Two types of divestitures are _____

Our discussions of business-level strategies (Chapter 4) and the competitive rivalry and competitive dynamics associated with them (Chapter 5) have concentrated on firms competing in a single industry or product market.1 In this chapter, we introduce you to corporate-level strategies, which are strategies firms use to diversify their operations from a single business competing in a single market into several product markets—most commonly, into several businesses. Thus, a corporate-level strategy specifies actions a firm takes to gain a competitive advantage by selecting and managing a group of differ- ent businesses competing in different product markets. Corporate-level strategies help companies to select new strategic positions—positions that are expected to increase the firm’s value.2 As explained in the Opening Case, General Electric competes in 16 widely diverse industries.

As is the case with GE, firms use corporate-level strategies as a means to grow rev- enues and profits, but there can be different strategic intents in addition to growth. Firms can pursue defensive or offensive strategies that realize growth but have different strategic intents. Firms can also pursue market development by moving into different geographic markets (this approach will be discussed in Chapter 8). Firms can acquire competitors (horizontal integration) or buy a supplier or customer (vertical integration). These strategies will be discussed in Chapter 7. The basic corporate strategy, the topic of this chapter, focuses on diversification.

The decision to take actions to pursue growth is never a risk-free choice for firms. Indeed, as the Opening Case explored, GE experienced difficulty in its media businesses, especially NBC, and its environmental record suffered. In one case, it tried to control NBC too much, trying to protect the firm. In so doing, it created questions about the objectivity of NBC’s reporting. Its environmental record likely suffered because of the lack of adequate oversight and the strong interest in producing returns for the share- holders. Effective firms carefully evaluate their growth options (including the different corporate-level strategies) before committing firm resources to any of them.3

Because the diversified firm operates in several different and unique product markets and likely in several businesses, it forms two types of strategies: corporate-level (or com- pany-wide) and business-level (or competitive).4 Corporate-level strategy is concerned with two key issues: in what product markets and businesses the firm should compete and how corporate headquarters should manage those businesses.5 For the diversified corporation, a business-level strategy (see Chapter 4) must be selected for each of the businesses in which the firm has decided to compete. In this regard, each of GE’s product divisions uses different business-level strategies; while most focus on differentiation, its consumer electronics business has products that compete in market niches to include some that are intended to serve the average income consumer. Thus, cost must also be an issue along with some level of quality.

As is the case with a business-level strategy, a corporate-level strategy is expected to help the firm earn above-average returns by creating value.6 Some suggest that few corporate-level strategies actually create value.7 As the Opening Case indicates, realizing value through a corporate strategy can be achieved but it is challenging to do so. In fact, GE is one of the few widely diversified and large firms that has been successful over time.

Evidence suggests that a corporate-level strategy’s value is ultimately determined by the degree to which “the businesses in the portfolio are worth more under the management of the company than they would be under any other ownership.”8 Thus, an effective corporate-level strategy creates, across all of a firm’s businesses, aggre- gate returns that exceed what those returns would be without the strategy9 and con- tributes to the firm’s strategic competitiveness and its ability to earn above-average returns.10

Product diversification, a primary form of corporate-level strategies, concerns the scope of the markets and industries in which the firm competes as well as “how managers buy, create and sell different businesses to match skills and strengths with opportunities presented to the firm.”11 Successful diversification is expected to reduce variability in the firm’s profitability as earnings are generated from different businesses.12 Diversification can also provide firms with the flexibility to shift their investments to markets where the greatest returns are possible rather than being dependent on only one or a few markets.13 Because firms incur development and monitoring costs when diversifying, the ideal portfolio of businesses balances diversification’s costs and benefits. CEOs and their top-management teams are responsible for determining the best portfolio for their company.14

We begin this chapter by examining different levels of diversification (from low to high). After describing the different reasons firms diversify their operations, we focus on two types of related diversification (related diversification signifies a moderate to high level of diversification for the firm). When properly used, these strategies help create value in the diversified firm, either through the sharing of resources (the related con- strained strategy) or the transferring of core competencies across the firm’s different businesses (the related linked strategy). We then discuss unrelated diversification, which is another corporate-level strategy that can create value. The chapter then shifts to the topic of incentives and resources that may stimulate diversification which is value neu- tral. However, managerial motives to diversify, the final topic in the chapter, can actually destroy some of the firm’s value.

Levels of Diversification

Diversified firms vary according to their level of diversification and the connections between and among their businesses. Figure 6.1 lists and defines five categories of businesses according to increasing levels of diversification. The single- and dominant- business categories denote relatively low levels of diversification; more fully diversi- fied firms are classified into related and unrelated categories. A firm is related through its diversification when its businesses share several links; for example, businesses may share products (goods or services), technologies, or distribution channels. The more links among businesses, the more “constrained” is the relatedness of diversification. “Unrelated” refers to the absence of direct links between businesses.

Low Levels of Diversification

A firm pursuing a low level of diversification uses either a single- or a dominant-business, corporate-level diversification strategy. A single-business diversification strategy is a corporate-level strategy wherein the firm generates 95 percent or more of its sales revenue from its core business area.15 For example, Wm. Wrigley Jr. Company, the world’s largest producer of chewing and bubble gums, historically used a single-business strategy while operating in relatively few product markets. Wrigley’s trademark chewing gum brands include Spearmint, Doublemint, and Juicy Fruit, although the firm produces other prod- ucts as well. Sugar-free Extra, which currently holds the largest share of the U.S. chewing gum market, was introduced in 1984.

In 2005, Wrigley shifted from its traditional focused strategy when it acquired the confectionary assets of Kraft Foods Inc., including the well-known brands Life Savers and Altoids. As Wrigley expanded, it may have intended to use the dominant-business strategy with the diversification of its product lines beyond gum; however, Wrigley was acquired in 2008 by Mars, a privately held global confection company (the maker of Snickers and M&Ms).16

With the dominant-business diversification strategy, the firm generates between 70 and 95 percent of its total revenue within a single business area. United Parcel Service (UPS) uses this strategy. Recently UPS generated 60 percent of its revenue from its U.S. package delivery business and 22 percent from its international package business, with the remaining 18 percent coming from the firm’s non-package business.17 Though the U.S. package delivery business currently generates the largest percentage of UPS’s sales revenue, the firm anticipates that in the future its other two businesses will account for the majority of revenue growth. This expectation suggests that UPS may become more diversified, both in terms of its goods and services and in the number of countries in which those goods and services are offered.

Firms that focus on one or very few businesses and markets can earn positive returns, because they develop capabilities useful for these markets and can provide superior ser- vice to their customers. Additionally, there are fewer challenges in managing one or a very small set of businesses, allowing them to gain economies of scale and efficiently use their resources.18 Family-owned and controlled businesses are commonly less diversified. They prefer the focus because the family’s reputation is related closely to that of the busi- ness. Thus, family members prefer to provide quality goods and services which a focused strategy better allows.1

Moderate and High Levels of Diversification

A firm generating more than 30 percent of its revenue outside a dominant business and whose businesses are related to each other in some manner uses a related diversification corporate-level strategy. When the links between the diversified firm’s businesses are rather direct, a related constrained diversification strategy is being used. Campbell Soup, Procter & Gamble, and Merck & Company all use a related constrained strategy, as do some large cable companies. With a related constrained strategy, a firm shares resources and activities between its businesses.

Clearly, the Publicis Groupe uses a related constrained strategy, deriving value from the potential synergy across its various groups, especially the digital capabilities in its advertising business. Given its recent performance, the related constrained strategy has created value for Publicis customers and its shareholders.

The diversified company with a portfolio of businesses that have only a few links between them is called a mixed related and unrelated firm and is using the related linked diversification strategy (see Figure 6.1). As displayed in the Opening Case, GE uses this corporate-level diversification strategy. Compared with related constrained firms, related linked firms share fewer resources and assets between their businesses, concentrating instead on transferring knowledge and core competencies between the businesses. GE has four strategic business units (see Chapter 11 for a definition of SBUs) it calls “divisions,” each composed of related businesses. There are no relation- ships among the strategic business units, only within them. As with firms using each type of diversification strategy, companies implementing the related linked strategy constantly adjust the mix in their portfolio of businesses as well as make decisions about how to manage these businesses.20 Managing a diversified firm such as GE is highly challenging, but GE appears to have been well managed over the years given its success.

A highly diversified firm that has no relationships between its businesses follows an unrelated diversification strategy. United Technologies, Textron, Samsung, and Hutchison Whampoa Limited (HWL) are examples of firms using this type of corporate-level strategy. Commonly, firms using this strategy are called conglomerates. HWL is a leading international corporation with five core businesses: ports and related services; property and hotels; retail; energy, infrastructure, investments and others; and telecommunications. These businesses are not related to each other, and the firm makes no efforts to share activities or to transfer core competencies between or among them. Each of these five businesses is quite large; for example, the retailing arm of the retail and manufacturing business has more than 9,300 stores in 33 countries. Groceries, cosmet- ics, electronics, wine, and airline tickets are some of the product categories featured in these stores. This firm’s size and diversity suggest the challenge of successfully managing the unrelated diversification strategy. However, Hutchison’s CEO Li Ka-shing has been successful at not only making smart acquisitions, but also at divesting businesses with good timing.21

Reasons for Diversification

A firm uses a corporate-level diversification strategy for a variety of reasons (see Table 6.1). Typically, a diversification strategy is used to increase the firm’s value by improving its overall performance. Value is created either through related diversification or through unrelated diversification when the strategy allows a company’s businesses to increase revenues or reduce costs while implementing their business-level strategies.

Other reasons for using a diversification strategy may have nothing to do with increasing the firm’s value; in fact, diversification can have neutral effects or even reduce

a firm’s value. Value-neutral reasons for diversification include a desire to match and thereby neutralize a competitor’s market power (such as to neutralize another firm’s advantage by acquiring a similar distribution outlet). Decisions to expand a firm’s port- folio of businesses to reduce managerial risk can have a negative effect on the firm’s value. Greater amounts of diversification reduce managerial risk in that if one of the businesses in a diversified firm fails, the top executive of that business does not risk total failure by the corporation. As such, this reduces the top executives’ employment risk. In addition, because diversification can increase a firm’s size and thus managerial com- pensation, managers have motives to diversify a firm to a level that reduces its value.22 Diversification rationales that may have a neutral or negative effect on the firm’s value are discussed later in the chapter.

Operational relatedness and corporate relatedness are two ways diversification strate- gies can create value (see Figure 6.2). Studies of these independent relatedness dimen- sions show the importance of resources and key competencies.23 The figure’s vertical dimension depicts opportunities to share operational activities between businesses (oper- ational relatedness) while the horizontal dimension suggests opportunities for transfer- ring corporate-level core competencies (corporate relatedness). The firm with a strong capability in managing operational synergy, especially in sharing assets between its busi- nesses, falls in the upper left quadrant, which also represents vertical sharing of assets through vertical integration. The lower right quadrant represents a highly developed corporate capability for transferring one or more core competencies across businesses.

This capability is located primarily in the corporate headquarters office. Unrelated diversification is also illustrated in Figure 6.2 in the lower left quadrant. Financial econo- mies (discussed later), rather than either operational or corporate relatedness, are the source of value creation for firms using the unrelated diversification strategy.

Value-Creating Diversification: Related Constrained and Related Linked Diversification

With the related diversification corporate-level strategy, the firm builds upon or extends its resources and capabilities to build a competitive advantage by creating value for cus- tomers.24 The company using the related diversification strategy wants to develop and exploit economies of scope between its businesses.25 Available to companies operating in multiple product markets or industries,26 economies of scope are cost savings that the firm creates by successfully sharing some of its resources and capabilities or transferring one or more corporate-level core competencies that were developed in one of its busi- nesses to another of its businesses.

As illustrated in Figure 6.2, firms seek to create value from economies of scope through two basic kinds of operational economies: sharing activities (operational relatedness) and transferring corporate-level core competencies (corporate related- ness). The difference between sharing activities and transferring competencies is based on how separate resources are jointly used to create economies of scope. To create economies of scope tangible resources, such as plant and equipment or other business- unit physical assets, often must be shared. Less tangible resources, such as manu- facturing know-how and technological capabilities, can also be shared.27 However, know-how transferred between separate activities with no physical or tangible resource involved is a transfer of a corporate-level core competence, not an operational sharing of activities.28

Operational Relatedness: Sharing Activities

Firms can create operational relatedness by sharing either a primary activity (such as inventory delivery systems) or a support activity (such as purchasing practices)—see Chapter 3’s discussion of the value chain. Firms using the related constrained diversi- fication strategy share activities in order to create value. Procter & Gamble (P&G) uses this corporate-level strategy. P&G’s paper towel business and baby diaper business both use paper products as a primary input to the manufacturing process. The firm’s paper production plant produces inputs for both businesses and is an example of a shared activ- ity. In addition, because they both produce consumer products, these two businesses are likely to share distribution channels and sales networks.

Activity sharing is also risky because ties among a firm’s businesses create links between outcomes. For instance, if demand for one business’s product is reduced, it may not generate sufficient revenues to cover the fixed costs required to operate the shared facilities. These types of organizational difficulties can reduce activity-sharing success. Additionally, activity sharing requires careful coordination between the busi- nesses involved. The coordination challenges must be managed effectively for the appro- priate sharing of activities.2

Although activity sharing across businesses is not risk-free, research shows that it can create value. For example, studies of acquisitions of firms in the same indus- try (horizontal acquisitions), such as the banking industry and software, found that sharing resources and activities and thereby creating economies of scope contributed to post-acquisition increases in performance and higher returns to shareholders.30 Additionally, firms that sold off related units in which resource sharing was a possible source of economies of scope have been found to produce lower returns than those that sold off businesses unrelated to the firm’s core business.31 Still other research discov- ered that firms with closely related businesses have lower risk.32 These results suggest that gaining economies of scope by sharing activities across a firm’s businesses may be important in reducing risk and in creating value. Further, more attractive results are obtained through activity sharing when a strong corporate headquarters office facilitates it.33

Corporate Relatedness: Transferring of Core Competencies

Over time, the firm’s intangible resources, such as its know-how, become the founda- tion of core competencies. Corporate-level core competencies are complex sets of resources and capabilities that link different businesses, primarily through managerial and technological knowledge, experience, and expertise.34 Firms seeking to create value through corporate relatedness use the related linked diversification strategy as exempli- fied by GE.

In at least two ways, the related linked diversification strategy helps firms to cre- ate value.35 First, because the expense of developing a core competence has already been incurred in one of the firm’s businesses, transferring this competence to a second business eliminates the need for that business to allocate resources to develop it. Such is the case at Hewlett-Packard (HP), where the firm trans- ferred its competence in ink printers to high-end copiers. Rather than the standard laser print- ing technology in most high-end copiers, HP is using ink-based technology. One manager liked the product because, as he noted, “We are able to do a lot better quality at less price.”36 This capa- bility gives HP the opportunity to sell more ink products and create higher profit margins.

Resource intangibility is a second source of value creation through corporate relatedness. Intangible resources are difficult for competitors to understand and imitate. Because of this difficulty, the unit receiving a transferred corporate-level competence often gains an immediate competi- tive advantage over its rivals.37

A number of firms have successfully trans- ferred one or more corporate-level core competencies across their businesses. Virgin Group Ltd. transfers its marketing core competence across airlines, cosmetics, music, drinks, mobile phones, health clubs, and a number of other businesses.38 Honda has developed and transferred its competence in engine design and manufacturing among its businesses making products such as motorcycles, lawnmowers, and cars and trucks. Company officials state that Honda is a major manufacturer of engines and is focused on

providing products for all forms of human mobility.39 One way managers facilitate the transfer of corporate-level core competencies is by

moving key people into new management positions.40 However, the manager of an older business may be reluctant to transfer key people who have accumulated knowledge and experience critical to the business’s success. Thus, managers with the ability to facilitate the transfer of a core competence may come at a premium, or the key people involved may not want to transfer. Additionally, the top-level managers from the transferring business may not want the competencies transferred to a new business to fulfill the firm’s diversification objectives.41 Research also suggests too much dependence on outsourcing can lower the usefulness of core competencies and thereby reduce their useful transfer- ability to other business units in the diversified firm.42

Market Power

Firms using a related diversification strategy may gain market power when successfully using a related constrained or related linked strategy. Market power exists when a firm is able to sell its products above the existing competitive level or to reduce the costs of its primary and support activities below the competitive level, or both.43 Mars’ acquisi- tion of the Wrigley assets was part of its related constrained diversification strategy and added market share to the Mars/Wrigley integrated firm, as it realized 14.4 percent of the market share. This catapulted Mars/Wrigley above Cadbury and Nestle, which had 10.1 and 7.7 percent of the market share, respectively, at the time and left Hershey with only 5.5 percent of the market.44

In addition to efforts to gain scale as a means of increasing market power, as Mars did when it acquired Wrigley, firms can create market power through multipoint competition and vertical integration. Multipoint competition exists when two or more diversified firms simultaneously compete in the same product areas or geo- graphic markets.45 The actions taken by UPS and FedEx in two markets, overnight delivery and ground shipping, illustrate multipoint competition. UPS has moved into overnight delivery, FedEx’s stronghold; FedEx has been buying trucking and ground shipping assets to move into ground shipping, UPS’s stronghold. Moreover, geographic competition for markets increases. The strongest shipping company in Europe is DHL. All three competitors (UPS, FedEx, and DHL) are moving into large foreign markets to either gain a stake or to expand their existing share. If one of these firms successfully gains strong positions in several markets while competing against its rivals, its market power may increase. Interestingly, DHL had to exit the U.S. market because it was too difficult to compete against UPS and FedEx, which are dominant in the United States.

Some firms using a related diversification strategy engage in vertical integration to gain market power. Vertical integration exists when a company produces its own inputs (backward integration) or owns its own source of output distribution (forward integration). In some instances, firms partially integrate their operations, producing and selling their products by using company businesses as well as outside sources.46

Vertical integration is commonly used in the firm’s core business to gain market power over rivals. Market power is gained as the firm develops the ability to save on its operations, avoid market costs, improve product quality, possibly protect its technol- ogy from imitation by rivals, and potentially exploit underlying capabilities to handle special resources (e.g., sophisticated chemicals or technologies).47 Market power also is created when firms have strong ties between their assets for which no market prices exist. Establishing a market price would result in high search and transaction costs, so firms seek to vertically integrate rather than remain separate businesses.48

Vertical integration has its limitations. For example, an outside supplier may produce the product at a lower cost. As a result, internal transactions from vertical integration may be expensive and reduce profitability relative to competitors.49 Also, bureaucratic costs can be present with vertical integration.50 Because vertical integration can require substantial investments in specific technologies, it may reduce the firm’s flexibility, espe- cially when technology changes quickly. Finally, changes in demand create capacity bal- ance and coordination problems. If one business is building a part for another internal business but achieving economies of scale requires the first division to manufacture quantities that are beyond the capacity of the internal buyer to absorb, it would be neces- sary to sell the parts outside the firm as well as to the internal business. Thus, although vertical integration can create value, especially through market power over competitors, it is not without risks and costs.51

As noted in the Strategic Focus, Google is diversifying into new markets that allow it to engage in multipoint competition. For example, Google is competing with Microsoft and Apple now in several markets. All of its competitors know that Google is a formi- dable rival with significant resources to invest in the competition. As such, the com- petitors have reacted, some with substantive actions and others in less positive ways. For example, Apple acquired Siri, a small voice search firm, to help it compete with Google’s search business.52 As noted in the Strategic Focus, Microsoft filed a complaint with the EU about potential antitrust violations by Google. Yahoo! has undertaken advertising that criticizes Google, and Facebook hired a public relations firm to plant negative stories in the press about Google.53 Some of Google’s diversification moves represent a form of vertical integration because the new business areas build on the company’s substantial search business (forward integration).

Although Google appears to be increasing its vertical integration, many manufactur- ing firms have been reducing vertical integration as a means of gaining market power.54 In fact, deintegration is the focus of most manufacturing firms, such as Intel and Dell, and even some large auto companies, such as Ford and General Motors, as they develop independent supplier networks.55 Flextronics, an electronics contract manufacturer, rep- resents a new breed of large contract manufacturers that is helping to foster this revolu- tion in supply-chain management.56 Such firms often manage their customers’ entire product lines and offer services ranging from inventory management to delivery and after-sales service.

Simultaneous Operational Relatedness and Corporate Relatedness

As Figure 6.2 suggests, some firms simultaneously seek operational and corporate relat- edness to create economies of scope.57 The ability to simultaneously create economies of scope by sharing activities (operational relatedness) and transferring core competen- cies (corporate relatedness) is difficult for competitors to understand and learn how to imitate. However, if the cost of realizing both types of relatedness is not offset by the benefits created, the result is diseconomies because the cost of organization and incentive structure is very expensive.58

Walt Disney Co. uses a related diversification strategy to simultaneously create econ- omies of scope through operational and corporate relatedness. Within the firm’s Studio Entertainment business, for example, Disney can gain economies of scope by sharing activities among its different movie distribution companies such as Touchstone Pictures, Hollywood Pictures, and Dimension Films. Broad and deep knowledge about its custom- ers is a capability on which Disney relies to develop corporate-level core competencies in terms of advertising and marketing. With these competencies, Disney is able to cre- ate economies of scope through corporate relatedness as it cross-sells products that are highlighted in its movies through the distribution channels that are part of its Parks and Resorts and Consumer Products businesses. Thus, characters created in movies become figures that are marketed through Disney’s retail stores (which are part of the Consumer Products business). In addition, themes established in movies become the source of new rides in the firm’s theme parks, which are part of the Parks and Resorts business and provide themes for clothing and other retail business products.59

Thus, Walt Disney Co. has been able to successfully use related diversification as a corporate-level strategy through which it creates economies of scope by sharing some activities and by transferring core competencies. However, it can be difficult for inves- tors to actually observe the value created by a firm (such as Walt Disney Co.) as it shares activities and transfers core competencies. For this reason, the value of the assets of a firm using a diversification strategy to create economies of scope often is discounted by investors.

Unrelated Diversification

Firms do not seek either operational relatedness or corporate relatedness when using the unrelated diversification corporate-level strategy. An unrelated diversification strategy (see Figure 6.2) can create value through two types of financial economies. Financial economies are cost savings realized through improved allocations of financial resources based on investments inside or outside the firm.60

Efficient internal capital allocations can lead to financial economies. Efficient internal capital allocations reduce risk among the firm’s businesses—for example, by leading to the development of a portfolio of businesses with different risk profiles. The second type of financial economy concerns the restructuring of acquired assets. Here, the diversified firm buys another company, restructures that company’s assets in ways that allow it to operate more profitably, and then sells the company for a profit in the external market.61 Next, we discuss the two types of financial economies in greater detail.

Efficient Internal Capital Market Allocation

In a market economy, capital markets are thought to efficiently allocate capital. Efficiency results as investors take equity positions (ownership) with high expected future cash- flow values. Capital is also allocated through debt as shareholders and debt holders try to improve the value of their investments by taking stakes in businesses with high growth and profitability prospects.

In large diversified firms, the corporate headquarters office distributes capital to its businesses to create value for the overall corporation. The nature of these distributions may generate gains from internal capital market allocations that exceed the gains that would accrue to shareholders as a result of capital being allocated by the external capi- tal market.62 Because those in a firm’s corporate headquarters generally have access to detailed and accurate information regarding the actual and prospective performance of the company’s portfolio of businesses, they have the best information to make capital distribution decisions.

Compared with corporate office personnel, external investors have relatively limited access to internal information and can only estimate the performances of individual busi- nesses as well as their future prospects. Moreover, although businesses seeking capital must provide information to potential suppliers (such as banks or insurance companies), firms with internal capital markets may have at least two informational advantages. First, information provided to capital markets through annual reports and other sources may not include negative information, instead emphasizing positive prospects and outcomes. External sources of capital have limited ability to understand the operational dynamics of large organizations. Even external shareholders who have access to information have no guarantee of full and complete disclosure.63 Second, although a firm must dissemi- nate information, that information also becomes simultaneously available to the firm’s current and potential competitors. With insights gained by studying such information, competitors might attempt to duplicate a firm’s value-creating strategy. Thus, an ability to efficiently allocate capital through an internal market may help the firm protect the competitive advantages it develops while using its corporate-level strategy as well as its various business-unit–level strategies.

If intervention from outside the firm is required to make corrections to capital allo- cations, only significant changes are possible, such as forcing the firm into bankruptcy or changing the top management team. Alternatively, in an internal capital market, the corporate headquarters office can fine-tune its corrections, such as choosing to adjust managerial incentives or suggesting strategic changes in one of the firm’s businesses.64 Thus, capital can be allocated according to more specific criteria than is possible with external market allocations. Because it has less accurate information, the external capital market may fail to allocate resources adequately to high-potential investments. The cor- porate headquarters office of a diversified company can more effectively perform such tasks as disciplining underperforming management teams through resource allocations.65 GE (discussed in the Opening Case) has done an exceptionally good job of allocating capital across its many businesses. Although a related linked firm, it differentially allo- cates capital across its four major strategic business units. GE Capital has produced the greatest returns for GE over the last few decades (until the latest financial crisis) and thus has received a healthy amount of capital from internal allocations.

Large, highly diversified businesses often face what is known as the “conglomerate discount.” This discount results from analysts not knowing how to value a vast array of large businesses with complex financial reports. To overcome this discount, many unrelated diversified or industrial conglomerates have sought to establish a brand for the parent company. For instance, United Technologies initiated a brand development approach with the slogan “United Technologies. You can see everything from here.” United Technologies suggested that its earnings multiple (PE ratio) compared to its stock price is only average even though its performance has been better than other conglomer- ates in its group. It is hoping that the “umbrella” brand advertisement will raise its PE to a level comparable to its competitors.66 In another attempt to sway investors on the value of a large diversified company, United Technologies CEO Louis Chenevert stated that “... our future success depends on our ability to innovate—to find new and better ways to serve our customers. And, our ability to innovate relies on our ability to leverage the power of diverse inputs.”

In spite of the challenges associated with it, a number of corporations continue to use the unrelated diversification strategy, especially in Europe and in emerging markets. Siemens, for example, is a large German conglomerate with a highly diversified approach. Its former CEO argued that “When you are in an up-cycle and the capital markets have plenty of opportunities to invest in single-industry companies ... inves- tors savor those opportunities. But when things change pure plays go down faster than you can look.”68 In economic downturns, diversifica- tion can help some companies improve future performance.69

The Achilles’ heel for firms using the unre- lated diversification strategy in a developed economy is that competitors can imitate financial economies more easily than they can replicate the value gained from the economies of scope developed through operational relatedness and corporate relatedness. This issue is less of a problem in emerging economies, where the absence of a “soft infrastructure” (including effective financial intermediaries, sound regulations, and contract laws) supports and encourages use of the unrelated diversifica- tion strategy.70 In fact, in emerging economies such as those in Korea, India, and Chile, research has shown that diversification increases the performance of firms affiliated with large diversified business groups.7

Restructuring of Assets

Financial economies can also be created when firms learn how to create value by buy- ing, restructuring, and then selling the restructured companies’ assets in the external market.72 As in the real estate business, buying assets at low prices, restructuring them, and selling them at a price that exceeds their cost generates a positive return on the firm’s invested capital.

Unrelated diversified companies that pursue this strategy try to create financial econ- omies by acquiring and restructuring other companies’ assets but it involves significant trade-offs. For example, Danaher’s success requires a focus on mature manufacturing businesses because of the uncertainty of demand for high-technology products.73 In high- technology businesses, resource allocation decisions are highly complex, often creating information-processing overload on the small corporate headquarters offices that are common in unrelated diversified firms. High-technology businesses are often human- resource dependent; these people can leave or demand higher pay and thus appropriate or deplete the value of an acquired firm.74

Buying and then restructuring service-based assets so they can be profitably sold in the external market is also difficult. Sales in such instances are often a product of close personal relationships between a client and the representative of the firm being restructured. Thus, for both high-technology firms and service-based companies, relatively few tangible assets can be restructured to create value and sell profitably. It is difficult to restructure intangible assets such as human capital and effective relationships that have evolved over time between buyers (customers) and sellers (firm personnel). Care must be taken in an economic downturn to restructure and buy and sell at appropriate times. A downturn can present opportunities but also some risks. Ideally, executives will follow a strategy of buying businesses when prices are lower, such as in the midst of a recession, and selling them at late stages in an expansion.75

Value-Neutral Diversification: Incentives and Resources

The objectives firms seek when using related diversification and unrelated diversification strategies all have the potential to help the firm create value by using a corporate-level strategy. However, these strategies, as well as single- and dominant-business diversifica- tion strategies, are sometimes used with value-neutral rather than value-creating objec- tives in mind. As we discuss next, different incentives to diversify sometimes exist, and the quality of the firm’s resources may permit only diversification that is value neutral rather than value creating.

Incentives to Diversify

Incentives to diversify come from both the external environment and a firm’s internal environment. External incentives include antitrust regulations and tax laws. Internal incentives include low performance, uncertain future cash flows, and the pursuit of syn- ergy and reduction of risk for the firm.

Antitrust Regulation and Tax Laws

Government antitrust policies and tax laws provided incentives for U.S. firms to diversify in the 1960s and 1970s.76 Antitrust laws prohibiting mergers that created increased mar- ket power (via either vertical or horizontal integration) were stringently enforced during that period.77 Merger activity that produced conglomerate diversification was encour- aged primarily by the Celler-Kefauver Antimerger Act (1950), which discouraged hori- zontal and vertical mergers. As a result, many of the mergers during the 1960s and 1970s were “conglomerate” in character, involving companies pursuing different lines of busi- ness. Between 1973 and 1977, 79.1 percent of all mergers were conglomerate in nature.78

During the 1980s, antitrust enforcement lessened, resulting in more and larger hori- zontal mergers (acquisitions of target firms in the same line of business, such as a merger between two oil companies).79 In addition, investment bankers became more open to the kinds of mergers facilitated by regulation changes; as a consequence, takeovers increased to unprecedented numbers.80 The conglomerates, or highly diversified firms, of the 1960s and 1970s became more “focused” in the 1980s and early 1990s as merger constraints were relaxed and restructuring was implemented.81

In the late 1990s and early 2000s, antitrust concerns emerged again with the large volume of mergers and acquisitions (see Chapter 7).82 Mergers are now receiving more scrutiny than they did in the 1980s and through the early 1990s.83

The tax effects of diversification stem not only from corporate tax changes, but also from individual tax rates. Some companies (especially mature ones) generate more cash from their operations than they can reinvest profitably. Some argue that free cash flows (liquid financial assets for which investments in current businesses are no longer eco- nomically viable) should be redistributed to shareholders as dividends.84 However, in the 1960s and 1970s, dividends were taxed more heavily than were capital gains. As a result, before 1980, shareholders preferred that firms use free cash flows to buy and build companies in high-performance industries. If the firm’s stock value appreciated over the long term, shareholders might receive a better return on those funds than if the funds had been redistributed as dividends, because returns from stock sales would be taxed more lightly than would dividends.

Under the 1986 Tax Reform Act, however, the top individual ordinary income tax rate was reduced from 50 to 28 percent, and the special capital gains tax was changed to treat capital gains as ordinary income. These changes created an incentive for share- holders to stop encouraging firms to retain funds for purposes of diversification. These tax law changes also influenced an increase in divestitures of unrelated business units after 1984. Thus, while individual tax rates for capital gains and dividends created a shareholder incentive to increase diversification before 1986, they encouraged lower diversification after 1986, unless it was funded by tax-deductible debt. The elimination of personal interest deductions, as well as the lower attractiveness of retained earnings to shareholders, could prompt the use of more leverage by firms (interest expenses charged to firms are tax deductible).

Corporate tax laws also affect diversification. Acquisitions typically increase a firm’s depreciable asset allowances. Increased depreciation (a non-cash-flow expense) produces lower taxable income, thereby providing an additional incentive for acquisi- tions. Before 1986, acquisitions may have been the most attractive means for secur- ing tax benefits,85 but the 1986 Tax Reform Act diminished some of the corporate tax advantages of diversification.86 More recent changes recommended by the Financial Accounting Standards Board eliminated the “pooling of interests” method to account for the acquired firm’s assets and it also eliminated the write-off for research and devel- opment in process, and thus reduced some of the incentives to make acquisitions, espe- cially acquisitions in related high-technology industries (these changes are discussed further in Chapter 7).87

Although federal regulations were partially loosened in the 1980s and then retight- ened in the late 1990s, a number of industries experienced increased merger activity due to industry-specific deregulation, including banking, telecommunications, oil and gas, and electric utilities. For instance, in banking the Garns–St. Germain Deposit Institutions Act of 1982 (GDIA) and the Competitive Equality Banking Act of 1987 (CEBA) reshaped the acquisition frequency in banking by relaxing the regulations that limited interstate bank acquisitions.88 Regulation changes have also affected convergence between media and telecommunications industries, which has allowed a number of mergers, such as the successive Time Warner and AOL mergers. The Federal Communications Commission (FCC) made a highly contested ruling “allowing broadcasters to own TV stations that reach 45 percent of U.S. households (up from 35 percent), own three stations in the larg- est markets (up from two), and own a TV station and newspaper in the same town.”89 Thus, regulatory changes such as the ones we have described create incentives or dis- incentives for diversification. Interestingly, European antitrust laws have historically been more strict regarding horizontal mergers than those in the United States, but more recently have become similar.9

Low Performance

Some research shows that low returns are related to greater levels of diversification.91 If “high performance eliminates the need for greater diversification,”92 then low perfor- mance may provide an incentive for diversification. In 2005, eBay acquired Skype for $3.1 billion in hopes that it would create synergies and improve communication between buyers and sellers. However, within three years, eBay decided to sell Skype because it has failed to increase cash flow for its core e-commerce business and the expected syner- gies were not realized. In 2011, eBay sold Skype to Microsoft for $8.5 billion. Although analysts thought the premium paid by Microsoft may have been too high, one review in the Financial Times suggested that Skype could play a prominent role in Microsoft’s multimedia strategy. Thus, the potential synergies between Skype and Microsoft may be greater than those with eBay.93 The poor performance may be because of errors made by top managers (such as eBay’s original acquisition of Skype), and thus lead to divestitures similar to eBay’s action.94

Research evidence and the experience of a number of firms suggest that an overall curvilinear relationship, as illustrated in Figure 6.3, may exist between diversification and performance.95 Although low performance can be an incentive to diversify, firms that are more broadly diversified compared to their competitors may have overall lower performance.

Uncertain Future Cash Flows

Synergy exists when the value created by business units working together exceeds the value that those same units create working independently.

As a firm’s product line matures or is threatened, diversification may be an important defensive strategy.96 Small firms and companies in mature or maturing industries some- times find it necessary to diversify for long-term survival.97 For example, music retail- ers began to diversify as CD sales started to decline. By the end of 2009, CD sales had declined by about 50 percent from their peak. Best Buy started to sell musical instru- ments in 2008 in response to the decline in CD sales. The musical instrument industry accumulated sales revenues of $5.9 billion in 2009. Best Buy continues to sell music CDs but adds other products to make up for the loss in revenue from CDs.98

Diversifying into other product markets or into other businesses can reduce the uncertainty about a firm’s future cash flows. Merck decided to expand into the bio- similars business (production of drugs that are similar to approved drugs) in hopes of stimulating its prescription drug business due to lower expected results as many of its drug patents expire.99 Thus, in 2009 it purchased Insmed’s portfolio of follow-on biolog- ics for $130 million. It will carry out the development of biologics that prevent infections in cancer patients receiving chemotherapy. One such drug, INS-19, is in late-stage trials, while INS-20 is in early-stage development.10

Synergy and Firm Risk Reduction

Diversified firms pursuing economies of scope often have investments that are too inflex- ible to realize synergy between business units. As a result, a number of problems may arise. Synergy exists when the value created by business units working together exceeds the value that those same units create working independently. But as a firm increases its relatedness between business units, it also increases its risk of corporate failure, because synergy produces joint interdependence between businesses that constrains the firm’s flexibility to respond. This threat may force two basic decisions.

First, the firm may reduce its level of technological change by operating in environ- ments that are more certain. This behavior may make the firm risk averse and thus uninterested in pursuing new product lines that have potential but are not proven.

Alternatively, the firm may constrain its level of activity sharing and forgo potential benefits of synergy. Either or both decisions may lead to further diversification.101 The former likely leads to related diversification into industries in which more certainty exists.102 The latter may produce additional, but unrelated, diversification. Research sug- gests that a firm using a related diversification strategy is more careful in bidding for new businesses, whereas a firm pursuing an unrelated diversification strategy may be more likely to overprice its bid, because an unrelated bidder is less likely to have full informa- tion about the acquired firm.103 However, firms using either a related or an unrelated diversification strategy must understand the consequences of paying large premiums.104 In the situation with eBay, former CEO Meg Whitman received heavy criticism for pay- ing such a high price for Skype, especially when the firm did not realize the synergies it was seeking. Alternatively, it sold Skype six years later at 175 percent of the price at which eBay purchased the business. The question now is whether Microsoft paid too high a premium to achieve positive returns from the acquisition of Skype.

Resources and Diversification

As already discussed, firms may have several value-neutral incentives as well as value- creating incentives (such as the ability to create economies of scope) to diversify. However, even when incentives to diversify exist, a firm must have the types and levels of resources and capabilities needed to successfully use a corporate-level diversification strategy.105 Although both tangible and intangible resources facilitate diversification, they vary in their ability to create value. Indeed, the degree to which resources are valu- able, rare, difficult to imitate, and nonsubstitutable (see Chapter 3) influences a firm’s ability to create value through diversification. For instance, free cash flows are a tangible financial resource that may be used to diversify the firm. However, compared with diver- sification that is grounded in intangible resources, diversification based on financial resources only is more visible to competitors and thus more imitable and less likely to create value on a long-term basis.106 Tangible resources usually include the plant and equipment necessary to produce a product and tend to be less-flexible assets. Any excess capacity often can be used only for closely related products, especially those requiring highly similar manufacturing technologies. For example, large computer makers such as Dell and Hewlett-Packard have underestimated the demand for tablet computers, espe- cially Apple’s iPad. Apple developed the iPad and may expect it to eventually replace the personal computer (PC). In fact, H-P’s and Dell’s sales of their PCs have been declining since the introduction of the iPad. Apple expects to sell 70 million iPads in 2011 and analysts projects sales of the iPad to reach 246 million in 2014. HP and Dell likely need to diversify their product lines.10