Topics Included  Definition of Diversification  Levels

Topics Included Definition of Diversification Levels of Diversification Reasons of Diversification

Definition of Diversification Diversification is a corporate strategy to increase sales volume from new products & new markets. Diversification can be expanding into a new segment of an industry that the business is already in or investing in a promising business outside of the scope of the existing business.

Diversification is a method of portfolio management whereby an investor reduces the volatility (and thus risk) of his or her portfolio by holding a variety of different investment that have low correlations with each other. Samsung is the world’s biggest diversified company. We probably now Samsung best for its smart phones, tablets and televisions. Another example is McCafe which at first was found in Japan and was amazed by its different style from traditional McDonald store.

McDonald's starting of McCafe is an excellent example of diversification. By starting McCafe, McDonald's is offering new products that were not available in traditional McDonald's stores. McCafe specializes in serving cafes, which attracts customers that usually don't come to McDonald's to eat fastfood . McCafe is also not only a product development. McCafe has its own section of the store and clearly distinguishes itself from the traditional McDonald store. The store has modern, yet relaxing mood. This is important to attract new market segments, probably customers that go to cafe not to satisfy hunger, but possibly to take a sip of coffee and chat in a relaxing environment. Thus, McDonald's McCafe serves as an example performing diversification by developing both new products and new markets.

Levels Of Diversification Low level Diversification More than 95% of Single Business: revenue from a single business. A

Levels Of Diversification Low level Diversification Dominant Business: Between 70% and 95% of revenue comes from a single business A B

Moderate to high level Diversification Related Constrained: Less than 70% of revenue comes from the dominant business and all business share product, technological and distribution linkage. A B C

Moderate to high level Diversification Related Linked (Mixed related and unrelated): Less than 70% of revenue comes from the dominant business, and there are only limited links between businesses. A B C

Very high level Diversification: Unrelated: Less than 70% of revenue comes from the dominant business and there are no common links between businesses. A B C

Some Examples: Low Levels of Diversification: Single Business Diversification Strategy: Wm.wrigley jr.company,the worlds largest producer of chewing and bubble gums, historically used a single business strategy while operating in relatively few product markets.

Dominant Business Diversification Strategy: United parcel service (UPS) uses this strategy. Recently UPS generated 74% of its revenue from its U.S package delivery business and 17% from its international package business, with the remaining 9% coming from the firm’s nonpackage business. Though the U.S package delivery business currently generates the largest percentage of UPS’s sales revenue, the firm anticipates that in the years to come its other two businesses will account for the majority of growth in revenues.

Moderate to high levels of Diversification: Related constrained Diversification Strategy: Campbell soup, Procter & Gamble ,Kodak and Merck & Company all use a related constrained strategy,a firm shares resources and activities between its businesses. Related linked Diversification Strategy: Johnson & Johnson, General Electric (GE) and cendant use this corporate-level diversification strategy.

Very High Levels of Diversification: Unrelated Diversification Strategy: A highly diversified firm that has no relationship 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.

Reasons for Diversification Value-Creating Diversification Economies of scope (related diversification) Sharing activities Transferring core competencies Market power (related diversification) Blocking competitors through multipoint competition Vertical integration Financial economies (unrelated diversification) Efficient internal capital allocation Business restructuring Value-Neutral Diversification Antitrust regulation Tax laws Low performance Uncertain future cash flows Risk reduction for firm Tangible resources Intangible resources Value-Reducing Diversification Diversifying managerial employment risk Increasing managerial compensation

Related Diversification Firm creates value by building upon or extending: – Resources – Capabilities – Core competencies Economies of Scope – Cost savings that occur when a firm transfers capabilities and competencies developed in one of its businesses to another of its businesses.

Related Diversification: Economies of Scope Value is created from economies of scope through: – Operational relatedness in sharing activities – Corporate relatedness in transferring skills or corporate core competencies among units. The difference between sharing activities and transferring competencies is based on how the resources are jointly used to create economies of scope.

Sharing Activities Operational Relatedness – Created by sharing either a primary activity such as inventory delivery systems, or a support activity such as purchasing. – Activity sharing requires sharing strategic control over business units. – Activity sharing may create risk because businessunit ties create links between outcomes.

Transferring Corporate Competencies Corporate Relatedness Using complex sets of resources and capabilities to link different businesses through managerial and technological knowledge, experience, and expertise.

Corporate Relatedness Creates value in two ways: – Eliminates resource duplication in the need to allocate resources for a second unit to develop a competence that already exists in another unit. – Provides intangible resources (resource intangibility) that are difficult for competitors to understand and imitate. A transferred intangible resource gives the unit receiving it an immediate competitive advantage over its rivals.

Related Diversification: Market Power Market power exists when a firm can: – Sell its products above the existing competitive level and/or – Reduce the costs of its primary and support activities below the competitive level.

Related Diversification: Market Power (cont’d) Multipoint Competition – Two or more diversified firms simultaneously compete in the same product areas or geographic markets. Vertical Integration – Backward integration—a firm produces its own inputs. – Forward integration—a firm operates its own distribution system for delivering its outputs.

Related Diversification: Complexity Simultaneous Operational Relatedness and Corporate Relatedness – Involves managing two sources of knowledge simultaneously: Operational forms of economies of scope Corporate forms of economies of scope – Many such efforts often fail because of implementation difficulties.

Unrelated Diversification Financial Economies – Are cost savings realized through improved allocations of financial resources. Based on investments inside or outside the firm – Create value through two types of financial economies: Efficient internal capital allocations Purchase of other corporations and the restructuring their assets

Unrelated Diversification (cont’d) Efficient Internal Capital Market Allocation – Corporate office distributes capital to business divisions to create value for overall company. Corporate office gains access to information about those businesses’ actual and prospective performance. – Conglomerates have a fairly short life cycle because financial economies are more easily duplicated by competitors than are gains from operational and corporate relatedness.

Unrelated Diversification: Restructuring Restructuring creates financial economies – A firm creates value by buying and selling other firms’ assets in the external market. Resource allocation decisions may become complex, so success often requires: – Focus on mature, low-technology businesses. – Focus on businesses not reliant on a client orientation.

External Incentives to Diversify Anti-trust Legislation Antitrust laws in 1960s and 1970s discouraged mergers that created increased market power (vertical or horizontal integration. Mergers in the 1960s and 1970s thus tended to be unrelated. Relaxation of antitrust enforcement results in more and larger horizontal mergers. Early 2000: antitrust concerns seem to be emerging and mergers now more closely scrutinized.

External Incentives to Diversify (cont’d) Anti-trust Legislation High tax rates on dividends cause a corporate shift from dividends to buying and building companies in highperformance industries. Tax Laws 1986 Tax Reform Act Reduced individual ordinary income tax rate from 50 to 28 %. Treated capital gains as ordinary income. Thus created incentive for shareholders to prefer dividends to acquisition investments.

Internal Incentives to Diversify Low Performance High performance eliminates the need for greater diversification. Low performance acts as incentive for diversification. Firms plagued by poor performance often take higher risks (diversification is risky).

FI The Curvilinear Relationship between Diversification and Performance

Internal Incentives to Diversify (cont’d) Low Performance Uncertain Future Cash Flows Diversification may be defensive strategy if: Product line matures. Product line is threatened. Firm is small and is in mature or maturing industry.

Internal Incentives to Diversify (cont’d) Low Performance Uncertain Future Cash Flows Synergy and Risk Reduction Synergy exists when the value created by businesses working together exceeds the value created by them working independently but synergy creates joint interdependence between business units. A firm may become risk averse and constrain its level of activity sharing. A firm may reduce level of technological change by operating in more certain environments.

Resources and Diversification A firm must have both: – Incentives to diversify – The resources required to create value through diversification—cash and tangible resources (e.g., plant and equipment) Value creation is determined more by appropriate use of resources than by incentives to diversify. Managerial Motives to Diversify – Managerial risk reduction – Desire for increased compensation

Summary Model of the Relationship between Firm Performance and Diversification