Corporate-Level Strategies: Corporate Diversification
Professor Umberto Garfagnini
ITAM
March 29, 2012
Professor Umberto Garfagnini (ITAM)
Lesson 22: Corporate Diversification
March 29, 2012
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Road Map
Corporate-level strategies:
1
Vertical Integration
2
Corporate Diversification
3
Strategic Alliances
4
Mergers & Acquisitions
5
International Strategies
Professor Umberto Garfagnini (ITAM)
Lesson 22: Corporate Diversification
March 29, 2012
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Outline of Lesson
Define Corporate Diversification
Define Economies of Scope
Types of Corporate Diversification
When does Corporate Diversification create value?
Required reading: Barney & Hesterly, Chapter 7
Professor Umberto Garfagnini (ITAM)
Lesson 22: Corporate Diversification
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What is Corporate Diversification?
Definition: Corporate diversification (CD) is a Corporate-level
strategy that involves operations in more than one industry or market
at the same time
Product diversification: When a firm operates in more than one
industry
Example: General Electric runs operations as diverse as home electric
appliances, financial services, etc.
Geographic market diversification: When a firm operates in only
one industry but in multiple geographic markets
Example: Wal-Mart runs large discount department stores in many
countries
Professor Umberto Garfagnini (ITAM)
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Vertical Integration vs. Corporate Diversification
Vertical Integration: When a firm begins operations in new
industries/markets that are parts of the firm’s value chain
=⇒ Value-Chain Economies!
Corporate Diversification: When a firm begins operations in new
industries/markets that may not be related to the firm’s value chain
=⇒ Economies of Scope! (Yet to be defined)
Both types of strategies should be implemented when they create
value
=⇒ Different businesses combined should be worth more together
than individually
Otherwise, diversification can be achieved by shareholders through
their portfolio of stocks
Professor Umberto Garfagnini (ITAM)
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Types of Corporate Diversification
Limited CD
1
Single-business: When most of a firm’s revenues (≥ 95%) come from
only one business
Example: Airline companies
2
Dominant-business: When at least 70% of a firm’s revenues come from
only one business
Related CD
1
Related-constrained: When all the businesses in which a firm operates
share a large number of inputs, production technologies, distribution
channels, etc.
Example: Disney when the company expanded into theme parks,
Disney stores, etc.
2
Related-linked: When the businesses in which a firm operates are
linked only in a few dimensions
Example: Disney after it entered the motion pictures (other than
animated movies), TV industry, etc.
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Types of Corporate Diversification (Continued)
Unrelated CD: When a firm operates in businesses that share few or
no links
Example: General Electric diversified in business like home appliances,
financial services, energy products, etc.
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How to Create Value through Corporate Diversification
CD creates value when it exploits valuable “economies of scope”
Definition: Economies of scope arise when a firm’s economic value
increases in the number of businesses operated
However, these economies of scope must be cheaper to realize
through CD than by shareholders on their own
Initial empirical studies argued that CD destroys rather than creating
value
This view has since been challenged
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Types of Economies of Scope
Operational economies of scope
When they arise from operational links among the diverse businesses
a firm operates
Shared activities: Activities that are common across the value chain
of different businesses, like R&D, marketing, distribution channels,
etc.
Reducing costs: Using the same sales force to sell different products;
large volumes increase a firm’s bargaining power, etc.
Increasing the perceived value of a firm’s products/services
Example: America Movil (Carlos Slim) offers home telephone services,
internet (Telmex) and cell phone services (Telcel)
All those activities share customers, technical support, networks, etc.
=⇒ Source of cost reductions, as well as value for customers through
bundled offers
Professor Umberto Garfagnini (ITAM)
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Types of Economies of Scope
Operational economies of scope
Limits to sharing activities:
Organizational complexity
Excessive standardization =⇒ lower customers’ perceived value of
firm’s products/services
Bad reputation of a firm’s business unit can spread to other businesses
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Lesson 22: Corporate Diversification
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Types of Economies of Scope
Operational economies of scope
CD can also create value when it exploits a firm’s core competencies
Definition:[Prahalad and Hamel] A Core Competence is the collective
learning in the organization, especially how to coordinate diverse
production skills and integrate multiple streams of technologies
More simply, core competencies relate to managerial and technical
know-how, experience, etc.
Example: Johnson & Johnson has an extensive expertise in
pharmaceutical and medical products (used as the common
denominator of all its diverse businesses)
Limits to core competencies:
Core competencies are hard to measure, so they may not really exist
Core competencies may have only a marginal effect on a firm’s
economic value
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Types of Economies of Scope
Financial economies of scope
Capital allocation: Funding a diversified firm rather than individual
businesses may reduce the cost-of-capital
=⇒ A diversified firm has more information than external financiers
about the various businesses, thus better allocation of resources
=⇒ Lower chance to reveal information to competitors
Limits on capital allocation benefits:
1
2
3
Allocating capital efficiently in large diversified firms may be hard to
achieve
Division managers can still lie or distort the information reported to
gain more funds
Escalation of commitment: Managers may keep investing in failing
projects to avoid admitting an initial mistake
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Types of Economies of Scope
Financial economies of scope
Risk reduction: A diversified firm may be less risky than its
individual businesses
Tax advantages: When losses in one business offset profits in
another business, the firm experiences tax savings
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Types of Economies of Scope
Exploiting anticompetitive economies of scope
1
Multipoint competition: When diversified firms compete in multiple
markets simultaneously
=⇒ It can lead to tacit collusion...
...because a firm increasing competition in one business is afraid of
possible retaliations by the same competitor in another business(es)
2
Market power: Suppose a firm has monopoly power or large market
power in one of its businesses...
...the firm can subsidize other businesses to drive out competitors and
gain market share (predatory pricing )
Professor Umberto Garfagnini (ITAM)
Lesson 22: Corporate Diversification
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Sustaining CA through Corporate Diversification
Rarity and Inimitability
CD must involve a rare resource or capability
Example: ESPN’s expansion into the restaurant business with its own
chain
ESPN made use of its extensive rights on various kinds of sports to
appeal sport-oriented customers
The resources used must be costly to imitate
Example: ESPN’s strategy was hard to imitate due to the exclusive
rights to broadcast various sport events
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