Creating Value through Diversification
Chapter Six
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

After reading this chapter, you should have a good understanding of:
LO1 The reasons for the failure of many diversification efforts.
LO2 How managers can create value through diversification initiatives.
LO3 How corporations can use related diversification to achieve synergistic benefits through economies of scope and market power.
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LO4 How corporations can use unrelated diversification to attain synergistic benefits trough corporate restructuring, parenting, and portfolio analysis.
LO5 The various means of engaging in diversification-mergers and acquisitions, joint ventures/strategic alliances, and internal development.
LO6 Managerial behaviors that can erode the creation of value.
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• Diversification
 the process of firms expanding their operations by entering new businesses.
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• What businesses should a corporation compete in?
• How should these businesses be managed to jointly create more value than if they were freestanding units?
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• Diversification initiatives must create value for shareholders
 Mergers and acquisitions

Strategic alliances
 Joint ventures

Internal development
• Diversification should be synergistic
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• Related businesses (horizontal relationships)
 Sharing tangible resources

Sharing intangible resources
• Unrelated businesses (hierarchical relationships)

Value creation derives from corporate office

Leveraging support activities
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• Related diversification
 a firm entering a different business in which it can benefit from leveraging core competencies, sharing activities, or building market power.
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• Economies of scope
 cost savings from leveraging core competencies or sharing related activities among businesses in a corporation.
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McKesson, a large distribution company, sells many product lines such as pharmaceuticals and liquor through its super warehouses. This is an example of
A.
Achieving economies of scope through related diversification
B.
Achieving market power through related diversification
C.
Attaining the benefits of restructuring through unrelated diversification
D. Attaining the benefits of parenting through unrelated diversification
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• Core competencies
 a firm’s strategic resources that reflect the collective learning in the organization.
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Core competencies reflect the collective learning in a firm:
• How to coordinate diverse production skills
• How to integrate multiple streams of technologies
• How to market diverse products and services
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• Core competencies must enhance competitive advantages by creating superior customer value
• Different businesses in the firm must be similar in at least one important way related to the core competence
• Core competencies must be difficult for competitors to imitate or find substitutes for
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Philip Morris bought Miller Brewing and used its marketing expertise to improve
Miller's market share. This justification for diversification is best described as
A . Utilizing common infrastructures
B . Capitalizing on core competencies
C . Reducing corporate risk
D . Using portfolio analysis
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• Corporations can also achieve synergy by sharing tangible and value-creating activities across their business units

Common manufacturing facilities

Distribution channels

Sales forces
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• Sharing activities provide two payoffs

Cost savings
 Revenue enhancements
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• Market power
 firms’ abilities to profit through restricting or controlling supply to a market or coordinating with other firms to reduce investment.
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• Pooled negotiating power
 The improvement in bargaining position relative to suppliers and customers.
• Vertical integration
 an expansion or extension of the firm by integrating preceding or successive production processes.
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Pooled Negotiating Power
• Similar businesses working together can have stronger bargaining position relative to
 Suppliers

Customers

Competitors
• Abuse of bargaining power may affect relationships with customers, suppliers and competitors
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Benefits
• A secure source of raw materials or distribution channels.
• Protection of and control over valuable assets.
• Access to new business opportunities.
• Simplified procurement and administrative procedures.
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Risks
• Costs and expenses associated with increased overhead and capital expenditures.
• Loss of flexibility resulting from large investments.
• Problems associated with unbalanced capacities along the value chain.
• Additional administrative costs associated with managing a more complex set of activities.
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1.
Is the company satisfied with the quality of the value that our present suppliers and distributors are providing?
2.
Are there activities in our industry value chain presently being outsourced or performed independently by others that are a viable source of future profits?
3.
Is there a high level of stability in the demand for the organization’s products?
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Making Vertical Integration Decisions
(cont.)
4.
Do we have the necessary competencies to execute the vertical integration strategies?
5.
Will the vertical integration initiative have potential negative impacts on our stakeholders?
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• Transaction Cost Perspective
 the choice of a transaction’s governance structure, is influenced by transaction costs, such as search, negotiating, contracting, monitoring, and enforcement costs
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• Unrelated diversification
 a firm entering a different business that has little horizontal interaction with other businesses of a firm.
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• Parenting advantage
 the positive contributions of the corporate office to a new business as a result of expertise and support provided
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• Corporate Restructuring

The intervention of the corporate office in a new business that substantially changes the assets, capital structure, and/or management
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• Corporate management must

Have insight to detect undervalued companies or businesses with high potential for transformation
 Have requisite skills and resources to turn the businesses around
• Can involve changes in

Assets

Capital

Management
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• Portfolio management
 assessing the competitive position of a portfolio of businesses within a corporation,
 suggesting strategic alternatives for each business
 identifying priorities for the allocation of resources across the businesses.
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Key
Each circle represents one of the firm’s business units
Size of circle represents the relative size of the business unit in terms of revenue
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• Church & Dwight has a well balanced portfolio of products, which includes
 Arm & Hammer
 Trojan condoms
 Oxi Clean
 AIM toothpastes
 First Response
 Nair
 Xtra laundry detergent

Brillo
Source: www.churchdwight.com
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• Allocate resources
• Expertise of corporate office in locating attractive firms to acquire
• Provide financial resources to business units on favorable terms reflecting the corporation’s overall ability to raise funds
• Provide high quality review and coaching for units
• Provide a basis for developing strategic goals and reward/evaluation systems
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• SBUs compared on only two dimensions
• SBUs viewed as stand-alone entities
• Process becomes largely mechanical
• Reliance on “strict rules” regarding resource allocation across SBUs can be detrimental
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• Acquisitions or mergers
• Pooling resources of other companies with a firm’s own resource base

Joint venture

Strategic alliance
• Internal development

Corporate entrepreneurship
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• Can be a means of obtaining valuable resources that can help an organization expand its product offerings and services
• Can lead to consolidation within an industry and can force other players to merge
• Corporations can also enter new market segments by way of acquisitions
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• Competing firms often can imitate any advantages realized or copy synergies that result from the M&A.
• There can be many cultural issues that may doom the intended benefits from M&A endeavors.
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• Introduce successful product or service into a new market
 Lacks requisite marketing expertise
• Join other firms to reduce manufacturing
(or other) costs in the value chain

Pool capital, value-creating activities, facilities
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• Develop or diffuse new technologies

Use expertise of two or more companies
 Develop products technologically beyond the capability of the companies acting independently
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Unmet Expectations: Strategic
Alliances and Joint Ventures
• Improper partner

Each partner must bring desired complementary strengths to partnership

Strengths contributed by each should be unique
• Partners must be compatible
• Partners must trust one another
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Managerial Motives Can
Erode Value Creation
• Growth for growth’s sake
• Egotism
• Antitakeover tactics

Greenmail

Golden parachute

Poison pills
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