for one reason or another are uncertain, especially when the industry has formidable resource requirements.

Each attractiveness measure is then assigned a weight reflecting its relative importance in determining an industry’s attractiveness—not all attractiveness measures are equally important. The intensity of competition in an industry should nearly always carry a high weight (say, 0.20 to 0.30). Strategic-fit considerations should be assigned a high weight for companies with related diversification strategies and dropped from the list of attractiveness measures altogether for companies pursuing unrelated diversification. Seasonal and cyclical factors should generally be eliminated (or perhaps assigned a low weight) except in situations where that are obviously relevant. The importance weights must add up to 1.0.

Next, every industry is rated on each of the chosen industry attractiveness measures, using a rating scale of 1 to 10 (where a high rating signifies high attractiveness and a low rating signifies low attractiveness). Keep in mind here that the more intensely competitive an industry is, the lower the attractiveness rating for that industry. Likewise, the higher the capital and resource requirements associated with being in a particular industry, the lower the attractiveness rating. Weighted attractiveness scores are then calculated by multiplying the industry’s rating on each measure by the corresponding weight. For example, a rating of 8 times a weight of 0.25 gives a weighted attractiveness score of 2.00. The sum of the weighted scores for all the attractiveness measures provides an overall industry attractiveness score. This procedure is illustrated in Table 8.1.

Table 8.1 Calculating Weighted Industry Attractiveness Scores

Rating scale: 1 = Very unattractive to company; 10 = Very attractive to company]

Industry Attractiveness Assessments Industry A Industry B Industry C

Industry Attractiveness Measures

Importance Weight

Attractive- ness Rating

Weighted Score

Attractive- ness

Rating Weighted

Score Attractive-

ness Rating Weighted

Score Market size and projected growth rate 0.10 8 0.80 3 0.30 5 0.50 Intensity of competition 0.25 8 2.00 2 0.50 5 1.25 Emerging opportunities and threats 0.10 6 0.60 5 0.50 4 0.40 Cross-industry strategic fits 0.20 8 1.60 2 0.40 3 0.60 Resource requirements 0.10 6 0.60 5 0.50 4 0.40 Seasonal and cyclical influences 0.05 9 0.45 5 0.25 10 0.50 Social, political, regulatory, and environmental factors 0.05 8 0.40 3 0.15 7 0.35 Industry profitability 0.10 5 0.50 3 0.30 6 0.60 Industry uncertainty and business risk 0.05 5 0.25 1 0.05 10 0.50 Sum of importance weights 1.00 Weighted overall industry attractiveness scores 7.20 2.95 5.10

Chapter 8 • Diversification Strategies 185

Interpreting the Industry Attractiveness Scores Industries with a score much below 5.0 probably do not pass the attractiveness test. If a company’s industry attractiveness scores are all above 5.0, it is probably fair to conclude that the group of industries the company operates in is attractive as a whole. But the group of industries takes on a decidedly lower degree of attractiveness as the number of industries with scores below 5.0 increases, especially when industries with low scores account for a sizable fraction of the company’s revenues.

For a diversified company to be a strong performer, a substantial portion of its revenues and profits must come from business units in industries with relatively high industry attractiveness scores. It is particularly important that a diversified company’s principal businesses be in industries with a good outlook for growth and above- average profitability. Having a big fraction of the company’s revenues and profits come from industries with slow growth, low profitability, intense competition, or other troubling conditions or characteristics tends to drag overall company performance down. Business units in the least attractive industries are potential candidates for divestiture, unless they are positioned strongly enough to overcome the unattractive aspects of their industry environments or they are a strategically important component of the company’s business make-up.

Step 2: Assessing Business Unit Competitive Strength The second step in evaluating a diversified company is to appraise the competitive strength of each business unit in its respective industry. Doing an appraisal of each business unit’s strength and competitive position not only reveals its chances for success in its industry but also provides a basis for ranking the units from competitively strongest to competitively weakest and sizing up the competitive strength of all the business units as a group.

Calculating Competitive Strength Scores for Each Business Unit Quantitative measures of each business unit’s competitive strength can be calculated using a procedure similar to that for measuring industry attractiveness. The following factors are used in quantifying the competitive strengths of a diversified company’s business subsidiaries:

n Relative market share. A business unit’s relative market share is defined as the ratio of its market share to the market share held by the largest rival firm in the industry, with market share measured in unit volume, not dollars. For instance, if Business A has a market-leading share of 40 percent and its largest rival has 30 percent, A’s relative market share is 1.33. (Note that only business units that are market share leaders in their respective industries can have relative market shares greater than 1.0.) If Business B has a 15 percent market share and its largest rival has 30 percent, B’s relative market share is 0.5. The further below 1.0 a business unit’s relative market share is, the weaker its competitive strength and market position vis-à-vis rivals. A 10 percent market share, for example, does not signal much competitive strength if the leader’s share is 50 percent (a 0.20 relative market share), but a 10 percent share is actually strong if the leader’s share is only 12 percent (a 0.83 relative market share). This is why a company’s relative market share is a better measure of competitive strength than a company’s market share based on either dollars or unit volume.

n Costs relative to competitors’ costs. Business units that have low costs relative to those of key competitors tend to be in a stronger position in their industries than business units struggling to maintain cost parity with major rivals. The only time a business unit’s competitive strength may not be undermined by having higher costs than rivals is when it has incurred the higher costs to strongly differentiate its product offering and its customers are willing to pay premium prices for the differentiating features.

n Ability to match or beat rivals on key product attributes. A company’s competitiveness depends in part on being able to satisfy buyer expectations with regard to features, product performance, reliability, service, and other important attributes.

n Ability to benefit from strategic fits with sister businesses. Strategic fits with other businesses within the company enhance a business unit’s competitive strength and may provide a competitive edge.

Using relative market share to measure competitive strength is analytically superior to using straight­percentage market share.

Chapter 8 • Diversification Strategies 186

n Ability to exercise bargaining leverage with key suppliers or customers. Having bargaining leverage signals competitive strength and can be a source of competitive advantage.

n Brand image and reputation. A widely known and respected brand name is a valuable competitive asset in most industries.

n Other competitively valuable resources and capabilities. Valuable resources and capabilities, including important alliances and collaborative partnerships, enhance a company’s ability to compete successfully and perhaps contend for industry leadership.

n Profitability relative to competitors. Business units that consistently earn above-average returns on investment and have bigger profit margins than their rivals usually have stronger competitive positions. Moreover, above-average profitability signals competitive advantage, whereas below-average profitability usually denotes competitive disadvantage.

After settling on a set of competitive strength measures that are well matched to the circumstances of the various business units, weights indicating each measure’s importance need to be assigned. A case can be made for using different weights for different business units whenever the importance of the strength measures differs significantly from business to business, but otherwise it is simpler just to go with a single set of weights and avoid the added complication of multiple weights. As before, the importance weights must add up to 1.0. Each business unit is then rated on each of the chosen strength measures, using a rating scale of 1 to 10 (where a high rating signifies competitive strength and a low rating signifies competitive weakness). In the event the available information is too skimpy to confidently assign a rating value to a business unit on a particular strength measure, it is usually best to use a score of 5—this avoids biasing the overall score either up or down. Weighted strength ratings are calculated by multiplying the business unit’s rating on each strength measure by the assigned weight. For example, a strength score of 6 times a weight of 0.15 gives a weighted strength rating of 0.90. The sum of weighted ratings across all the strength measures provides a quantitative measure of a business unit’s overall competitive strength. Table 8.2 provides sample calculations of competitive strength ratings for three businesses.

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

[Rating scale: 1 = Very weak; 10 = Very strong]

Competitive Strength Assessments Business A in

Industry A Business B in

Industry B Business C in Industry C

Competitive Strength Measures

Importance Weight

Strength Rating

Weighted Score

Strength Rating

Weighted Score

Strength Rating

Weighted Score

Relative market share 0.15 10 1.50 2 0.30 6 0.90 Costs relative to competitors’ costs 0.20 7 1.40 4 0.80 5 1.00 Ability to match or beat rivals on key product attributes 0.05 9 0.45 5 0.25 8 0.40 Ability to benefit from strategic fits with sister businesses 0.20 8 1.60 4 0.80 8 0.80 Bargaining leverage with suppliers/customers 0.05 9 0.45 2 0.10 6 0.30 Brand image and reputation 0.10 9 0.90 4 0.40 7 0.70 Other valuable resources/ capabilities 0.15 7 1.05 2 0.30 5 0.75 Profitability relative to competitors 0.10 5 0.50 2 0.20 4 0.40 Sum of importance weights 1.00 Weighted overall competitive strength scores 7.85 3.15 5.25

Chapter 8 • Diversification Strategies 187

Interpreting the Competitive Strength Scores Business units with competitive strength ratings above 6.7 (on a scale of 1 to 10) are strong market contenders in their industries. Businesses with ratings in the 3.3 to 6.7 range have moderate competitive strength vis-à-vis rivals. Businesses with ratings below 3.3 have a competitively weak standing in the marketplace. If a diversified company’s business units all have competitive strength scores above 5.0, it is fair to conclude that its business units are all fairly strong market contenders in their respective industries. But as the number of business units with scores below 5.0 increases, there’s reason to question whether the company can perform well with so many businesses in relatively weak competitive positions. This concern takes on even more importance when business units with low scores account for a sizable fraction of the company’s revenues.

Using a Nine-Cell Matrix to Simultaneously Portray Industry Attractiveness and Competitive Strength The industry attractiveness and competitive strength scores can be used to portray the strategic positions of each business in a diversified company. Industry attractiveness is plotted on the vertical axis, and competitive strength on the horizontal axis. A nine-cell grid emerges from dividing the vertical axis into three regions (high, medium, and low attractiveness) and the horizontal axis into three regions (strong, average, and weak competitive strength). As shown in Figure 8.5, scores of 6.7 or greater on a rating scale of 1 to 10 denote high industry attractiveness, scores of 3.3 to 6.7 denote medium attractiveness, and scores below 3.3 signal low attractiveness. Likewise, high competitive strength is defined as a score greater than 6.7, average strength as scores of 3.3 to 6.7, and low strength as scores below 3.3. Each business unit is plotted on the nine-cell matrix according to its overall attractiveness score and strength score, and then shown as a “bubble.” The size of each bubble is scaled to what percentage of revenues the business generates relative to total corporate revenues. The bubbles in Figure 8.5 were located on the grid using the four industry attractiveness scores from Table 8.1 and the strength scores for the four business units in Table 8.2.

The locations of the business units on the attractiveness–strength matrix provide valuable guidance in deploying corporate resources to the various business units. Businesses positioned in the three cells in the upper left portion of the attractiveness–strength matrix (like Business A) have both favorable industry attractiveness and competitive strength, and thus merit top priority in the corporate parent's resource allocation ranking.

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

Chapter 8 • Diversification Strategies 188

Figure 8.5 A Nine-Cell Industry Attractiveness–Competitive Strength Matrix

High priority for resource allocation

Medium priority for resource allocation

Low priority for resource allocation

Circle sizes are scaled to reflect the percentage of companywide revenues generated by the business unit.

Business A in

Industry A

Business C in

Industry C

Business B in

Industry B

Businesses positioned in the three diagonal cells stretching from the lower left to the upper right (like Business C in Figure 8.5) usually merit medium or intermediate priority in the parent’s resource allocation ranking. However, some businesses in the medium-priority diagonal cells may have brighter or dimmer prospects than others. For example, a small business located in the upper right cell of the matrix, despite being in a highly attractive industry, may occupy too weak of a competitive position in its industry to justify the investment and resources needed to turn it into a strong market contender and shift its position left in the matrix over time.

The nine­cell attractiveness–strength matrix provides strong logic for fully funding the resource needs of competitively strong businesses in attractive industries, investing selectively in businesses with intermediate position on the grid, and getting rid of competitively weak businesses in unattractive industries unless they generate sizable cash flows that can be redeployed elsewhere or have important strategic value despite their competitive weakness.

Chapter 8 • Diversification Strategies 189

here. The real question is how much competitive value can be generated from whatever strategic fits exist? Are there value chain matchups that present sizable opportunities to reduce costs by combining the performance of certain value chain activities and thereby capture economies of scope? Could cost savings associated with economies of scope give one or more individual businesses a cost-based advantage over rivals? Can much competitive value be gained from cross-business transfer of technology, skills, or know-how to correct the resource deficiencies of certain businesses and boost their bottom lines? Are there potential competitive benefits from cross-business sharing of a corporate parent’s umbrella brand name or corporate reputation? Could cross-business collaboration to create new competitive capabilities lead to significant gains in performance? Without significant cross-business strategic fits and strong company efforts to capture them, one has to be skeptical about the potential for a diversified company’s related businesses to perform better together than apart.

Step 4: Checking for Good Resource Fit The businesses in a diversified company’s lineup need to exhibit good resource fit. Resource fit exists when (1) each company business had adequate access to the resources and capabilities it needs to be competitively successful (these resources can either be internal to its own operations or supplied by its corporate parent) and (2) the parent company has sufficient financial resources and parenting capabilities to support its entire group of businesses without spreading itself too thin.

Financial Resource Fit The most important dimension of financial resource fit concerns whether a diversified company can generate the internal cash flows sufficient to fund the capital requirements of its businesses, pay dividends, meet its debt obligations, and otherwise remain financially healthy. Different businesses have different cash flow and investment characteristics. For example, business units in rapidly growing industries are often cash hogs—so labeled because the cash flows they are able to generate from internal operations aren’t big enough to fund their operations and capital requirements for growth. To keep pace with rising buyer demand, rapid- growth businesses frequently need sizable annual capital investments—for new facilities and equipment, for

Businesses in the three cells in the lower right corner of the matrix (like Business B in Figure 8.5) have comparatively low industry attractiveness and minimal competitive strength, typically making them weak performers with little potential for improvement. At best, they have the lowest claim on corporate resources and often are good candidates for being divested (sold to other companies). However, there are occasions when a business located in the three lower right cells generates sizable positive cash flows or has other traits with important strategic value that justify its retention. It makes sense to retain such businesses and manage them in a manner calculated to maximize their value. For example, it makes sense to maximize the operating cash flows from low-performing/low-potential businesses and divert them to financing expansion of business units with greater potential for revenue and profit growth or to making new acquisitions.

Step 3: Evaluating the Competitive Value of Cross-Business Strategic Fits While this step can be bypassed for diversified companies whose businesses are all unrelated (since, by design, no strategic fits a re p resent), the presence of important s trategic fi ts ac ross the va lue chains of a company’s related businesses is central to concluding just how good a company’s related diversification strategy is. But more than CORE CONCEPT just checking for the presence of good strategic fits is required

A company’s related diversification strategy derives its power in large part from the presence of competitively valuable strategic fits among its businesses and forceful company efforts to capture the benefits of these fits.

CORE CONCEPT Resource fit concerns whether each company business has adequate access to the resources and capabilities needed to be competitively successful and whether the corporate parent has the financial means and parenting capabilities to support its entire group of businesses.

Chapter 8 • Diversification Strategies 190

new product development or technology improvements, and for additional working capital to support inventory expansion and a larger base of operations. A business in a fast-growing industry becomes an even bigger cash hog when it has a relatively low market share and is pursuing a strategy to become an industry leader. Because a cash hog’s financial resources must be provided by the corporate parent, corporate managers must decide whether it makes good financial and strategic sense to keep pouring new money into a business that is likely to need cash infusions for some years to come (until slowing growth causes its capital requirements to diminish and/or until increased profitability and bigger cash flows from operations become large enough to fund its capital requirements).

In contrast, business units with leading market positions in mature industries may be cash cows in the sense that they generate substantial cash surpluses over what is needed to adequately fund their operations. Market leaders in slow-growth industries often generate sizable positive cash flows over and above what is needed for growth and reinvestment because their industry-leading positions tend to give them the sales volumes and reputation to earn attractive profits and because the slow-growth nature of their industry often entails relatively modest annual investment requirements. Cash cows, though not always attractive from a growth standpoint, are valuable businesses from a financial resource perspective. The surplus cash flows they generate can be used to pay corporate dividends, finance acquisitions, and provide funds for investing in the company’s promising cash hogs. It makes good financial and strategic sense for diversified companies to keep cash cows in healthy condition, fortifying and defending their market position to preserve their cash-generating capability over the long term and thereby have an ongoing source of financial resources to deploy elsewhere. The cigarette business is one of the world’s biggest cash cow businesses. The businesses of both Microsoft and Apple are huge cash cows; for example, in fiscal 2018, Microsoft had revenues of $110.4 billion and realized a net cash flow from operations of $43.9 billion, of which $11.6 billion was used to fund additions to property and equipment and $12.7 billion was used to pay dividends, resulting in free cash flow of about $19.6 billion (17.7 percent of revenues); as of December 31, 2018, Microsoft’s balance sheet showed the company had cash, cash equivalents, and short-term investments totaling $127.7 billion. Wrigley’s, a producer of chewing gum and candies and now a subsidiary of Mars, Inc., is said to be a consistent generator of surplus cash flows approaching 15 percent of revenues.13

Viewing a diversified group of businesses as a collection of cash flows and cash requirements (present and future) is a major step forward in understanding the financial ramifications of diversification and why having businesses with good financial fit is so important. The ideal condition is that a diversified corporation’s cash cow businesses generate sufficiently large free cash flows to fund the capital needs of all its other businesses, pay dividends, cover its debt repayments, and have funds left over for making new acquisitions. While additional capital can usually be raised in financial markets if internal cash flows are deficient, it is still important for a diversified firm to have a healthy internal capital market adequate to support the financial requirements of its business lineup. The greater the extent to which a diversified company is able to fund the needed investment in its businesses through internally generated cash flows rather than from borrowing or issuing additional shares of common stock, the more powerful its financial resource fit, the less dependent the firm is on external sources of capital, and the stronger its credit rating. This can provide a competitive advantage over single business rivals with small cash flows from operations, a weaker credit rating, and limited ability to raise capital from external sources.

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

CORE CONCEPT 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.

Chapter 8 • Diversification Strategies 191

Aside from cash flow considerations, two other factors should be considered when assessing whether a diversified company’s businesses exhibit good financial fit:

1. Do any of the company’s individual businesses present financial challenges in contributing adequately to the company’s financial performance and overall well-being? A business exhibits a poor financial fit if it soaks up a disproportionate share of a corporate parent’s financial resources, makes subpar or inconsistent bottom-line contributions, is too small to make a material earnings contribution, or is unduly risky (so that the financial well-being of the whole company could be jeopardized in the event it falls upon hard times).

2. Does the company have adequate financial strength to fund its different businesses, pursue growth via new acquisitions, and maintain a healthy credit rating? A diversified company’s strategy fails the resource fit test when its financial resources are stretched across so many businesses that its credit rating is impaired. Severe financial strain sometimes occurs when a company borrows so heavily to finance new acquisitions that it has to trim way back on capital expenditures for existing businesses and use the majority of its financial resources to meet interest obligations and to pay down debt. Several of the world’s largest banks (Citigroup and Royal Bank of Scotland) recently found themselves so undercapitalized and financially overextended they had to sell some of their business assets to meet regulatory requirements and restore confidence in their solvency.

Nonfinancial Resource Fits Just as a diversified company must have adequate financial resources to support its various individual businesses, it must also have a big enough and deep enough pool of managerial, administrative, and other parenting capabilities to ensure that each of its business units has the resources and capabilities it requires for competitive success and good financial performance. The following three questions help reveal whether a diversified company has adequate nonfinancial resources:

1. Is there any evidence indicating that any of the company’s business units are resource deficient—either because certain needed resources and/or capabilities cannot be transferred in or shared with sister businesses or because the missing resources and/or capabilities cannot be supplied by the corporate parent?

2. Are the corporate parent’s resources and parenting capabilities poorly matched to the resource requirements of one or more businesses it has diversified into? For instance, BTR, a multibusiness company in Great Britain, discovered that the company’s resources and managerial skills were well suited for parenting industrial manufacturing businesses but not for parenting its distribution businesses (National Tyre Services and Texas-based Summers Group). As a result, BTR decided to divest its distribution businesses and focus exclusively on diversifying around small industrial manufacturing.14

3. Are the parent company’s resources and capabilities being stretched too thinly by the resource/capability requirements of one or more of its businesses? A diversified company must guard against overtaxing its resources and capabilities, a condition that can arise when (1) it goes on an acquisition spree and management is called upon to assimilate and oversee many new businesses quickly or (2) it lacks sufficient supplies of competitively valuable resources and capabilities that it can transfer from one or more existing business to bolster the competitiveness of resource-deficient businesses. The broader the diversification, the greater the concern about whether corporate executives are overburdened or overwhelmed by the demands of competently parenting so many different businesses. Plus, the more a company’s related diversification strategy is tied to transferring know-how or technologies from existing businesses to newly acquired or competitively weak businesses, the more time and money that has to be put into developing a deep-enough pool of business-level and corporate-level resources and capabilities to supply both new businesses and competitively weak businesses with the quantity and quality of the resource infusions they need to be successful.15 Otherwise, its resource pool is spread too thinly across many businesses, and the opportunity for achieving 1 + 1 = 3 outcomes slips through the cracks.

Chapter 8 • Diversification Strategies 192

Step 5: Ranking the Performance Prospects of Business Units and Assigning a Priority for Resource Allocation Once a diversified company’s businesses are evaluated from the standpoints of industry attractiveness, competitive strength, strategic fit, and resource fit, the next step is to use this information to rank the performance prospects of the businesses from best to worst. Such rankings help top-level executives assign each business a priority for corporate resource support and new capital investment.

The locations of the different businesses in the nine-cell industry attractiveness–competitive strength matrix provide a solid basis for identifying high-opportunity businesses and low-opportunity businesses. Normally, competitively strong businesses in attractive industries have significantly better performance prospects than competitively weak businesses in unattractive industries. Also, normally, the revenue and earnings outlook for businesses in fast-growing businesses is better than for businesses in slow-growing businesses. As a rule, business subsidiaries with the brightest profit and growth prospects, attractive positions in the nine-cell matrix, and solid strategic and/or resource fits should receive top priority in allocating corporate resources to individual business units. However, in ranking the prospects of the different businesses from best to worst, it is usually wise to also take into account each business’s past performance regarding sales growth, profit growth, contribution to company earnings, return on capital invested in the business, and cash flow from operations. While past performance is not always a reliable predictor of future performance, it does signal whether a business is a consistent or inconsistent performer and how well it has coped with shifting market conditions in times past.

Allocating Financial Resources Figure 8.6 shows the chief strategic and financial options for allocating a diversified company’s financial resources. Divesting businesses with the weakest future prospects and businesses that lack adequate strategic fit and/or resource fit is one of the best ways of generating additional funds for redeployment to businesses with better opportunities and better strategic and resource fits. Free cash flows from cash cow businesses and the company’s profit sanctuaries also add to the pool of funds that can be usefully redeployed. Ideally, a diversified company will have sufficient resources to strengthen or grow its existing businesses, make any new acquisitions that are desirable, fund other promising business opportunities, pay down existing debt, and periodically increase dividend payments to shareholders and/or repurchase shares of stock. But, as a practical matter, a company’s resources are limited. Thus, to make the best use of the available resources, top executives must steer resources to businesses with the best opportunities and performance prospects and either divest or allocate minimal resources to businesses with marginal or dim prospects—this is why ranking the performance prospects of the various businesses from best to worst is so crucial. Strategic uses of corporate financial resources (see Figure 8.6) should usually take precedence over financial uses unless there are strong reasons to strengthen the firm’s balance sheet or better reward shareholders. And, as emphasized earlier, when a corporate parent has nonfinancial resources that particular business units will find uniquely valuable in strengthening their performance and/or accelerating their growth, allocating such resources to these business units should be automatic—they usually represent 1 + 1 = 3 opportunities that should not be missed.

For a company to make the best use of its limited pool of resources, both financial and nonfinancial, top executives must be diligent in steering resources to those businesses with the best opportunities and performance prospects, and allocating only minimal resources to businesses with weak prospects.

Chapter 8 • Diversification Strategies 193

Figure 8.6 The Chief Strategic and Financial Options for Allocating a Diversified Company’s Financial Resources

Strategic Options for Allocating Company

Financial Resources

Financial Options for Allocating Company

Financial Resources

Invest in ways to strengthen or grow existing businesses

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

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

Step 6: Crafting New Strategic Moves to Improve Overall Corporate Performance The diagnosis and conclusions flowing from the five preceding analytical steps set the agenda for crafting strategic moves to improve a diversified company’s overall performance. The strategic options boil down to five broad categories of actions:

n Sticking closely with the existing business lineup and pursuing the profitable growth opportunities these businesses present.

n Broadening the company’s business scope by making new acquisitions in new industries.

n Divesting certain businesses and retrenching to a narrower base of business operations.

n Restructuring the company’s business lineup and putting a whole new face on the company’s business makeup.

n Pursuing multinational diversification and striving to globalize the operations of several of the company’s business units.

Sticking with the Present Business Lineup The option of sticking with the current business lineup makes sense when the company’s present businesses offer attractive growth opportunities that should boost earnings and contribute to greater shareholder value. As long as the company’s set of existing businesses have good prospects for enhancing corporate performance and these businesses have good strategic and/or resource fits, then major changes in the company’s business mix are usually unnecessary. Corporate executives can concentrate their

Chapter 8 • Diversification Strategies 194

attention on getting the best performance from each of its businesses and steering corporate resources into those areas of greatest potential and profitability. The specifics of “what to do” to wring better performance from the present business lineup have to be dictated by each business’s circumstances and the preceding analysis of the corporate parent’s diversification strategy.

Broadening the Company’s Business Scope Diversified companies sometimes find it desirable to build positions in new industries, whether related or unrelated.16 Several motivating factors are in play. One is sluggish growth and meager performance improvements that make the potential revenue and profit boost of a newly acquired business look attractive. A second is the potential for transferring resources and capabilities from existing businesses to newly-acquired related or complementary businesses. A third is rapidly changing conditions in one or more of a company’s core businesses that make it desirable to expand into other industries. A fourth, and often important, motivating factor for adding new businesses is to complement and strengthen the market position and competitive capabilities of one or more of its present businesses. Procter & Gamble’s acquisition of Gillette strengthened and extended P&G’s reach into personal care and household products— Gillette’s businesses included Oral-B toothbrushes, Gillette razors and razor blades, Duracell batteries, Braun shavers and small appliances (coffee makers, mixers, hair dryers, and electric toothbrushes), and toiletries (Right Guard, Foamy, Soft & Dry, White Rain, and Dry Idea). Johnson & Johnson has used acquisitions to diversify far beyond its well-known Band-Aid and baby care businesses to become a major player in pharmaceuticals, medical devices, and medical diagnostics.

Usually, expansion into new businesses is undertaken by acquiring companies already in the target industry. Some companies depend on new acquisitions to drive a major portion of their growth in revenues and earnings, and thus are always on the acquisition trail.

Retrenching to a Narrower Diversification Base A number of diversified firms have had difficulty managing a diverse group of businesses and have elected to exit some of them. Retrenching to a narrower diversification base is usually undertaken when top management concludes its diversification strategy has ranged too far afield and the company can improve long-term performance by concentrating on building stronger positions in a smaller number of core businesses and industries. For instance, PepsiCo spun off its fast food restaurant businesses (Kentucky Fried Chicken, Pizza Hut, Taco Bell) as a publicly traded company to boost internal cash flows available for strengthening its soft drink business (which was losing market share to Coca-Cola) and growing its more profitable Frito-Lay snack foods business; PepsiCo’s CEO said divesting the three restaurant chains was needed in order to “bring all our human and financial resources to bear on our soft drink and snack foods businesses and to dramatically sharpen PepsiCo’s focus.”17 In 2015, Nike divested its Cole Haan and Umbro brands to focus on its Jordan and Converse footwear brands that are more complementary to its Nike brand. eBay divested its PayPal business in 2015 by selling it to the public via an initial public offering of common stock that generated proceeds to eBay of $45 billion, about 30 times what it paid to acquire PayPal in 2002.

But there are other important reasons for divesting one or more of a company’s present businesses. Sometimes divesting a business must be considered because market conditions in a once-attractive industry have badly deteriorated. A business can become a prime candidate for divestiture because it lacks adequate strategic or resource fit, because it is a cash hog with questionable long-term potential, or because remedying its competitive weaknesses is too expensive relative to the likely gains in profitability. Sometimes a company acquires businesses that, down the road, just do not work out as expected even though management has tried all it can think of to make them profitable—mistakes cannot be completely avoided because it is hard to foresee how getting into a new line of business will actually work out. Subpar performance by some business units is bound to occur, thereby raising questions of whether to divest them or keep them and attempt a turnaround. Other business units, despite adequate financial performance, may not mesh as well with the rest of the firm as was originally thought.

Focusing corporate resources on a few core and mostly related businesses avoids the mistake of diversifying so broadly that resources and management attention are stretched too thin.

Chapter 8 • Diversification Strategies 195

On occasion, a diversification move that seems sensible from a strategic-fit standpoint turns out to be a poor cultural fit.18 When several pharmaceutical companies diversified into cosmetics and perfume, they discovered their personnel had little respect for the “frivolous” nature of such products compared to the far nobler task of developing miracle drugs to cure the ill. The absence of shared values and cultural compatibility between the medical research and chemical-compounding expertise of the pharmaceutical companies and the fashion/ marketing orientation of the cosmetics business was the undoing of what otherwise was diversification into businesses with technology-sharing potential, product development fit, and some overlap in distribution channels.

A useful guide to determine whether or when to divest a business subsidiary is to ask, “If we were not in this business today, would we want to get into it now?”19 When the answer is no or probably not, divestiture should be considered. In general, diversified companies need to divest low-performing businesses or businesses that don’t fit in order to concentrate on expanding high-potential businesses and entering new ones with promising opportunities.

Selling a business outright to another company is the most frequently used option for divesting a business. But sometimes a business selected for divestiture has ample resource strengths to compete successfully on its own. In such cases, a corporate parent may “spin off” the unwanted business as a financially and managerially independent company, by selling shares to the investing public via an initial public offering or by distributing shares in the new company to the corporate parent’s existing shareholders.

Restructuring a Company’s Business Lineup Restructuring involves divesting some businesses and acquiring others to put a whole new face on the company’s business lineup.20 Performing radical surgery on a company’s business lineup is appealing when its financial performance is being squeezed or eroded by:

n Mismatches between the businesses it has diversified into and the parent company’s resources and parenting capabilities.

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

n Too many competitively weak businesses.

n The emergence of new technologies that threaten the survival of one or more important businesses.

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

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

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

Restructuring is also undertaken when a newly appointed CEO decides to redirect the company. On occasion, restructuring can be prompted by special circumstances—for example, when a firm has a unique opportunity to make an acquisition so big and important it has to sell several existing business units to finance the new acquisition, or when a company needs to sell off some businesses to raise the cash to enter a potentially big industry with wave-of-the-future technologies or products.

Candidates for divestiture in a corporate restructuring effort typically include not only weak or up-and-down performers or those in unattractive industries, but also business units that lack strategic fit with the businesses to be retained, businesses that are cash hogs or that lack other types of resource fit, and businesses that top executives deem incompatible with the company’s revised diversification strategy (even though they may be profitable or in an attractive industry). As businesses are divested, corporate restructuring generally involves aligning the remaining business units into groups with the best strategic fits and then redeploying the cash flows from the divested businesses to either pay down debt or make new acquisitions to strengthen the parent company’s business position in the industries it has chosen to emphasize.21

Chapter 8 • Diversification Strategies 196

In 2012, Kraft Foods instituted a dramatic restructuring by dividing itself into two companies. One company, which retained the Kraft Foods name, included all the North American grocery operations and such brands as Kraft and Cracker Barrel cheeses, Velveeta, Oscar Mayer meats, A1 Steak Sauce, Claussen pickles, Cool Whip, Jell-O, Kraft mayonnaise and salad dressings, and assorted others. The second company, named Mondelēz International, included all of the former company’s global snack brands (Oreo, Cadbury, Nabisco, Philadelphia cream cheeses, Ritz, Triscuit, and Wheat Thins, among many others). In announcing the restructuring, Kraft’s CEO said the two companies “will each benefit from standing on its own and focusing on its unique drivers for success…each will have the leadership, resources, and mandate to realize its full potential.”

Pursuing Multinational Diversification This strategic approach to diversification offers two major avenues for growing revenues and profits: One is to grow by entering additional businesses, and the other is to grow by extending the operations of existing businesses into additional country markets. Pursuing both growth avenues at the same time has exceptional competitive advantage potential:

n A multinational diversification strategy facilitates full capture of economies of scale and learning/ experience curve effects. In some businesses, the volume of sales needed to realize full economies of scale and/or benefit fully from experience and learning-curve effects exceeds the volume that can be achieved by operating within the boundaries of just one or several country markets, especially small ones. The ability to drive down unit costs by expanding sales to additional country markets is one reason why a diversified company may seek to acquire a business and then rapidly expand its operations into more and more countries.

n A multinational diversification strategy provides opportunities to capture economies of scope arising from cost-saving strategic fits among related businesses. Diversifying into related businesses offering economies of scope paves the way for realizing a low-cost advantage over less diversified rivals. Consider, for example, the competitive power that Sony derived from economies of scope when it entered the video game business in 2000 with its PlayStation product line. Sony had an in-place distribution capability to go after video game sales in all country markets where it presently did business in other electronics product categories (TVs, computers, CD and DVD players, radios, and cameras). Plus, it had the marketing clout and instant brand name credibility to persuade retailers to give Sony’s PlayStation products prime shelf space and promotional support. These strategic-fit benefits helped Sony quickly build a profitable presence in the global video game marketplace.

n A multinational diversification strategy provides opportunities to transfer competitively valuable resources both from one business to another and from one country to another. A company pursuing related diversification can gain a competitive edge over less diversified rivals by transferring competitively valuable resources from one business to another; a multinational company can gain competitive advantage over rivals with narrower geographic coverage by transferring competitively valuable resources from one country to another. However, a strategy of multinational diversification enables simultaneous pursuit of both sources of competitive advantage.

n A multinational diversification strategy provides opportunities to leverage use of a well-known and competitively powerful brand name. Diversified multinational companies that market the products of different businesses under an umbrella brand name that is widely known and well-respected across the world gain important marketing and advertising advantages over rivals with lesser-known brands. A globally powerful brand name enables a company to (1) get prominent space on retailers’ shelves for the products of its different businesses sold under that brand, (2) win sales and market share simply on the confidence buyers place in products carrying the brand name, and (3) spend less money than lesser-known rivals for advertising. For instance, while Sony may spend money to make consumers aware of the availability of its newly introduced Sony products, it does not have to spend nearly as much on achieving brand recognition and market acceptance as do competitors with lesser-known brands. Further, if Sony moves into a new country market for the first time and does well selling Sony

Chapter 8 • Diversification Strategies 197

PlayStations and video games, it is easier to sell consumers in that country Sony TVs, DVD players, home theater products, headphones, cameras, and tablets. Additionally, the related advertising costs are likely to be less because of having already established the Sony brand in buyers’ minds.

n A multinational diversification strategy provides opportunities for sister businesses to collaborate in developing and leveraging competitively valuable resources and capabilities.22 For instance, by channeling corporate resources into a combined R&D/technology effort for all related businesses, as opposed to letting each business unit fund and direct its own R&D effort however it sees fit, a diversified corporate parent can merge its expertise and efforts worldwide to advance core technologies, expedite cross-business and cross-country product improvements, speed the development of new products that complement existing products, and pursue promising technological avenues to create altogether new businesses—all significant contributors to competitive advantage and better corporate performance.23 Honda has been very successful in building corporate-level R&D expertise in gasoline engines and transferring the resulting technological advances to its businesses in automobiles, motorcycles, outboard engines, snow blowers, lawn mowers, garden tillers, and portable power generators.

What makes a strategy of multinational diversification exceptionally appealing is that all five paths to competitive advantage can be pursued simultaneously. A strategy of diversifying into related industries and then competing globally in each of them thus has great potential for being a winner in the marketplace because of the long- term growth opportunities it offers and the multiple corporate-level competitive advantage opportunities it contains. Indeed, a strategy of multinational diversification contains more competitive advantage potential (above and beyond what is achievable through a particular business’s own competitive strategy) than any other diversification strategy. The strategic key to actually capturing maximum competitive advantage is for a diversified multinational company to focus its diversification efforts in industries where there are resource-sharing and resource-transfer opportunities and where there are important economies of scope and big benefits to cross-business use of a potent brand name. The more a company’s diversification strategy yields these kinds of strategic-fit benefits, the more powerful a competitor it becomes and the better its profit and growth performance is likely to be. Such advantages explain why such consumer products companies as Procter & Gamble, Unilever, Nestlé, Kimberly-Clark, Colgate-Palmolive, and Coca-Cola employ a strategy of multinational diversification.

Key Points

A “good” diversification strategy must produce increases in long-term shareholder value—increases that shareholders cannot otherwise obtain on their own. For a move to diversify into a new business to have a reasonable prospect of adding shareholder value, it must be capable of passing the industry attractiveness test, the cost-of-entry test, and the better-off test.

There are two fundamental approaches to diversifying—into related businesses and into unrelated businesses. The rationale for related diversification is strategic: Diversify into businesses with strategic fits along their respective value chains, capitalize on strategic-fit relationships to gain competitive advantage over rivals whose operations do not offer comparable strategic fit benefits, and then use competitive advantage to boost profitability and achieve the desired 1 + 1 = 3 impact on shareholder value. The greater the relatedness among the value chains of a diversified company’s sister businesses, the bigger the window for converting strategic fits into competitive advantage via (1) cross-business transfer of valuable competitive assets, (2) the capture of cost- saving efficiencies via sharing use of the same resources, (3) cross-business use of a well-respected brand name, and/or (4) cross-business collaboration to create new resource strengths and capabilities.

CORE CONCEPT A strategy of multinational diversification into related businesses has more built­in potential for competitive advantage than any other diversification strategy.

Chapter 8 • Diversification Strategies 198

The basic premise of unrelated diversification is that any business that has good profit prospects and can be acquired on good financial terms is a good business to diversify into. Unrelated diversification strategies surrender the competitive advantage potential of strategic fit and seek to add long-term shareholder value in five ways: (1) acquiring companies in any industry with growth and earnings prospects that can satisfy the industry attractiveness test, (2) acquiring undervalued or underperforming businesses that present appealing opportunities for being overhauled in ways that will result in big gains in profitability, (3) being disciplined enough to acquire companies at prices sufficiently low to pass the cost of entry test, (4) developing and nurturing outstanding corporate parenting resources and capabilities, and (5) discerning when it is time to exit a business and finding buyers who will pay the highest price. However, the greater the number of businesses a company has diversified into and the more diverse these businesses are, the harder it is for corporate executives to select capable managers to run each business, know when the major strategic proposals of business units are sound, or help guide the creation of an effective action plan to restore profitability when a business unit encounters trouble.

Analyzing the attractiveness of a company’s diversification strategy is a six-step process:

Step 1. Evaluate the long-term attractiveness of the industries into which the firm has diversified. Industry attractiveness needs to be evaluated from three angles: the attractiveness of each industry on its own, the attractiveness of each industry relative to the others, and the attractiveness of all the industries as a group.

Step 2. Evaluate the relative competitive strength of each of the company’s business units. The purpose of rating the competitive strength of each business is to gain a clear understanding of which businesses are strong contenders in their industries, which are weak contenders, and the underlying reasons for their strength or weakness. Drawing an industry attractiveness–competitive strength matrix helps identify the prospects of each business and suggests the priorities for allocating corporate resources and investment capital to each business.

Step 3. Evaluate the competitive value of cross-business strategic fits. A business is more attractive strategically when it has value chain relationships with sister business units that offer potential to (1) realize economies of scope or cost-saving efficiencies; (2) transfer technology, skills, know-how, or other resource capabilities from one business to another; (3) leverage use of a well-known and trusted brand name; and/or (4) collaborate with sister businesses to build new or stronger resource strengths and competitive capabilities. Cross-business strategic fits represent a significant avenue for producing competitive advantage beyond what any one business can achieve on its own.

Step 4. Check whether the firm’s resources fit the requirements of its present business lineup. Resource fit exists when (1) each company business has adequate access to the resources it needs to be competitively successful (these resources can either be internal to its own operations or supplied by its corporate parent) and (2) the parent company has sufficient financial resources and parenting capabilities to support its entire group of businesses without spreading itself too thin.

Step 5. Rank the performance prospects of the businesses from best to worst and determine what the corporate parent’s priority should be in allocating resources to its various businesses. The most important considerations in judging business unit performance are sales growth, profit growth, contribution to company earnings, and the return on capital invested in the business. Sometimes, cash flow generation is a big consideration. Normally, strong business units in attractive industries have significantly better performance prospects than weak businesses or businesses in unattractive industries. Business subsidiaries with the brightest profit and growth prospects and solid strategic and resource fits generally should head the list for corporate resource support.

Step 6. Craft new strategic moves to improve overall corporate performance. This step draws upon the results of the preceding steps to devise actions for improving the collective performance of the company’s different businesses. There are basically five strategic options: (1) sticking closely with the existing business lineup and pursuing the opportunities these businesses present, (2) broadening the company’s business scope by making new acquisitions in new industries, (3) divesting certain businesses and retrenching to a narrower base of business operations, (4) restructuring the company’s business lineup and putting a whole new face on the company’s business makeup, and (5) pursuing a strategy of multinational diversification.