Corporate Diversification

Chapter 7: Corporate Diversification

Corporate Diversification Overview

• Definition: A corporate diversification strategy involves a firm operating in multiple industries or geographic markets simultaneously.

• Types of Corporate Diversification:

  • Product Diversification: Firm operates in various industries.

  • Geographic Market Diversification: Firm operates in several geographic regions.

  • Product-Market Diversification: Firm engages in both product and geographic diversification.

• Prevalence: Most large firms are diversified, competing in multiple industry/product markets or geographic areas.

Types of Corporate Diversification

1. Limited Corporate Diversification:

   • Most activities fall within a single industry and geographic market.

   • Sub-types:

     • Single-Business Firms: 95% of sales from a single product market (e.g., WD-40).

     • Dominant-Business Firms: 70-95% of sales from a single product market (e.g., Domino’s Pizza).

2. Related Corporate Diversification:

   • Less than 70% of revenues from a single product market with linked businesses.

   • Sub-types:

     • Related-Constrained (e.g., Coca-Cola, Apple): Businesses share significant resources (production technologies, distribution channels).

     • Related-Linked (e.g., Disney): Limited sharing of resources among businesses.

3. Unrelated Corporate Diversification:

   • Businesses have few or no common attributes (e.g., General Electric, Siemens, Berkshire Hathaway).

Value of Corporate Diversification

• Main Source of Value: Economies of scope - value increases because the firm operates in multiple businesses.

• Economies of Scope Can create value by:

  • Reducing costs.

  • Increasing revenues.

• Types:

  1. Operational Economies of Scope.

  2. Financial Economies of Scope.

  3. Anticompetitive Economies of Scope.

Operational Economies of Scope

• Shared Activities: Different businesses share value chain activities to reduce costs.

  • Examples of Shared Activities:

  • Input activities: Purchasing.

  • Production activities: Assembly facilities.

  • Warehousing: Distribution activities.

  • Sales and marketing: Advertising efforts.

  • After-sales support: Dealer services.

• Benefits:

  • Lower costs through shared activities.

  • Higher revenues via product bundling.

• Limits:

  • Organizational challenges and restrictions on meeting customer needs.

  • Reputation issues can affect interconnected businesses.

• Shared Core Competencies:

  • Focus on intangible resources like managerial and technical knowledge.

  • Core competencies link different businesses and are developed over time.

  • Example: 3M’s shared R&D efforts in substrates and adhesives.

• Limits of Core Competencies:

  • Challenges in organization and the risk of misidentified competencies.

• Multipoint Competition: When companies compete across multiple markets, leading to less aggressive competition in individual markets through mutual forbearance.

  • Example: Airline industry dynamics.

• Market Power: Profitability from one business can subsidize operations in another industry, leading to predatory pricing strategies.

• Example: Microsoft and Xbox.

Realizing Scope Economies

• Most scope economies cannot be captured directly by equity holders since shareholders can't coordinate across businesses.

  • Only risk reduction can be realized effectively by shareholders.

• Unrelated diversification mainly offers limited benefits compared to related diversification.

• Easier/Lower Cost to Duplicate:

  • Shared activities.

  • Risk reduction.

  • Tax advantages.

• Difficult/Costly to Duplicate:

  • Core competencies, internal capital allocation, multipoint competition, and market power require substantial coordination and capabilities.

• Corporate diversification encompasses a variety of strategies aimed at enhancing firm value through careful management of assets across different markets and resources. Related diversifiers generally perform better than unrelated diversifiers in terms of financial outcomes and strategic flexibility.