Most companies have their business roots in a single industry. Even though they may have since diversified into other industries, a substantial part of their revenues and profits still usually comes from the original or core business. Diversification becomes an attractive strategy when a company runs out of profitable growth opportunities in its original business. The purpose of diversification is to build shareholder value.
Diversification builds shareholder value when a diversified group of businesses can perform better under the auspices of a single corporate parent than they would as independent, stand-alone businesses—the goal is to achieve not just a 1 _ 1 _ 2 result but to realize important 1 _ 1 _ 3 performance benefits. Whether getting into a new business has potential to enhance shareholder value hinges on whether a company's entry into that business can pass the attractiveness test, the cost-of-entry test, and the better-off test.
Entry into new businesses can take any of three forms: acquisition, internal startup, or joint venture or strategic partnership. Each has its pros and cons, but acquisition is the most frequently used; internal start-up takes the longest to produce home-run results, and joint venture or strategic partnership, though used second most frequently, is the least durable.
There are two fundamental approaches to diversification—into related businesses and into unrelated businesses. The rationale for related diversification is strategic: diversify into businesses with strategic fits along their respective value chains, capitalize on strategic-fit relationships to gain competitive advantage, and then use competitive advantage to achieve the desired 1 _ 1 _ 3 impact on shareholder value. Businesses have strategic fit when their value chains offer potential (1) for realizing economies of scope or cost-saving efficiencies associated with sharing technology, facilities, functional activities, distribution outlets, or brand names; (2) for facilitating competitively valuable cross-business transfers of technology, skills, know-how, or other resource capabilities; (3) for leveraging use of a well-known and trusted brand name; and (4) for engaging in competitively valuable cross-business collaboration to build new or stronger resource strengths and competitive capabilities.
The basic premise of unrelated diversification is that any business that has good profit prospects and can be acquired on good financial terms is a good business to diversify into. Unrelated diversification strategies surrender the competitive advantage potential of strategic fit in return for such advantages as (1) spreading business risk over a variety of industries and (2) providing opportunities for financial gain (if candidate acquisitions have undervalued assets, are bargain-priced and have good upside potential given the right management, or need the backing of a financially strong parent to capitalize on attractive opportunities). In theory, unrelated diversification also offers greater earnings stability over the business cycle (a third advantage), but this advantage is very hard to realize in actual practice. The greater the number of businesses a conglomerate is in and the more diverse these businesses are, the harder it is for corporate executives to select capable managers to run each business, know when the major strategic proposals of business units are sound, or decide on a wise course of recovery when a business unit stumbles. Unless corporate managers are exceptionally shrewd and talented, unrelated diversification is a dubious and unreliable approach to building shareholder value when compared to related diversification. Analyzing how good a company's diversification strategy involves a six-step process:
Step 1: Evaluate the long-term attractiveness of the industries into which the firmhas diversified. Industry attractiveness needs to be evaluated from three angles: the attractiveness of each industry on its own, the attractiveness of each industry relative to the others, and the attractiveness of all the industries as a group. Quantitative measures of industry attractiveness tell a valuable story about how and why some of the industries a company has diversified into are more attractive than others. The two hardest parts of calculating industry attractiveness scores are deciding on appropriate weights for the industry attractiveness measures and knowing enough about each industry to assign accurate and objective ratings.
Step 2: Evaluate the relative competitive strength of each of the company's businessunits. Again, quantitative ratings of competitive strength are preferable to subjective judgments. The purpose of rating the competitive strength of each business is to gain clear understanding of which businesses are strong contenders in their industries, which are weak contenders, and the underlying reasons for their strength or weakness. The conclusions about industry attractiveness can be joined with the conclusions about competitive strength by drawing an industry attractiveness-competitive strength matrix displaying the positions of each business on a nine-cell grid. The attractiveness-strength matrix helps identify the prospects of each business and what priority each business should be given in allocating corporate resources and investment capital.
Step 3: Check for cross-business strategic fits.A business is more attractive strategically when it has value chain relationships with sister business units that present opportunities to transfer skills or technology, reduce overall costs, share facilities, or share a common brand name—any of which can represent a significant avenue for producing competitive advantage beyond what any one business can achieve on its own. The more businesses with competitively valuable strategic fits, the greater a diversified company's potential for achieving economies of scope, enhancing the competitive capabilities of particular business units, and/or strengthening the competitiveness of its product and business lineup, thereby realizing a combined performance greater than the units could achieve operating independently.
Step 4: Check whether the firm's resource strengths fit the resource requirements ofits present business lineup. Resource fit exists when (1) businesses add to a company's resource strengths, either financially or strategically; (2) a company has the resources to adequately support the resource requirements of its businesses as a group without spreading itself too thin; and (3) there are close matches between a company's resources and industry key success factors. One important test of resource fit concerns whether the company's business lineup is well matched to its financial resources. Assessing the cash requirements of different businesses in a diversified company's portfolio and determining which are cash hogs and which are cash cows highlights opportunities for shifting corporate financial resources between business subsidiaries to optimize the performance of the whole corporate portfolio, explains why priorities for corporate resource allocation can differ from business to business, and provides good rationalizations for both invest-and expand strategies and divestiture.
Step 5: Rank the performance prospects of the businesses from best to worst and determinewhat the corporate parent's priority should be in allocating resources toits various businesses. The most important considerations in judging business-unit performance are sales growth, profit growth, contribution to company earnings, and the return on capital invested in the business. Sometimes, cash flow generation is a big consideration. Normally, strong business units in attractive industries have significantly better performance prospects than weak businesses or businesses in unattractive industries. Information on each business's past performance can be gleaned from a company's financial records. While past performance is not necessarily a good predictor of future performance, it does signal which businesses have been strong performers and which have been weak performers. The industry attractiveness-competitive strength evaluations provide a basis for judging future prospects. Normally, strong business units in attractive industries have significantly better prospects than weak businesses in unattractive industries. And, normally, the revenue and earnings outlook for businesses in fast-growing industries is better than for businesses in slow-growing industries. The rankings of future performance generally determine what a business unit's priority for resource allocation by the corporate parent should be. Business subsidiaries with the brightest profit and growth prospects and solid strategic and resource fits generally should head the list for corporate resource support.
Step 6: Craft new strategic moves to improve overall corporate performance. This step entails using the results of the preceding analysis as the basis for devising actions to strengthen existing businesses, make new acquisitions, divest weak-performing and unattractive businesses, restructure the company's business lineup, expand the scope of the company's geographic reach multinationally or globally, and otherwise steer corporate resources into the areas of greatest opportunity. Once a company has diversified, corporate management's task is to manage the collection of businesses for maximum long-term performance. There are four different strategic paths for improving a diversified company's performance: (1) broadening the firm's business base by diversifying into additional businesses, (2) retrenching to a narrower diversification base by divesting some of its present businesses, (3) corporate restructuring, and (4) multinational diversification.
Broadening the diversification base is attractive when growth is sluggish and the company needs the revenue and profit boost of a newly acquired business, when it has resources and capabilities that are eminently transferable to related or complementary businesses, or when the opportunity to acquire an attractive company unexpectedly lands on its doorstep. Furthermore, there are occasions when a diversified company makes new acquisitions to complement and strengthen the market position and competitive capabilities of one or more of its present businesses.
Retrenching to a narrower diversification base is usually undertaken when corporate management concludes that the firm's diversification efforts have ranged too far a field and that the best avenue for improving long-term performance is to concentrate on building strong positions in a smaller number of businesses. Retrenchment is usually accomplished by divesting businesses that are no longer deemed suitable for the company to be in. A business can become a prime candidate for divestiture because market conditions in a once attractive industry have badly deteriorated, because it lacks adequate strategic or resource fit, because it is a cash hog with questionable long-term potential, or because it is weakly positioned in its industry with little prospect for earning a decent return on investment. Sometimes a company acquires businesses that just do not work out as expected even though management has tried all it can think of to make them profitable. Divesting such businesses frees resources that can be used to reduce debt, to support expansion of the remaining businesses, or to make acquisitions that materially strengthen the company's competitive position in one or more of the remaining core businesses. Most of the time, companies divest businesses by selling them to another company, but sometimes they spin them off as financially and managerially independent enterprises in which the parent company may or may not retain an ownership interest.
Corporate restructuring strategies involve divesting some businesses and acquiring new businesses so as to put a whole new face on the company's business makeup. Performing radical surgery on the group of businesses a company is in becomes an appealing strategy alternative when a diversified company's financial performance is being squeezed or eroded by (1) too many businesses in slow-growth or declining or low-margin or otherwise unattractive industries, (2) too many competitively weak businesses, (3) ongoing declines in the market shares of one or more major business units that are falling prey to more market-savvy competitors, (4) an excessive debt burden with interest costs that eat deeply into profitability, or (5) ill-chosen acquisitions that haven't lived up to expectations.
Multinational diversification strategies feature a diversity of businesses and a diversity of national markets. Despite the complexity of having to devise and manage so many strategies (at least one for each industry, with as many variations for country markets as may be needed), multinational diversification strategies have considerable appeal. They offer two avenues for long-term growth in revenues and profitability— one is to grow by entering additional businesses, and the other is to grow by extending the operations of existing businesses into additional country markets. Moreover, multinational diversification offers six ways to build competitive advantage: (1) full capture of economies of scale and experience- or learning-curve effects, (2) opportunities to capitalize on cross-business economies of scope, (3) opportunity to transfer competitively valuable resources from one business to another and from one country to another, (4) ability to leverage use of a well-known and competitively powerful brand name, (5) ability to capitalize on opportunities for cross-business and cross-country collaboration and strategic coordination, and (6) opportunities to use cross-business or cross-country subsidization to wrest sales and market share from rivals. A strategy of multinational diversification contains more competitive advantage potential than any other diversification strategy.
