07 Diversification

Corporate Strategy
Diversification
Prof. Dr. Bernd Venohr Berlin, June 2007
2006 Dr. Bernd Venohr
Agenda (NEU)
Introduction to Strategy
1 2 3 4 5 6 7 Course Overview and Strategy Concept Communication and Problem Solving Economics of Strategy Shareholder Value External Environment Internal Environment Competitive Positioning
Business Strategy
Corporate Strategy
8 Diversification 9 Mergers & Acquisitions 10 Global Strategy 11 Organizational Structure and Control 12 Strategic Leadership
2
Strategy Process
Where are we today?

Introduction to Strategy 1
Strategy Concept
Economics of Strategy 3
2 4
Communication and Problem Solving
Shareholder Value
Business Strategy 5
External Environment
Corporate Strategy 8 9
Diversification Global Strategy
Internal Environment
Competitive Positioning
Mergers & Acquisitions
10
Strategy Process 11
Organizational Structure and Control
12 Leadership
Strategic
Corporate vs. business level strategy: a diversified company, which is active in more than one business, has two levels of strategy (BITTE LOGOS DP HINEINKOPIEREN( Example: Deutsche Post World Net CORPORATE LEVEL
Example: Deutsche Post World Net
DPWN
Mail BUSINESS LEVEL
Express
Logistics
Financial Services
Source: Corey Phelps; Mgmt 430

Key issues corporate versus business strategy

CORPORATE STRATEGY: How to create a competitive advantage for the whole company What businesses should we be in? How should these be managed? How to create value for the corporation as a whole? BUSINESS STRATEGY: How to create a competitive advantage in specific, individual product markets Which customers to serve (who?) segmentation Which customers needs to satisfy (what?) differentiation Resources and value chain activities necessary to satisfying customer needs (how?) core competencies
Key Challenges for a value-creating corporate strategy Direct competition occurs at the business unit level
Corporate Strategy adds costs and constraints to business units
Shareholders can easily diversify themselves
Source: Porter, From competitive advantage to corporate strategy

Goal of Corporate Strategy: create corporate advantage Goal of corporate strategy - to build corporate advantage - earn above normal returns Three tests on the existence of corporate advantage - Does ownership of the business create benefit somewhere in the corporation? (Does parentage matter?) - Are those benefits greater than the cost of corporate overhead? - Does the corporation create more value with the business than any other possible corporate parent or alternative governance structure?
Source: Collis and Montgomery, 1998
Focus of corporate strategy: where a firm competes, i.e. the scope of its activities
Vertical Scope [A] Single Integrated Firm [B] Several Specialized Firms linked by Markets
V1 V2 V3 V1 V2 V3
Market Scope
Geographical Scope
P1
P2
P3
C1
C2
C3
P1
P2
P3
C1
C2
C3
In situation [A] the business units are integrated within a single firm. In situation [B] the business units are independent firms linked by markets. Are the administrative costs of the integrated firm less than the transaction costs of markets?
Source: Robert M. Grant, Contemporary Strategy Analysis: Concepts, Techniques, Applications (5th edition, Blackwell, 2004)
Corporate strategy: diversification into new areas by employing one of the three levers 1 2 3 Markets: Products and Services and Customer segments Vertical: Value Chain Geography
Levels and types of diversification: therelated ratio
Low Levels of Diversification

Single business Dominant business > 95% of revenues from single business unit Between 70% and 95% of revenues from single business unit < 70% of revenues from dominant business; all businesses share activities in value chain < 70% of revenues from dominant business, only limited links exist
A A B A B A C
Moderate to High Levels of Diversification

Related constrained
Related linked (mixed)
B A C
Very High Levels of Diversification B Business units not closely related UnrelatedSource: Robert M. Grant, Contemporary Strategy Analysis: Concepts, Techniques, Applications (5th edition, Blackwell, 2004) Diversified
10
Two alternative diversification strategies: related versus unrelated

Related diversification strategies: firm moves from a core of activities in a specific product market to other related activities and markets Demand and/or cost linkages between lines of business Sharing value chain activities and transferring core competencies
Unrelated diversification strategies Replace external capital market with internal capital market allocation No linkages between businesses
11
Two directions of related diversification: vertical and horizontal

Horizontal diversification (HD) : different businesses in similar stage of value chain concentric diversification: businesses are highly related conglomerate: businesses are unrelated Vertical diversification (VD) : Number of stages a firm engages in the value chain Forward (into distribution channels) vs. backward integration (sources of supply) Make vs. buy

12
Vertical Diversification: Number of stages a firm engages in the value chain
Vertical Dimension
IT Hardware
Software
IT Consulting and Outsourcing

13

Horizontal Diversification: number of different product markets a company is active in
Horizontal Diversification Power Generation I&C Net-works Medical Solutions

14
Degree of vertical diversification (integration) explained by transaction cost theory

Developed by Ronald Coase ( Nobel Memorial Prize in Economics in 1991 ; The Nature of the Firm) Why economy is populated by a number of business firms, instead of consisting exclusively of a many independent, selfemployed people who contract with one another ? Key driver: transaction costs of the market (= cost of locating, negotiating, and enforcing a contract) . Firms will arise when they can arrange to produce what they need internally and avoid these costs. There is a natural limit to what can be produced internally : "decreasing returns to the entrepreneurial function ( overhead costs and mistakes in resource allocation)
Source: Coase, Ronald. "The Nature of the Firm".; Wikepedia

15
Vertical diversification: Owning and directing additional activities makes sense if external markets dont function well
Activity is more efficient within the firm (cost / benefit) Lower transaction costs and improved coordination vs. Sacrifice scale/scope economies Protect leakage of technology Create market power via creation of entry barriers Integrate backwards: buy up key supplier Integrate forward: lock up distribution Undo effects of market power: eliminate market power of supplier or buyer Acquire information about value chain steps
16
Vertical diversification: Some Vertical Integration Fallacies

Firms should make (integrate) to keep for themselves profits earned by market firms: profits represent returns necessary to attract investment and would be required of any firm Vertically integrated firms can produce an input at cost and will have cost advantage over nonintegrated firms who have to buy inputs at market prices hidden opportunity costs for vertically integrated firm: no sales in open market (less scale economies); less competitive pressures increasing cost of coordinating vertical activities
17
Vertical diversification: recent trends in vertical relationships

From competitive contracting to supplier partnerships, e.g. in autos From vertical integration to outsourcing (not just components, also IT, distribution, and administrative services) Diffusion of franchising Technology partnerships (e.g. IBM-Apple; Canon-HP) Inter-firm networks General conclusion: Boundaries between firms and markets becoming increasingly blurred.
18
Vertical diversification: Different Types of Vertical Relationships

High
Long-term contracts Franchises Joint ventures
Formalization
Spot sales/ purchases
Agency agreements
Low
Informal supplier/ customer relationships
Supplier/ customer partnerships
Vertical integration
Low
Degree of Commitment
High
Horizontal diversification benefits (synergies) arise because of shared resources that exist across product market boundaries
Cost-driven synergies: Sharing of activities lowers costs Supply-based joint resources (Economies of scope): if a firm produces two related products, the total costs of producing them jointly is lower than the sum of the cost of producing them separately (share fixed costs between different products) due to resource sharing. Examples : common distribution facilities, brands, joint R&D Demand-based synergies: raise differentiation customers perceive linkages in products risky, since quite often based on customers cognitive links betweeen products (perceptions) which can change quickly

20
Horizontal diversification: Identify cross-business shared resources by comparing value chains across businesses
Value Chain Activities
Inbound Logistics Technology Operations Sales and Marketing Distribution Service
Business A Business B Business C Business D Business E

Opportunity to combine purchasing activities (gain more leverage with suppliers) Opportunity to share technology, transfer technical skills, combine R&D Opportunity to combine sales & marketing activities, use common distribution channels, leverage use of a common brand name, and/or combine after-sale service No sharing
21
Example horizontal diversification: Procter & Gamble using a common physical distribution system and sales force
Procter & Gamble Strategic Field
Source: Walker W. Lewis, The CEO and Corporate Strategy in the 80s: Back to Basics, 1984 Reprinted by permission of The institute of Management Sciences, Providence, RI
22
Horizontal diversification: Transferring Core Competencies

Exploit intangible interrelationships among divisions Identify ability to transfer skills and expertise among similar value chains (across divisions) Activities must be sufficiently similar that sharing is possible Transfer of skills involve activities which are important to competitive advantage The skills transferred represent significant sources of advantage for the receiving business unit Examples: Deutsche Post logistics expertise Toyotas core competence in engines Apple`s core competence in design
23
Horizontal diversification: Significant management challenges in actually achieving the potential benefits
Diversification alone will not produce superior performance: benefits dont just happen Management skills in capturing potential benefits of interrelationships are a key success factor Key levers are: strong sense of corporate identity and mission that emphasizes the importance of integrating business units allocation of management attention allocation of capital and shared resources to different business units management hiring/training incentive systems that reward more than just business unit performance
24
Unrelated Diversification: diversifying into businesses with no meaningful value chain relationships or demand side synergies
Conglomerates/Holding Companies: to venture into any business in which we think we can make a profit Assumptions Managers have superior information vs. outside investors Top management can more precisely allocate resources to businesses than external market Key characteristics of unrelated diversification Often pursued through acquisitions: sound companies in attractive markets Acquired businesses will stay autonomous Corporate headquarter acts as portfolio manager Supplies needed capital to each business Transfers resources from cash cows to businesses with high growth potential
Add professional management and strict financial controls Unit managers compensated on unit results
25
Example of unrelated diversification: Virgin Group
*Source: virgin.com Homepage

26
Example of unrelated diversification: Virgin Group Richard Branson as founder and CEO
27
Unrelated diversification: benefits and risks

Potential benefits Business risk scattered over different industries Financial resources directed to those industries offering best profit prospects Stability of profits : Hard times in one industry may be offset by good times in another industry If bargain-priced firms with big profit potential are bought, shareholder wealth can be enhanced Potential risks Difficulties of competently managing many diverse businesses Lack of strategic fit which can be leveraged into competitive advantage Consolidated performance of unrelated businesses tends to be no better than sum of individual businesses on their own (and it may be worse). 1 + 1 = 2, rather than 1 + 1 =3 Promise of greater sales-profit stability over business cycles seldom realized
28
Theory of unrelated diversification: Why an internal capital market can be more efficient than the external capital market?
Create value by exploiting financial economies: large organizations can fund projects more quickly and economically than external market small projects are bundled large projects can be taken on key challenge :find products and markets that provide negatively correlated cash flows Reduce funding costs through superior financial resource allocation: internal capital market is like a debt market with all the benefits of equity ownership resolve borrower-lender problem (moral hazard): internal funding allows for information sharing and better control over the use of funds by the lender less likely that borrower and lender expropriate each other

29
Theory of unrelated diversification: common diversification problems

Internal capital markets are less efficient than external ones Higher quality information not guaranteed Individual investors can generally diversify more effectively Capital allocation can quickly stretch abilities of top managers Managers personal interests drive diversification decision Top executives compensation often based on peer companies (diversify to increase compensation) : empire building When diversification buffers performance its harder for top execs to get fired (Reduce employment risk) Poor performance may lead firms to diversify to achieve better returns (the grass is always greener)

30
Underrated good reason for unrelated diversification: business life cycles

All business go through life cycles no matter how good a business is today , it will eventually mature and decline Companies in growth industries should devote the majority of their management time and attention to exploit the potential Corporations in maturing industries with little diversification and low expected long-term growth should introduce growth businesses into their portfolio: here most of the benefits of moderate diversification can be achieved. Anecdotal evidence: the experience of very old and still very successful companies like Haniel or Siemens (all active in several businesses; in most cases original business has been shed)
31
Moderate levels of diversification yield higher levels of performance than either limited or extensive diversification (1)*
Level of Diversification
Performance
Single/ Dominant Business

*Source: Palich/ Cardinal/ Chet Miller, 2000
Related
Unrelated
32
New Assignment and Outlook next Session

Read slides on session 7 on ILIAS Visit company web pages and prepare as team a brief description of your companies corporate strategy (degree of relatedness; potential linkages among businesses) Topics of next session: Brief page presentation on each company; send in advance per e-mail or bring presentation on usb stick Lecture: Corporate Strategy: M&A
33
Appendix
34
Remarks-Premises of Corporate Strategy

Direct competition occurs at the business unit level - Corporations dont compete; only their business units do - Value created at the business unit level, only added at the corporate level - Successful corporate strategy must grow out of and reinforce business strategy Corporate Strategy inevitably adds costs and constraints to business units - Corporate overhead - Costs of coordination and monitoring: communication between headquarter and business units Shareholders can easily diversify themselves - Shareholders can diversify their own portfolios of stocks, and they can often do it more cheaply with less risk than corporations - Shareholders can buy shares at market prices and avoid paying large acquisition premiums
Source: Porter, From competitive advantage to corporate strategy
35
Vertical diversification: Transactions cost exist, when there is market failure (market transactions inappropriate or too costly), which in turn lead to firms vertically integrating
A vertical market "fails" when transactions within it are too risky and the contracts designed to overcome these risks are too costly (or impossible) to write and administer. Where transaction costs are high , the firm is a more efficient means of organization Examples (causes) ofmarket failures: One Seller, One Buyer Difficulty in Writing Contracts: Bounded Rationality; Opportunism; Pre Adverse Selection; Post - -Moral Hazard Asset Specificity Frequency of Transaction: The more frequent a transaction, all else equal, the more likely integration will occur By vertically integrating a firm makes its resource decisions internally, using management mechanisms, as opposed to using the market . The objective is to adopt the organizational mode that best economizes on transaction costs, minimizes the risk of market failure, while taking into account the expense of governance costs. Firms must balance transaction costs with the cost of governance. Rapid decline of vertical integration in the last few years: rise of outsourcing advances of computer technology allow for easy cooperation between companies (lowering transaction costs and incentive and coordination poblems) increased ability to write more complete and enforceable contracts
Source: Coase, Ronald. "The Nature of the Firm".; Wikepedia
36
Vertical diversification: The Costs and Benefits of Vertical Integration

Benefits Technical economies from integrating processes e.g. iron and steel production Superior coordination Avoids transactions costs of market contracts in situations where there are: small numbers of firms transaction-specific investments opportunism and strategic misrepresentation taxes and regulations on market transactions Costs Differences in optimal scale of operation between different stages prevents balanced vertical integration Strategic differences between different vertical stages creates management difficulties Inhibits development of and exploitation of core competencies Limits flexibility in responding to demand cycles in responding to changes in technology, customer preferences, etc. Compounding of risk
37
Remarks-Theory of unrelated diversification: Why an internal capital market can be more efficient than the external capital market?
Create value by exploiting financial economies: large organizations can fund projects more quickly and economically than external market small projects are bundled, large company can borrow more cheaply (company as securitized bundle of projects) large projects: diversified firm may take on projects whose risk is too great to be taken on by any one or a group of smaller companies key challenge for related diversifiers: find products and markets that can take advantage of competitive strengths but at the same time provide negatively correlated cash flows Reduce funding costs through superior financial resource allocation: internal capital market is like a debt market with all the benefits of equity ownership resolve borrower-lender problem (moral hazard): once lending contract is signed borrower has an incentive to increase risk of project financed increasing his expected return while decreasing that of a lender. Contracts can only imperfectly control this risk internal funding allows for information sharing and better control over the use of funds by the lender less likely that borrower and lender expropriate each other
38

Remarks-Theory of unrelated diversification: common diversification problems

Internal capital markets are less efficient than external ones Higher quality information not guaranteed Individual investors can generally diversify more effectively: combined cash flows may reduce unique risk (assuming not perfectly correlated) NOT considered a benefit to outside equity holders; may be insurance for employees, customers, suppliers, debt holders Capital allocation can quickly stretch abilities of top managers; additional problem: escalation of commitment more likely Managers personal interests drive diversification decision Top executives compensation often based on peer companies (diversify to increase compensation) : empire building When diversification buffers performance its harder for top execs to get fired (Reduce employment risk) Poor performance may lead firms to diversify to achieve better returns (the grass is always greener)
39
Empirical results on diversification: Most large firms are probably still remarkably diversified, but there seems to be somewhat of a a trend to focus on one or more core businesses
Degree of diversification of 250 largest publicly listed companies in Germany/Switzerland/Austria*
1991 Single Dominant Related Unrelated 16% 27% 25% 32% 1994 17% 30% 24% 29% 1997 19% 27% 20% 34%
EX
AM
PLE
Current strategic priorities of DAX 30 companies**

Konzentration auf Kerngeschftsfelder Wachstum
14 14 13 13 12 10 9 4 4 3 4
40
Realisierung von Synergieeffekten zwischen den Geschftsbereichen Internationalisierung Innovationsstrategie Kooperationsstrategien Risikoausgleich zwischen den einzelnen Geschftsbereichen Finanzielles Gleichgewicht zwischen den Geschftsbereichen Kapazittsabbau/Schrumpfung
*Source: Szeless (2001): page 81-96; data taken from DATASTREAM database (original sample of 250 companies reduced to 93 companies); own calculations **Source: Prner (2003): data based on telephone interviews with Heads of Strategic Planning/Corporate Development of 16 out of 30 Dax companies 2006 Dr. Bernd Venohr
Diversifikation Sonstige
Empirical results diversification and firm performance: moderate levels of diversification yield higher levels of performance than either limited or extensive diversification (2)*
Key results most profitable firms are those that have diversified around a set of resources that are specialized enough to confer an advantage in an attractive industry, yet fungible enough to be applied in other industries least profitable are those that are broadly diversified and whose strategies are built around very general resources that are applied in a wide variety of industries but are rarely instrumental in competitive advantage in an attractive industry Limits of diversification Bureaucratic costs place a limit on the amount of diversification that can profitably be pursued Arise in large, complex organizations due to managerial inefficiencies (diverse businesses in a companys portfolio; Information overload; coordination among businesses)
*Source: Palich/ Cardinal/ Chet Miller, 2000
41
Alternative strategy concept for internal analysis: Focus on companys competencies / capabilities and ressoures to explain the underlying factors for a competitive advantage (CCR-Framework)
Above-average returns () Value Chain Analysis Criteria of Sustainable Advantages
Core Competencies Sources of Competitive Advantage Capabilities Teams of Resources Resources Tangible Intangible
Robert M. Grant, Contemporary Strategy Analysis: Concepts, Techniques, Applications (5th edition, Blackwell, 2004)
42
Core Competencies: What a firm does that is strategically valuable

What a firm does that is strategically valuable the essence of what makes an organization unique in its ability to provide value to customers. Criteria for resource to be a core competency and generate sustained competitive advantage Valuable: Capabilities that either help a firm to exploit opportunities in the environment to create value or to neutralize threats in the environment Rare: Capabilities possessed by few, if any, current or potential competitors Costly to imitate: Capabilities that other firms cannot develop easily, usually due to unique historical conditions, causal ambiguity or social complexity Non substitutable: Capabilities that do not have strategic equivalents, such as firm-specific knowledge or trust-based relationships
43
Resources: What a firm has

Resources What a firm has to work with Its assets, including its people and the value of its brand name Represent inputs into a firms production process and contribute to its ability to provide value Such as capital equipment, employees skills and knowledge, brand names, finances, managerial talent Are observable Are tradeable Contribute to the firms market position by improving value, by lowering cost or both. Have value if difficult to imitate or substitute
Robert M. Grant, Contemporary Strategy Analysis: Concepts, Techniques, Applications (5th edition, Blackwell, 2004)
Tangible resources Financial Physical Organizational Technological Intangible resources Human Innovation Reputation
44
Capabilities: What a firm does

Capabilities Cannot be readily observed Are not tradeable separately from the company. Are developed by a company through coordinated action Become important when they combine resources in unique combinations that create economic value and can lead to competitive advantage (Can contribute to higher value, lower cost or both.) Firms compete on resources & capabilities as much as they do on products Visible competition product market competition Invisible competition resource & capability development and deployment
45
Core Competencies: the roots of a business
46
Canon: Products and Core Technical Capabilities Precision Mechanics

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Corporate Strategy

Prof. Dr. Bernd Venohr Berlin, June 2007

2006 Dr. Bernd Venohr

2006 Dr. Bernd Venohr

Where are we today?

Communication and Problem Solving

Mergers & Acquisitions

Mail BUSINESS LEVEL

Source: Corey Phelps; Mgmt 430

Key issues corporate versus business strategy

Corporate Strategy adds costs and constraints to business units

Shareholders can easily diversify themselves

Source: Porter, From competitive advantage to corporate strategy

2006 Dr. Bernd Venohr

Levels and types of diversification: therelated ratio

Low Levels of Diversification

Moderate to High Levels of Diversification

Related linked (mixed)

Two alternative diversification strategies: related versus unrelated

Two directions of related diversification: vertical and horizontal

Source: Corey Phelps; Mgmt 430

Vertical Diversification: Number of stages a firm engages in the value chain

IT Consulting and Outsourcing

Source: Corey Phelps; Mgmt 430

Horizontal Diversification: number of different product markets a company is active in

Horizontal Diversification Power Generation I&C Net-works Medical Solutions

Source: Corey Phelps; Mgmt 430

Degree of vertical diversification (integration) explained by transaction cost theory

Source: Coase, Ronald. "The Nature of the Firm".; Wikepedia

Vertical diversification: Some Vertical Integration Fallacies

Vertical diversification: recent trends in vertical relationships

Vertical diversification: Different Types of Vertical Relationships

Long-term contracts Franchises Joint ventures

Spot sales/ purchases

Informal supplier/ customer relationships

Supplier/ customer partnerships

Source: Corey Phelps; Mgmt 430

Business A Business B Business C Business D Business E

Horizontal diversification: Transferring Core Competencies

Example of unrelated diversification: Virgin Group

*Source: virgin.com Homepage

2006 Dr. Bernd Venohr

Unrelated diversification: benefits and risks

Source: Corey Phelps; Mgmt 430

Theory of unrelated diversification: common diversification problems

Source: Corey Phelps; Mgmt 430

Underrated good reason for unrelated diversification: business life cycles

Single/ Dominant Business

New Assignment and Outlook next Session

2006 Dr. Bernd Venohr

2006 Dr. Bernd Venohr

Remarks-Premises of Corporate Strategy

Vertical diversification: The Costs and Benefits of Vertical Integration

Source: Corey Phelps; Mgmt 430

Remarks-Theory of unrelated diversification: common diversification problems

Current strategic priorities of DAX 30 companies**

Core Competencies: What a firm does that is strategically valuable

Resources: What a firm has

2006 Dr. Bernd Venohr

Capabilities: What a firm does

Core Competencies: the roots of a business

2006 Dr. Bernd Venohr

Canon: Products and Core Technical Capabilities Precision Mechanics

Basic fax Laser fax