Contemporary Strategy Analysis (6th edition) NOTES AND SUGGESTIONS ON SELF-STUDY QUESTIONS Chapter 15. Diversification Strategy 1. An ice cream manufacturer is proposing to acquire a soup manufacturer on the basis that, first, its sales and profits will be more seasonally balanced and, second, from year to year, sales and profits will be less affected by variations in weather. Will this risk spreading create value for shareholders? Under what circumstances could this acquisition create benefits for shareholders? The discussion of “Risk Reduction” (pp. 399–400) makes clear that the combined cash flows from the two businesses will be less variable than those of each of the individual businesses (since they are negatively correlated). However, does this create value for the owners of the business? As long as the cash flows of the individual businesses are unaffected by the merger, less variability does not create value for owners. If the two businesses are public companies, then shareholders can undertake their own risk reduction through holding portfolios of different companies’ stocks. It is more likely that the merger will destroy value – especially for the shareholders of the acquiring company. While individual investors can diversify their portfolios with minimal transactions costs, the transaction costs associated with mergers and acquisitions (especially investment bank fees) are considerable (not to mention the premium that the acquiring company must pay to effect the takeover). Under what conditions might the merger create value? The answer is: where real economies can be gained by merging the two businesses. Thus, if employees can be redeployed between ice cream and soup production and if certain functions (e.g. distribution, HR, accounts, and finance) can be combined, then the merger might boost the cash flows of each business. Note: During the 1920s, a British company, Thomas Wall and Son Ltd., a producer of meat pies and sausages, began producing ice cream at its West London plant during the summer months to utilize excess capacity. 2. Tata Group is one of India’s largest companies, employing 203,000 people in many different industries including steel, motor vehicles, watches and jewelry, telecommunications, financial services, management consulting, food products, tea, chemicals and fertilizers, satellite TV, hotels, energy, IT, and construction. Such diversity far exceeds that of any North American or western European company. What are the conditions in India that might make such broad-based diversification both feasible and profitable? In discussing the refocusing trend (pp. 396–7), I noted that conglomerate firms have all but disappeared in North America and Europe, but continue to be very important in emerging countries. The reasons are discussed more fully in the sections on “Economies from Internalizing Transactions” and “The Diversified firm as an Internal Market” (pp. 403–5). Tata Group lacks close operational linkages between its businesses – they are simply too diverse. Tata Group adds value through allocating investment funds and personnel between its different businesses, deploying its top management expertise, and establishing and developing new businesses. The essential condition for this to work is that Tata needs to be more efficient in managing these processes than are external markets. In the US and UK, conglomerate firms no longer have any general advantage in allocating investment funds, motivating business managers, or starting-up new businesses – all these functions are performed efficiently by the capital markets. In India, capital markets are less efficient, venture capital is less developed, and labor markets for managers and other skilled professionals are less developed. In these circumstances, not only is Tata able to utilize internal information and sophisticated decision-making systems to allocate resources more effectively than can external markets, it may also benefit from lower resource costs (in particular, a lower cost of capital than smaller, more specialized companies). Apart from financial and human resources, other resources that Tata can deploy across its different business are influence and business relationships. In a highly regulated country like India, political influence is critically important. Tata’s size and diversity undoubtedly give it considerable power within both state and federal governments. Its international network of relationships also allows it to be a preferred joint venture partner for foreign multinationals seeking to invest in India. 3. Giorgio Armani SpA is an Italian private company owned mainly by the Armani family. Most of its clothing and accessories are produced and marketed by the company (some are manufactured by outside contractors). For other products, notably fragrances, cosmetics, and eyewear, Armani licenses its brand names to other companies. Armani is considering expanding into athletic clothing, hotels, and bridal shops. Advise Armani on whether these new businesses should be developed in-house, by joint ventures, or by licensing the Armani brand to specialist companies already within these fields. In choosing between licensing, joint venture, or wholly owned diversifications, the key criteria are likely to be: • The transaction costs associated with licensing Armani’s brand: If licensing contracts can be easily written and easily enforced, then licensing represents a viable and attractive strategy for exploiting these markets. However, if there are risks from licensees oversupplying the market, supplying products that are not consistent with Armani’s image and quality, or undermining Armani’s reputation in any other way, then licensing may be risky. • The opportunities for sharing or transferring Armani’s other resources and capabilities with/to the new businesses: Apart from its brand, which of Armani’s other resources and capabilities can be utilized in the new business? In the case of bridal clothing and accessories, Armani can probably utilize its existing design, manufacturing, marketing, and distribution capabilities – in which case Armani can develop this business in-house. In the case of athletic clothing and equipment, Armani may need to access the technical capabilities needed to design products for different sports – hence, a joint venture may be appropriate. In the case of hotel management, it is not apparent that any of Armani’s resources and capabilities (other than its brand) relate to the design and operation of luxury hotels – hence, licensing may be the best solution. 4. General Electric, Berkshire Hathaway, and Richard Branson’s Virgin Group each comprise a wide range of different businesses that appear to have few close technical or customer linkages. Are these examples of unrelated diversification and do the corporate and ownership links within each of the groups result in the creation of any value? If so, what are the sources of this value creation? The discussion of “The Meaning of Relatedness in Diversification” (pp. 407–8) answers this question. When we think of sharing resources and transferring capabilities, we tend to think primarily of operational linkages: using the same technology, sharing distribution channels, and pooling purchases of raw materials and other supplies. However, an equally (potentially more) important type of relatedness between businesses will be common strategic characteristics. The ability to design corporate systems that allocate capital, monitor performance, assess and reward managers, and create new business opportunities depends on a similarity of strategic characteristics across businesses. This is fundamental to the ability of corporate management to create value in the individual businesses. Thus, as identified on page 408, most of the Virgin Group comprises startup companies that supply branded goods and services to consumers. Most of Berkshire Hathaway’s businesses are mature, stable, low-tech businesses that face limited international competition. As such they fit well with the conservative, non-interventionist management approach of Warren Buffett and Charlie Munger. GE’s business are mostly large scale, capital intensive, and international. Their strategic similarities allow them to benefit from GE’s highly sophisticated systems of strategic and financial management and management development.
