University of Cagliari, Faculty of Economics, a.a. 2012-13

Business Strategy and PolicyA course within the II level degree in

Managerial Economicsyear II, semester I, 6 credits

Lecturer:Dr Alberto Asqueraasquer@unica.it

Phone: 070 6753399

Business Strategy and Policy

Lecture 6

Diversification Strategy

Introduction

1. What is diversification?

2. Why do firms diversify?

3. How do firms enter a new business?

4. Where do firms diversify?

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5. Summary

1. What is diversification?

Diversification consists of expanding the range of business activities carried out by a firm away from the present product line and market structure

Diversification involves:

Search and selection of new business areas

Formulation and implementation of an entry strategy

Search and activation of synergies between business areas

Definition of priorities for the allocation of resources among business areas

1. What is diversification?

Diversification through the development of new products delivered in new markets (Ansoff, 1957)

Currentproduct X

Newproduct X1

Another newproduct X2

Newproduct Y....

Currentmarket A

Newmarket A1

Another newmarket A2

....

Market penetration

Product development

Market development

Diversification

1. What is diversification?

Diversification may be also directed towards the input market, often through the acquisition of a supplier (upstream vertical integration)

Outputmarket

Currentproduct X

Firm

Input market Supplier Supplier

SupplierSupplierSupplier

Upstream integratione.g., oil refinery into

oil extraction

1. What is diversification?

Diversification may be also directed towards the output market, often through the acquisition of a supplier (downstream vertical integration)

Firm

Output market Client Client

ClientClientClient

Downstream integratione.g., movie makers into

movie distribution

2. Why do firms diversify?

Diversification allows the firm to grow rapidly by expanding operations into new business fields

Why is (rapid) growth beneficial?

Economies of scale

Learning and experience curve effects

Lower average unit costs (running at full capacity)

More bargaining power with suppliers and customers

Exploiting differences between diverse geographical areas

2. Why do firms diversify?

Instance: Tiscali (1998-2009)

1998

Internet (free) access

1999

Market entry

Market development

2003 2009

Product development

Diversification

Acquisitions in the EU

Fixed phone lines, ADSL

Virtual MobileNetwork Operator

Telecom in Italy and the UK

2. Why do firms diversify?

Instance: Tiscali (2009-2011)

2009

Product development

Diversification

Fixed phone lines, ADSL

Virtual MobileNetwork Operator

Telecom in Italy and the UK The opposite of diversification:focus strategy

2011

UK division sold in 2009

2. Why do firms diversify?

Instance: Tiscali (2000-2011)

(a struggle to protect shareholders' value)

2. Why do firms diversify?

Diversification is sometimes regarded as beneficial to shareholders, because it allows to spread risk among various businesses (whose performance presumably are not correlated)

Diversification is sometimes considered as detrimental to shareholders, because they would be better off if they diversify risk of their investment portfolio rather than having it done by the company management

(Note: but diversifying your investment portfolio among various financial assets is quite different from exploiting synergies between different product and market lines within the same firm!)

3. How do firms enter a new business?

Acquisitions of other companies that already operate in another business (a rapid way to acquire assets, employees, know-how, market presence, access to distribution channels, etc.)

Internal start-ups by developing own business ideas, allocating capital and other resources, and venturing into a new business (i.e., “corporate venturing”)

Joint ventures by partnering with other companies that already operate in another business and sharing assets, employees, know-how, etc. – typically by searching for synergies between respective resources and distinctive capabilities

3. How do firms enter a new business?

Acquisition Joint ventureInternal start-up

4. Where do firms diversify?

Two types of diversification:

Related: when the value chains of two businesses that are managed within the same firm (i.e., the same company or company group) share cross-linkages that provide opportunities for superior performance than when they are managed by two independent firms

Unrelated: when the value chains of two businesses do not share any linkage, i.e., they are completely different and they do not offer any opportunities for competitive advantage if managed within the same firm

(Note: this discussion bears some relatedness to issues about why firms exist, i.e., why higher performance is achieved through hierarchical organisations rather than market exchange; see transaction cost economics; Coase, 1937)

4. Where do firms diversify?

Instance of related diversification: Johnson & Johnson

Consumers products

Baby care

Skin and hair care

Wound care

Oral care

Women's care Medicines

Nutritionals Vision care

4. Where do firms diversify?

When should firms pursue related diversification?

When there is 'strategic fit', that is, opportunities for

Transfer of skills, knowledge, and other competences across businesses

Economies of scope

Advantages arising from 'umbrella branding'

Developing innovative products and/or processes

4. Where do firms diversify?

Instance of unrelated diversification: General Electrics

Appliances

Consumer products Energy

Financial services

HealthcareAviation

4. Where do firms diversify?

Instance of unrelated diversification: Virgin

Radio

Travel agent

Telecom and media

Radio

Airlines

Railways

Megastore

Soft drinks

4. Where do firms diversify?

When should firms pursue unrelated diversification?

Some scholars (and practitioners) would argue that firms should not pursue unrelated diversification at anytime (Rumelt, 1974; Teece et al., 1997) – except when the firm is clearly facing decline in traditional products and markets

When unrelated diversification is pursued, generally firms have robust financial resources and are in search for new investments

either the unrelated business presents attractive profitability/risk and growth prospects

or the unrelated business presents attractive speculative prospects

5. Summary

Main points

Diversification consists of expanding the range of business activities carried out by a firm away from the present product line and market structure

Diversification can foster rapid growth and provide better shareholder value. Sometimes, however, an opposite focus strategy delivers better results

Diversification can be conducted through internal development of new businesses, acquisitions, or joint ventures

Diversification may be directed towards related or unrelated business areas. Generally, related diversification delivers better performance