Techniques For Analyzing Corporate Diversification Strategies

TECHNIQUES FOR ANALYZING CORPORATE DIVERSIFICATION STRATEGIES The most popular analytical technique for probing the overall makeup of a diversified group of business units involves constructing a business portfolio matrix, a two-dimensional graphic portrait of the comparative positions of different businesses. Matrixes can be constructed using any pair of strategically relevant variables, but in practice the revealing variables have proved to be industry growth rate, market share, long-term industry attractiveness, competitive strength, and stage of product/market evolution. Use of two-dimensional business portfolio matrixes as a tool of corporate strategy evaluation is based on the relative simplicity of constructing them and on the clarity of the overall picture that they produce. Three types of business portfolio matrixes have been used the most frequently: the Boston Consulting Group’s growth-share matrix, the GE 9-cell matrix, and the Hofer—Arthur D. Little product/market evolution matrix. The four-cell BCG growth-share matrix

Industry growth rate

The first business portfolio matrix to receive widespread usage was a four-square grid pioneered by the Boston Consulting Group (BCG), one of the leading management consulting firms. An illustrative BCG-type matrix is depicted in the figure below. The matrix is formed using industry growth rate and relative market share as the axes. Each business unit in the corporate portfolio appears as a “bubble” on the four-cell matrix, with the size of each bubble or circle scaled according to the percent of revenues it represents in the overall corporate portfolio.

Relative market share position High (above 1.0) Low (below 1.0) Stars

Question marks/Problem children

High (faster than the economy as a whole)

Cash cows

Dogs

Low (slower than the economy as a whole)

BCG methodology arbitrarily places the dividing line between “high” and “low” industry growth rates at around twice the real GNP growth rate plus inflation, but the boundary percentage can be raised or lowered when it makes sense to do so The essential criterion is to place the line so that business units in the “high growth” cells can fairly be said to be in industries growing faster than 1

the economy as a whole and those in the “low growth” cells are growing slower than the economywide rate and are in industries that merit labels like mature, aging, stagnant, or declining. Relative market share is defined as the ratio of a business’s market share to the market share held by the largest rival firm in the industry, with market share being measured in terms of unit volume, not dollars. For instance, if business A has a 15 percent share of the industry’s total volume and the share held by the largest rival is 30 percent, then A’s relative market share is 0.5. If business B has a market-leading share of 40 percent and its largest rival has a 30 percent share, then H’s relative market share is 1.33. Given this definition, only business units that are market share leaders in their respective units will have relative market share values greater than 1.0; business units in the portfolio that trail rival firms in market share will have ratios below 1.0. The most stringent BCG standard calls for the border between “high” and “low” relative market share on the grid to be set at 1.0, as shown in the figure. With 1.0 as the boundary, those circles in the two left-side cells of the matrix identify how many and which businesses in the firm’s portfolio are leaders in their industry; those falling in the two right-side cells trail the leaders, with the degree to which they trail being indicated by the size of the relative market share ratio. A ratio of .10 indicates that the business has a market share only one tenth of the market share of the largest firm in the market, whereas a ratio of .80 indicates a market share that is four-fifths, or 80 percent as big as the leading firm’s share. A less stringent criterion is to fix the high-tow boundary so that businesses to the left enjoy positions as market leaders (though not necessarily the leader), and those to the right are in below-average or underdog market-share positions. Locating the dividing line between “high” and “low” at about .75 or .8 is a reasonable compromise. The merit of using relative market share instead of the actual market share percentage to construct the growth-share matrix is that the former is a better indicator of comparative market strength and competitive position - a 10 percent market share is much stronger if the leader’s share is 12 percent than if it is 50 percent; the use of relative market share captures this feature. An equally important consideration in using relative market share is that it is also likely to be a reflection of relative cost based on experience in producing the product and on economies of large-scale production. With these features of the BCG growth-share matrix in mind, we are ready to explore the portfolio implications for businesses falling into each cell of the matrix. Question Marks and Problem Children. Business units falling in the upper-right quadrant of the growth-share matrix have been named by BCG as “question marks” or “problem children”. Rapid market growth makes such business units attractive from an industry standpoint, but their low relative market share positions (and thus reduced access to experience curve effects) raise questions whether the profit potential associated with market growth can realistically be captured - hence the “question mark” or “problem child” designation. Question mark businesses, moreover, are typically, “cash hogs” - so labeled because their cash needs are high (because of the investment requirements of rapid growth and product development) and their internal cash generation is low (because of low market share, less access to experience curve effects and scale economies, and consequently thinner profit margins). The corporate parent of a cash hog business has to decide whether it is worthwhile to invest corporate capital to support the needs of a question mark division. BCG has argued that the two best strategic options for a question mark business are (1) an aggressive grow-and-build strategy to capitalize on the high growth opportunity, or (2) divestiture (in the event that the costs of strengthening its market share standing via a grow-and-build strategy outweigh the potential payoff and financial risk). Pursuit of a grow-and-build strategy is imperative anytime an attractive question mark business is characterized by strong experience 2

curve effects because of the lower-cost position enjoyed by firms with the cumulative production experience that attends bigger market shares. The stronger the experience curve effect, the more powerful the competitive position enjoyed by the competitor that is the low-cost producer. Consequently, according to the BCG thesis, unless a question mark/problem child business is managed via a grow-and-build type strategy, it will not be in a position to remain cost competitive vis-a-vis large-volume firms—in which case divestiture becomes the only other viable long-term alternative. The corporate strategy prescriptions for managing question mark/problem child business units thus become straightforward: divest those that are weaker and less attractive and groom the attractive ones to become tomorrow’s “stars.” Stars. Businesses with high relative market share positions in high growth markets rank as “stars” in the BCG grid because they offer both excellent profit and excellent growth opportunities. As such, they are the business units that an enterprise comes to depend on for boosting overall performance of the total portfolio. Given their dominant market-share position and rapid growth environment, stars typically require large cash investments to support expansion of production facilities and working capital needs, but they also tend to generate their own large internal cash flows due to the low-cost advantage that results from economies of scale and cumulative production experience. Star-type businesses vary as to whether they can support their investment needs totally from within or whether they require infusions of investment funds from corporate headquarters to support continued rapid growth and high performance. According to BCG, some stars (usually those that are well established and beginning to mature) are virtually self-sustaining in terms of cash flow and make little claim on the corporate parent’s treasury. Young stars, however, often require substantial investment capital beyond what they can generate on their own and may thus be cash hogs. Cash Cows. Businesses with a high relative market share in a low-growth market have been designated as “cash cows” by BCG because their entrenched position tends to yield substantial cash surpluses over and above what is needed for reinvestment and growth in the business. Many of today’s cash cows are yesterday’s stars. Cash cows, though less attractive from a growth standpoint, are nonetheless a valuable corporate portfolio holding because they can be “milked” for the cash to pay corporate dividends and corporate overhead; they provide cash for financing new acquisitions; and they provide funds for investing in young stars and in those problem children that are being groomed as the next round of stars (cash cows provide the dollars to “feed” the cash hogs). Strong cash cows are not “harvested” but are maintained in a healthy status to sustain long-term cash flow. The idea is to preserve market position while efficiently generating money to reallocate to business investments elsewhere. Weak cash cows, however, may be designated as prime candidates for harvesting and eventual divestiture if their industry becomes unattractive. Dogs. Businesses with low growth and low relative market share carry the label of “dogs” in the BCG matrix because of their weak competitive position (owing, perhaps, to high costs, lowquality products, less effective marketing, and the like) and the low profit potential that often accompanies slow growth or impending market decline. Another characteristic of dogs is their inability to generate attractive cash flows on a long-term basis; sometimes they do not even produce enough cash to adequately fund a rear-guard hold-and-maintain strategy - especially if competition is brutal and profit margins are chronically thin. Consequently, except in unusual cases, the BCG corporate strategy prescription is that dogs be harvested, divested, or liquidated, depending on which alternative yields the most attractive amount of cash for reallocating to other businesses or to new acquisitions. Implications for Corporate Strategy. The chief contribution of the BCG growth-share matrix is the attention it draws to the cash flow and investment characteristics of various types of 3

businesses and how corporate financial resources can be shifted from business unit to business unit in an effort to optimize the long-term strategic position and performance of the whole corporate portfolio. According to BCG analysis, the foundation of a sound, long-term corporate strategy is to utilize the excess cash generated by cash cow business units to finance market-share increases for cash hog businesses—the young stars still unable to finance their own growth internally and those problem children that have been singled out as having the best potential to grow into stars. If successful, the cash hogs eventually become self-supporting stars and then, when the markets of the star businesses begin to mature and their growth slows down, they will become the cash cows of the future. The “success sequence” is thus problem child/question mark to young star (but perhaps still a cash hog) to self-supporting star to cash cow. The weaker, less attractive question mark businesses not deemed worthy of the financial investment necessary to fund a long-term grow-and-build strategy are often portfolio liabilities. These question marks become prime divestiture candidates unless they can be kept profitable and viable with their own internally generated funds (all problem child businesses are not untenable cash hogs; some may be able to generate the cash to finance a “hold-and-maintain” strategy and thus contribute enough to corporate earnings and return on investment to justify retention in the portfolio). Even so, such question marks still have a low-priority claim on corporate financial resources; as market growth slows and maturity-saturation sets in, they will move vertically downward in the matrix, becoming less and less a source of corporate growth. Dogs should be retained only as long as they can contribute positive cash flow and do not tie up assets and resources that could be more profitably reallocated. The BCG recommendation for managing a weakening or already weak dog is to employ a harvesting strategy. If and when a harvesting strategy is no longer attractive, then a weak dog business becomes a candidate for elimination from the portfolio. There are two “disaster sequences” in the BCG scheme of things: (I) when a star’s position in the matrix erodes over time to that of a problem child and then falls to become a dog, and (2) when a cash cow loses market leadership to the point where it becomes a dog on the decline. Other strategic mistakes include overinvesting in a safe cash cow; underinvesting in a question mark so that instead of moving into the star category it tumbles into a dog; and spreading resources over many question marks rather than concentrating them on the best question marks to boost their Relative market share chances of becoming stars. Grow and build

Profit margins relative to competitors Ability to compete on price and quality Knowledge of customer and market Competitive strengths and weaknesses the BCG matrix has beencapability pioneered by General Electric, with Technological McKinsey &Caliber Company. The GE effort is nine-cell portfolio of management Long-term industry attractiveness

Strategy prescription

The Nine-Cell GE Matrix

An alternative matrix approach of Hold and maintain help from the consulting firm of matrix based on the two dimensions of long-term product-market attractiveness and business Harvest/divest strength/competitive position. In this matrix, shown in figure below, the area of the circle is proportional to the size of the industry, and the pie slices within the circle reflect the business’s strength/Competitive position (defined as a market share. The vertical axis represents each Business industry’s long-term attractiveness composite weighting of market growth rate, market size, historical and projected industry profitability, market structure and competitive intensity, scale economies, seasonality and cyclical influences, technological and capital requirements, emerging threats and opportunities, and social, Market size and growth rate environmental, and regulatory influences). Industry profit margins (historical and projected) Competitive intensity Seasonality Cyclicality Economies of scale Technology and capital requirements Social, environmental, legal, and human impacts Emerging opportunities and threats

4

The procedure involves assigning each industry attractiveness factor a weight according to its perceived importance, rating the business on each factor (using a 1 to 5 rating scale), and then obtaining a weighted composite rating as shown below: Industry Attractiveness Factor Market size Projected rate of market growth Historicel end projected profitability Intensity of competition Emerging opportunities end threats Seasonelity end cyclical influences Technological and capital requirements Environmental impact Social, political, regulatory factors

Weight .15 .20 .10 .20 .15 .05 .10 .05 Must be acceptable 1.00

Rating 5 1 1 5 1 2 3 4 ---

Value 0.73 0.20 0.10 1.00 0.15 0.10 0.30 0.20 --2.90

To arrive at a measure of business strength/competitive position, each business is rated (using the same approach shown above) on such aspects of business strength/competitive position as relative market share, success in increasing market share and profitability, ability to match rival firms in cost and product quality, knowledge of customers and markets, how well the firm’s skills and competencies in the business match the various requirements for competitive success in the industry (distribution network, promotion and marketing, access to scale economies, technological proficiency, support services, manufacturing efficiency), adequacy of production capacity, and caliber of management. The two composite values for long-term product-market attractiveness and business strength/competitive position are then used to plot each business’s position in the matrix.

5

Corporate Strategy Implications. The nine cells of the GE matrix are grouped into three categories or zones. One zone (vertical lines) consists of the three cells at the upper left where long-term industry attractiveness and business strength/competitive position are favorable. The general strategic prescription here is grow-and-build, and businesses in these zones are accorded a high priority in allocating investment funds. The second zone (unshaded) consists of three diagonal cells stretching from the lower left to the upper right; businesses falling into these cells usually carry a medium investment allocation priority in the portfolio (hold-and-maintain is the strategy type). The third zone (horizontal lines) is composed of the three cells in the lower right corner of the matrix; the strategy prescription for these businesses is typically harvest or divest (in exceptional cases it can be rebuild and reposition using some type of turnaround approach). The strength of the nine-cell GE approach is threefold: (1) it allows for intermediate rankings between high and low and between strong and weak; (2) it incorporates explicit consideration of a much wider variety of strategically relevant variables; and most important, (3) the powerful logic of GE’s approach is its emphasis on directing corporate resources to those businesses that combine medium-to-high product-market attractiveness with average-to-strong business strength or competitive position (the thesis is that the greatest profitability of competitive advantage and performance lies in these combinations).

The industry’s stage in the evolutionary life-cycle

However, the nine-cell GE matrix, like the four cell growth-share matrix, provides no real clues or hints about the specifics of business strategy. The GE matrix analysis yields only general prescriptions: grow and build, hold and maintain, or harvest-divest. Such prescriptions may occasionally suffice insofar as corporate-level strategy formulation is concerned, but the issue of specific competitive approaches remains wide open. Another weakness has been pointed out by Hofer and Schendel: the GE approach does not depict as well as it might the positions of businesses that are about to emerge as winners because the product/market is entering the takeoff stage. The Life-cycle Matrix To better identify a developing-winner type of business, Hofer developed a 15-cell matrix in which businesses are plotted in terms of stage of industry evolution and competitive position, as shown in figure below. Again, the circles represent the sizes of the industries involved and pie wedges denote the business’s market share. Looking at the plot in figure, business A would appear to be a developing winner; business C might be classified as a potential loser; business E might be labeled an established winner;The business businessFunit’s couldcompetitive be a cashposition cow; and business G a loser or a dog. The power of the life-cycle matrix is the story it tells about the distribution of the firm’s businesses across the stages of industry evolution.

6

Actually, there is no need to force a choice as to which type of portfolio matrix to use; any or all can be constructed to gain insights from different perspectives, and each matrix type has its pros and cons. The important thing is analytical accuracy and completeness in describing the firm’s current portfolio position—all for the larger purpose of discerning how to manage the portfolio as a whole and get the best performance from the allocation of corporate resources.

7