Success Criteria within Corporate Diversification - a Resource-Based View

Cand.Merc in Finance & Strategic Management Master Thesis - deadline 19/2-2014 181.387 anslag / 79,73 normal-sider © Rasmus T. Tobiasen Vejleder: Nicolai J. Foss

Executive Summary ............................................................................................................. 3 1. - Introduction ................................................................................................................... 4 1.1 - Research question ...................................................................................................... 5 1.2 - Methodology.............................................................................................................. 5 1.3 - Research design ....................................................................................................... 10 1.4 - Definitions ............................................................................................................... 11 1.5 - Scholarly reflections................................................................................................. 13 2. - Literature Review ........................................................................................................ 14 2.1 - Strategic Management .............................................................................................. 14 2.2 - Organizational Theories ........................................................................................... 19 2.3 - Resource-Based View .............................................................................................. 22 2.4 - Corporate Finance .................................................................................................... 27 2.5 - Summary ................................................................................................................. 32 3. - Possible reasons for inconsistencies............................................................................. 35 3.1 - Relatedness .............................................................................................................. 35 3.2 - Success measurement ............................................................................................... 37 3.3 - Geographic origin .................................................................................................... 38 3.4 - Summary ................................................................................................................. 39 4. - Success criteria of corporate diversification ............................................................... 41 4.1 - Relatedness .............................................................................................................. 42 4.2 - Risk reduction .......................................................................................................... 44 4.3 - Market conditions .................................................................................................... 45 4.4 - Enabling resources & capabilities ............................................................................. 46 4.5 - Summary ................................................................................................................. 49 5. - Case studies .................................................................................................................. 51 5.1 - A. P. Moller-Maersk ................................................................................................ 52 5.2 - NKT......................................................................................................................... 54 5.3 - SEAS-NVE .............................................................................................................. 56 5.4 - Siemens ................................................................................................................... 57

Page 1

6. - Empirical analysis ........................................................................................................ 60 6.1 - Relatedness .............................................................................................................. 60 6.2 - Risk Factors ............................................................................................................. 62 6.3 - PLC-stages............................................................................................................... 64 6.4 - Enabling resources & capabilities ............................................................................. 67 6.5 - Summary ................................................................................................................. 70 7. - Criteria evaluation and refinement ............................................................................. 72 7.1 - Enabling resources & capabilities ............................................................................. 72 7.2 - Success Criteria........................................................................................................ 74 8. - Conclusion .................................................................................................................... 77 9. - Appendix ...................................................................................................................... 80 9.1 - PLC-stage characteristics ......................................................................................... 80 9.2 - Interviews ................................................................................................................ 81 9.3 - Questionnaire ........................................................................................................... 82 9.4 - Matching of advantages/disadvantages and success criteria ...................................... 86 10. - References .................................................................................................................. 87

Page 2

Executive Summary

The purpose of this thesis was to investigate the role of moderating conditions in the diversification-performance relationship, and on these grounds develop a model that would help companies considering corporate diversification increase their likelihood of success. Through a comprehensive review of the key contributions on the topic of corporate diversification, it was established that the diversification-performance relationship is indeed influenced by multiple independent variables at the same time (multiple causality), thereby enabling a search into the role of these moderating conditions. Over the past decades, scholars have taken turns in proposing advantages, disadvantages and pitfalls of corporate diversification, while reaching widespread conclusions on its impact on performance. I conducted a brief investigation into the possible causes for these inconsistencies, and found that, besides the multiple causality causing spuriousness in many analysis, 1.) relatedness measured through SIC-codes, 2.) endogeneity of the diversification-discount, and 3.) the geographic concentration of US-based analysis were likely to be biasing the results. Thereby, my research into the moderating conditions would attempt to develop criteria that could maximize the utilization of the advantages while minimizing the effects of the disadvantages meanwhile also accounting for the pitfalls of corporate diversification and adjust for the biasing effects in the literature. This resulted in the development of seven hypothetical success criteria for corporate diversification, with three `success criteria´ concerning the diversification target, and four `enabling resources & capabilities´ that should be present in the organization prior to the expansion. An empirical analysis and adjacent refinement of the criteria later reduced and modified the original proposition slightly into the final model, suggesting that: A company in possession of the `enabling resources & capabilities´ of strong managerial & marketing capabilities, sufficient capital and strong governance structures may consider diversifying into an industry where the critical success factors match the core competencies of the organization. Meanwhile this new industry must be at PLC-stage `Introduction´ or `Growth´, whilst exposing the company to as uncorrelated/negatively correlated risk factors to its existing ones as possible.

Page 3

1. - Introduction

Since the early contributions of Ansoff (1958) and Penrose (1959) corporate diversification, and especially its influence on performance, have attracted considerable attention in empirical research (Pehrsson; 2006 b). For long periods of time it was considered a sensible riskspreading growth strategy, which resulted in the conglomerate waves in the 1960’s and 1970’s (Martin et al. (2003), Servaes (1996)). Disappointing performances from many of these large and extensively diversified corporations, attracted the attention of scholars to initiate further research. This lead Rumelt (1974) to make the clear distinction, that related diversification is superior to unrelated diversification, which have more or less constituted the only achievable consensus on the topic ever since (Markides et al. (1994), Pehrsson (2006 b)). The following decades of diversification research have been characterized by an inability to agree upon an overall research framework, which consequently means that the results are not very complementary or affirmative. These very inconsistent results, along with the introduction of the Resource-Based View and an increasing acceptance of multiple causality and spuriousness in the diversification-performance relationship (Palich et al. (2000 b), Ramanujam et al. (1989)), facilitated an investigation into the moderation conditions affecting it. The purpose of this thesis therefore is to examine the influence of moderating conditions in the diversification-performance relationship, and based on this make a contribution towards developing a forward-looking tool for companies considering corporate diversification. In order to explore this issue, the empirical analysis will be carried out from a different timeperspective than most previous scholars, as I will attempt to analyze the presence or fulfillment of certain criteria at the time a company enters a new industry. The report is structured in eight chapters, with Chapter I introducing the reader to the topic and methodologies used. Chapter II will carry out an extensive literature review of the most significant contributions to the topic within the different schools of thought. Chapter III will attempt to clarify possible reasons for the inconsistencies in corporate diversification literature, as awareness of this may help avoiding likely pitfalls in setting up the research design. Chapter IV will combine the findings of chapter II and III into an analysis, with the intention of developing hypothetical criteria that could increase the likelihood of success through corporate diversification. Chapter V provides the reader with small qualitative case

Page 4

studies of four diversifying Danish companies, with chapter VI carrying out an empirical analysis of these case companies' fulfillment of the hypothetical success criteria at the time of their diversified expansion. Chapter VII will evaluate to what degree these findings correspond with the assumptions of the research design, and adjust the proposed hypothetical criteria accordingly. Finally the conclusion in Chapter VIII summarize all the findings of the thesis and provide recommendations for further research.

1.1 - Research question The objective of this thesis is to analyze and answer the following research question:

What is the role of moderating conditions in the diversification-performance relationship, and can these factors be used in making forward-looking recommendations for companies, which could increase the likelihood of success through corporate diversification?



What are the likely causes of the inconsistencies in diversification literature?



Knowing this, can a literature review provide some hypothetical success criteria?



Will empirical case studies on diversifying companies dismiss or refine these criteria?

1.2 - Methodology In the following section, I will present the methodological concepts and reflections that form the foundation of this thesis, and thus are largely influential on the final outcome. It will give the reader an insight into the data collection process, as well as revealing the assumptions necessary to carry out the analysis. A chapter of delimitations will help set the outer boundaries of the study and finally everything is summarized into the overall research design in chapter 1.3. It is important to keep in mind, that the topic of corporate diversification finds itself located in the middle ground between Strategic Management and Corporate Finance, which means that fairly diverse contributions will be included into the analysis, in an attempt to reach complementary conclusions.

Page 5

1.2.1 - Primary data Having established the overall research objective as the development of hypothetical success criteria for corporate diversification and assessing whether these may be applicable in a business environment, the next task is to create a data collection strategy. In order to conduct the latter part of the research objective, primary data becomes a necessity as there will be no secondary data available testing for the influence of these exact criteria, at the time of the expansion. Primary data will furthermore ensure the uniqueness of the analysis. The methods used in gathering and analyzing the primary data have been strongly inspired by the work of George and Bennett (2005), in an attempt to reduce selection bias and ensure some level of validity despite a low number of cases. In their case study methodology, the first step is to identify the `universe´ in which the case-objectives are present, in this case; companies located in Denmark that have had experience with diversifying into a distinctly different industry. Searching for companies to include in the `universe´ was done through newspapers, magazines, acquaintances and the internet, in the hope of including a diverse selection of companies. The geographic choice was partly motivated by convenience in travel distance, but was also a deliberate choice of a culture significantly different from USA, which has previously been the center of the majority of the publications on the topic - see section 3.3. The data collection process for the primary data will be done through qualitative interviews and questionnaires among companies in the above specified `universe´. To avoid influencing the case studies or the respondents’ answers, this will be done following a standardized questionnaire (see appendix 8.2) as advised by George & Bennett (2005). The actual case study will then be based on these interviews supported by secondary data. Selecting the cases to study as objectively as possible is also important, in order to minimize selection bias. Ideally the companies should be picked randomly among a large number of suitable cases. However, the total population of my `universe´ (that I became aware of) only amounted to 29 companies, of which only 7 were interested in participating. As it was never the intention to reach a statistically significant number of respondents, I decided that qualitative case studies of four of these companies would be sufficient to determine whether the hypothetical success criteria were likely to have been influential on their performance. Size measured through the number of employees, and a 50/50 proportion of firms with success/failure in diversification

Page 6

(as proposed by Ramanujam et al.; 1989) then became the final selection criteria, resulting in the companies; Siemens, SEAS-NVE, A. P. Moller-Maersk and NKT.

1.2.2 - Secondary data With the exception of the empirical analysis, this thesis will primarily be based on secondary data, which means that the data has been collected, analyzed and expressed by someone else. Consequently, these publications will inevitably be influenced by their author’s pursuit of a certain agenda, which raises the risk that some conclusions and opinions may have been emphasized over others. Awareness of this potential bias will in itself help minimize the problem, as important conclusions will not be based on single source contributions. This thesis will mainly rely on scientific articles from top management journals. Using renowned academic publications will help secure a certain level of academic integrity, since they have high selection requirements for new articles in order to maintain a high reputation. Since the quantity of literature on this topic is so extensive, selecting which articles to use became an important task. Here I chose mainly to focus on publications from the past 30 years, as seminal works prior to this is likely to have been quoted and refined in these articles. Within this time-frame, relevance to the key topics of the different sections of the report was the primary sorting tool, as well as adjusting for the possibly biasing effects. Finally articles that were repeatedly quoted as a source to a given issue were added, which resulted in a continuously growing list of relevant secondary data.

1.2.3 - Analytical methods The initial motivation for writing my thesis on this topic, were a profound skepticism towards the increasing consensus that corporate diversification is value-destructive. This induced a search for further knowledge on the topic, which gradually helped shape the research design. In deciding the overall research strategy, Ramanujam et al.’s (1989) diversification synthesis became a strong inspiration in their suggestions for future research, with statements such as; ”Specifically, we need to learn more about the motives for, and implementation of, diversification as a strategy and to evaluate specific diversification projects, if possible using project-specific success criteria in addition to broad assessments using firm performance

Page 7

measures” and ”Firms that are generally successful with their many diversification moves need to be identified and compared with firms whose diversification projects have been more often unsuccessful than successful”. The diversification-performance relationship is affected by multiple complementary variables simultaneously (multiple causality), which makes it difficult for large statistical surveys to reach useful results. With the Resource-Based View (RBV) enabling relatedness to be measured on entirely new scales, this lead me to believe in the existence of success criteria for corporate diversification based on moderating conditions. Since the scholarly literature about corporate diversification is already very extensive, I decided it should be possible to deduce the hypothetical success criteria from a comprehensive review of the existing literature. However, in order to reach useful results and not repeat previous scholars’ deluded paths, it was deemed necessary to supplement this analysis with a brief investigation of the possible causes of the very inconsistent conclusions on the topic. The next step then is to develop the research strategy, which is done by identifying the dependent and independent variables under investigation. Since the research objective is to analyze the applicability of hypothetical success criteria, these criteria are set as the independent variables. The comparative method applied is termed the `Indirect method of difference´, which is a modified variant of John Stuart Mill’s `Agreement/difference-method´ (George & Bennett; 2005). The `Indirect method of difference´ tests cases with a given outcome for independent variables, and then afterwards checks cases with the opposite outcome for a lack of these variables. Thereby a two-sided case study test will be conducted in this thesis, analyzing the influence of the hypothetical success criteria on the dependent variables: success or failure in corporate diversification. In order to determine the independent variables' influence on the outcome (the dependent variables), all case study analysis’ are analyzed at the time the company entered the new market.

1.2.4 - Assumptions The report will adopt the assumption of semi-efficient capital markets, which means that the CAPM model is deemed sufficiently accurate. As a result, it is accepted that the unsystematic risk of a given company can be diversified away equally well by the investor as by the company, as opposed to what has been claimed by some Strategic Management scholars. However, unlike the assumption of perfectly efficient capital markets, the semi-efficient

Page 8

capital markets also take into account the influence of bounded rational behavior among individuals, along with the fact that stock prices cannot reflect all available information at any given time.

1.2.5 - Delimitations In order to ensure the quality of the thesis' content, it is necessary to set the outer boundaries of the analysis in the form of delimitations. This means determining which peripherally relevant topics should not be analyzed in the report, as their contribution to the main topic is not sufficiently significant. As it is the case with most topics, corporate diversification can be viewed and evaluated from many different perspectives, such as the employee-perspective, the company-perspective or the industry-perspective among others. Depending on the perspective some conclusions may differ slightly, and it is therefore decided to adopt the company-perspective (stakeholder value maximization) throughout this Master thesis and not evaluate any other views. Although claimed to have influence on the ex post performance (Dierickx et al.; 1989), this report will not make a distinction to whether the `Diversification Mode´ (entry mode) has been through internal development or acquisition, nor will it make any inquiries into deciding if one is advantageous over the other in any way. This topic is deliberately suppressed because I feel convinced that it is very industry-specific whether internal development or acquisition is preferable. The research in this thesis have led me to believe that the domestic market of a diversifying company could be influential on the diversification-performance relationship. This will however not be analyzed in this thesis, as it is too extensive at this point. Finally, since the purpose of this thesis is to develop forward-looking success criteria, it will not attempt conclusions on any of the major issues within diversification.

Page 9

1.3 - Research design Based on these methodological decisions, the overall research design can be illustrated - see figure 1.1 below. The purpose of the research design is to ensure, that the collected data and implemented analysis’ enables us to answer the initial research question as unambiguously as possible. For this thesis, the research is initiated by noting pronounced inconsistencies in the diversification-performance literature, which justifies questioning the current consensus. However, in order to make this analysis more accurate and applicable, the next step is to investigate why previous research has been able to reach opposing conclusions on the same topic. The findings in this section can then be applied in conjunction with the literature review, in order to deduct hypothetical success criteria for corporate diversification, and finally these hypothetical success criteria are subject to an empirical analysis through qualitative case studies of Siemens, SEAS-NVE, A.P. Møller-Maersk and NKT.

Figure 1.1 - Research design

Page 10

1.4 - Definitions The following section will provide the reader with explanations as to how this thesis decides to interpret certain expressions or concepts that are important to its conclusions, but may be subject to scholarly debate about its actual meaning, significance and contextual relevance.

1.4.1 - SBU A Strategic Business Unit (SBU) is an entity within a larger corporation centered around a particular product category. The SBU may represent one or several products that share strategic similarities from an organizational point of view. Each SBU is often located in separate departments or even buildings, and will function a bit like an individual company within the corporation with their own strategies and some amount of autonomy.

1.4.2 - Agency problems When the beneficiary (principal) and the executioner (agent) of a given task is not the same person, there may be potential for conflicts of interest between the two, often referred to as the principal-agent problem. In a corporate diversification context, this conflict of interest is most evident in two scenarios. Initially it is found between the owners (principal) and the managers (agent) when the decision is made to expand operations into a new industry, since this could be motivated by the managers personal interests. After the expansion the principalagent problem may arise again between the new SBU and the corporation, as they may have different views and agendas. Throughout this report the term agency problems will therefore mainly refer to these two conflicts of interest, which are both best minimized through strong governance structures.

1.4.3 - Governance structures Governance structures is a term that expresses the many different tools and mechanisms in an organization, that are implemented to ensure that agent(s) acts in accordance with the principals best wishes. Every company is host to numerous potential principal-agent conflicts, but for the sake of simplicity this thesis has limited the number of preventive governance

Page 11

mechanisms to three of the ones most relevant in a corporate diversification context. The governance structures that are included are 1.) an independent board of directors ensuring that management acts in accordance with shareholder wishes, 2.) implementation programs ensuring that a new SBU feels like a valued member of the organization, and 3.) performancebased bonus-schemes for the management.

1.4.4 - Core Competencies Core competencies is a term that have been subject to much scholarly debate over the years, with particular disagreement about how unique and valuable a competence must be before it becomes `core´. This thesis will adopt the view, that core competencies in a corporation is its key value-generating strengths that distinguish them from competitors, and have been developed and refined over long periods of time through a combination of strong resources and capabilities. Furthermore, as proposed by Prahalad & Hamel (1990), the core competence should 1.) provide potential access to a wide variety of markets, 2.) make a significant contribution to the perceived customer value in the end-product, and 3.) be very difficult for competitors to imitate.

1.4.5 - Critical Success Factors The term critical success factors describe factors that are vital to achieving competitive advantage in a particular industry. These factors are different from industry to industry, and can vary in number depending on interpretation. This thesis will adopt a view, that each industry have 1-3 critical success factors that are absolutely vital for companies to fulfill to a satisfactory level, if they are to achieve success in this market.

1.4.6 - Causal ambiguity The term causal ambiguity refer to situations where the direct relation between an outcome and its cause(s) are not clear, particularly to outsiders, as it may have been affected by numerous influential factors in interaction with each other. Causal ambiguity is often used by RBV scholars when explaining a firm's competitive advantage, as they argue that competitors

Page 12

will have difficulties in copying it, when the causes are unclear and the advantage may be created from an entire system of activities.

1.5 - Scholarly reflections Overall I am quite pleased with the outcome and the proposed model that was developed in this Master thesis. It would have been interesting to see if the tendencies drawn from the empirical analysis would have been reinforced from a larger population, thereby lending more credit to the success criteria. This will have to be left for further research however, as it was not within the capacity of this thesis. Methodologically I would have liked to have used a more structured approach in finding and selecting the case companies. This was nonetheless made fairly difficult by the very few firms that were interested in participating. Here it also turned out that A. P Moller-Maersk was not well-suited for the empirical analysis, as their diversified expansion was run as a completely separate entity. By the time I realized the consequences of this however, it was too late to conduct interviews with a new case company. In hindsight it was also a mistake not to record the case-interviews on tape, as this could have provided more details, exact quotations and documentation of the interviews. Generally I believe, that the two-sided case study test using the `Indirect method of difference´ is a useful tool in analyzing the fulfillment of certain criteria within corporate diversification, and hope that future scholars might be inspired by my analytical design.

Page 13

2. - Literature Review

The following section will provide the reader with a review of the key contributions in the literature on the topic of corporate diversification. As it is such an extensively analyzed subject with many important aspects, it was decided to divide the articles into the overall categories of Strategic Management, Organizational Theories, Resource-Based View and Corporate Finance View. In this way it will be easier to keep an overview and to establish whether there are conflicting views between different schools of thought.

2.1 - Strategic Management In large parts of the strategic management literature on the topic of corporate diversification, scholars have repeatedly attempted to develop new theories and ways to define diversification and relatedness, rather than making complementary contributions. Most of the literature in this orientation support the view that the diversification should be related in one way or the other, but disagree how. In 1987 Michael E. Porter makes publish the article "From Competitive Advantage to Corporate Strategy", in which he analyzes what creates success within corporate diversification. He points out that all the competition takes place at the business unit level, and that the SBU’s cannot succeed if the overall corporate strategy does not add value to their operations. ”To understand how to formulate corporate strategy, it is necessary to specify the conditions under which diversification will truly create shareholder value”, P.4, line 54-57. The analysis identify three conditions that must be fulfilled in order to achieve success through corporate diversification. First the `Attractiveness test´ which determines that an industry chosen for diversification must be structurally attractive or capable of being made attractive. Second the `Cost-of-entry test´ which states that the cost of entry must not be so high that it absorbs all future profits, and finally the `Better-off test´ which emphasize that either the existing business unit(s) or the new one must gain competitive advantages by linking it to the corporation. The article also evaluates the relatedness part of diversification, and suggest that to harvest potential synergies, a company must be able to: 1.) transfer skills

Page 14

and expertise between the value chain activities of two similar SBU’s and 2.) share some activities (e.g. sales force or distribution network). Ramanujam et al. makes a synthesis of the existing literature in 1989 called "Research on Corporate Diversification: A Synthesis", which investigate different aspects within corporate diversification. The article states that the organizational structure and management can affect the firm's performance in implementing a diversification strategy, and that the outcome of the strategy may not occur until years or decades later. It is finally concluded that the diversification-performance relationship is a spurious one, influenced by multiple factors other than relatedness and therefore recommend future research to focus more on the process and contextual issues in diversification. In 1995 Campbell et al. makes an important contribution to the strategic management literature in form of the article “Corporate strategy: The quest for parenting advantage”, which focuses on a corporation’s choice of SBU’s to include in its business portfolio. It states, that a parent organization only can justify their diversification strategy if it creates value for the underlying SBU's, and that the company therefore must investigate how this should be done before implementing a diversification strategy. The article proposes a method of doing this, by `analyzing the fit´ between the parent organization and the potential diversification target. Here the corporation must first examine the `Critical Success Factors´ of the new industry and see to which degree the parent organization are in possession of or able to acquire these factors. Then the parent firm must identify areas in the acquisition target’s business where performance can be improved, as there will otherwise be little room for value generation. To evaluate the method, the article analyzes oil companies' diversification attempts into the minerals industry, which despite obvious relatedness in multiple factors were mainly unsuccessful. It concludes that every industry has several `Critical Success Factors´ that are vital to achieving competitive advantage, and that successful diversification thereby is a result of matching the capabilities of the parent organization to these. In his 1996 article “What is Strategy?”, Porter highlights the importance of distinguishing between operational effectiveness and strategy as two different entities, and emphasize that competition based solely on operational effectiveness will be mutually destructive for all parties involved, as the customers will capture all the benefits. In a successful strategic positioning companies must accept important trade-offs in order to avoid inconsistencies in

Page 15

the overall branding strategy. Sustainability in a given strategy is achieved by creating a whole (value) chain of activities that are mutually reinforcing, while supporting the overall strategic positioning. ”In fact, fit [among activities] is a far more central component of competitive advantage than most realize”, p. 12, line 73-74. ”When activities complement one another, rivals will get little benefit from imitation unless they successfully match the whole system”, p. 16, line 39-42. Due to this `causal ambiguity´ of the interlocked activities, it will be very difficult for rivals to determine exactly which factors generate the competitive advantage, thereby making it preferable for a competitor to find another strategic positioning rather than being the second or third imitator of an occupied position. In conclusion the article states that a firm’s core activities and strategic positioning should include a tailoring of the entire organization to the strategy, and that any pursuit of growth ought to look for extensions to leverage its current activity system. Teece et al. (1997) later provide research attempting to find common ground between the theories of Strategic Management, Agency Theory and RBV in the article "Dynamic Capabilities and Strategic Management". It establishes, that a company's success depends on its ability to find or create one or more competencies that are truly unique and distinctive. The article states that not all assets are tradable, and the ones that are usually are priced to reflect all their future value, which alienates the possibility of superior economic gains through purchasing valuable assets in the open markets. It then introduces the term dynamic capabilities, which covers the fact that truly valuable capabilities are developed and refined over long periods of time, and concludes that both vertical integration and diversification are ways of capturing rents on such scarce firm-specific assets and/or capabilities. In 1998 Susan Ross Perry publish her Ph.D. dissertation "A meta-analytic review of the diversification-performance relationship: aggregating findings in strategic management" which attempts to align and combine the vast amount of research on the diversificationperformance relationship, in order to draw overarching conclusions. The report provides information about the corporate structure in USA, which reveal that the board of directors in large American corporations rarely are very objective. Here the chairman of the board is often the CEO, with the other board members being part of the management or outsiders appointed by the CEO. From a European perspective, the board of directors ought to be a neutral governance mechanism, ensuring that the management of a company acts in accordance with

Page 16

shareholder wishes. The lack of this leaves plenty of room for agency problems to flourish, and could thereby have important performance implications. She also points out, that relatedness among non-strategic assets cannot provide the foundation for competitive advantage, as the benefits from these are mainly short-term. Instead the argument is provided, that a company’s capabilities in utilizing their valuable resources will provide the advantages over competitors, since their exact benefits - from an outsider’s perspective - will be causally ambiguous as they are influenced by numerous tangible and intangible assets. However, the report also maintain that competitors will eventually always catch up by finding ways to copy and/or substitute even the rarest of resources, which means that the competitive advantage is actually provided by the time-gap gained by the head-start on the competition. The dissertation concludes that performance should be considered at least two-dimensional (risk & return), that unrelated diversification has the highest risk-reducing effects, and confirms that the diversification-performance relationship is influenced by multiple moderating conditions. ”This might explain why, even after the combined moderator analysis between measurement of performance and industry effects, a substantial amount of unexplained variance remained. Apparently other unknown variables are acting to moderate the relationship between diversification strategies and returns” (Perry, 1998 - p.145, line 15-21). Farjoun's article "The independent and joint effects of the skill and physical bases of relatedness in diversification" (1998) proclaim that relatedness is multidimensional and attempts to develop a relatedness measure, using both SIC-codes and industry cluster analysis, based on the Occupational Employment Survey (OES). The article suggest, that physical resources are less suited for diversification, as they are often more product-specific and difficult to apply to other industries. Capabilities and other intangible assets are often more valuable if applied correctly, mainly based on their dynamic aspects. ”Human skills are not easy to identify. Individuals cannot always articulate what they know, and there is uncertainty about the new domains to which their knowledge can be successfully applied. Additionally, individuals are distinguished from physical resources by their ability to learn and improve their services, to transfer their knowledge from one domain to many others, and to combine resources in increasingly productive ways” (Farjoun, 1998 - p. 3, line 56-66). The article concludes, that previous studies measuring relatedness through a single base have only identified a subset of the potentially valuable relationships.

Page 17

Iversen publish his Ph.D. dissertation “Organization of synergies in large diversified firms - A corporate management perspective” in 1999, which mainly analyzes the optimal utilization of synergies between multiple SBU’s, and how this can be converted into sustainable competitive advantages. The report divides synergies of a diversified firm into two categories, asset-sharing synergies and synergies from complementary activities. He also supports the RBV view that resources must be hard and/or expensive to imitate or substitute in order to be truly valuable, and that these are accumulated and refined over long periods of time. It is established that the first-mover in obtaining a strategic asset should have used its head-start (time-gap) for further developments, which means that the competitor may invest large sums in catching up, only to realize he is still behind. Whilst asset sharing in itself may only lead to short-term performance improvements, achieving a fit between complementary activities could lead to sustainable competitive advantage, since rivals would have to successfully match the whole system to imitate this. In addition to having to copy a large number of complex activities, the advantages deriving from complementarities are protected by the uncertainty as to which specific activities that actually yields the advantages (causal ambiguity). In 2006 Swedish university professor Anders Pehrsson makes two adjacent contributions to the diversification literature in form of the papers "Business relatedness measurements - stateof-the-art and a proposal" and "Business relatedness and performance: a study of managerial perceptions". These articles investigate the issue of relatedness from both an empirical and a theoretical point of view, and end up proposing a new model to measure relatedness between two or more business units. In his analysis he finds support for the views that relatedness is a multidimensional construct, and that some degree of diversification is advantageous. It is proposed to divide the relatedness-attributes into the 5 main categories 1.) Product technology, 2.) Management skills, 3.) End customers, 4.) Brand recognition and 5.) Supply channel types - and it is concluded that SBU's with relatedness within product technologies outperform those with relatedness in consumer characteristics. Sebastian Knoll provides some further insight into the generation and utilization of valuable synergies in his Ph.D. dissertation "Cross-Business Synergies" in 2008. The report derives two new types of synergies, namely Growth Synergies - which represents the profitable growth advantages originating from complementary activities in multiple SBU's, and

Page 18

Corporate Management Synergies - which are the performance advantages gained by leveraging a company's strong managerial capabilities across multiple business units. It is emphasized, that cross-business synergies must be viewed as the difference between total synergy potential and the costs of achieving these synergies. He furthermore believes that the optimal realization of the potential synergies requires a selective strategic focus and organizational design fostering decentralized collaboration. The report also support the claim, that resources and capabilities founded on intangible assets are more suitable for diversification than their tangible counterparts. The report concludes, that synergies in a diversified firm are generated by asset-sharing and complementary activities, and stresses that an organizational structure which facilitate a combination of cross-divisional collaboration as well as a search for valuable growth synergy opportunities will be highly beneficial. In 2011 Purkayastha et al. attempts to evaluate possible differences in the diversificationperformance relationship between developed and emerging markets in the article “Diversification and Performance in Developed and Emerging Market Contexts: A Review of the Literature”. They find general support in favor of the views, that strategic assets must be rare and hard/expensive to imitate or substitute, that poor governance structures are often the cause of diversification failure, and that performance should be viewed as a two-dimensional construct in form of return and risk. More interestingly the analysis concludes, that the diversification-discount is significantly higher in developed economies, due to more efficient capital markets penalizing diversified firms, and that unrelated diversification is actually favorable in emerging markets, as this is not the case here.

2.2 - Organizational Theories Organizational theory was traditionally concerned with the optimal organization of labor and support functions needed to produce and sell a given product or service. Since then, the area became more complex with the introduction of transaction costs, rationality models and agency theory, and in recent years these topics along with other related areas have been unified under the overarching umbrella of the Theory of the Firm. In a diversification-context, this section of the Literature Review will therefore include just about anything that does not

Page 19

naturally belong in one of the other three categories, ranging from managerial capabilities over agency problems to stakeholder views and organizational structure. In 1982 Teece published his article “Towards an economic theory of the multiproduct firm”, in which he investigates why firms choose to diversify, and analyzes the advantages and disadvantages of doing so. The article lists some of the main reasons for corporate diversification as being, economies of scope, managerial discretion, taxes & regulations, capturing synergies, reducing the cost of debt, corporate growth and internal capital markets. It highlights the lower cost of debt, achieved through lower variance in cash flows, as one of the most valuable, along with synergies and economies of scope. It claims, that a company will usually consider diversification when it starts facing a saturated market in its current line of business, which results in unused assets in the form of excess capacity or cash. The dynamic aspects facing the firm are also briefly evaluated, with a particular emphasis on the continuous accumulation of tacit knowledge, as being valuable but hard to sell in the open markets. Wernerfelt & Montgomery examines industry attractiveness in their 1986 article “What is an attractive industry?”. They start by looking at the basic ideas behind Business Portfolio Planning (BPP), which sees strong performance as the outcome of matching business strengths and industry attractiveness, but generally assume independence between these two components. Most previous literature have seen the industry attractiveness as a combination of industry growth and profitability, but this article argue that these two measures may in fact have opposing effects on different types of firms. Furthermore it is suggested that a truly sustainable competitive advantage should be derived from multiple resources and activities complementing each other, which at the same time makes it much harder for rivals to imitate. In 1994 Cynthia A. Montgomery attempts to synthesize the different views on diversification in her article “Corporate Diversification”. She examines the three different views: 1.) The Market-Power View, 2.) The Agency View and 3.) The Resource View. The Market-Power view represents the view that a company should use the market-power gained through diversification to aggressively pursue competitive advantages. The Agency view on the other hand points to some of the disadvantages of corporate diversification, by assuming individuals to be opportunistic and in pursuit of their own self-interest. This view generally assumes managers profiting at the expense of shareholders, and that the managers prefer

Page 20

diversification because it will reduce their employment risk, enhance their reputation and compensation as the company grows (Empire Building), and increase the firm’s dependence of the manager’s particular capabilities (Managerial Entrenchment). Lastly the Resource view looks at companies as a bundle of resources and capabilities that have been acquired and/or developed and refined over time. This view claims diversification to be an outcome of excess resources in a company, for which market imperfections makes it difficult/impossible to trade them in the open markets. On this basis, researchers have claimed that companies with high levels of intangible assets are more likely to achieve success through corporate diversification, and that companies should invest in resources & capabilities that are applicable across multiple products. The article concludes, that different firms have different optimal levels of diversification, and the fact that many companies have diversified too much, in the wrong ways and for questionable reasons should not obscure the point, that the optimal level of diversification for most firms is unlikely to be zero. Denis, Denis & Sarin (1997) make a contribution to the diversification literature in form of the article ”Agency Problems, Equity Ownership, and Corporate Diversification”. Here the authors wish to analyze the influence of agency problems and equity ownership in relation to corporate diversification. They list the arguments of increased prestige and compensation, reduced employment risk and increased dependence of the manager as the main reasons why firms pursue diversification, but argue that part of the reason for the poor financial performances of diversifying firms may also be caused by an overpayment for the acquisition. The article claims, that managers will only reduce diversification if they are pressured to do so by internal or external governing mechanisms. The article concludes that it is unable to confirm the hypothesis that managers engage in diversification because of agency problems. In 1997 Campbell publish the article ”Reviewing Portfolio Strategy”, where he assess how and why a diversification strategy should be carried out. He argues, that due to the fact that a firm must usually pay an acquisition premium when purchasing another company, the acquiring firm must be able to create additional value compared to existing owners, as the diversification will otherwise generate a net loss. ”Only diversify into businesses that have critical success factors similar to your core business and limit your investments to businesses where you have a contribution to make that will more than pay for the premium it will cost you to get in”, p.3, line 25-29. The article also emphasizes the importance of leadership and

Page 21

organizational structure in managing a portfolio of diversified SBU’s, and claim that if the company attempts to make a common organizational structure and corporate culture over a very diverse selection of businesses, it may end up with a compromise culture that does not fully utilize any of the SBU’s potential. Often managers in diversified firms end up weakening the individual unit’s strengths through an overarching alignment of the SBU’s in a misguided attempt to achieve synergies. Palich et al. later (2000 b) publish the article ”The impact of internationalization on the diversification-performance relationship”, which is concerned with diversification in an international context. It supports the notion that related diversification is superior to unrelated diversification, but argue that the performance of diversifying firms is often diminished by difficulties in achieving the expected synergies, and the administrative costs of doing so outweighing the benefits. This article also claims, that a purely domestic firm will enjoy greater benefits of diversification, since the cultural similarities will naturally make the realization of synergies easier.

2.3 - Resource-Based View In 1984 an article by Birger Wernerfelt titled “A Resource-Based View of the Firm” was published in the Strategic Management Journal, which would change the way many strategic scholars analyzed companies, and lay the foundation for the new theory of the ResourceBased View (RBV). The theory builds on the ideas first proposed by Penrose (1959), which viewed a firm as a collection of resources that could be used in generating a competitive advantage. This inside-out perspective initially appeared in clear contrast to outside-in perspective of Porter’s Industrial Analysis Framework (IO-economics perspective) commonly used at the time, but scholars (Barney, 2001) have later claimed that the two views can be complementary of each other. In his 1984 article, Wernerfelt makes the point that the more rare and hard/expensive to imitate or substitute a given resource is, the more valuable it will be. In this sense, some very valuable resources will even serve as potential entry barriers and help keep new entrants out of the industry. Development of these valuable resources will furthermore represents a type of first-mover advantage, in the sense that later acquirers of this resource will diminish the

Page 22

potential economic gains from that resource in a demand-supply context, and hence make the investment to gain it less desirable. The article also proposes that in a M&A context, the RBV will offer potential benefits in evaluating the match between the firms. Here the theory will help determining whether the resources of an acquisition target are supplementary to the resources already in the buyers possession, and complementary which will enhance the value of the firms current resources and help in developing new ones. Dierickx & Cool (1989) make a contribution that is strongly linked to Barney’s 1986 article1, but propose some improvements to his ‘Strategic Factor Market’ concept, as well as developing a complementary framework based the same ideas. In the original concept, Barney assumes that all assets can be bought and sold in these ‘Strategic Factor Markets’, and that their price will reflect all the assets future benefits. Dierickx & Cool (1989) disagree slightly with this view, as they believe the really valuable assets cannot be bought in the open markets. They term these valuable assets ‘Strategic Asset Stocks’, and claim that they can only be developed through strong dedication over long periods of time. ”It takes a consistent pattern of resource flows (investment/effort) to accumulate a desired change in strategic asset stocks (fx. reputation or R&D knowledge)”. These ‘Strategic Asset Stocks’ must be: 1.) nontradable, 2.) nonimitable and 3.) nonsubstitutable in order to conform the foundation of a competitive advantage. The authors continuously emphasize the importance of the time aspect in the ‘Strategic Asset Stocks’ development (‘Time compression diseconomies’) and claim, that spending twice the time and half the money in R&D research, will usually give you better results than twice the money and half the time. The article concludes that the ‘causal ambiguity’ of ‘Strategic Asset Stocks’ working in complementarity will be very hard for rivals to imitate, and that this head start (‘Time-gap advantage’) - if used in continuous development - thereby can help achieve sustainability in the competitive advantage. Prahalad & Hamel (1990) takes a more pragmatic approach to investigating the link between resources and core competencies, by dedicating large parts of their article “The Core Competence of the Corporation” to analyzing the success of NEC, Honda and Canon. They propose that one of the causes of NEC’s success was that they viewed their corporation as a portfolio of competencies, and committed significant resources to pursuing ambitious goals for competence building. Corporate success is all about developing competencies that enables 1

”Strategic Factor Markets: Expectations, Luck and Business Strategy” - Management Science, Vol. 32 (1986)

Page 23

the businesses to adapt quickly to changing opportunities, which is often diminished by the strict concepts of Western companies. They also stray upon the dynamic aspects of competencies, in claiming that core competencies are continuously enhanced and improved as they are applied and shared. They recognize three distinct characteristics of a core competence; 1.) it provides potential access to a variety of markets, 2.) it makes a significant contribution to the perceived customer value in the end-product, and 3.) it must be very difficult for competitors to imitate. The article furthermore emphasizes the dangers of outsourcing, claiming that outsourcing will make the company loose competencies in this particular area, whilst the new producer will gain valuable expertise and perhaps market power. In this regard, Canon is said to have a 84% world manufacturing share in desktop laser printer ’engines’ achieved through their OEM supply to other printer manufacturers, while their end-product market share is insignificant. The article concludes, that employees should be considered key assets belonging to the entire corporation, and that competence sharing across organizational divisions is vital in the development and refinement of core competencies. In 1991 Chatterjee & Wernerfelt publish the article “The link between resources and type of diversification: theory and evidence”. Here they attempt to analyze whether some resources are more suitable for certain types of diversification. They acknowledge that financial resources are the ones with the greatest flexibility in their application, that physical and financial assets only can be used to the point where they are physically exhausted, and that intangible assets are the ones with the least potential to be sold in the open markets. The article also recognizes the advantages of the ‘internal capital markets’ in a diversified firm, and claim that external funds are rarely available for unrelated projects despite potential profitability. The article support the ‘spuriousness’-view of the diversification-performance relationship, and concludes that its success relies on the match between the diversification strategy and the resource profile of the firm. In her 1993 contribution “The Cornerstones of Competitive Advantage: a resource-based view” Margaret A. Peteraf develops a model based on the foundations of the RBV, predicting that fulfillment of certain criteria should help firms obtain a sustainable competitive advantage. The article support the views that diversification is often a result of excess resources with poor market demand, and that it will mainly be successful when these

Page 24

resources match the requirements in the new industry. The article concludes, that it is the strategic fit between internal resources & capabilities and the firm’s industrial environment that will result in above-normal returns, and that this competitive advantage is best sustained through the exploitation of the `time-gap advantage´. In the same year (1993) Amit & Schoemaker publish their article ”Strategic Assets and Organizational Rent”, which attempt to link the industry analysis framework, RBV, behavioral decision biases and organizational implementation issues. They argue, that an organization’s success depends on the match between its core competencies and the key success factors (KSF) of the industry, which ironically will not be KSF’s for long if too many firms in the industry gain a high fulfillment of them. Managers must therefore identify the current KSF’s of the industry and attempt to predict how these will change in the future. Based on this analysis, it can then be decided which existing and new `strategic assets´ are worth investing in. The article concludes that the `causal ambiguity´ and complexity of these `strategic assets´ is what makes them difficult to imitate, and if it was not for the presense of bounded rationality and market imperfections, all companies would pursue the optimal strategy resulting in a `zero-sum game´. In 1994 Markides & Williamson publish an interesting contribution to the debate, in form of the article “Related Diversification, Core Competencies and Corporate Performance”. In this paper they argue, that the inconsistent findings in the literature is a result of poor methods of measuring relatedness as well as a too narrow-minded view that all benefits of relatedness are generated through economies of scope. They argue that the valuable relatedness is found between strategic assets, and list 4 potential advantages of such relatedness termed: `Asset Amortization´, `Asset Improvement´, `Asset Creation´ and `Asset Fission´. These classifications cover benefits such as the sharing of a strategic asset (e.g. distribution system) between two SBU’s, how knowledge from one SBU may help improve a strategic asset in another, how experience from developing a strategic asset in one SBU means it can be developed faster and cheaper in another SBU, and how the development of new strategic assets may in fact help generate core competencies. The article claim, that a sustainable competitive advantage can only be maintained through continuous adaptation and improvement of its strategic assets to meet the ever-changing market conditions. First/early mover advantages is also acknowledged as being important in entering an industry, as

Page 25

established firms in the industry will have an advantage over new-comers. This can to some extent be compensated by diversifiers drawing on a more wide-spread competence pool, enabling them to imitate or develop new strategic assets faster and/or cheaper than other new entrants. A study of cross-business knowledge synergies by Tanriverdi & Venkatraman was published in 2005, which stated that relatedness among intangible resources (such as knowledge) is more valuable than relatedness among physical resources, and therefore ought to be the center of synergy research. It also claimed that relatedness among product knowledge, customer knowledge and management knowledge is a necessary condition for success in a multibusiness firm, but it is also vital that the three types of knowledge relatedness are complementary to each other. The synergies of diversification are generated through both economies of scope (sub-addictive costs) and complementarity of resource combinations (super-addictive value gains), and it is important to keep in mind that most companies are only able to convert a fraction of the potential relatedness between two SBU’s into actual performance-improving synergies. The authors also support the view that a system of complementary value-generating resources will be much more difficult for competitors to imitate, due to the `causal ambiguity´ of the relationship. The article analyzed and confirmed cross-business knowledge synergy as a cohesive and complex multi-dimensional strategy influenced by multiple factors simultaneously. In a more recent contribution, Andersén (2011) examine the complex relationship between a strategic resource and firm performance. The article claims, that it is not sufficient for a strategic resource to satisfy the VRIO-conditions (valuable, rare, imperfectly mobile and nonsubstitutable) to generate superior performance, and lists five additional criteria that may influence the relationship in a positive or negative way. The strategic asset must fit with the existing pool of resources (complementarity), the company must possess the managerial capabilities to utilize the value of the resource, and the company must possess marketing capabilities in order to position the product properly in the market. It is also important to keep in mind in the performance examination, that the rent generation may not be reflected in above-industry profits (as often measured), but may be appropriated by other stakeholders such as the salary of key employees. In conclusion the article propose, that these criteria may help managers explain why certain strategic assets are not generating superior returns, or why

Page 26

it is not beneficial to invest heavily in one area if the trade-off is a lack of investment in another important function.

2.4 - Corporate Finance Scholars within corporate finance have often expressed skepticism towards the benefits of corporate diversification, and empirical studies in this school of thought have reached and since amplified a consensus that the disadvantages of diversification outweigh the benefits, and a focused strategy therefore is preferable. In 1991 Lubatkin & Chatterjee publish their article “The strategy-shareholder value relationship: Testing temporal stability across market cycles”, where they examine the relationship between diversification and shareholder value over three different market cycles. The analysis measure shareholder value as a two-dimensional construct of 1.) systematic risk and 2.) excess return, which are both subject to investors’ ex ante perceptions of future uncertainties, and the company’s response to these. The cyclic effects of good or bad market cycles will have a significant influence on companies performance, thereby increasing the variations in the VAR(Rm). Since β [Beta] = COV(Ri,Rm)/ VAR(Rm), this implies that the Beta of any firm will change between market cycles due to variations in VAR(Rm) ceteris paribus, with the COV(Ri,Rm) representing the company returns’ response to market cycle events. Hence all firms are influenced by the same set of market risk factors, but their impact can be manipulated to some extent by the company’s exposure towards them. As this article assumes managers and shareholders to be risk-averse, and more so in bad times than good, the implication VAR(Rm)good > VAR(Rm)medium > VAR(Rm)bad becomes clear, and thus β good < β -medium < β-bad . Portfolio theory argue that unrelated diversification has a larger risk-reducing effect than its related counterpart. This article finds that related diversification is preferable since its benefits outweigh the risk-reducing effects of unrelated diversification. The article concludes that corporations can achieve a reduction in their systematic risk which stockholders cannot achieve on their own, mainly as a result of the diversified firm’s lower cost of capital. Davis & Duhaime make another contribution to the financial literature on diversification in 1992, called “Diversification, Vertical Integration, and Industry Analysis: new perspectives

Page 27

and measurement”. This article dedicate most of its attention to evaluating the usefulness and accuracy of different classification measures, such as COMPUSTAT II, SIC-codes, TRINET data, Entrophy index and SSIC-codes, and find each of them to suffer different disadvantages in their segment measurement. The accuracy of the COMPUSTAT II data is found to be deteriorated by a lack of consistency in the reporting done both by the companies and by the S&P personnel. The TRINET data on the other hand includes data on all `establishments´ employing more than 20 people, which results in large corporations often reporting 100+ `establishments´, including support functions such as cleaning and maintenance or pension and health insurance, which would thereby each be assigned a share of the firm’s turnover. The COMPUSTAT II database also report segment SIC classifications (SSIC), where companies and/or S&P personnel may cluster different SIC-activities into one primary and one secondary segment. Many assessments of activity relatedness such as the Entrophy index have defined unrelated segments as those dissimilar on the 2-digit SIC-level. Comparing such measures to the manually clustered SSIC reportings reveals some compelling flaws, particularly in regards to vertical relatedness. In this type of measurement, activities such as ’manufacture of dairy products’ (SIC 2020) and ’wholesale of dairy products’ (SIC 5143) would be classified as unrelated. The comparisons also revealed, that activities reported as related by the companies, but deemed unrelated through measurement, often turned out to be within-stage vertically integrated, meaning the production of a sub-component as one category, and the main product as another. The article concludes, that the COMPUSTAT II segment SSIC are the most appropriate to use for measurement of diversity, and actually exposes a relatively low correlation between the two measures COMPUSTAT II and TRINET. One of the more notable contributions on diversification from a financial viewpoint came in 1994, in form of the article “Tobin’s Q, Corporate Diversification, and Firm Performance” by Lang & Stulz. This article investigate whether the markets valuation of a firm is correlated with its degree of diversification, and does so by comparisons of Tobin’s Q’s which are supposed to reflect the value of companies’ intangible assets and market opportunities. In the analysis they resemble the composition of the diversified firms’ industries, by adding up the Q’s of stand-alone firms in these segments. Even after adjusting for industry effects and other potentially biasing factors, they find a positive and significant diversification discount in every year of the sample. The article finds, that shareholder wealth would (on average) be

Page 28

increased if conglomerates were split up and each division would have the average Q of specialized firms in the same industry. In conclusion they establish that highly diversified firms have significantly lower Q ratios than single segment firms, and that corporate diversification does not generally improve performance, but does not as such find it to destroy value either. It suggests that diversification is likely to be pursued by companies that have exhausted the growth opportunities in their current industry. In 1994 Lubatkin & Chatterjee publish an article on the topic of diversification called ”Extending modern portfolio theory into the domain of corporate diversification: Does it apply?”, in which they investigate the risk-reducing effects of corporate diversification. Modern portfolio theory suggest, that if the income streams of two SBU’s are weakly or negatively correlated, the unsystematic variance (risk) in the returns will be drastically reduced. ”Conversely, the more related the businesses of a firm, the more their returns are expected to move in unison, and therefore the less the reduction in unsystematic risk”, p. 7-8, line 43-44 + 1-2. This view assumes systematic risk per definition to be undiversifiable, based on the assumptions that stockholders are fully diversified and the capital markets are perfect. Another argument presented in this paper, is that corporate diversification increases a company's potential debt capacity, and since the interest paid on debt is tax deductable, investments financed by debt rather than equity is favorable to stockholders. The authors propose, that diversification can be advantageous if it matches the strengths of a firm to the critical success factors of the new industry, as these knowledge synergies combined with the other advantages of diversification might outweigh the disadvantages. The analysis finds that the risk characteristics of corporate diversification are inconsistent with modern portfolio theory, and therefore conclude that the CAPM/Beta-based methods of risk assessment are perhaps not accurate and well-suited for corporate diversification decisions. Berger & Ofek make a contribution titled “Diversification’s effect on firm value” in 1995, with the intention of analyzing what effect diversification has on the company value. It does so by considering the segments of the diversified firm as individual entities, and then comparing these to stand-alone firms in the same industry. They find that diversified firms are on average valued 13% to 15% lower than the imputed sum of its segments during the period 1986-1991. The article states, that there are both value-enhancing and value-reducing effects associated with diversification. Risk reduction through imperfectly correlated income streams,

Page 29

increased debt capacity and tax advantages are emphasized as some of the more valuable benefits, with overinvestment and cross-subsidization of poorly performing SBU’s pointed out as some of the main negative forces. The article finds related diversification to have a less negative effect on profitability than unrelated diversification, but concludes diversification overall to be a suboptimal managerial strategy. In 1996 Henri Servaes publish his article “The value of diversification during the conglomerate merger wave”, which analyze the presence and size of the diversification discount during the 1960’s and 1970’s, as it was during this period that the conglomerate merger wave peaked. The analysis is carried out by examining COMPUSTAT data every third year from 1961 to 1976, and classified according to 2-digit SIC codes. He uses a method similar to that of Lang & Stulz (1994), in which the Tobin’s Q’s of a diversified company’s SBU’s were compared to the Q’s of single segment firms. The analysis finds diversified firms trading at a significant discount compared to single segment firms for many of the years in the sample period. ”...these benefits [of diversification] may have been too small to outweigh the huge penalty imposed by the stock market”, p.15, line 7. The article concludes that the diversification discount was present during the 1960’s and 1970’s. It also claims, that in conjunction with the contributions of Lang & Stulz and Berger & Ofek (1995), the findings of the article should prove that overall diversification has not been beneficial for US corporations. In 1999 Servaes join forces with Karl Lins, and publish the article “International evidence on the value of corporate diversification”. Here they attempt to analyze diversification in a more international context, by examining samples of firms from Germany, Japan and United Kingdom. They find that the effect of diversification on firm value is different across countries, and document differences in governance structures to be a significantly contributing factor to these results. ”The institutional environment in Germany and Japan is very different from that in the United States, and various authors have suggested that agency problems may be less severe in those countries...”, p.2, line 8-10. UK on the other hand show many similarities to the US. Since the analysis of the article also reveals significantly lower diversification discounts in both Japan and Germany than in the UK and US, these results are interpreted as a clear indication that the governance structure in a particular company has an important impact on diversification-performance. When analyzing the Japanese industrial

Page 30

structure, the authors find that a membership of a so-called Keiretsu industrial group increases the diversification discount for a diversifying firm, as the Keiretsu itself resembles a conglomerate and thereby already possess many of the advantages of diversification. In 2003 Martin & Sayrak publish the article ”Corporate diversification and shareholder value: a survey of recent literature”, which serves as a critical synthesis from a financial viewpoint. “Conventional wisdom among finance scholars suggests that corporate diversification, especially conglomerate diversification, destroys shareholder wealth such that the shares of diversified firms sell at a discount”, p.2, line 10-12. They argue, that virtually all finance texts claim that diversification is value-destructive, often supported by the argument that a corporation should not diversify because the stockholders can do so easier and cheaper themselves. The article describes the advantages of reduced risk, increased debt capacity and internal capital markets that can be attained through diversification, and points to a shifting trend in the financial literature. Here an increasing number of scholars are starting to question, not the existence, but the causality of the diversification discount, arguing that the discount may be attributable to factors other than the diversification itself. The authors emphasize corporate governance impacts and relatedness measurement as some of the major pitfalls in the diversification literature. The article concludes by questioning the methodology of comparing the value of a diversified firm’s individual segments to the value of focused onesegment firms, as it is difficult to establish the causality in the relationship between diversification and value. Belén Villalonga publish an article in 2004 titled “Does diversification cause the diversification discount?”, in which she attempts to analyze the causality of the diversification discount by using techniques from the “treatment effects”-literature. She argues that diversification is endogenous and that the mere existence of the diversification discount therefore cannot be interpreted as evidence that diversification is the cause of value destruction. The article suggest that prior analysis' assumptions of size and industry as the two main influential variables to control for is an over-interpretation, and that there are in fact many more that may even differ from company to company. The article concludes, that on average diversification does not destroy value, but at the same time acknowledge that the assumptions of the treatment effect estimators, upon which the analysis is based, are unlikely to be fully met in the data samples used.

Page 31

In 2009 Xi He makes an interesting contribution in form of the article “Corporate Diversification and Firm Value: Evidence from post-1997 Data”, in which he attempts to analyze the diversification-performance relationship on a post-1997 data set. Previous studies have often found diversifying firms to be trading at a discount relative to stand-alone firms, usually explained by an increase in agency problems and/or inefficient cross-subsidization among segments. This analysis on the other hand, finds that the diversification discount actually turns into a diversification premium after controlling for endogeneity. He argues that this is probably due to the different data sets, with post-1997 data being subject to new segment reporting standards, but also due to the different diversity measures being used. The paper concludes that analysis performed on pre-1998 data is more likely to show a diversification discount, and points to differences in the segment reportings to explain the dramatic variance in the findings.

2.5 - Summary The purpose of this literature review was to document the vast scope of contributions on the diversification-performance relationship, in order to maintain a better overview despite inconsistent conclusions, and highlight how the different schools of thought on the topic emphasized dissimilar, sometimes even opposing agendas and key findings. Here we saw how the Strategic Management view in generally pursued a pro diversification agenda, with the basic idea that the advantages of diversification will outweigh the disadvantages if done correctly. The main arguments here is that relatedness must be considered in terms of valuable synergies between SBU’s rather than physical assets, but also that the relatedness is only one among many determining factors in the diversification-performance relationship. It is considered a valuable strategy because it has both risk-reducing effects, and is a way of leveraging a company’s non-tradable assets and capabilities. Furthermore it is important that the diversification is made into an attractive industry, where the company’s resources and capabilities match the key success factors of this particular industry. The Strategic Management literature also emphasize that the organizational structure and corporate management has a large influence on the implementation of a diversification strategy. Poor governance structures is pointed out as the main pitfall in achieving a successful diversification strategy.

Page 32

In the literature about the organizational theories, focus shifts from the strategic viewpoint to a more practically oriented view, concerned with the actual advantages and disadvantages along with their enabling circumstances. Economies of scale and scope form the center of the advantages motivating diversification, supported by lower cost of debt (through reduced risk) and internal capital markets. It is proposed that companies will pursue growth through diversification when the markets of their main SBU become `saturated´, and will achieve the highest success-rate in doing so when they manage to match their existing capabilities to the critical success factors of the new industry. Obtaining a sustainable competitive advantage however, requires complementarity of multiple resources and activities, and can only be developed through years of dedication and trade-offs. Opportunistic behavior and agency problems are emphasized as some of the main reasons for unsuccessful diversification in the organizational literature, as the actual decision to diversify is therefore based on a faulty foundation. Also the fact that an acquisition premium must often be paid, means that the value-generating synergies of combining the two companies must be even greater in order to be profitable. It is suggested that the agency problems can be reduced by internal and external governance mechanisms, and that the success or failure of a diversification strategy in general is highly dependent on the company’s organizational structures and management capabilities. The resource-based view literature naturally has a more concentrated focus on the internal resources and capabilities in a company, and generally supports the view that diversification will be beneficial if done properly through the right combinations of complementary resources and activities. In order for this to capitalize, these resources and capabilities must be valuable, rare, imperfectly immobile and non-imitable/substitutable (VRIO-conditions). Once these criteria are fulfilled, the resources between two SBU’s must complement each other in a way that the combined outcome exceeds their individual contributions as well as the costs of realizing these synergies incl. the acquisition premium. In the ex ante evaluation of the diversification potential, it is vital to keep in mind that companies are usually only able to convert a fraction of the potential synergies between two SBU’s. The RBV states, that corporate diversification is the result of valuable excess resources (often intangible) with a poor market demand, but also claims that relatedness between intangible assets is more valuable than between physical assets. RBV also argue that the complementarity of numerous resources and capabilities creates `causal ambiguity´, meaning that it will be difficult for competitors to identify the value-creating mechanisms without copying the entire system. If

Page 33

utilized properly for further developments, this `time-gap´ advantage can help a company maintain its competitive advantage. The theory also propose, in accordance with strategic management and organizational theories, that established firms in an industry will generally have an advantage over new entrants ceteris paribus, and that the `key success factors´ of a given industry are dynamic and will not be key for long if too many firms reach their fulfillment. RBV recognize lack of valuable relatedness between two SBU’s as the largest cause of unsuccessful diversification. The financial literature have always been the most skeptical towards diversification, mainly promoting an agenda that shareholders would be better off if the company remained focused at its main industry. It claims that companies pursue diversification when they have exhausted the growth opportunities in their current industry, when they should rather liquidate excess resources and pay it out as dividends. The financial authors also seem fairly united in the view that performance must be considered as an (at least) two-dimensional construct consisting of both risk and return. It recognizes that corporate diversification does generate some advantages in the form of increased debt capacity, reduced risk and tax advantages, but still finds diversified companies’ stock to be trading at a discount of 10-15%. Through analysis of Tobin’s Q’s it was also found that shareholders would be better off if conglomerates were split up, and each segment were assigned the average Q of that particular industry. The main reasons for this poor performance are pointed out to be agency problems and crosssubsidization of poorly performing segments. From a CAPM/Beta perspective all companies are subject to the same market risk factors, but are able to manipulate their exposure towards them. It is in this sense that corporate diversification, at least theoretically, is argued to have a large risk-reducing effect. The risk reduction is significantly higher the more un- or negatively correlated the cash flows are, which have led some scholars to believe that modern portfolio theory is not suitable for diversification purposes. Overall the financial literature emphasize that diversification has not been beneficial for US corporations, but also provide evidence that this is not necessarily the case in other countries, mainly due to differences in governance structure. In recent years, some scholars have even pointed out that the diversification discount may in fact be `endogenous´, meaning that the discount might not be caused by diversification itself.

Page 34

3. - Possible reasons for inconsistencies

With the amount of literature and research on the topic of corporate diversification, it is rather surprising that so little common ground and similar findings have been achieved. Granted, it is an extremely large and complex topic with a wide variety of influential factors, reaching from economies of scale and scope, over risk reduction and strategic implications to internal capital markets and other finance-related areas - with all the above issues also being examined in regards to the amount of relatedness in question. This chapter therefore seeks to investigate some of the more influential pitfalls in analyzing corporate diversification, with an emphasis on misinterpretations that may have facilitated conclusions in conflict with our assumption that a level of diversification different from zero is optimal, given that certain criteria are fulfilled. The brief investigation of the major pitfalls will be based upon the literature review.

3.1 - Relatedness When Rumelt made the clear distinction that related diversification was superior to unrelated diversification in 1974, he based the research on subjective measures of relatedness assessed through a company’s skills, resources, markets and purposes (Markides et al.; 1994). In this way, he was able to discover valuable linkages between companies that were not always obvious to the unenlightened, for example between the functional skills in one work function and the capability requirements in a completely different industry. On these grounds, to be unrelated meant having no valuable relatedness whatsoever between any value-chain functions, which was often the case in the early conglomerates pursuing diversification as a risk-spreading strategy. Through the following decades, the empirical analysis - and thereby the data quantities required - grew significantly in size, which forced scholars to introduce tools to interpret larger surveys. Personal computers and statistical software suddenly enabled scientists to analyze hundreds of companies in a reasonable amount of time, but within corporate diversification it was still necessary to distinguish between related and unrelated diversification. This lead to the usage of new classification measures, such as the Standard Industrial Classification codes (SIC-codes), the Herfindahl Index (based on SIC), the Page 35

Entrophy Index (based on SIC) and the Concentric Index (based on SIC) - which enabled quick categorization of multiple companies and their relatedness (Martin & Sayrak, 2003; Perry, 1998). The SIC-codes are 4-digit industry classifications that are used in the United States, with the first two digits representing the overall industrial group and the last two specifying which sub-segment of the industry this particular company belongs to. Thereby it is assumed, that if two companies share the first 2, 3 or 4 digits of the code they are related, and if they do not they are unrelated. Due to their convenience in analyzing the relatedness between companies and industries in large data quantities, the standard industrial classification (SIC) codes and the Herfindahl index quickly became the most commonly used measurements of relatedness and still is to this date (Pehrsson, 2006). Along with numerous internal flaws in the SIC-index, the downside to using these classification measures in diversification analysis however, is that they only capture the most obvious levels of physical business relatedness. “SIC codes tend to capture shared resources in production and raw material usage. They disregard shared intangible resources and people-based skills - probably the most strategically important resources of the firm” (Perry, 1998 - p.72, line 5-8). Furthermore their classifications are very inflexible, often neglecting obvious cross-category relatedness; ”One possible reason for the classification differences is that continuous measures based on SIC codes assume that all business combinations on the same 2-digit SIC code are related, while business combinations across 2-digit SIC codes are unrelated. For example, drugs (SIC 2830) and health products (SIC 3800) would be considered unrelated using the SIC-based rationale of relatedness. However, researchers may subjectively classify these as related on the basis of marketing to hospitals and physicians” (Perry, 1998 - p.139, line 10-19). Following the notion of Dierickx & Cool (1989), synergies formed through the combinations of resources and capabilities between two different SBU’s in a company’s implementation of corporate diversification, can be termed Strategic Asset Stocks. In order for these Strategic Asset Stocks to be valuable and to constitute the foundation of a sustainable competitive advantage in an industry, the characteristics of the Strategic Asset Stocks must be 1.) nontradable, 2.) non-imitable and 3.) non-substitutable. (Peteraf, 1993; Barney, 1991; Markides & Williamson, 1996). It is therefore a vital criterion in obtaining and sustaining a competitive advantage that the competitors are unable to imitate and/or substitute the resources, activities

Page 36

or combinations thereof involved in creating synergies (Iversen, 1999). If valuable relatedness between two companies could be found through classification measures such as SIC by the click of a computer, then these synergies would be very easy for competitors to copy and would thereby not be valuable for long. ”RBV theory suggests that developing a diversification strategy based on relatedness of a common input that is not characterized as valuable, durable, neither imitable and/or substitutable, runs the risk of wrongly attributing a benefit to related diversification across markets where the relatedness is primarily among nonstrategic assets. Although this type of relatedness can offer important, short-term advantages in the form of reduced costs and improved differentiation, it is unlikely to provide the bases of a sustainable competitive advantage” (Perry, 1998 - page 44, line 7-17). On these grounds, it would seem that the classification index’s such as SIC-codes, Herfindahl index and Entrophy measure and others based on the SIC-index are not very useful in analyzing the diversification-performance relationship, as they only capture the most apparent levels of business relatedness that are less valuable and can easily be imitated by competitors. As a consequence, the large number of articles that have based their studies and conclusions on these measures, may have been victims of the possible Spuriousness in the diversificationperformance relationship, and thereby unintentionally reached results influenced by unanalyzed moderating conditions. This could furthermore help explain the very inconsistent results of otherwise similar research on the topic.

3.2 - Success measurement The financial markets and institutions may also have helped fuel the consensus that corporate diversification destroyed value. This is a result of the academic research and literature within corporate finance (often based on the above classification measures) always supporting this view, putting too much emphasis on the relatedness-issue and the fact that corporate diversification should not be used as a risk-spreading growth strategy. “Financial economists have spent much of the last two decades amassing evidence that corporate diversification destroys shareholder value. These findings have become so pervasive that they form the basis for the treatment of the topic within corporate finance...” (Martin & Sayrak, 2003).

Page 37

Since the majority of the current credit rating agents, consultants, insurance employees, stock brokers and investment bankers have been educated in this school of thought, this financial consensus that corporate diversification is value-destructive has now become a self-fulfilling prophecy (endogenous), as these are the very institutions that determine the prices on a company’s loans, insurances and share price, along with its general reputation and predictions of the future growth opportunities. Thereby the company’s valuation in a semi-efficient capital market will reflect the opinions of these bounded rational employees, making it easy for scholars to find examples of reinforcing the value-destroying claim even further. Purkayastha et. al. (2011) even find that unrelated diversification is advantageous in emerging economies, whereas the more efficient capital markets in developed countries will emphasize the diversification-discount harder, thereby making diversification non-preferable. While the bounded rationality combined with decades of emphasizing the value-destructive claim may offer an explanation why market-based measures cannot be considered a perfectly objective measure of diversification performance, scholars have in recent years started questioning the accuracy of accounting-based measures (ROI, ROA etc.) in evaluating the performance of diversifying firms (Andersén, 2011). With the RBV providing an increased attention to the intangible assets in the company, it has been suggested that the rents generated will not always be displayed in the bottom line. If some stakeholders, such as key employees, are considered a vital strategic asset in one way or another, this will be reflected in the bargaining power of these stakeholders. As a result, company performance and accountingbased measures may not always be perfectly correlated, and could thereby bias the results on analysis based on these.

3.3 - Geographic origin Some researchers have also suggested that the characteristics of a company’s domestic markets may influence its ability to successfully implement a corporate diversification strategy (Palich, 2000). The domestic markets may be developed vs. emerging, large vs. small, wealthy vs. poor etc. which are all factors that have a significant impact on the strategic choices a company makes. As mentioned in section 1.2.5 - Delimitations, this area will not be

Page 38

investigated thoroughly in this thesis, but it may still help offer yet another partial explanation of the inconsistent research results within the diversification-performance relationship. If the characteristics of a company’s domestic market has an impact on its ability to successfully implement a corporate diversification strategy, then the geographic origins of the surveys upon which the academic literature on the topic are based, should also be influential. Seeing how the vast majority of articles within the different journals of Finance and Strategic Management concentrate or refer to studies carried out in the US, it seems fair to claim that they do not represent a sufficiently diverse geographic universe (from a statistical point of view) to be drawing worldwide conclusions from. Furthermore, the legislation in the domestic market could be highly influential on the diversification-performance relationship. An important example of geographic influence is provided by Agency theory, which suggests that managers will pursue diversification in an effort to make personal gains. Since diversification and firm size are highly correlated, as are firm size and executive compensation, along with a reduced managerial employment risk, this is a tempting strategy for opportunistic individuals (Montgomery, 1994). Such non-value maximizing activities are usually closely monitored and kept at a minimum by governance mechanisms, such as the board of directors. In many US companies the CEO serves as the chairman of the board, with the remaining members filled by other in-house managers or outsiders appointed by the CEO (Perry, 1998). In short, this does not constitute a very neutral or objective board put in place to supervise their own bad behavior, which would suggest a larger presence and extent of principal-agent problems in the US due to its domestic legislation (or lack thereof). As a consequence one could argue, that the large amount of literature based on US companies may be biased, and thereby not provide an accurate picture of the worldwide diversification-performance relationship.

3.4 - Summary This chapter looked at three different factors that may have influenced the research of the diversification-performance relationship, and thereby contributed to the lack of consensus in the conclusions. It was suggested that the extensive use of SIC-codes in determining the relatedness between two companies may have diminished the literature’s success-rate of corporate diversification, as these classifications mainly tend to capture non-valuable physical

Page 39

relatedness. Another potentially influencing factor are the individuals working in the powerful financial institutions, as decades of corporate finance consensus have taught them that corporate diversification is value-destructive. Since the contributions from these financial institutions have such a large influence on corporate performance and valuation, the employees’ enforcement of the diversification-discount have made the value-destruction claim a self-fulfilling prophecy (endogenous). It was also proposed, that the prevalent concentration of literature originating from any one country - in this case United States - may bias the results of the analysis, since domestic market characteristics may be influential. A full analysis of each of these factors’ influence on corporate diversification should be carried out in order to determine exactly how they may have influenced the literature on the diversification-performance relationship. However, since this is not the purpose of this thesis, I will simply attempt to minimize the influence of these factors in the analysis.

Page 40

4. - Success criteria of corporate diversification On the basis of the literature review and the investigation into the possible causes of the inconsistent findings on the topic, it was established that the extensive use of SIC-codes in measuring relatedness,

endogeneity of the `diversification discount´, and the high US

concentration of academic contributions may have biased the conclusions. The inconsistencies also support the propositions made by several scholars (Ramanujam et al. (1989), Perry (1998), Martin et al. (2003), Chatterjee et al. (1991), Palich (2000), He (2009), Teece et al. (1994)), claiming that the diversification-performance relationship is a spurious one and/or subject to multiple causality. Thereby the success-rate of the diversification-performance relationship would be determined by at least one, if not multiple moderating factors. The strategy of corporate diversification involves numerous advantages and disadvantages (see table 4.1 below), and for decades scholars have argued whether it was beneficial or not. In order to develop forward-looking criteria which, upon fulfillment, will increase the likelihood of success through corporate diversification, an analysis of the different modifying conditions will be performed through the literature review, determining how most of the advantages of diversification are achieved, while minimizing the disadvantages. The matching of these advantages/disadvantages to the different criteria, to diversification in general, or to the biasing factors (if not assigned) is displayed in Appendix 9.4, and will explained in the following chapters.

Table 4.1 - Advantages and disadvantages of diversification Page 41

4.1 - Relatedness It has been established beyond doubt through decades of literature, that the disadvantages of diversification will outweigh the advantages when combining two completely unrelated SBU's. Here the synergy potential is simply not be great enough to outweigh the acquisition premium and the costs of obtaining the synergies. Therefore some type of relatedness between existing activities and the new market under consideration is a necessary requirement for corporate diversification to be potentially value-generating. This means that either the existing core business must somehow create value for the new SBU or vice versa (Porter (1987), Campbell et al. (1995), Perry (1998)). We previously established SIC-based measures as a deficient method of evaluating valuable relatedness, as they primarily capture the physical (tangible) similarities, which at best may offer some short-term advantages (Perry (1998), Knoll (2008)). Accepting this to be true, along with the presumption that valuable relatedness does exist, means that the more valuable relatedness must therefore be based within the more intangible aspects of a corporation, such as knowledge, experience and capabilities (Montgomery (1994), Tanriverdi et al. (2005), Peteraf (1993)). Intangible assets are difficult/impossible to sell in the open markets, and thereby have their highest utilization potential through market expansion (Montgomery, 1994). Furthermore, they are notoriously difficult to measure which means that they would make a greater contribution towards obtaining the `time-gap advantage´ through causal ambiguity. Overall we can thereby establish, that intangible assets possess some valuable benefits in a corporate diversification context, but their intangible nature and lack of measurability presents a challenge in using them as a relatedness measure. Rather than attempting to do so, I will therefore try to look at the outcome of their presence, while incorporating Perry's (1998) proposition that relatedness based on a combination of assets and capabilities is preferable. From an RBV-perspective, strengths within knowledge, experience and capabilities will play a major role in a company's core competencies (Dierickx et al. (1989), Prahalad et al. (1990), Peteraf (1993)), which in turn are generated by a whole [value] chain of interlocked activities that are mutually reinforcing (Porter, 1996), and have been developed and refined over long periods of time (Teece at al. (1997), Dierickx et al. (1989), Prahalad et al. (1990)). One of the key characteristics of a core competence is, that it provides potential access to a wide variety of markets, and along with increased causal ambiguity its

Page 42

value-generating capabilities would make core competencies ideally suited for corporate diversification. This correspond well with Pehrsson (2006 b) who propose, that relatedness should be considered as a multi-dimensional construct that is not easily measured or categorized. In my opinion therefore, successful corporate diversification requires a type of relatedness based on the firm’s core competencies. In itself, this type of relatedness would probably find more valuable matches than the SICbased measures, but in order to optimize the synergy-potential and narrow the field of potential acquisition targets, conditions must be added at the other end of the relation as well. Amit & Schoemaker (1993) and Vasconcellos & Hambrick (1989) argue that the success of an organization depends on matching its core competencies with the key success factors of a given industry. This view is also supported by Peteraf (1993) and Porter (1987), who claims that diversification is mainly successful when you match valuable internal resources & capabilities with the requirements of the new industry. Campbell et al. analyze the valuegenerating factors of diversified corporations in their 1995-article, where parts of it investigate why oil companies’ attempts of diversifying into the mineral industries in large parts failed, despite clear relatedness to some of their key competencies. Two reasons were found. First, relatedness between key competencies and the new market is not sufficient, as it must be linked to the `Critical Success Factors´ of the particular industry, and secondly there must be room for performance improvement in the industry, which will be examined in more detail in section 4.3. Lubatkin & Chatterjee (1994) make a similar discovery, proposing that corporate diversification may be advantageous if it is able to match the strong competencies of a corporation to the critical success factors of the new industry. These proposals would indicate that diversifying into an industry where the company match the `Critical Success Factors´ would be valuable in proposing a new relatedness-measure. This section thereby established, contrary to the presumption in large parts of the academic literature, that valuable relatedness which could constitute the foundation of successful diversification is not found between two companies. Instead it should be considered in terms of the strategic fit between the core competencies of a company on one side, and the critical success factors in a given industry on the other. By fulfilling this criteria the company could potentially gain the advantages of: knowledge-sharing synergies, utilization of non-tradable assets, less excess capacity, and exposure to new growing markets (indirectly). The indirect

Page 43

exposure to new growing markets is meant in the sense, that a strong strategic fit will lead to such strong knowledge-sharing synergies that it is likely to spawn development of new products, or strong performance in other related high-growth markets.

4.2 - Risk reduction One of the very important synergies of corporate diversification is its risk reducing effects and the consequential increased debt capacity, lower cost of debt and tax advantages. Through the 60’s and 70’s risk reduction was one of the main motivations behind diversification (Servaes (1996), Pehrsson (2006 b)), but with the disadvantages of the resulting conglomerates by far outweighing the benefits, failure was inevitable and managed to give corporate diversification as a whole a bad reputation. With all firms generally being affected by the same set of market risk factors, their impact can only be manipulated to some extent by the company’s exposure towards them (Lubatkin et al., 1991). The reason corporate diversification has a risk reducing effect therefore, is that each SBU is exposed to a number of different risk factors, and by combining two or more SBU’s in one corporation the company is thereby able to maintain steady earnings, as bad times in one SBU is usually offset by good times in another. In this Modern Portfolio theory perspective, unrelated diversification will have a significantly larger risk reducing effect, as it exposes the firm to very different (unrelated), and possibly even negatively correlated risk factors (Lubatkin et al. (1991), Lins et al. (1999), He (2009), Martin et al. (2003)). However, because of the conflicting directions between the advantages of related diversification versus the risk reducing effects of unrelated diversification, scholars have argued that perhaps CAPM/Beta-based measures such as Modern Portfolio theory is simply not well-suited or accurate in a diversification context (Lubatkin & Chatterjee (1991) & (1994)). I believe however, that Beta-based measures are suitable in understanding the underlying risk exposures of different SBU’s, and argue that this confusion is to a larger degree caused by an over-simplification of the relatedness part. Here scholars have had a tendency to consider two SBU’s as either related or unrelated, since this could easily be measured through large databases, when perhaps considering it as a scale of the amount of relatedness would have been more suitable. By broadening the relatedness-perspective through RBV insights, we are able to determine valuable relatedness on many more levels, including my proposition that truly valuable relatedness shall be found between the core

Page 44

competencies of a company and the critical success factors of a given industry. In accepting this, a corporation would be able to make related diversification, whilst at the same time exposing the firm to uncorrelated risk factors in a Modern Portfolio perspective, which under the current perceptions would be combing a related and an unrelated component. So to summarize, a company considering diversification should do so into an industry that exposes the company to as uncorrelated/negatively correlated risk factors to its existing ones as possible, thereby maximizing the effects of risk reduction. By fulfilling this criteria the company could potentially gain the advantages of: risk reduction, increased debt capacity and tax advantages.

4.3 - Market conditions One of the motives of companies pursuing a diversification strategy is often a search for growth when it starts facing saturated markets in their current activities (Teece (1982), Wernerfelt et al. (1986)). Porter (1980) described this as the Product Life Cycle where every SBU will pass through the four phases (PLC-stages) of `Introduction´, `Growth´, `Maturity´ and `Decline´ - with each stage characterized by numerous distinctions (Appendix 9.1). This theory share many similarities with the BCG-matrix developed by the Boston Consulting Group in 1970, which to a larger degree however was developed as a tool recommending companies what to do at the different stages. By combining insights from the two theories, recommendations about the preferred actions at the different PLC-stages may occur. Companies will usually start facing saturated markets during the PLC-stage of `Maturity´, which means that it will eventually no longer be profitable to make growth-generating investments in this market. The `Maturity´-stage is characterized by standardized production, some overcapacity, threats from cheaper imports, price competition and lower profits (Porter, 1980). This is what the BCG-matrix would describe as a `Cash Cow´ or `Dog´ (depending on relative market share). At these stages the BCG-matrix propose that a company should already have established their desired market positioning, and thereby be able to harvest the profits in a stabilizing market with reasonable little effort. So for all the above-mentioned reasons, and before the market will start facing drastic decline, this would be the ideal stage to pursue the growth strategy of corporate diversification.

Page 45

Since the market at the `Maturity´-stage is characterized by overcapacity, price competition and declining profits, this is also an extremely bad PLC-stage to be finding the potential acquisition target for corporate diversification. The acquisition premium will be high, as the company would be selling off a stable cash generating SBU, and at the same time there would be very little room for improvements against well-established competitors. This has been one of the major, though often overlooked, pitfalls of diversification moves throughout the times, namely that companies expect that they can diversify into an industry at PLC-stage `Maturity´ and still generate sufficient value to justify the investment (Campbell (1995), Porter (1987)). As pointed out in chapter 4.1, there must be significant room for improvement in at least one of the SBU’s beyond common synergies, in order to generate enough value to justify the investments. Wernerfelt (1984) proposed that possession of valuable resources/capabilities in a given market could also serve as potential entry barriers against new competitors, since the potential economic gains for later acquirers will be diminished in a demand-supply sense, and that it is therefore important to enter the market early. Along the same lines, RBV-scholars (Dierickx et al., (1989), Peteraf (1993)) propose that the `time-gap advantage´ gained by early entry into a given market is very valuable, if it is used in continuous development of complementary resources & capabilities, as it could help obtain sustainability in the competitive advantage through `causal ambiguity´ (Perry (1998), Iversen (1999), Prahalad et al. (1990)). Thereby, in order to avoid the disadvantages of the `Maturity´-stage and gain the advantages of early entry into a given market, a company wishing to pursue diversification should do so into an industry at PLC-stage `Introduction´ or `Growth´, and do so while its main SBU is at the stable and cash generating PLC-stage of `Maturity´. By fulfilling this criteria, the company could potentially gain the advantages of exposure to new growing markets, whilst securing themselves against the high costs of the strategy, and do so before the excess capacity increases further, damaging market conditions.

4.4 - Enabling resources & capabilities While the above-mentioned success criteria to a large degree relate to the actual diversification-move, there are still plenty of internal pitfalls that could cause the strategy to fail. In order to avoid these and increase the chances of successful corporate diversification, I

Page 46

propose that certain enabling resources and capabilities must be in place prior to the diversification-move. RBV-scholars often argue diversification to be a result of excess resources & capabilities with a poor potential to sell in the open markets (Dierickx et al., (1989), Peteraf (1993), Chatterjee et al. (1991)). As previously highlighted, this would mainly be the more intangible assets, such as strong managerial & marketing capabilities. These are reflected in firm's core competencies, but will also play a vital role in obtaining the potential synergies after the merger. Campbell et al. (1995) argue, that a diversified corporation with multiple SBU’s that could otherwise function independently, can only justify its existence if it creates value for the businesses it owns. Porter (1987) makes a similar point in claiming that the corporate strategy must be designed in a way that it creates value for all the business units. Managing a portfolio of diversified SBU’s requires strong leadership and a suitable organizational structure. If a company attempts to make a common corporate culture over a very diverse selection of businesses, it may end up with a compromise culture that does not fully utilize any of the SBU’s full potential (Campbell, 1997). When combining two previously independent firms, it is also quite likely to cause some frictions between the two entities. Employees may fear losing their jobs, feel the new management makes poor decisions, or generally just dislike the merger. With the overall objective of achieving value-generating synergies by combining multiple SBU's, strong managerial & marketing capabilities are a necessary requirement in order to minimize problems and maintain decent productivity rates during the merger, but more importantly in order to enable the realization of the full synergy-potential. By fulfilling this criteria the company could therefore be helped towards better utilization of their nontradable assets, while potentially avoiding disadvantages related to capital misallocation and the increased complexity of the organization. Along similar lines, obtaining the full synergy-potential of a given diversification move will require some adaptation in organizational structures and procedures. In combining any two SBU's several basic cost-saving synergies are likely to occur, in the form of double-filled positions, sharing of resources, or assets not needed twice. As previously established, costsaving synergies are insufficient for success however, as the expenses in achieving synergies through corporate diversification are high (Iversen, (1999), Knoll, (2008)). Prahalad et al. (1990) propose competence sharing across organizational divisions as a vital component in

Page 47

building and refining core competencies, which should be based upon a few value chain activities where the company possesses superior skills. Amit et al. (1993) furthermore argue, that it is the complementarity of a corporation’s resources & capabilities that generate a higher combined value than the sum of each’ individual value. So in order to generate truly valuable

synergies

beyond

cost-savings,

cross-divisional

knowledge

sharing

and

complementarity of resources must be facilitated in the new organization. I therefore believe, that well-developed organizational structures that cultivate cross-divisional knowledgesharing are necessary in order to exploit the full synergy potential in a diversification strategy. By fulfilling this criteria the company could potentially gain the advantages of not only costsaving synergies, but also the more valuable knowledge-sharing synergies, whilst adjustments in the organizational structures could also help deal with the increased complexity. The next criteria seems fairly obvious, and yet have caused many diversification attempts to fail. A company must have sufficient capital at its disposal prior to the diversification move, as this is not a cheap strategy to pursue. Even ignoring the initial acquisition price or cost of internal development, it can take years sometimes even decades to fully streamline the SBU’s to each other, and thereby achieve the full synergy potential (Iversen, (1999), Perry (1998), Knoll, (2008)). New investments and strategic changes may have to be implemented, and in the meantime it is vital for the overall success of the corporation, that it is not forced into compromise decisions by economic constraints. As discussed earlier, one of the main motives behind corporate diversification are saturated markets, which means that the SBU will gradually start generating less profits. Pursuing an expensive growth strategy while facing declining profits can be challenging, so in order to maintain uncompromised strategies simultaneously, I believe that sufficient capital, often generated by one or more SBU’s at PLC-stage `Maturity´, is a necessary enabling resource of successful corporate diversification. By fulfilling this criteria the company would be better protected against the disadvantages of the lengthy time-span and high costs of obtaining synergies through corporate diversification. The final enabling capability proposed that should be present in a company prior to diversification, will help in diminishing one of the major threats to successful diversification, namely agency problems. Agency problems are caused by some degree of opportunism in individuals, and generally assumes managers profiting at the expense of the shareholders. According to this theory, the manager would rather keep free cash flows in-house than pay it

Page 48

out to shareholders, and therefore engage in questionable M&A investments for his/her own benefit. This would increase the size of the corporation and accordingly the managerial prestige and compensation called `empire building´. Simultaneously it would reduce the overall risk of the company and hence the `employment risk´, and finally the expansion may be done in a way that will increase the demand for his/her particular skills, termed `managerial entrenchment´ (Montgomery (1994), Perry (1998), Denis et al. (1997)). Scholars arguing against corporate diversification often credit agency problems like these along with a lack of relatedness for most of its failure, and claim that managers will only reduce diversification if they are pressured into doing so by governing mechanisms (Denis et al., 1997). This proposition is further enhanced by international studies on the topic, establishing that the effect of diversification on firm value is different across countries, mainly due to large differences in governance structures in different parts of the world (Servaes et al. (1999), Perry (1998)). Since there seems to be consensus among scholars that agency problems are best diminished through governance mechanisms, and that corporate diversification is quite likely to initiate agency problems, I believe that the presence of strong governance structures is a necessary enabling capability of successful corporate diversification. By fulfilling this criteria the company could potentially avoid or minimize the disadvantages of: capital misallocation, unrelated diversification and agency problems.

4.5 - Summary At this point, the report has established clear inconsistencies in the diversificationperformance relationship through the literature review in chapter 2. Chapter 3 presented possible explanations for these inconsistencies and why the literature arguing diversification overall to be value-destructive may be off. The objective for this chapter was therefore to combine and analyze the obtained knowledge in order to deduct hypothetical success criteria, which might increase the likelihood of success through corporate diversification upon fulfillment. By looking at the major pitfalls of diversification attempts, it became evident that companies considering diversification would not only have to meet particular criteria in the diversification-move itself, but also be in possession of certain `enabling resources &

Page 49

capabilities´ before even considering it. While the `success criteria´ for the diversification move itself mainly focused on maximizing the advantages of corporate diversification, the `enabling resources & capabilities´ have their greatest features in minimizing the disadvantages. It was found, that a company must be in possession of strong managerial & marketing capabilities, as they play an important role in obtaining the full synergy-potential and in minimizing discrepancies in the transition-phase. A strong management will furthermore be less inclined to commit capital misallocation, and would be better equipped in dealing with the challenges of a larger and more complex organization. It was also proposed, that well-developed organizational structures are instrumental in achieving both cost saving synergies as well as knowledge-sharing synergies. Well-developed organizational structures will furthermore help ensuring the complementarity of resources in an increasingly complex business environment, and is therefore included as an enabling resource. The analysis also established sufficient capital as one of the enabling resources, since corporate diversification is an expensive strategy to undertake, while economic constraints could force the company into damaging compromise strategies. The final enabling capability that must be present in the company at the time of the expansion is strong governance structures, such as an independent board of directors and performance-based management compensation just to mention a few. This would help minimize agency problems such as unrelated diversification and capital misallocation, and is therefore deemed vital if success within corporate diversification is to be obtained. Once these enabling resources & capabilities are fulfilled to satisfactory levels, the company is qualified to consider corporate diversification. At this point the company must identify the unique strengths of its organization, also referred to as core competencies. In order to be truly valuable and unique, these competencies must be a combination of multiple complementary resources & capabilities that have been developed and refined over long periods of time, and is now what characterize this firm over competitors and generate perceived value in the endproduct. Then the company must search for an ideal target industry, which is an industry where the critical success factors matches its core competencies, and at the same time is exposed to as uncorrelated/negatively correlated risk factors to its existing ones as possible. Finally it is very important that this new SBU is at the PLC-stages of `Introduction´ or `Growth´ as the competition here is not yet too fierce, the acquisition premium is reasonable

Page 50

and there is still plenty of room for improvements, and that the expansion is done while the company has one or more SBU's at PLC-stage `Maturity´ (illustrated in figure 4.1 below).

Figure 4.1 - Hypothetical success criteria

Page 51

5. - Case studies

The following section will provide case studies of the four companies A. P. Moller-Maersk, NKT, SEAS-NVE and Siemens, which were chosen among the companies willing to participate. As some of these companies have activities in multiple SBU's, a specific diversification move in each were chosen for the analysis. The case studies will address the point in time where the company made the specific diversification move under investigation, and will therefore be based at four different points in time. The case studies will rely on interviews with key employees (Appendix 9.2) following a standardized questionnaire (Appendix 9.3), supported by secondary data in form of books, articles, internet etc.

5.1 - A. P. Moller-Maersk A. P. Moller-Maersk is one of the largest corporations in Denmark, employing approx. 152,000 people worldwide with a 2012 turnover of 59 billion USD2. The company was originally founded as a shipping company in 1902, but have existed in its current format since 2003. Today they have activities in several different industries all over the world, mainly related to their two major SBU's `container shipping´ and `oil production´, but it is in fact their expansion into the `supermarket industry´ that will be under investigation in this case study. The diversification move into the `supermarket industry´ happened in 1964 through a 50% purchase into the company Salling. This was later increased to a ownership share of 67,5% and the name of the company was changed to Dansk Supermarked. At the time of the expansion A. P. Moller-Maersk was mainly involved in the shipping business, with beginning activities in oil production and an ownership share of 20% in Danske Bank. Their key strengths at this time, were their innovative operation (first in containers, oil and supermarkets), strong corporate culture, logistical talents, good business sense and sufficient capital (interview). The expansion into the `supermarket industry´ was not a well-planned strategic move, but the result of a well-timed and profitable investment opportunity. Herman

2

www.maersk.com

Page 52

Salling had been inspired from travelling the world to open a store selling both food-items and textiles, later known as supermarkets, and did so by opening the first Fotex in Aarhus in 1960 (Ellemose, 2006). He wished to expand the company quickly, building new supermarkets in other parts of the country, but did not possess the capital needed for such an expansion. Rapid expansion was vital to the success, as one of the key strengths of the concept were economies of scale and scope, and he also felt a need to maintain the earlymover advantage (Ellemose, 2006). After an intense search for a suitable investor, the first of several meetings were arranged between mr. Salling and mr. Møller (senior). During these meetings mr. Salling managed to convince them of the investment potential, and the cooperation were further enhanced by the fact that mr. Salling possessed many of the values that were in high regard in the A. P. Moller-Maersk corporation. Similarly to the expansion into `container shipping´ in the 1960's, which had only been developed in 1955, the expansion into the `supermarket industry´ also happened at an early stage of the industry's existence. The first ever supermarket in Denmark had opened in 1953 and it was still a very new concept for the consumers to grasp when A. P. Moller-Maersk entered in 1964 (Ellemose, 2006). Through the 1950's and 1960's the company had very strong earnings, and despite paying everything in cash generated so much excess capital that they were actively seeking good investment opportunities. A. P. Moller-Maersk deliberately decided not to be actively involved in the operation of Dansk Supermarked, but always prioritized having high-level managers representing their interests at the boards of directors. The only real synergy potential between the two companies could have been within the very similar corporate cultures or logistics, but even here A. P. Moller-Maersk allowed Dansk Supermarked full autonomy to engage whichever distributors they felt like. The key to success within the `supermarket industry´ at the time were the first-mover advantage, having large stores with a wide assortment, a strong brand and sufficient capital (interview). The risk-factors of the `supermarket industry´ were quite different to the company's existing ones, but then the `supermarket industry´ in itself also possessed a diversified internal risk profile. As the two companies were run completely separately, no initiatives were made to make the new colleagues feel more like a part of the overall organization. It is unclear whether result-based management compensation was used in the early years. If A. P. Moller-Maersk had not invested in Salling (Dansk Supermarked) it would probably not have remained Danish-owned, and without an investor it certainly would not have developed and expanded the way it has managed to do. Overall the engagement has

Page 53

been a very profitable investment, but may have taken focus somewhat away from the main SBU's of A. P. Moller-Maersk (interview). The only real advantages the company have gained from the involvement is a more diversified risk profile and some economies of scale and scope, although not much since they have not actively pursued this.

5.2 - NKT NKT was founded in 1891 under its original name Nordisk Kabel og Tråd, with the primary operations within production and sale of cables. Since then the organization have undergone significant changes and rapid expansion. Today they have activities in the three main areas `cables´, `industrial cleaning machinery´ and `fiber-optics and laser equipment´, generating a combined turnover of 15,3 billion DKK3. NKT have specialized in acquiring companies related to their existing portfolio where they see a value-generating potential. It is however their unsuccessful expansion into the `biotech equipment´ industry that will be elaborated in this section. In the years around 1999 NKT aggressively pursued this strategy by launching approx. 40 new companies over a few years span. The idea was, that if just 3 of these became successful the investment would be profitable. In 1999 this expansion entered the `biotech equipment´ industry with the launch of multiple small firms, including Cantinon, Picosep, Nanon and SMB. At this point the company already had activities in `cables´, `flexibles´, `industrial cleaning machinery´, `electronic components´, `IT´ and `fiber-optics and laser equipment´. The new firms primarily originated from internal development, sometimes by purchasing a newly patented idea, or as a spin-off from one of the existing units. The very extensive diversification strategy was a deliberate strategic choice in pursuit of growth and the hope of hitting the next HIGH-growth industry, but also because NKT felt they were in possession of unique capabilities in growing and shaping young innovative industrial firms, that they wished to exploit further (interview). The economic situation in the company around 1999 were okay without being great. Some of the firms were generating profits, but many of the young ones mainly required further investments. The organizational setup at NKT at the time were focused around the two blocks NKT Holding and NKT Research & Innovation that were 3

www.nkt.dk

Page 54

specifically designed to create value for the small firms. NKT Holding was responsible for all the strategic or business-related matters, and NKT Research & Innovation were in possession of large amounts of technological expertise and experience in developing new companies. Through this setup they felt they had an advantage over private equity companies in the launch and development of small innovative technological firms, and could benefit these firms in areas where they had weaknesses. NKT believed they had the technological knowhow to produce biotech equipment products, but would have to gradually acquire the necessary market knowledge. As it turned out however, the abrupt market penetration and their lack of network within the industry outweighed the potential advantages. Overall the organization was well-equipped for such an expansion, but had been too technology-focused and underestimated the influence of market-knowledge. The whole idea of the strategic setup, was that the pool of competencies concentrated in the `competence net´ would generate sufficient value for small innovative technological firms to overcome the lack of expertise in the particular industry (interview). At the time they entered the `biotech equipment´ industry it was a very young and innovative industry, driven by entrepreneurs with high motivation and desire. It had some similarities to NKT's existing activities, mainly within technologies and production methods. The key to success in the `biotech equipment´ industry is believed to have been a better insight into the development time and investments required, as well as market knowledge and a professional network (interview). The `biotech equipment´ industry exposed the company to entirely new risk factors, although their risk portfolio was already fairly diversified. The strengths of the NKT corporation at the time was a very strong technology platform and the ability to develop new technologies. Also their experience in launching and growing new SBU's were seen as one of their strengths, and it was these competencies they hoped to exploit further through their diversification strategy. In order to make the new SBU's feel like a more integrated part of the organization, NKT had several intro-programs along with the `competence net´ to serve this particular purpose. Incentive payment schemes were extensively used in order to have fully motivated managers running the new entities. Based on the failed biotech adventure and similar experiences, combined with changing world-market conditions, NKT have now changed the aggressive diversification strategy, and have acknowledged the need for greater industry know-how before entering new industries. They initially felt they had some unique advantages in exploiting the capabilities gathered in the `competence net´ over multiple SBU's, but probably

Page 55

under-estimated the commonness of some of the competencies. After realizing they did not possess the necessary qualifications required in the `biotech equipment´ industry, they closed down or sold off all the activities in the industry before obtaining any real competitive advantages.

5.3 - SEAS-NVE SEAS-NVE was founded in 1912 as a private limited company under the original name SEAS, and in 2012 reached a turnover of 3,5 billion DKK. Today they have concentrated their activities around the `energy´ industry and the `fiber-internet´ industry, but this case study will focus on their mistaken entry into the `tomatoes´ industry. SEAS first entered the `tomatoes´ industry in 1989 and at this time had their core activities in the `electricity production & distribution´ industry, with side-activities in the `wind power´ industry and the `salmon breeding´ industry. The tomato-project was started through internal development, and the original plan was to build Scandinavia's largest greenhouse horticulture heated by the surplus cooling water from the energy production at SEAS' Masnedø-plant. The greenhouse space could then be leased in small parts by independent gardeners (Arnesen et al., 1994). Several industries were considered for the expansion where the excess hot water could be beneficial, but since they were somewhat restricted by the plant's locations `salmon breeding´ and `tomatoes´ were chosen. At the time of the expansion SEAS were doing reasonably well financially, generating steady profits in the `electricity production & distribution´ industry. The motivations behind the expansion was a keen interest in environmental issues by the CEO at the time, Ove W. Dietrich, who had previously worked at the Ministry of Environmental Affairs, and wished to make the company more environmentally friendly. Also there was some political pressure to pursue this agenda, since the company was highly dependent on public contracts (interview). SEAS did not possess any qualifications for the `tomatoes´ industry, so the idea was to lease space out to small independent gardeners through cooperation with the Danish gardening trade association. Similar projects a few years earlier had however not spiked a great deal of interest nor proved profitable, so the Danish gardening trade association was skeptical, and decided to reject the proposal of a joint venture. SEAS felt offended by this rejection and after some further

Page 56

negotiations decided to go ahead with the project by themselves. In the following years the tension with the gardening trade association increased, and in 1992 the gardeners reported SEAS to the competitive authorities for illegally subsidizing their tomato-production (Arnesen et al., 1994). The organizational setup in the company was not ideally suited for this expansion either, but there was a pioneering learning-by-doing spirit that convinced them it could be done. Besides advantages in the initial electrical and heating installations, none of the processes or capabilities from their existing activities would be advantageous in the new industry, as there were no similarities between the two SBU's. At the time SEAS entered, the `tomatoes´ industry had already existed for many years, so they were immediately faced with fierce competition both nationally and internationally. The key to success in this market would probably have been a better knowledge of the industry, which they probably could have obtained by acting less arrogantly in the initial negotiations with the gardening trade association about a joint venture (interview). As the `tomatoes´ industry was completely unrelated to the company's existing activities, it also exposed SEAS to entirely new risk factors. The most important strengths of the corporation at this time were its capabilities in producing and delivering electricity to consumers at a high degree of stability, which over time had earned them a strong reputation in the industry. Since the employees of the new company ended up being SEAS-employees on loan, no initiatives were made to make them feel like an integrated part of the organization. The management compensation in the new SBU is not believed to have been result-based in any way (interview). Overall the tomatoadventure turned out to be a financial nightmare, estimated to have cost approx. 200 million DKK, which had to be paid by the electricity consumers in the years to come (Arnesen et al. 1994). The only good thing it generated was some publicity of SEAS as an innovative and environmentally friendly company.

5.4 - Siemens As one of the heavyweights within industrial manufacturing and renewable energy, Siemens has approx. 360,000 employees worldwide, generating a total turnover of about 583 billion DKK. The Siemens corporation has an incredibly diversified product portfolio, enabling them to deliver turn-key solutions for many industrial sectors. They have divided their activities into the nine overall product categories: `automation´, `building technologies´, `energy´,

Page 57

`drive technology´, `financial solutions´, `healthcare´, `consumer products´ `mobility´ and `services´4, each representing several underlying entities. The diversification move under scrutiny in this case study will be their expansion into the `wind power´ industry, one of the renewable energy SBU's in the `energy´ category. Siemens first expanded their activities into the `wind power´ industry in 2004 by the acquisition of the Danish windmill manufacturing company Bonus Energy. This was a strategically motivated move, as they felt this area was missing in their product portfolio in their quest for becoming a full-range supplier in the energy sector. At the time of the expansion the corporation already had activities in most of the previously mentioned product categories, so they were very experienced in corporate diversification. As this acquisition, along with many other investment opportunities in the organization were strategic choices, it was never really considered paying out excess funds as dividends to shareholders (interview). The financial situation in the company at the time of the expansion was extremely strong, as it has more or less always been (interview). Besides the pursuit of a complete product portfolio, the diversification move was motivated by the rapid growth rates predicted for the wind power industry, supplemented by the fact that renewable energy at the time were turning into a worldwide megatrend. Since Siemens already had decades of experience within electricity production, mechanical engineering and industrial machinery, the expansion was an almost perfect match to their existing capabilities. At the organizational level the corporation was also well-equipped for the diversification move. They had a lot of knowledge from similar industries regarding many of the sub-components, and the management were already acquainted with several of the large-scale industrial customers in the industry (interview). Siemens felt they were purchasing a company in possession of valuable knowledge and capabilities in the windmill-sector, particularly off-shore, but at the same time had plenty of room for improvements. Here Siemens competencies could help turn them into a professional industrial manufacturing company with a much more efficient production. The `wind power´ industry have existed since the early 1980's and was experiencing strong growth rates in 2004. It is however still highly vulnerable towards political support and economic subsidies. The key to achieving success in this market was to have access to the right technologies and production capacities, as well as large amounts of equity, as it is customary for the manufacturer in this industry to provide economic assurance before signing off on a multi4

www.siemens.com

Page 58

million dollars project. The expansion did not really expose Siemens to new risk factors, as they already had activities in many related industries and customer groups. The strengths of the Siemens corporation at the time of the expansion, were their technological know-how in a large number of related industries, large-scale project management, financial strength and innovative capabilities (interview). Almost immediately after the acquisition the businessprocesses of the new organization were aligned with the mother corporation, and several other initiatives were launched to integrate the new SBU into the corporation. All employees at management-level in Siemens receive 20-50% of their salaries through result-based bonusschemes. In hindsight there has hardly been any downsides to the acquisition of Bonus Energy, which may be one of the best acquisitions ever made by the Siemens corporation (interview). The timing of the purchase was perfect, getting large amounts of valuable knowledge and production technologies at a reasonable price, resulting in dramatic growth for the company ever since (interview). There was so many synergies in combining the two companies, in particular the financial strength and technological knowledge from related industries. In the following years the new company named Siemens Wind Power managed to obtain a position as the third largest wind power manufacturer in the world, being the second largest in the US market and having a sound leading position in the offshore segment (interview).

Page 59

6. - Empirical analysis

The empirical analysis carried out in this chapter will perform a two-sided case study test using the comparative method called the `Indirect method of difference´. This method tests cases with a given outcome for the presence/influence of independent variables, and then afterwards checks cases with the opposite outcome for a lack of these variables. In this analysis the given outcome is the success/failure obtained through corporate diversification, and the independent variables under scrutiny are the hypothetical success criteria deducted in chapter 4 - as presented in figure 6.1 below.

Figure 6.1 - Analytical design

6.1 - Relatedness The first of the hypothetical success criteria propose that valuable relatedness in a corporate diversification context shall be found between the core competencies of a company and the critical success factors of the industry it wishes to enter. The purpose of this section is therefore to analyze to what degree this criteria was fulfilled in the diversification moves carried out by the four case companies. In the first of the two successful cases, we saw how A. P. Moller-Maersk entered the `supermarket industry´ in 1964. The key to success in this

Page 60

industry at the time, was having large stores in the right locations, a fast turnover rate of products keeping prices low, rapid expansion maintaining early-mover advantage, scale economies, and an innovative nature adapting fast to changing trends. In order to meet requirements of stores in many locations, economies of scale, fast turnover rate etc., I propose that one of the main critical success factors of the `supermarket industry´ at the time, were logistical talents. In their `container shipping´ activities, A. P. Moller-Maersk have over the years gained a world-leader market position through a reputation of impeccable reliability and punctuality. Refined through decades of experience in the shipping industry, and optimized through organizational adjustment and complementary activities, it seems fair to claim that one of the core competencies of the organization are logistical talents, and were so to some degree at the time of the expansion as well (interview). Although they decided not to pursue the potential synergies of this relatedness through active involvement, they still maintained high-level executives on the board of directors, that could offer valuable inputs when needed. Overall A. P. Moller-Maersk' core competencies of logistical talents matched the critical success factors of the `supermarket industry´, and they thereby fulfill the relatedness-criteria. The second company under investigation which had achieved success through corporate diversification was Siemens, and their expansion into the `wind power´ industry in 2004. At the time of the expansion Siemens already had activities in multiple SBU's, with most of them centered around their core competencies of mechanical & electrical engineering and largescale project management. The key to achieving success in the `wind power´ industry at the time, evolved around having access to the right technologies or sub-component suppliers enabling production of high-tech windmills, as well as a strong financial foundation and a reliable reputation. Based on this, I would argue that the critical success factors of the `wind power´ industry were technological know-how in windmill-specific areas, sufficient capital and strong capabilities in large-scale project management. Since Siemens already produced several of the sub-components for the production, acquired important knowledge and patents from Bonus Energy, and were in possession of mechanical & electrical engineering knowledge, I believe they fulfilled the technological knowledge requirements. Furthermore their financial situation in the company was extremely healthy and with superb large-scale project management skills, it seems fair to claim that Siemens' core competencies were an almost perfect match to the critical success factors of the `wind power´ industry, and they thereby fulfill the relatedness-criteria.

Page 61

The first of the companies under examination that failed to achieve success through corporate diversification is NKT, and their mistaken entry into the `biotech equipment´ industry. This expansion happened around 1999 and were primarily done through internal development. In order to obtain success in this industry, it was important to have technological know-how about biotech equipment products, strong R&D capabilities, innovative skills and market knowledge. The critical success factors of the `biotech equipment´ industry at this time is therefore believed to have been extensive biotech knowledge, a network within the industry, as well as a strong financial situation to cover the substantial R&D investments required over long periods of time (interview). At the time of the expansion, the core competencies within NKT were their technological know-how and innovative capabilities. They did not however possess enough biotech-specific knowledge about the industry or the time-scale of the R&D development cycles, so overall the core competencies of NKT did not match the critical success factors of the `biotech equipment´ industry, and they thereby failed to fulfill the relatedness-criteria. The second company in the empirical analysis with a failed attempt of corporate diversification is SEAS-NVE, and their entry into the `tomatoes´ industry in 1989. This expansion was done through internal development by building new greenhouses near their Masnedø-plant. As the original plan was to own the facilities and then lease the space out to independent gardeners, SEAS-NVE did not possess any capabilities suitable for the `tomatoes´ industry, besides a little for the electricity- and heating-related maintenance. Since the `tomatoes´ industry is an industry with virtually no supplier-preferences, the key to success here was cheap production and efficient distribution, keeping the prices as low as possible. In order to achieve this, the critical success factors of the `tomatoes´ industry at the time would have been know-how about the production and a network to the industry and its stakeholders, of which SEAS-NVE had neither. Thereby, they failed to fulfill the relatednesscriteria.

6.2 - Risk Factors The second hypothetical success criteria proposed, argued that the company should attempt to find a diversification target in an industry that exposed the company to as uncorrelated, or

Page 62

even negatively correlated, risk factors to their existing ones as possible, thereby maximizing the risk reducing effects. Again we look at the four case companies, starting with the two successful ones. When A. P. Moller-Maersk entered the `supermarket industry´ they were already involved in the shipping industry, and had beginning activities in the oil industry and the bank sector. For these industries the most important risk factors were oil prices (cancelled out by the negative correlation to the oil industry), freight rates, legislation, environmental issues, financial crisis and currency fluctuations. The `supermarket industry´ itself has an extremely diversified risk profile, with some of the more overarching risk factors being freight rates (cancelled out by the negative correlation in shipping), changing purchasing trends and financial crisis. Overall the A. P. Moller-Maersk expansion into the `supermarket industry´ is an almost perfect example of corporate risk reduction, and they thereby fulfill the `risk factor´ criteria. The second successful company in the analysis is Siemens, and their expansion into the `wind power´ industry in 2004. At the time of the expansion Siemens was already an extremely diversified corporation, with activities in nine major product categories. I will not attempt to summarize all the risk factors of their SBU's, but mainly focus on the `energy´ sector, which in itself cover products categorized into `fossil power generation´, `renewable energy´, `power transmission´ and `power distribution´5. The main risk factors concerning these industries are price increases of materials, lower worldwide energy consumption and legislation regarding energy production, distribution and subsidies. These risk factors are nonetheless almost identical to the risk factors of the `wind power´ industry, so Siemens fail to fulfill the `risk factor´ criteria with this particular expansion. In analyzing NKT's failed attempt to diversify into the `biotech equipment´ industry in 1999, we see that they already had activities in the `cables´, `flexibles´, `industrial cleaning machinery´, `electronic components´, `IT´ and `fiber-optics and laser equipment´ industries. This was already a fairly diversified risk portfolio, exposing the company to risk factors such as raw material price increases, substituting products or technologies, and legislation. The `biotech equipment´ industry on the other hand has some fairly industry-specific risk factors, such as pharmaceutical legislation, price increases in plastics & electric components, patent infringements and ISO standardization approvals. Overall the NKT diversification move into 5

http://www.siemens.com/entry/cc/en/#188180

Page 63

the `biotech equipment´ industry exposed the company to some entirely new risk factors, and they thereby fulfill the `risk factor´ criteria. Finally we look at SEAS-NVE's diversification move into the `tomatoes´ industry in 1989. At the time of the expansion the company had activities in the `electricity production & distribution´ industry, the `wind power´ industry and the `salmon breeding´ industry. Here the main risk factors they were exposed to were legislation about electricity prices and distribution, environmental issues, wind power subsidization and salmon prices. The `tomatoes´ industry were primarily exposed towards tomato prices, distribution costs and farming regulations. In short, the `tomatoes´ industry exposed SEAS-NVE to entirely new risk factors, and they thereby fulfill the `risk factor´ criteria.

6.3 - PLC-stages The third and final hypothetical success criteria derived from the literature review, were the criteria that companies must diversify into an industry at PLC-stage `Introduction´ or `Growth´, while one or more of their key SBU's are at the stable and cash generating PLCstage of `Maturity´. Since the length-span of each PLC-stage varies significantly from industry to industry, it can be challenging to determine the current PLC-positioning of a SBU. A better indicator than age in establishing the PLC-stage is therefore the market characteristics of the industry (Porter, 2008), and the assessments of these in this chapter will be based upon the criteria Porter proposes in his 1980-article (see Appendix 9.1). When we look at the four case companies, A. P. Moller-Maersk had their main SBU in the shipping industry in 1964, with only sporadic activities elsewhere. At this time, the shipping industry was characterized by increasing adaptation to the introduction of standardized containers in 1956. Many new ships were being purchased to compensate the under-capacity in the container shipping industry, which resulted in high profit margins and thereby attracted new competitors6. Since these attributes are common to the `Growth´ PLC-stage in conjunction with the fact that recent decades of activities in the container shipping industry7 have been common to the `Maturity´ PLC-stage, I believe that the container shipping industry 6

www.worldshipping.org such as: cost reductions through larger and more modern ships, overcapacity and increasing focus on service and packaging just to mention some. 7

Page 64

were only at PLC-stage `Growth´ in 1964. The very first supermarket had opened in Denmark in 1953 and the concept of supermarkets with non-food items were introduced with the opening of the first Fotex in 1960. In 1960 this concept was so revolutionary that the customers were fairly skeptical towards the idea, and had to be convinced to try it (Ellemose, 2006), which is a clear indication of being in PLC-stage `Introduction´. It did not take long for the consumers to grasp this new concept, as it was such a clear improvement over its predecessors, and during the 1960's 14 new Fotex supermarkets were established8. This rapid expansion along with the extensive marketing efforts conducted by Dansk Supermarked in these years, convinces me that the supermarket industry would have been at PLC-stage `Growth´ in 1964. Thereby A. P. Moller-Maersk only partially fulfill the PLC-stage criteria, as their existing main SBU was not at PLC-stage `Maturity´, while the new industry was at PLC-stage `Growth´ as required. Next we will look into Siemens diversification move into the `wind power´ industry in 2004, and analyze whether they fulfilled the PLC-stage criteria at the time of their expansion. As previously mentioned, Siemens was already an extensively diversified corporation in 2004, with one of their many product categories being `home appliances´. The `home appliances´ category cover products such as washing machines, refrigerators and vacuum cleaners just to mention a few. These three products were all invented around the start of the 20th century, but with continuous product improvements have yet to reach the PLC-stage of `Decline´. Their respective markets are characterized by mass markets, repeated purchases and brand competition, which are characteristics of the PLC-stage `Maturity´. It is therefore my clear conviction that Siemens had several key SBU's at the `Maturity´ stage in 2004. The `wind power´ industry launched the first commercial serial production of electricity producing windmills in the mid 1970's. During the years around the expansion, the industry was characterized by new customer groups showing an interest, very high exports and a more consistent product quality, which leads me to believe that the `wind power´ industry in 2004 were in the latter part of PLC-stage `Growth´. Thereby Siemens diversification move into the `wind power´ industry in 2004 fulfill the PLC-stage criteria of having one or more key SBU's in PLC-stage `Maturity´, while expanding into an industry at PLC-stage `Introduction´ or `Growth´.

8

http://www.1960erne.dk/dkfotex.php

Page 65

When NKT made their expansion into the `biotech equipment´ industry in 1999, their main SBU were `electricity infrastructure cables´. The company produced their first electricity infrastructure cables over 100 years ago, but with continuous product improvements ever since, different types of cables are still the preferred method of electricity transportation. In 1999 the industry was characterized by fairly standardized products, with companies consolidating or researching specialized niche-products9. With similar product qualities and large-scale customers, the competition is mainly focused around price, service and delivery, and all these attributes points towards the industry being at PLC-stage `Maturity´. The `biotech equipment´ industry on the other hand is a much younger industry, which originated as a by-product of the biotechnology industry's rapid growth since the mid 1970's. Biotech products often require specialized equipment produced in certain materials or with particular surface-coatings, and with an increasing demand for specialized equipment, the `biotech equipment´ industry started to take shape since the late 1970's. Today the `biotech equipment´ industry is characterized by high profit margins, significant M&A activity, high product specificity & patented solutions, and large exports, which clarifies that the industry is currently at the PLC-stage `Growth´. Since the PLC-stages are chronological, the `biotech equipment´ industry must also have been at this stage or an earlier one in 1999, and NKT's diversification move into the `biotech equipment´ industry thereby fulfill the PLC-stage criteria. Finally I will analyze whether SEAS-NVE's diversification move into the `tomatoes´ industry in 1989 fulfilled the PLC-stage criteria. At this time their main SBU was their activities in the `electricity production & distribution´ industry, in which they had been an active player since 1912. The `electricity production & distribution´ industry have existed since 1891, but due to the continuously increasing demand for electricity have yet to reach the PLC-stage of `Decline´. In 1989 the attributes of the industry were steady profits, fixed prices & demand, and a focus on cost efficiency, which points towards the industry being at PLC-stage `Maturity´. The `tomatoes´ industry is said to have existed since approx. year 1800 when the first commercial growing were initiated. In recent decades the industry have been faced with falling prices, larger production sites and price competition, which indicate that the `tomatoes´ industry had already entered the PLC-stage of `Maturity´ at the time of the expansion in 1989. Thereby SEAS-NVE only partially fulfill the PLC-stage criteria, by having its existing main 9

www.nktcables.com

Page 66

SBU at PLC-stage `Maturity´, but also diversifying into a new industry at PLC-stage `Maturity´.

6.4 - Enabling resources & capabilities The report will now analyze whether the hypothetical enabling resources & capabilities required for successful corporate diversification were in place prior to the case companies diversification moves. Although strong managerial & marketing capabilities are proposed as one of the necessary conditions in achieving the full synergy potential of a diversification strategy, evaluating their fulfillment through the empirical analysis would require very subjective assessments on my part, so it is instead assumed that all four companies met this requirement. Next we have the enabling resource of well-developed organizational structures cultivating cross-divisional knowledge-sharing. In the first case company, A. P. Moller-Maersk, we saw that they decided to run their supermarket activities as a completely separate entity. Thereby they did not wish to have any cross-divisional knowledge-sharing beyond what was advised by their board members. A. P. Moller-Maersk deliberately did not intend to integrate their newly acquired supermarket component by an overarching organizational structure, and do thereby not achieve fulfillment of the second enabling resource criteria `organizational structure´. Siemens on the other hand took a more progressive approach in integrating their newly acquired wind-power entity. One of the key motives behind the acquisition was the great synergy potential, and Siemens knew from their extensive diversification experience that this was best achieved by making the new SBU feel well-integrated in the corporation. Fine-tuned through years of dedication, and centered around their knowledge-sharing division, the organizational setup at Siemens was almost ideally suited for corporate diversification, and they thereby fulfill the enabling resource criteria `organizational structure´. NKT's diversification move into the `biotech equipment´ industry was centered around a similar knowledge-sharing concept, with particular emphasis on sharing key functions and the corporate knowledge in launching young innovative start-up companies. The organizational structure in the company was designed to cultivate knowledge-sharing between divisions and help the many new SBU's, so NKT fulfill the enabling resource criteria

Page 67

`organizational structure´. Finally we have SEAS-NVE's diversification move into the `tomatoes´ industry, which was mainly motivated by finding a use for the surplus cooling water from the energy production. The organizational setup at SEAS at the time had not been altered much over the years, and the corporation as a whole was generally not well-suited for corporate diversification. With virtually no focus on cross-divisional knowledge-sharing in the organization, SEAS-NVE do not fulfill the enabling resource criteria `organizational structure´. The next enabling resource criteria to be analyzed, is whether or not the companies had sufficient capital at the time of their diversification move, in order to maintain both existing and new SBU's at uncompromised strategies. Here we first look at A. P. Moller-Maersk and their expansion into the `supermarket´ industry. In the case study we saw that the company's financial situation at the time was very healthy, and that they were in fact searching for profitable investment opportunities. Since financial strength was also pointed out by the interview respondent as one of the key strengths of the organization, it is determined that A. P. Moller-Maersk fulfilled the enabling resource criteria `sufficient capital´. At the time Siemens expanded their operations into the `Wind Power´ industry, the corporation was already a worldwide industrial conglomerate with multiple SBU's generating stable cash flows. With the financial situation in the company described by the interview respondent as `extremely healthy´, it is concluded that Siemens fulfilled the enabling resource criteria `sufficient capital´ at the time of the diversification move. Next we look at NKT and their expansion move into the `biotech equipment´ industry in 1999. At this point the company had several SBU's at stable cash-generating PLC-stages, but they were also aggressively pursuing a strategy of launching new companies which often require significant investments. The overall financial situation in the company at this point was described by the interview respondent as `okay, without being great´, but since the `sufficient capital´ criteria requires a company to have sufficient resources to undertake uncompromised strategies for all SBU's simultaneously, it is evaluated that NKT did not fulfill the enabling resource criteria `sufficient capital´. Finally we look at the last case company SEAS-NVE, and their expansion into the `tomatoes´ industry. At this point their main SBU `electricity production and distribution´ were generating stable cash flows at PLC-stage `Maturity´, while their other activities did not require heavy investments. The interview respondent describes their financial situation as `reasonably healthy, generating steady profits´, but since they had a

Page 68

manageable number of SBU's at the time, it is determined that SEAS-NVE fulfilled the enabling resource criteria `sufficient capital´. The last enabling capability to be analyzed, is the companies possession of `strong governance structures´ in order to minimize `agency problems´. For analytical purposes, section 1.4.4 established to reduce these to include an `independent board of directors´, `implementation initiatives´ and `performance-based bonus schemes´. A. P. Moller-Maersk was already a publicly traded company in 1964, and was thereby ensured a presumably independent shareholder-elected board of directors by Danish law. They deliberately decided to run their supermarket activities as a completely independent spin-off company, so therefore no attempt was made to integrate the new SBU into the corporation. According to the case study, it is uncertain whether A. P. Moller-Maersk used performance-based bonus schemes in the early years after the acquisition. However, performance-based bonuses for the managers have been an integrated part of the corporation through the past decades, so it is assumed that they were introduced at a fairly early stage. Although not convincingly, this means that A. P. Moller-Maersk just fulfill the enabling capability criteria of `strong governance structures´. Next we have Siemens and their entry into the `Wind Power´ industry in 2004. Again the corporation was a publicly traded company at the time of the expansion, and thereby ensured a reasonably independent board of directors by German law. Since this move was strategically based and Siemens had vast experience in similar acquisitions, numerous initiatives were in place to smoothen the transition of the new SBU. Furthermore all managers in Siemens receive a portion of their salaries as performance-based bonuses, so overall Siemens fulfill the enabling capability criteria of `strong governance structures´. NKT made their expansion move into the `biotech equipment´ industry in 1999, at which time the company was a publicly traded company and thereby had an independent board of directors. Most of the new start-ups were launched in-house, and NKT also had several introductory programs and the `competence net´ to help the new SBU off to a good start. The company had an extensive use of performance-based bonus schemes to keep the new managers fully motivated, and thereby it seems safe to claim that NKT also fulfilled the enabling capability criteria of `strong governance structures´. Finally we have SEAS-NVE and their expansion into the `tomatoes´ industry. At this time the company was run as a co-operative with the board of representatives as the highest authority. The co-operative was owned by the electricity-consumers, and thereby had a very large number of owners with a very small ownership-share each. This

Page 69

setup made it difficult to unify enough power to overthrow the board of representatives, and in conjunction with manipulative efforts from the company, SEAS-NVE did not have an independent board of representatives in 1989 (Arnesen et al., 1994). No initiatives were launched in order to integrate the new SBU in the corporation, nor was any of the management salaries performance-based. So overall SEAS-NVE fail to fulfill the enabling capability criteria of `strong governance structures´.

6.5 - Summary This chapter carried out an empirical analysis on the case companies fulfillment of the hypothetical success criteria, which will be summarized in this section (see Table 6.1 below). If we first look at A. P. Moller-Maersk, we see that they fulfilled the `relatedness´ and the `risk factor´ criteria, whilst only partially fulfilling the `PLC-stage´ criteria. Here they met the condition of diversifying into a young industry, but failed to do so while their existing activities were at PLC-stage `Maturity´. The benefits of having the main SBU at the `Maturity´-stage, is that it would be cash-generating and require little attention or new investments. However, looking back at the A. P. Moller-Maersk case study, we see that one of the motives behind the expansion was excess capital, and that they wished to run the `supermarket´ SBU as a completely separate entity, thereby neutralizing the advantages cashgeneration and low attention of being at the `Maturity´-stage somewhat. Within the enabling resources & capabilities, A. P. Moller-Maersk fulfill `managerial capabilities´, `sufficient capital´ and `governance structures´, but fail to comply with the cross-divisional knowledgesharing. This is again due to their deliberate choice of operating the two SBU's as entirely separate companies, not attempting to harvest any synergies from their diversified operation. Next we look at Siemens, who in their diversification into the wind power industry fulfilled the `relatedness´ and the `PLC-stage´ criteria, but failed to comply with the `risk factor´ criteria. However, at the time of the expansion Siemens already possessed an almost perfectly diversified risk exposure through their presence in such a large number of different industries. Thereby a little more exposure towards risk factors already present in their existing business portfolio will contribute significantly less to the overall business risk, than would have been the case if they only had activities in 2-3 SBU's. The analysis also reveals that Siemens

Page 70

perfectly fulfill all the enabling resources & capabilities criteria, which they have refined through years of diversification and search for synergies. Subsequently the first of the unsuccessful companies NKT will be under scrutiny. Here it is evident that they failed to meet the `relatedness´ criteria, while fulfilling the `PLC-stage´ and `risk factor´ criteria. We know from the NKT case study that they expanded into a large number of different industries simultaneously in the hopes of hitting a high-growth industry, but in doing so failed to base these diversification attempts on core competencies. Thereby it becomes very difficult to generate value in a new industry, since you are more or less starting from scratch against established competitors. In terms of the enabling resources & capabilities they actually fulfilled all of these except `sufficient capital´, which is however an important deficiency when expanding into multiple new SBU's at the same time. Finally we have SEAS-NVE and their unsuccessful expansion into the `tomatoes´ industry. Again we see that they fail to meet the `relatedness´ criteria, which means that they will have a hard task generating value. Simultaneously they only partially fulfill the `PLC-stage´ criteria, by expanding into an industry at PLC-stage `Maturity´, which means that they will be faced with fierce competition in a low-growth market. In fact their diversification attempt only fully comply with the `risk factor´ criteria, whereby it closely resembles the highly criticized conglomerate expansions of the past. In terms of the enabling resources & capabilities, they presumably fulfill `managerial capabilities´ and also meet the `sufficient capital´ criteria, but fail to comply with both `knowledge-sharing´ and `governance structures´.

Table 6.1 - Fulfillment of criteria Page 71

7. - Criteria evaluation and refinement

Having analyzed the fulfillment of the criteria in each of the case study companies in the previous chapters, this section, in accordance with the methodology of the `Indirect method of difference´, will now evaluate the implications of these results on the actual criteria. The dependent variables, namely the outcome of the diversification attempts were given in advance by the historic aspect of the analysis, so we know that A. P. Moller-Maersk and Siemens achieved success, and that NKT and SEAS-NVE failed in their diversification attempts. Based on literature reviews, seven hypothetical success criteria were proposed that could help companies maximize the advantages and minimize the disadvantages of corporate diversification, thereby increasing its likely success. These criteria were split into two types: `Enabling resources & capabilities´ which were to be in place prior to considering corporate diversification as well as maintained afterwards, and `Success criteria´ that must be followed in the actual diversification move. Thereby the task at hand, is to evaluate to what degree A. P. Moller-Maersk and Siemens fulfilled these hypothetical success criteria, and in which ways NKT and SEAS-NVE did not - and adjust the criteria accordingly.

7.1 - Enabling resources & capabilities In the category of `Enabling resources & capabilities´, the first criteria was that the diversifying company must be in possession of strong managerial & marketing capabilities prior to indulging in corporate diversification. This is very important because strong capabilities in these categories will help ensure a more trouble-free expansion, and more importantly contribute significantly to the value creation and utilization of the synergypotential in the new and more complex organization. Granted, it is an extremely superficial criteria in its current form, that would require significant further analysis before obtaining a more manageable framework. Consequently the empirical analysis merely assumed this criteria to be fulfilled in all four case companies, and therefore any refinement of the criteria at this point is obsolete. Serious consideration was put into leaving this criteria out of the analysis since it does not contribute much, but for the comprehensiveness and applicability of the proposed model it was decided to include it.

Page 72

The next criteria within the `Enabling resources & capabilities´ category is the possession of well-developed organizational structures that will cultivate cross-divisional knowledgesharing. The purpose of this criteria is the obtainment of synergies, both in the form of costsaving synergies through the sharing of certain organizational functions, as well as growth synergies generated through knowledge-sharing. In the empirical analysis it becomes evident however, that one of the case companies (A. P. Moller-Maersk) managed successful corporate diversification without fulfilling this criteria, whilst another case company (NKT) fulfilled this criteria without achieving success. Since the benefits of the criteria are not met in other ways, this would indicate that the `organizational structures´ criteria may be important in some aspects of diversification, but is not in itself vital to successful diversification in its current form. It is therefore decided to exclude it from the refined model. This is followed by the `Enabling resources & capabilities´ criteria of having sufficient capital in the corporation, as it is crucial for the overall success that each SBU can be run without compromise simultaneous to the diversified expansion. The sufficient capital criteria is highly important because of the long time-span of successful diversification, where it can often take years, sometimes even decades, before it becomes truly profitable. In the empirical analysis we saw that both of the successful case companies fulfilled this criteria, along with one of the unsuccessful ones (SEAS-NVE). The fact that one of the unsuccessful diversifiers also fulfilled this criteria actually lends support to the separation of the criteria into two categories, as it becomes evident that sufficient capital may be an important component in enabling successful diversification, but it cannot create it. This leads us to the fourth and final of the `Enabling resources & capabilities´ criteria, namely strong governance structures. The purpose of governance mechanisms in an organization is to minimize `opportunistic behavior´ among the managers and employees, and try to motivate them into pursuing the corporate goals instead. Since `principal-agent problems´ caused by `opportunistic behavior´ is accused of being one of the biggest threats against successful diversification, strong governance structures to minimize these problems are vital. From the empirical analysis we see that the two successful companies fulfill this criteria, along with one of the unsuccessful ones (NKT) again reinforcing the status as an enabling factor.

Page 73

7.2 - Success Criteria Having evaluated the `Enabling resources & capabilities´, the next step is to analyze the actual value-generating success criteria. Here previous parts of the thesis established that the relatedness component of corporate diversification needs to be considered in terms of a `strategic fit´ between the core competencies of a company and the critical success factors of an industry. Thereby you manage to link the strengths of an organization to an industry where these qualifications are the key to succeeding, which both directly and indirectly has greater synergy-potential than other types of relatedness. From the empirical analysis we learned, that the two successful case companies Siemens and A. P. Moller-Maersk both fulfilled this criteria, while the two unsuccessful ones did not. One might argue that A. P. Moller-Maersk possessing this `strategic fit´ to the supermarket industry is irrelevant, since they decided not to exercise any influence. It is my opinion however, that A. P. Moller-Maersk' core competencies within logistics may have contributed with valuable advise through their board member positions, particularly in the early years of the partnership. Since neither of the unsuccessful case companies fulfilled this criteria it meets the principles of the `Indirect method of difference´ and is accepted in its current form. Next we evaluate the fulfillment of the risk factor criteria. Here the empirical analysis reveals that only one of the successful companies (A. P. Moller-Maersk) meet this criteria, whilst both of the unsuccessful ones do. Initially this leads to some confusion, as it is contradictory to preceding assumptions. Upon further investigation however, it turns out that the successful company that did not fulfill the criteria was Siemens, who already possessed a fully diversified risk portfolio and thereby neutralizes the effects of fulfilling this criteria. It still leaves some reflection as to the effect of the criteria though, when both of the unsuccessful diversifiers also passed it. Here the extensive literature review becomes beneficial, as it leads the thoughts back to the conglomerate diversifiers of the 60's and 70's with the main motivation of risk reduction. Based on their failures it was established beyond any doubt that corporate diversification must be based on relatedness rather than risk reduction. So basically fulfilling the risk factor criteria without meeting the relatedness component is worthless. In my opinion the benefits of risk diversification is still a valuable part of corporate diversification, so rather than dismissing it as a criteria altogether, I believe a ranking of the `Success criteria´ may have to be introduced into the model.

Page 74

First we will evaluate the final success criteria `PLC-stage´ to see if this offers further insight. This criteria suggest, that the diversifying company must have one of its main SBU's at PLCstage `Maturity´, whilst diversifying into an industry at PLC-stage `Introduction´ or `Growth´. The benefits of this, is that the company will have a low-maintenance cash-generator, whilst expanding into an industry with plenty of growth potential and less established competitors. Here the empirical analysis revealed that one successful (Siemens) and one unsuccessful (NKT) case company fulfilled this criteria, while one successful (A. P. Moller-Maersk) and one unsuccessful (SEAS-NVE) case company only fulfilled it partially. At first glance this would indicate a dismissal of the criteria, but the differences in their partial fulfillment prove this unnecessary. Upon further investigation we see, that A. P. Moller-Maersk expanded into an industry at PLC-stage `Growth´, but did so at a time where their main SBU was also at PLC-stage `Growth´. On the other hand, SEAS-NVE had their main SBU at PLC-stage `Maturity´ at the time of the expansion, but diversified into an industry already at PLC-stage `Maturity´. These findings would indicate, that it is more important to diversify into a young industry than having your main SBU at PLC-stage `Maturity´, since the benefits of the `Maturity´-part can be found in other ways, but the downsides to not expanding into a young industry cannot be neutralized. Therefore the `Maturity´-part of the `PLC-stage´ criteria is dismissed. This leaves us with the final puzzle of how NKT could fulfill 2 and SEAS-NVE 1½ out of the three success criteria, and still become unsuccessful in their diversification attempts. Considering the effects of each of the three success criteria may help offer an explanation. The effects of the now refined `PLC-stage´ criteria, is in basic terms growth potential and limited competition, while the effects of the `risk factor´ criteria is simply risk reduction. The effects of the relatedness criteria on the other hand, is both short-term and long-term value generation. In comparison growth potential and risk reduction may be important parts of the full package, but become somewhat obsolete without value creation. Thereby I believe, that the criteria of `strategic fit´ between the core competencies of a company and the critical success factors of an industry should be promoted to the main success criteria of corporate diversification, whilst `PLC-stage´ and `risk factors´ remain important secondary success factors. Thereby the refined model that may help increase the likelihood of success through corporate diversification is visually presented below in figure 7.1.

Page 75

Figure 7.1 - Success criteria for corporate diversification

Page 76

8. - Conclusion

This master thesis set out to investigate the role of moderating conditions in the diversification-performance relationship, and in doing so develop a model that could provide guidelines to increase the likelihood of success for companies considering corporate diversification. The initial foundation of the analysis was based upon a comprehensive literature review conveying the key contributions from four different academic schools of thought. Here it was established, that the diversification-performance relationship is indeed influenced by multiple moderating conditions at the same time (multiple causality), which have lead scholars to believe that the inconsistent findings of the past may have been affected by this. Three other factors that may have biased previous research were identified as 1.) the use of SIC-codes in determining valuable relatedness, 2.) consensus of the `value-destructive claim´ in the financial world, and 3.) the lack of geographic diversity in the academic research. With this in mind, an analysis sought to develop criteria based on the moderating conditions, that could utilize most of the advantages of corporate diversification, while minimizing the disadvantages, thereby increasing the likelihood of success through their fulfillment. This resulted in the development of seven hypothetical success criteria for corporate diversification, with three `success criteria´ concerning the diversification target, and four `enabling resources & capabilities´ that should be in place in the organization prior to the expansion. The three `success criteria´ were a relatedness-component, arguing that the core competencies of the company must share a strategic fit with the critical success factors of the industry under consideration, in order to maximize the value-generating possibilities. The next `success criteria´ propose, that the company should attempt to diversify into an industry that have risk factors with as low or even negative correlation to its existing ones as possible, thereby maximizing the risk reducing effects of corporate diversification. The third `success criteria´ claim that a company must diversify into an industry at PLC-stage `Introduction´ or `Growth´, while at least one of their main SBU's are at PLC-stage `Maturity´. By meeting this criteria, the company would accomplish to have plenty of growth-opportunities in the new industry before the competition become too fierce, while other areas of the firm generate steady profits without requiring too much attention. Supplementing these, were four `enabling

Page 77

resources & capabilities´ criteria, that should be present in the company both before and after the diversification move. These were strong managerial & marketing capabilities enabling a smooth transition and a strong contribution to the utilization of the full synergy-potential. Next was the possession of well-developed organizational structures, with the purpose of increasing the synergy-potential through cross-divisional knowledge sharing and cost-saving synergies. This was followed by the criteria of having sufficient capital in the organization, thereby enabling the company to maintain uncompromised activities in all SBU's, with the fourth and final `enabling resources & capabilities´ criteria being the presence of strong governance structures, in order to keep principal-agent problems and opportunistic behavior at a minimum. After these hypothetical criteria were formulated, an empirical analysis based on the four case companies A. P. Moller-Maersk, NKT, SEAS-NVE and Siemens were conducted, with the purpose of evaluating and refining them. This analysis followed the guidelines of the `Indirect method of difference´, where cases with a given outcome (successful diversification) are tested for the presence of independent variables (success criteria), and then cases with the opposite outcome (unsuccessful diversification) are tested for the lack of these. The empirical analysis did not unambiguously confirm the anticipated results, which highlighted the need for some modifications. After some reflections, the `Maturity´-part of the PLC-stage criteria, as well as the enabling resource `organizational structures´ were removed from the model, as it became evident that these were not vital to successful corporate diversification, in spite of beneficial attributes. The empirical analysis also revealed a necessity of ranking the `success criteria´, since the relatedness-component of strategic fit proved itself indispensable to the success of corporate diversification on a larger scale than the PLC-stage and risk factor criteria. Thereby the conclusive recommendation of this master thesis is, that companies in possession of the `enabling resources & capabilities´ of strong managerial & marketing capabilities, sufficient capital and strong governance structures may consider diversifying into an industry where the critical success factors match the core competencies of the organization. Complementary to this strategic fit the new industry must be at PLC-stage `Introduction´ or `Growth´, whilst exposing the company to as uncorrelated/negatively correlated risk factors to its existing ones as possible (see figure 7.1).

Page 78

It is important to keep in mind, that this thesis never intended to enter the debate of whether or not corporate diversification overall is beneficial, but merely provide criteria that might increase the likelihood of its success. The qualitative nature of the empirical analysis also means that further research conducted upon a larger statistical `Universe´ will be required to confirm or dismiss the influence of these criteria with any statistical significance. Finally some further research into the proposed biasing factors may help clear the path for some affirmative overarching conclusions on the topic of corporate diversification.

Page 79

9. - Appendix

9.1 - PLC-stage characteristics

Page 80

9.2 - Interviews SEAS-NVE Jan Johansen Afdelingschef Interview: 22/8-2012 - Svinninge

SIEMENS Jukka Pertola Adm. Direktør, Siemens Danmark Interview: 10/10-2012 - Ballerup

A.P. MØLLER-MAERSK Jacob Stockmal Ditlevsen General Manager, Group Strategy Interview: 24/8-2012 - København

NKT Jacob D. Skov Adm. Direktør, NKT Photonics Interview: 13/1-2013 - Birkerød

Page 81

9.3 - Questionnaire

1. When did .....(company)...... first extend operations into .....(industry).......?

2. And at this time your other main industries were?

3. How was the expansion done (acquisition/internal development)?

4. Was the expansion a result of .....(company)...... possessing valuable resources it did not fully exploit?

5. Were alternatives to going in to this industry considered (more dividends to stockholders, going into other industries, selling/leasing out some excess resources etc.)?

6. Were .....(company)......doing well financially at the time?

7. What were the motivations/influencing factors behind this move?

8. Do you think the company had the qualifications to operate in this industry?

9. Was the organization (managers, marketing, operations etc.) prepared for such an expansion?

Page 82

10. Could the new industry benefit from the existing organizational capabilities?

11. What characterized this new industry (young, innovative, competitive etc.)?

12. Were there any similarities to existing operations (raw materials, procedures, distribution etc.)?

13. What do you think was the key to succeeding in this new industry?

14. Were the risks in the new industry similar to the risks the company was already exposed to?

15. What would you say were some of the most important strengths of .....(company)...... before the expansion?

16. Could some of these competencies be beneficial in the new industry?

17. Which initiatives were taken to make the new company feel it belonged in the `family´ (corporation)?

18. Did the manager of .....(industry)....... receive any of his/her wages through performancebonuses?

19. Looking back at the expansion, which advantages and disadvantages did it create? Page 83

20. Did any benefits arise from the joint operation of these two (or more) business areas?

21. Did you end up having any competitive advantages over competitors in the new industry?

Please answer the following scales with an X

The company had sufficient capital to run all business areas without compromise after the expansion?

Strongly disagree

Disagree

Neutral

Agree

Strongly agree

The new industry was fairly young at the time of the expansion and therefore had moderate competition?

Strongly disagree

Disagree

Neutral

Agree

Strongly agree

The company’s existing resources & capabilities matched the success criteria of the new industry?

Page 84

Strongly disagree

Disagree

Neutral

Agree

Strongly agree

The new industry exposed the company to different risk factors than existing operations?

Strongly disagree

Disagree

Neutral

Agree

Strongly agree

The company made an effort to make the new company feel appreciated and part of the corporation?

Strongly disagree

Disagree

Neutral

Agree

Strongly agree

The company had some organizational capabilities that could become beneficial in a new industry?

Strongly disagree

Disagree

Neutral

Agree

Strongly agree

Page 85

9.4 - Matching of advantages/disadvantages and success criteria

Page 86

10. - References

Ansoff, H. I. (1958): ”A model for diversification”, Management Science Andersén, J. (2011): Strategic Resources and Firm Performance, Management Decision, Vol. 49 Arnesen, L. & Eggers-Lura, A. (1994): Skandalen om SEAS, J. H. Schultz Information A/S Barney, J. (1991): Firm Resources and Sustained Competitive Advantage, Journal of Management, Vol. 17 Berger, P. G. & Ofek, E. (1995): Diversification’s effect on firm value, Journal of Financial Economics Berger, P. G. & Ofek, E. (1996): Bust-up takeovers of value destroying diversified firms, Journal of Finance Besanko, D. et al. (2004): Economics of Strategy - John Wiley & Sons Ltd. Campbell, A., Goold, M. & Alexander, M. (1995): Corporate Strategy: The Quest for Parenting Advantage, Harvard Business Review, March-April Campbell, A. (1997): Reviewing Portfolio Strategy - Strategic Leadership Forum, Feb/March Denis, D. J., Denis, D. K. & Sarin, A. (1997): Agency Problems, Equity Ownership, and Corporate Diversification - The Journal of Finance, March, 1997 Dierickx, I. & Cool, K. (1989): Asset Stock Accumulation and Sustainability of Competitive Advantage, Management Science, Vol. 35 Ellemose, Søren (2006): Giganten - fra Salling til Dansk Supermarked, Jyllands-postens Forlag Farjoun, M., (1998): The independent and joint effects of the skill and physical bases of relatedness in diversification - Strategic Management Journal, Vol. 19 George, A. L. & Bennett, A. (2005): Case Studies and Theory Development in the Social Sciences - MIT Press

Page 87

Grant, R. M. (2010): Contemporary Strategy Analysis - John Wiley & Sons Ltd. He, X. (2009): Corporate Diversification and Firm Value: Evidence from Post-1997 Data, International Review of Finance, Vol. 9 Henry, A. (2008): Understanding Strategic Management - Oxford University Press Iversen, M. (1999): Organization of synergies in large diversified firms - A corporate management perspective - Copenhagen Business School Jacobsen, S. (2007): Danske Dynastier - Ekstra Bladets Forlag Knoll, S. (2008): Cross-Business Synergies - A Typology of Cross-Business Synergies and a Mid-Range Theory of Continuous Growth Synergy Realization, Dissertation Universität St. Gallen Lang, L. H. P. & Stulz, R. M. (1994): Tobin’s Q, corporate diversification and firm performance, Journal of Political Economy Lund, J. (2003): The Importance of Corporate Diversification: Can Changes in Corporate Diversification Explain Changes in Performance? - Copenhagen Business School Makadok, R. (2001): Toward a synthesis of the resource-based and dynamic-capability views of rent creation, Strategic Management Journal, Vol. 22 Markides, C. & Williamson, P. J. (1994): Related Diversification, Core Competences and Corporate Performance, Strategic Management Journal, Vol. 15 Martin, J. D. & Sayrak, A. (2003): Corporate Diversification and Shareholder Value: a survey of recent literature, Journal of Corporate Finance, Vol. 9 Montgomery, C. A. (1994): Corporate Diversification, Journal of Economic Perspective, Vol. 8 Palich, L. E., Cardinal, L. B. & Miller, C. C. (2000 a): Curvelinearity in the DiversificationPerformance Linkage: an examination of over three decades of research, Strategic Management Journal, Vol. 21 Palich, L. E., Carini, G. R. & Seaman, S. L. (2000 b): The Impact of Internationalization on the Diversification-Performance Relationship: A Replication and Extention of Prior Research, Journal of Business Research, Vol. 48

Page 88

Pehrsson, A. (2006 a): Business Relatedness Measurements - state-of-the-art and a proposal, European Business Review, Vol. 18 Pehrsson, A. (2006 b): Business Relatedness and Performance: a study of managerial perceptions, Strategic Management Journal, Vol. 27 Penrose, E. (1959): The Theory of the Growth of the Firm - Oxford University Press Perry, S. R. (1998): A meta-analytic review of the diversification-performance relationship: aggregating findings in strategic management - Florida Atlantic University Peteraf, M. A. (1993): The Cornerstones of Competitive Advantage: A Resource-Based View, Strategic Management Journal, Vol. 14 Porter, M. E. (1980): Competitive Strategy: Techniques for Analyzing Industries and Competitors - The Free Press Porter, M. E. (1987): From Competitive Advantage to Corporate Strategy, Harvard Business Review, Vol. 65 Porter, M. E. (1996): What is Strategy?, Harvard Business Review, Vol. Nov.-Dec. Porter, M. E. (2008): The Five Competitive Forces that Shape Strategy, Harvard Business Review, Vol. 86 Prahalad, C. K. & Hamel, G. (1990): The Core Competence of the Corporation, Harvard Business Review, Vol. May-June Purkayastha, S., Manolova, T. S. & Edelman, L. F. (2011): Diversification and Performance in Developed and Emerging Market Contexts: A Review of the Literature, International Journal of Management Reviews Ramanujam, V. & Varadarajan, P. (1989): Research on Corporate Diversification: a synthesis, Strategic Management Journal, Vol. 10 Rumelt, R. P. (1974): Strategy, Structure and Economic Performance - Division of Research, Harvard Business School Servaes, H. (1996): The value of diversification during the conglomerate merger wave, The Journal of Finance, Vol. 4 Lins, K. & Servaes, H. (1999): International evidence on the value of Corporate Diversification, Journal of Corporate Finance Page 89

Teece, D. J. (1982): Towards an economic theory of the multiproduct firm, Journal of Economic Behavior & Organization Teece, D. J., Pisano, G. & Shuen, A. (1997): Dynamic Capabilities and Strategic Management, Strategic Management Journal, Vol. 18 Tobiasen, R. & Rudolf, J. (2010): Success Criteria in Corporate Diversification Copenhagen Business School Vasconcellos, J. A. S. & Hambrick, D. C. (1989): Key Success Factors: test of a general theory in the mature industrial-product sector, Strategic Management Journal, Vol. 10 Wernerfelt, B. & Montgomery, C. A. (1988): Tobin’s Q and the importance of focus in firm performance, American Economic Review de Wit, B. & Meyer, R. (2010): STRATEGY: Process, Content, Context - an international perspective - Cengage Learning EMEA

Page 90