4.6. Diversification

Question 1

Define diversification

Answer 1

It is a corporate strategy to enter into a new industry/market which the business is not currently in whilst also creating a new product for that new market.

Question 2

Types of diversification

Answer 2

1. related diversification
2. unrelated diversification
   hard to define what related really means

Question 3

Related diversification

Answer 3

expanding into businesses that have a lot in common with each other, for example in terms of:
– Skills
– Sharing manufacturing plants
– Shared R&D

Question 4

Unrelated diversification

Answer 4

expanding into business that do not have a lot in common with each other
– The current wisdom is that “unrelated” diversification is not good for firm performance: remember Parmalat?
– There are exceptions (e.g. Virgin)

Question 5

Reasons to diversify

Answer 5

• Behavioral (related to limits of human rationality) - people are more stupid than we think
• Managerial Reasons(related to opportunism) - selfish behaviour, benefit for top leaders/managers
• Economics Reasons
  In general, the first 2 bullet points are bad reasons for diversifying

Question 6

Behavioral reasons

Answer 6

• Naive(imitation of successful firms,did not listen to Porter about being ”unique”)
• Emotional attachment (e.g. Parmalat, likes football -> invest in that business)
• Need to spend cash( ”free cashflow” hypotheses by Jensen (1988)) :
  + If managers are given the chance not to pay out dividends (”retained earnings”) they usually waste that money

Question 7

Managerial reasons

Answer 7

a) Empire building
– ”I was the presiding CEO when we grew the company from selling milk to sellling everything under the sun”)
b) Larger compensation (more money)
c) Diversifying risks for managers
– Often managers’compensation is in stock(so unlike investors they cannot diversify risk by buying different stock)

Question 8

Economics reasons

Answer 8

a) Internal capital markets
– Existing firms can fund projects that would not get funded through the market:
• Information asymmetry: funders do not hold enough information about entering companies to give out capital
(existing companies have more credibility and experience -> more likely to receive funds
b) Diversifying risk for shareholders
– The counter argument says that shareholders can do that themselves by buying different stock
c) Gaining market power
d) Economies of scope

Question 9

Define economies of scope

Answer 9

Reductions in unit costs deriving from the fact that the total cost of producing a two different goods together in one firm is lower than the cost of producing them separately in two firms.

Question 10

Differences between the economies

Answer 10

• Scale: looks at average costs across two different capacity levels of the same good
• Fixed cost absorption: looks at average costs across two different utilization rates of the same good
• Learning: looks at average costs across two different cumulative production rates of the same good
• Scope: look at average costs of several goods done jointly vs. done separately

Question 11

Example of economies of scope

Answer 11

• Poste Italiane: postal services but also communications, logistic and financial products and services:
– It uses its wide network of local branches to sell a range of services ranging from postal service and
financial service, to mobile telephony, stationery, books and music
• Sources of economies of scope may be material (shared distribution networks, customer care) but also intangible (shared brand and corporate image, know- how)
• Proctor & Gamble (P&G): Given the high need for marketing in consumer goods, P&G can market toothpaste, razors, soap etc with lower average costs than specialized firms (shared graphic designers, skills for advertising)

Question 12

2 specific types of diversification

Answer 12

• vertical integration

- horizontal integration

Question 13

Horizontal integration

Answer 13

The introduction of additional business activities that are at the same level of the value chain in different industries.

Question 14

Advantages of horizontal integration

Answer 14

• Eliminates one competitor -> increased market powers over suppliers and distributors
• Possible economies of scale
• Economies of scope: achieved by sharing resources common to different products
• Scope for rationalising
• Customer perception of quality: Linkages between products

Question 15

Disadvantages of horizontal integration

Answer 15

• Lack of competition means the consumers have less choice => prices are higher => may react negatively
• Lack of experience in this sector of the industry - a successful manufacturer does not necessarily make a good retailer

Question 16

Different levels of diversification

Answer 16

– Single business (Devro - sausage casings)
– Dominant business (IKEA - furniture and meatballs)
– Related business (Barilla)
– Unrelated business
– Conglomerates (Mitsubishi - Lager beer, cars, boats)

Question 17

Unrelated diversification: Virgin

Answer 17

• Maybe just seemingly unrelated?
• Brand seen as slightly rebellious, rooted in origins as music label
• Virgin prides itself in providing excellent customer service
– It used this ”service capability” to enter the airline market and differentiate in the 1980s, brand helps appeal inititally to a niche market
– Spectacular failure of Virgin Cola in the 1990s (maybe customer service not as important? Incumbents were able to block access to distribution channels)

Question 18

Useful Tests (to see if company should diversify)

Answer 18

• What are we good at in our current market?
– Markides (1997) calls these strategic assets
– Virgin: brand, customer service
• What do we need to be good at to succeed in the new market?
– Do we have all the necessary ’strategic assets’?
– If not, can we ‘build them’? Either alone or through mergers, partnerships…?

Question 19

When is diversification good?

Answer 19

• In general diversified firms trade at a discount (lower price) than single businesses in comparable industries
• often related diversification and in particular horizontal integration (as well as vertical) are considered better than unrelated

Question 20

Negative effects of diversification

Answer 20

• Loss of focus: dispersed managerial attention (especially for unrelated)
• Barriers to redeployment of managerial expertise
• Challenging to realize synergies between old and new businesses (e.g. integrating different businesses)
• Diversification done for ”wrong” reasons wastes $
– Remember, a corporate strategy needs to support an overall vision…

Question 21

Delta Song: Economies of scope?

Answer 21

• Brand
• Know-how
• Management (?)
• Advertising
• Cost issues (unions) carry over
• Hard to justify paying one set of pilots more than others/hard to justify
different working conditions
• In some sense there are “diseconomies of scope”
What happened:
• “Leisure” customers from NE USA to Florida and West Cost USA to
Florida
• Competition with Jetblue
• Same leather seats, same entertainment, same “cheap but chic”
image
• By 2006, Delta Song has 47 planes
• In 2005 Delta starts bankruptcy proceedings
• Later that year: Song “merges” with Delta as part of a restructuring to
regain profitability