I wrote about this last week and got quite a few emails asking questions about this topic so I’ll expand on it a bit more here. What motivates companies to diversify into new markets? This is a corporate strategy decision. Let’s assume that diversification strategies are mainly driven by the a common strategic rational of exploiting interrelations between products/services/capabilities/markets. This would imply that two “interrelated” market segments would exhibit a higher probability to be simultaneously captured by a firm than two “untied” ones. These interrelations cannot be defined but with reference to the direction in the product space along which such link is measured: e.g. two products can exhibit a strong link on the bases of their functionality and a weak link on the bases of their design attributes. Take Toyota personal transport system as an example. Or what if Apple get into the energy drinks business? Or Lego getting into the building construction business (photos underneath)?
In this case, in the presence of product market segmentations based on functional attributes, the two products will belong to strongly interrelated market segments; while in the presence of product market segmentation based on design attributes, the two products will belong to weakly interrelated market segments. Being as much potential links between segments as the number of different directions in the space of product market characteristics, we compare different product market attributes, at different levels of aggregation, in order to estimate which one enables firms to realize the maximum value of synergy exploitation.
But what about diversification that do not provide synergistic opportunities but rather hedging the companies particularly they are the top-end of the S curve? Who is more efficient in innovation, the diversified or less diversified firms? These are more complicated questions. And what’s the motivation for corporations? Here are the most common motivations:
- the most legitimate reasons is to mitigate the effects of declining size or margin or slow down in existing business,
- the other is to smooth out cyclical swings in business cycles, that is, to reduce risk if market conditions change.
- to capitalize on distinctive innovation that creates a new growth path and the financial markers see positively about these growth plans.
- to build a balanced portfolio of businesses, using current 'cash generators' to finance 'cash takers' with potential for future performance.
- to achieve sufficient size so as to have efficient access to capital markets.
to satisfy management’s ego
Large diversified corporations have been widely criticized as being inefficient innovators with an orientation to maximizing short-term profits. Empirical research finds no statistically discernible effect of diversification on innovative efficiency. This is consistent with the argument that diversified organizations are rationally designed to minimize incentive and communication problems which may hinder their innovative efforts. In support of this argument, diversified firms are more likely to have separate research and development centers, which can be administered by people whose compensation is tailored to maximize innovation and supported by a more flexible structure.
Caterpillar Tractor Company’s entry into the field of diesel engines is a case of internal diversification. Since 72, the company poured more than $1 billion into developing new diesel engines “in what must rank as one of the largest internal diversifications by a US corp.” Hershey Foods ventured into the restaurant business by buying the Friendly Ice Cream Corporation, illustrating diversification by acquisition. Hershey adopted the diversification strategy for growth because its traditional business, chocolate and candy, was stagnant because of a decline in candy consumption, sharp increases in cocoa prices, and changes in customer habits. Hershey subsequently sold to a private company. Amazon’s move to selling computing power like a utility company sells electricity.
Such efforts could represent new growth areas and smart diversification moves for these companies. Or they could prove to be costly distractions. The big question: Should a company stay focused on the core competencies and competitive advantages that made it great, or should it diversify to keep up with, or attempt to surpass, its peers? What kinds of expansions are synergistic with the core business, and which are just distractions?
Here’s a case in point. Last week Former Intel CEO Andy Grove has joined other Silicon Valley elites advocating for an industry shift into energy technology. In an interview with The Wall Street Journal, Grove said he is urging Intel to invest in battery manufacturing as a way to diversify from its core chip business. Grove told the Journal that Intel's "strategic objective is tackling big problems and turning them into big businesses." He said Intel, with its cash resources, could invest in battery technology and manufacturing to bring down the cost of car batteries, which would drive adoption of plug-in electric cars.
Batteries are the most expensive component (and the bottle neck in performance) in plug-in electric vehicles, a market being pursued by a few U.S. companies. Mass adoption won’t happen unless someone can drive down the cost of manufacturing. So we are talking about massive R&D and building big manufacturing facilities, very similar to the chipset business.
Intel has invested in battery technology through its venture capital arm and other energy-related firms. Earlier this year, Intel also spun out SpectraWatt, which intends to lower the cost of manufacturing solar cells. But the bigger question is will the board be convinced that Intel should get into the battery business big time and slowly disinvest in the chip business? Intel has been trying to align its strategy and roadmap tightly to its main core business and it is doing quite well in sustaining and increasing its market share in both microprocessor and chipset business. This can be evidenced when Intel decided to sell off its Xscale core processor business unit to Marvell back in 2006. No doubt, this is quite a good opportunity in view of current hybrid car battery technology is still in very premature stage and investing into it may potentially bring Intel to be the next leading technology provider and manufacturer in the field with its strong research and development support. Should Intel diversify into battery business? There are the three tests and no matter what kind of diversification a company seeks, the four essential tests of success are
- The Attractiveness Test The industries chosen for diversification must be structurally attractive or capable of being made attractive from an industry structure perspectives
- The Cost-of-Entry Test The cost of entry must not capitalize all future profits. What is the investment required in order to achieve meaningful presence.
- The Better-off Test The new business must either gain competitive advantage from its link with the corporation or vice versa. The new business must at some point benefit the parent company significantly.
- The Synergy Test The new business should create synergistic value with the current business and the two combined must have high valuation than as stand alone.
