Corporate Level Strategy & Diversification

Question 1

Diversification:

Answer 1

is the expansion of operations by entering new businesses or product lines

Question 2

Why might an investor want a CEO to diversify?

Answer 2

Value creation purposes

Question 3

Key ideas about diversification

Answer 3

• 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

Question 4

Reasons to diversify:

Answer 4

1. Value Creating: Achieve economic of scope, increase market power and achieve financial economies(good parenting)
2. Value-Neutral: Regulatory (antitrust, tax laws) and Low performance, risk reduction
3. Value-Reducing: Managerial self-interest

Question 5

Corporate-Level Strategy:

Answer 5

• 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?

Question 6

Good Parenting?

Answer 6

● 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

Question 7

Cost of Parental Ownership

Answer 7

● 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

Question 8

Key idea

Answer 8

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?

Question 9

The Value Creation Toolkit

Answer 9

• Sharing resources
• Market power
• Corporate parenting
• Portfolio management
• Restructuring

Question 10

Related diversification

Answer 10

Example:
LVMH
- Dior
- Fendi
- Sephora
- Louis Voution
- Moet & Chaandon
- Belmond
- Dom Perignon

Question 11

Related Diversification

Answer 11

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

Question 12

Quick summary: Related Diversification

Answer 12

● 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

Question 13

Unrelated Diversification: Dissimilar Business

Answer 13

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

Question 14

Related Diversification

Answer 14

• Sharing of resources and capabilities
• Increased market power

Question 15

Unrelated Diversification:

Answer 15

• Constructive corporate parenting

Question 16

Shared Resources and Capabilities: Examples

Answer 16

Research & Development
- Technical Expertise ‘Marketing
- Marketing
- Corporate Reputation
- Logistics (Inventory, shipping)
- Brand
- Design
- Online platform
- Manufacturing

Question 17

How sharing resources Creates Value: Part 1

Answer 17

● 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

Question 18

How sharing resources Creates Value: Part 2

Answer 18

● 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

Question 19

Related Diversification

Answer 19

The type of diversification affects value creation
Related Diversification:
- Sharing resources
- Increased market power

Question 20

Unrelated Diversification:

Answer 20

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

Question 21

Unrelated Diversification: How to achieve Market Power

Answer 21

• 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

Question 22

Unrelated Diversification: Constructive Corporate Parenting

Answer 22

Constructive Corporate Parenting (Aka, “Financial Economies”)
- Providing efficient and effective managements practices and strategies
- Efficient capital allocation/portfolio management
- Restructuring

Question 23

Portfolio Management:

Answer 23

• 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

Question 24

Assets Restructuring

Answer 24

• Sale of unproductive assets or business units
• Acquisitions to strengthen core business

Question 25

Capital Restructuring

Answer 25

• Parent may have access to cheaper

Question 26

Management restructuring

Answer 26

• Change business unit management teams
• Tighten financial controls and reward systems for business unit

Question 27

Value Reducing Diversification

Answer 27

• 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

Question 28

How to diversify:

Answer 28

• Build : Organic growth, “DIY” (do it yourself)
• Borrow:
  Outsource capabilities through contracts
  Partnerships (strategic alliances)
• Buy: Mergers & Acquisitions
  See slide 52

Question 29

Summary: Corporate-Level Strategy

Answer 29

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)?