Corporate Level Strategy & Diversification Flashcards
Diversification:
is the expansion of operations by entering new businesses or product lines
Why might an investor want a CEO to diversify?
Value creation purposes
Key ideas about diversification
- In finance, or investment Portfolio management, diversification is used primarily as a risk-management technique
- In corporate strategy: diversification can be a means of creating value for shareholders
Reasons to diversify:
- Value Creating: Achieve economic of scope, increase market power and achieve financial economies(good parenting)
- Value-Neutral: Regulatory (antitrust, tax laws) and Low performance, risk reduction
- Value-Reducing: Managerial self-interest
Corporate-Level Strategy:
- Focuses on building value by managing operations on multiple business
- Addresses 2 issues: 1. What business should a corporation participate in? and 2. Can the corporation and value to its business u its(and how)?
- Does parental ownership of a business unit create value?
- The “Better Of” Test: Are the parent and business unit better off together or apart?
Good Parenting?
● Jersey Pizza recently acquired Mr. Tom’s cookie company
● Jersey Pizza has:
- A bloated cost structure (too many managers relative to kitchen and
waitstaff)
- A very bureaucratic culture (lots of rules, process)
- Strong ideas about expansion (urban markets only; won’t consider suburban
markets)
● Jersey Pizza will manage Tom’s Cookies in the following ways:
- Jersey Pizza will charge monthly “management fee” = 10% of Tom’s revenues
- All new cookie recipes must be approved by Jersey Pizza (6 month process)
- Mr. Tom’s must abandon its expansion pains for the suburbs and focus on
city location
● One more thing: by owning Tom’s Cookies, the management of Jersey Pizza will do a
worse job of managing the original pizza business
● Are these 2 businesses better off together or separate? They better off separate
● Why did Jersey Pizza buy Tom’s Cookies in the first place? Cause Jersey wants
diversification, and want to invest with the money/profit they have now
Cost of Parental Ownership
● Allocation of corporate overhead (headquarters staff)
● Imposition of inappropriate policies or services
Due to HQ not understanding the subsidiary business
●Inefficient approval process for significant decisions
Bureaucracy
●Conflict of goals
For example: HQ might make expansion in Europe a priority but the subsidiary might have better prospects in Asia
Key idea
Because parental ownership imposes costs on its subsidiaries, we need to find ways in which parental ownership also adds value
How can we pass the “Better Off” test?
The Value Creation Toolkit
- Sharing resources
- Market power
- Corporate parenting
- Portfolio management
- Restructuring
Related diversification
Example:
LVMH
- Dior
- Fendi
- Sephora
- Louis Voution
- Moet & Chaandon
- Belmond
- Dom Perignon
Related Diversification
Expanding the Value Chain (also known as “Vertical Integration”)
Example:
1. Walmart
- Walmart Opens Milk Processing Plant
- Walmart
- Pick-Walmart
2. Ecco
- Ecco produces its own shoes, but it also sells to other businesses
Quick summary: Related Diversification
● Horizontal Diversification: adding similar business units
● Vertical Diversification (or Vertical Integration) : expanding the value chain
- Often by acquiring or building a business unit focused on a new chain
capability
Unrelated Diversification: Dissimilar Business
Example:
- Honeywell:
- Well Diversified Portfolio Positioned for Sustainable Growth
- See slide 29
- Johnson & Johnson
- J&J operates approximately 250 business units
- Consumer Health Products
- Pharmaceutical Productions
- Medical Devices
● Value Creation Through Diversification: Getting the Job Done
● How We Create Depends on the Type of Diversification
Related Diversification
- Sharing of resources and capabilities
- Increased market power
Unrelated Diversification:
- Constructive corporate parenting
Shared Resources and Capabilities: Examples
Research & Development
- Technical Expertise ‘Marketing
- Marketing
- Corporate Reputation
- Logistics (Inventory, shipping)
- Brand
- Design
- Online platform
- Manufacturing
How sharing resources Creates Value: Part 1
● Sharing a resource/capability across different business units reduces the unit cost of
that resource/capability
- Economies of scope: = reduction in unit costs that results from spreading a
fixed cost over a wider variety of products
- Economies of of scale: = reduction in unit costs that results from spreading
a fixed cost over a greater volume of one product
● Shared Resources at Proctor & Gamble Economies of Scope: Research &
Development, Manufacturing, Marketing, Logistics (Inventory shipping
How sharing resources Creates Value: Part 2
● Sharing a resource/capability can confer value to different business units that is
especially valuable or difficult to replicate
● Example: Nestle; pure water, nescafe, leche en polvo
Related Diversification
The type of diversification affects value creation
Related Diversification:
- Sharing resources
- Increased market power
Unrelated Diversification:
Market Power: Refers to the ability of a firm to influence market level of prices
- Greater market (negotiation) power enables an enterprise to:
- Charge customer prices above the existing competitive level: Example: reduce supplier power
- Both above
Unrelated Diversification: How to achieve Market Power
- Scale (size), which leads to:
Increased bargaining power over customers OR suppliers - Vertical diversification/integration
Backward (production of own inputs)
Forward (capture of distribution)
See slide 42
Unrelated Diversification: Constructive Corporate Parenting
Constructive Corporate Parenting (Aka, “Financial Economies”)
- Providing efficient and effective managements practices and strategies
- Efficient capital allocation/portfolio management
- Restructuring
Portfolio Management:
- 3 key aspects to portfolio management:
Assess competitive position of each business
Suggest strategic alternatives for each business
Allocate resources across the business - Key purpose:
Achieve a balanced portfolio of business
That is, business whose profitability, growth, and cash flow complement each other
Assets Restructuring
- Sale of unproductive assets or business units
- Acquisitions to strengthen core business
Capital Restructuring
- Parent may have access to cheaper
Management restructuring
- Change business unit management teams
- Tighten financial controls and reward systems for business unit
Value Reducing Diversification
- Senior executives may pursue diversification out of self interest
Compensation is positively correlated with the size of the firm
More prestige associated with larger firms
Unrelated diversification may reduce risk, and therefore, employment risk - Good corporate governance may limit management tendencies to over diversify
Board of directors, monitoring by shareholders, executives compensation, etc
How to diversify:
- Build : Organic growth, “DIY” (do it yourself)
- Borrow:
Outsource capabilities through contracts
Partnerships (strategic alliances) - Buy: Mergers & Acquisitions
See slide 52
Summary: Corporate-Level Strategy
Two key questions:
1. The “Better Off” Test:
Are the parent and business unit better off together or apart?
2. How do we use diversification as a force for value creation (and not value destruction)?
