Firms using diversification strategies enter entirely new industries. While vertical integration involves a firm moving into a new part of a value chain that it is already in, diversification requires moving into new value chains. Many firms accomplish this through a merger or an acquisition, while others expand into new industries without the involvement of another firm.
Three Tests for Diversification
A proposed diversification move should pass these three tests or it should be rejected.
- Attractiveness Test – How attractive is the industry that a firm is considering entering? Unless the industry has strong profit potential, entering it may be very risky.
- Cost-of-Entry Test – How much will it cost to enter the industry? Executives need to be sure that their firm can recoup the expenses that it absorbs in order to diversify.
- Better Off Test – Will the new unit and the firm be better off? Unless one side or the other gains a competitive advantage, diversification should be avoided.
Because it leverages strategic fit, companies that engage in related diversification are more likely to achieve gains in shareholder value. Related diversification occurs when a firm moves into a new industry that has important similarities with the firm’s existing industry or industries. Because films and television are both aspects of entertainment, Disney’s purchase of ABC is an example of related diversification. Some firms that engage in related diversification aim to develop and exploit a core competency to become more successful. A core competency is a skill set that is difficult for competitors to imitate, can be leveraged in different businesses, and contributes to the benefits enjoyed by customers within each business. For example, Newell Rubbermaid is skilled at identifying underperforming brands and integrating them into their three business groups: (1) home and family, (2) office products, and (3) tools, hardware, and commercial products.
Example 7.7 Related Diversification
In February 2019, Spotify announced it had acquired two companies, Gimlet Media Inc. and Anchor. The move allows Spotify to add the capability to produce and publish podcasts. This action allows Spotify to strengthen its existing role as a music provider by adding podcasting options. Gimlet Media Inc. was founded in 2014 and has become home to numerous award-winning podcasts including Reply All, StartUp, and Crimetown. Anchor claims that a third of all podcasts are created using its platform.
Source: WERSM, Spotify Goes ‘All In’ Οn Podcasts With Its Latest Acquisitions, Anak Agung Kompiyang Ratih Maldini, 2019Wi
Sometimes the benefits of related diversification that executives hope to enjoy are never achieved. For example, both soft drinks and cigarettes are products that consumers do not need. Companies must convince consumers to buy these products through marketing activities such as branding and advertising. Thus, on the surface, the acquisition of 7Up by Philip Morris seemed to offer the potential for Philip Morris to take its existing marketing skills and apply them within a new industry. Unfortunately, the possible benefits to 7Up never materialized.
Why would a soft-drink company buy a movie studio? It’s hard to imagine the logic behind such a move, but Coca-Cola did just this when it purchased Columbia Pictures in 1982 for $750 million. This is a good example of unrelated diversification, which occurs when a firm enters an industry that lacks any important similarities with the firm’s existing industry or industries. Luckily for Coca-Cola, its investment paid off—Columbia was sold to Sony for $3.4 billion just seven years later.
Example 7.8 Unrelated Diversification
General Electronic operates in many different market segments, including oil and gas, healthcare, transportation, aviation, power and water, energy management, appliances and lighting, GE capital. GE is a good example of unrelated diversification. In the story, which follows a months-long series of disappointing earnings, markets voiced their approval with the stock’s best trading day since March 2009. The company’s poor performance in its power business (revenues have fallen 25% in the past year) were offset by profits in aviation, health care, and oil and gas. Meanwhile, the company was helped by GE Capital’s divesting of $15B in assets and paying down another $21B in debt. The story is not fully told yet, but these mixed results suggest one reason for unrelated diversification where strong performance in one division can compensate for weak performance in an unrelated market.
Source: CNBC, GE shares surge 11%, the most in 9 years, after a better-than-feared quarter, Zehui Si, 2019Wi
Most unrelated diversification efforts, however, do not have happy endings. Harley-Davidson, for example, once tried to sell Harley-branded bottled water. Starbucks tried to diversify into offering Starbucks-branded furniture. Both efforts were disasters. Although Harley-Davidson and Starbucks both enjoy iconic brands, these strategic resources simply did not transfer effectively to the bottled water and furniture businesses.