DIVERSIFICATION

WHAT IS DIVERSIFICATION ? TYPES OF DIVERSIFICATION AND WHY DIVERSIFICATION ? 

DIVERSIFICATION :

 

Diversification involves moving into new lines of business. When an industry consolidates and becomes mature, most of the firms in that industry would have reached the limits of growth using vertical and horizontal growth strategies. If they want to continue growing any further the only option available to them is diversification by expanding their operations into a different industry. Diversification strategies also apply to the more general case of spreading market risks: adding products to the existing lines of business can be viewed as analogous to an investor who invests in multiple stocks to “spread the risks”. Diversification into other lines of business can especially make sense when the firm faces uncertain conditions in its core product-market domain. 

While intensification limits the growth of the firm to the existing businesses of the firm, diversification takes it beyond the confines of the current product-market domain to uncharted and unfamiliar products- market territory. In other words, this strategy steers the organization away from both its present products and its present market simultaneously. Of the various routes to expansion, diversification is definitely the most complex and risky route. Diversification approach to expansion is complex since it seeks to enter new product lines, processes, services or markets which involve different skills, processes and knowledge from those required for the current business. It is risky since it involves deviating from familiar territory: familiar products and familiar markets. 

Diversification of a firm can take the form of concentric and conglomerate diversification. Concentric (Related) diversification is appropriate when a firm has a strong competitive position but industry attractiveness is low. Conglomerate (unrelated) diversification is an appropriate strategy when current

industry is unattractive and that the firm lacks exceptional and outstanding capabilities or skills in related products or services. Generally, related diversification strategies have been demonstrated to achieve higher value creation (profitability and stock value) than unrelated diversification strategies (conglomerates). The interpretation of this finding is that there must be some advantage achieved through shared resources, experience, competencies, technologies, or other value-creating factors. This is the so called synergy effect of diversification i.e., ‘the whole is greater than the sum of its parts’. While it is difficult to predict what is a “synergistic” match of a business to an existing corporate portfolio, the test must be that the business creates new value when it is added to a corporation’s line of existing businesses. 

 

1. RELATED DIVERSIFICATION (CONCENTRIC DIVERSIFICATION) 

In this alternative, a company expands into a related industry, one having synergy with the company’s existing lines of business, creating a situation in which the existing and new lines of business share and gain special advantages from commonalities such as technology, customers, distribution, location, product or manufacturing similarities, and government access. In essence, in concentric diversification, the new industry is related in some way to the current one. This is often an appropriate corporate strategy when a company has a strong competitive position and distinctive competencies, but its existing industry is not very attractive. Thus, a firm is said to have pursued concentric diversification strategy when it enters into new product or service area belonging to different industry category but the new product or service is similar to the existing one with respect to technology or production or marketing channels or customers. Such diversification may be possible in two ways: internal development through product and market expansion utilizing the existing resources and capabilities or through external acquisitions operating in the same market space. Addition of lease financing activity in India is a case of market-related concentric diversification. Another type of concentric diversification is technology related in which the firm employs similar technology to manufacture new products. Addition of tomato ketchup and sauce to the existing ‘Maggi’ brand processed items of Food Specialities Ltd. is an instance of technological-related concentric diversification. 

2. UNRELATED DIVERSIFICATION (CONGLOMERATE DIVERSIFICATION) 

Conglomerate diversification is a growth strategy in which a company seeks to grow by adding entirely unrelated products and markets to its existing business. A company that consists of a grouping of businesses from unrelated streams is called a conglomerate. In conglomerate diversification, a firm generally introduces new products using different technologies in new markets. A conglomerate consists of a number of product divisions, which sell different products, principally to their own markets rather than to each other. Conglomerates diversify their business risk through profit gained from profit centres in various lines of business. However, some may become so diversified and complicated that they are too difficult to manage efficiently. However, since their huge popularity in the 1960s to 80s, many conglomerates have reduced their business lines by restricting to a choice few. The reasons for considering this alternative are primarily to seek more attractive opportunities for growth, spread the risk across different industries, and/or to exit an existing line of business. Further, this may be an appropriate strategy when, not only the present industry is unattractive, but the company also lacks outstanding competencies that it could transfer to related products or industries. However, since it is difficult to manage and excel in unrelated business units, it is often difficult to realize the expected and anticipated results. 

In India, a large number of companies diversified their operations following economic liberalization. Gujarat Narmada Valley Fertilizers Ltd. has diversified from fertilizers to personal transport, chemicals and electronic industries, while Arvind group, hitherto confined to textiles, diversified into unrelated activities such as manufacturing of agro- products, floriculture and export of fresh fruits. Likewise, BPL has decided to venture into sectors like power generators, cement, steel and agricultural inputs in a big way. Wipro is another company with wide ranging business interests encompassing vegetable oils, computer hardware, and software, medical equipment, hydraulic systems, consumer products, lighting, export of leather shoe nippers and has recently entered into financial services. 

Examples of conglomerate Diversification :

 

Aditya V Birla Group: A Case of a Highly Diversified Group 

The Aditya V Birla group is one of the fastest growing industrial houses in the country. Grasim, a group company, was incorporated as Gwalior Rayon Silk Manufacturing (Weaving) Co Ltd in 1947. It started as a textile manufacturing mill and integrated backward in 1954, to produce VSF (Viscose Staple Fiber) used in textiles. It expanded its capacity further through backward integration into manufacture of rayon grade wood pulp, caustic soda and manufacturing equipment to become a low cost producer. Grasim diversified into cement when industry was decontrolled. It also diversified into production of sponge iron in 1993. Grasim has presence in exports and computer software as well. It holds significant equity in several other Birla group companies. 

The manufacturing facilities of Grasim are spread all across the country. Grasim’s sponge iron plant is located at Raigarh near Mumbai, while its cement plants are located at Jawad, Shambhupura in Rajasthan and Raipur in MP. The VSF plants are located at Mavoor and Harihar in Karnataka and Nagda in MP and it has recently set up a new VSF plant at Surat, Gujarat. It has pulping facilities at Nagda, Harihar and Mavoor. Grasim’s textile mills are located at Gwalior and Bhiwani near Delhi. 

The Aditya Birla Group’s strategy has been to diversify into capital-intensive businesses and become a cost-leader by leveraging on its various strengths. Apart from Grasim, major companies in the group include Hindalco Industries Ltd (aluminium), Indian Rayon (Cement, VFY, carbon black, insulators etc), Indo-Gulf Fertilizer (Fertilizer - Urea), Tanfac Industries (Chemicals for aluminum), Bihar Caustic & Chemicals Ltd (Caustic Soda/ chlorine), Hindustan Gas Industries (gas producer), Birla Growth Fund (financial services), Mangalore Refinery (oil refinery). Grasim holds a 58.6% stake in Kerala Spinners Ltd, which manufactures synthetic/ blended yarn. Grasim’s fully owned subsidiaries, Sun God Trading and Investments Ltd and Samruddhi Swastik Trading and Investments Ltd, are into asset based financing. The group also owns several companies in Thailand, Indonesia and Malaysia manufacturing textiles, synthetic/ acrylic yarn, rayon, carbon black and other chemicals.

 

WHY  DIVERSIFICATION ? 

Under strict assumptions of an efficient market theory, there is no convincing rationalefor one company to acquire another, especially less efficient or unrelated businesses. Since the markets are imperfect and do not follow the norms of efficient market theory, companies do diversify for several reasons given below: 

Economies of Scale and Scope (Synergy): The merger of two companies producing similar products should allow the combined firms to pool resources and attain lower operating costs. By making optimal use of existing marketing, investment, operating and managerial facilities of the two combining firms and eliminating redundant and overlapping activities, the combined entity can lower the operating costs and increase operational efficiency. The saving may come from reduced overheads or the ability to spread a larger amount of production over lower (consolidated) fixed costs. There may also be differential management capabilities: an efficiently managed firm may acquire a less efficient firm with the intent of bringing better management to the business. Efficiencies can also be gained through pooled financial resources or simply through pooled risk. 

Widen Market Base and Enhance Market Power: Large number of collaborations and acquisitions are aimed at expanding the market for the firm’s products. For instance, HCL and Hewlett Packard Ltd., Tata-IBM, Ranbaxy Laboratories and Eli Lilly Company, Hindustan Motors and General Motors and Tata Tea and Tetley of USA, entered into tie-up arrangements mainly to exploit the market opportunities. Mergers and acquisitions can increase a firm’s market share when both firms are in the same business. But, market share does not necessarily translate to higher profits or greater value for owners unless the merger substantially reduces the inter-firm rivalry in the industry. 

Profit Stability: Acquisition of new business can reduce variations in corporate profits by expanding the company’s lines of business. This typically occurs when the core business depends on sales that are seasonal or cyclical. A large number of organizations pursue diversification strategy just to avoid instability in sales and profits which can result from events such as cyclical and seasonal shifts in demand, changes in the life cycles and other destabilizing forces in the micro, meso and macro environment. 

Improve Financial Performance: Large firms generate cash that can be invested in other ventures. The firm acts as a banker of an internal capital market. The core business sustains itself on its moneymaking ventures, and uses this cash flow to create new ventures that generate additional profits. A firm may also be tempted to exploit diversification opportunities because it has liquid resources far in excess of the total expansion needs. Sometimes a company may seek a merger with another organization with the intention of tiding over its financial problems. 

Growth: Diversification is basically a way to grow. Indeed, managers often cite growth as the principle reason for diversification. The most important factor that motivates management to diversify is to achieve higher growth rate than which is possible with intensification strategy. If the management feels that the existing products and markets do not have the potential to deliver expected growth, the only alternative they have is to diversify into new territories. Unlike organic growth, which is slow, an acquisition or merger (inorganic) can deliver the results rather quickly since resources, skills, other factors essential for faster growth are immediately available. 

Counter Competitive Threats: Organizations are driven at times towards external diversification through merger by competitive pressures. Such a strategic move is expected to counter the competitive threats by reducing the intensity of competition. 

Access to Latest Technology: Many Indian firms enter into strategic alliances with foreign firms to gain access to the latest technologies without spending huge amount of money on R&D. For instance, Johnson and Nicholson India Ltd., a leading domestic paint manufacturer, has strengthened its position in the Indian market and also diversified into industrial electronics along with its German partner, Carl Schevek AG of Germany. 

Regulatory Factors: A large number of organizations have diversified their operations geographically to exploit opportunities in different regions and countries and also to take advantage of the incentives being offered by the various governments to attract investment. Many companies enter other countries to avoid restrictions placed by the regulators in their host country.