Amazon plans to sell computing power like a utility company sells electricity. Google is building a suite of productivity software programs connected to the web to take on Microsoft. And Yahoo has launched or acquired so many properties that they run the risk of competing with each other.

Such efforts could represent new growth areas and smart diversification moves for these web giants. Or they could prove to be costly distractions. The big question: Should a company stay focused on the core competencies and competitive advantages that made it great, or should it diversify to keep up with, or attempt to surpass, its peers? Experts at Wharton say it’s one of the trickier questions facing Internet companies because the barrier to entry is so low for many online business models.  

“What’s different about online businesses is that the cost of moving into adjacent areas may be significantly lower than in the physical world,” says Wharton legal studies and business ethics professor Kevin Werbach. “Given the flexibility of the online environment, the tough question is: What kinds of expansions are synergistic with the core business, and which are tangential? Answering that question effectively forces companies to assess their true competitive advantages.”

But finding those advantages is easier said than done, says Wharton management professor Sarah Kaplan. Under classical management theory, companies should leverage existing expertise or assets into new businesses to generate returns. The caveat: It’s extremely difficult to figure out what asset — such as customer relationships, product design or manufacturing prowess — to leverage. Meanwhile, companies need to balance the requirements of running their current businesses with the demands of operating new ones. “In a fast-changing market, you must innovate and diversify to keep up, but on the other hand there are risks of diversifying too much,” says Kaplan.

Another issue: Companies that try to expand too quickly may spread themselves too thin, says Wharton management professor Lawrence Hrebiniak. “These companies feel like they have to do something and then don’t follow the basics of planning, execution and strategic logic.”

It’s unclear where Google, Amazon and Yahoo will land with their diversification strategies, but none of them has been shy about tackling new markets.

Among the more notable expansion efforts currently underway:

  • Amazon is renting out the infrastructure it has used to become an e-commerce giant. For example, the company has two services, EC2, or Elastic Compute Cloud, and S3, or Simple Storage Service, that offer on-demand computing power and online storage, respectively. The services are sold as a utility where customers buy only the computing power or data storage they use. An example of the pricing scheme: Amazon charges 15 cents per gigabyte per month for its storage service along with 20 cents per gigabyte for data transferred in and out of Amazon’s computing centers.  

  • In October, Google announced Google Docs and Spreadsheets, an online software suite that could ultimately compete with Microsoft’s Office. The effort “makes it easier for people to create, manage, and share documents and spreadsheets online,” the company said.Today’s desktop software will be overtaken by Internet-based services that enable users to choose the document formats, search tools and editing capability that best suit their needs,” said Google CEO Eric Schmidt in a recent interview with the Economist.

  • In addition to developing its own online services, Yahoo has acquired a series of companies such as Flickr, a photo sharing site, and, a site for organizing and sharing web bookmarks, among others. However, in a recent memo — dubbed the “Peanut Butter Manifesto” — leaked to The Wall Street Journal, Yahoo senior vice president Brad Garlinghouse lamented that the company “lacks a focused, cohesive vision…. I’ve heard our strategy described as spreading peanut butter across the myriad opportunities that continue to evolve in the online world. The result: a thin layer of investment spread across everything we do and thus we focus on nothing in particular.” Perhaps spurred on by the issues outlined in the memo, Yahoo announced in early December that it is restructuring into three main units and shuffling its management ranks to speed decision making.  

Eric Clemons, professor of operations and information management, notes that Yahoo’s predicament illustrates what can happen when companies expand so much they lose focus. Inevitably, there will be some bad moves, especially with acquisitions that divert resources from a core mission. “Any acquisition needs profound business logic behind it,” he says.

For instance, Clemons sees Amazon’s utility computing venture as an unnecessary detour. “It’s already a tough business,” says Clemons. “There is so much left to do in the provision of traditional retailing online. If I were an officer at Amazon, I would sooner diversify into more retailing than try selling computer services.” 

However, Kendall Whitehouse, senior director for IT at Wharton, says sticking to a single line of business can limit opportunities, especially if the new ventures leverage core competencies. “Although you can spread yourself too thin, diversification can be key to sustaining a competitive advantage over other fast-moving Internet companies,” says Whitehouse. “Amazon moved from books to electronics to apparel and now to data storage. The question is, what’s their core competency? Book sales or e-commerce? If it’s e-commerce, maybe computing power is just an extension of its line of business. Amazon has invested heavily in developing that infrastructure. Why not leverage it further?”

When Expansion Makes Sense

Amazon, Google and Yahoo all have unique characteristics to consider when analyzing a potential diversification strategy. Kaplan says the challenge is finding the right characteristic to leverage into a new business. “The problem is that you only know what to leverage in retrospect.” Compounding the issue: Amazon, Google and Yahoo have to continue experimenting with new markets in order to keep up with the competition, she notes.

Add it up, and Clemons says a lot of common sense can be lost amid the diversification. He argues that all companies need to do three things when expanding: First, find natural synergies that can lead to growth. An example is Amazon moving from books to DVDs and music. Second, leverage a lofty stock price, as in Google buying YouTube with $1.6 billion in stock. And finally, think before moving into markets you don’t understand. For example, Clemons argues, there is no guarantee that Google will make money from its YouTube acquisition, and in fact may suffer from a “winner’s curse.” The company won a bidding war for YouTube, but grossly overvalued the property in the process, he says.

Hrebiniak notes that due diligence and competitive analysis are also important. If an Internet company expands into a market with a product that can be easily replicated, it’s unlikely to be profitable. “Companies overestimate the power of their brands and their abilities,” he says.

Diversifying for its own sake doesn’t make sense, but companies need to keep thinking ahead, adds Werbach. In Amazon’s case, he argues that the company “realized that it is fundamentally an engine for online transactions, which can be made available as a platform to other companies at the same time as it powers Amazon’s own stores.” Viewed through that prism, the company’s utility computing venture doesn’t look all that strange. “Amazon isn’t diversifying; it’s unlocking the potential of what it has already built and repurposing it,” says Werbach.  

The calculus for Google, however, is different, he notes. Google’s empire is built on one business — matching Internet users with advertisers looking for leads. While that business is booming today, Google has to find new ones in the future. “Google doesn’t want to keep all its eggs in one basket. So it’s wisely looking to expand to adjacent areas,” such as brokering different kinds of ads in other places, as well as finding new opportunities that take advantage of its infrastructure and user base, including web-based productivity applications,” says Werbach. “These new efforts need only generate traffic. Google’s core competencies are in scaling systems to handle that traffic, and monetizing it.”

Strip away the business details and Google looks a lot like Microsoft — a company that generates nearly all of its profit from one or two businesses (text ads for Google; Windows and Office for Microsoft), says Werbach, adding that both companies know their primary businesses “won’t be cash cows forever.”

Yahoo faces a different set of challenges. It doesn’t have one core revenue stream and serves more as the web’s “Swiss army knife,” — which is both an advantage and a disadvantage, says Werbach. “Yahoo’s goal is to build relationships with as many users as possible, and to deepen those relationships in as many ways as possible. Its challenge is to diversify as much as it can, but not too much.” Meanwhile, Yahoo’s plan to split its business into three core units is an effort to improve the audience’s experience, arm advertisers with more ways to reach customers and build technology platforms to compete better with Google.

Kaplan is optimistic about Google’s expansion efforts, adding that the company is leveraging customer relationships to sell more ads. It is unclear whether Google will actually make money on new ventures such as Google Docs and Spreadsheets, but the strategy can work if it reinforces the company’s main profit engine — Internet ad sales, says Kaplan.

Calculating the Risks

The biggest risk facing Google’s expansion is complexity. “Given the market, Google has to throw a lot of things against the wall, but the downside is complexity for the user and management,” notes Kaplan. “If you diversify too much it can divert management attention.” For instance, new businesses can require new economic models, especially if monetizing software turns out to be different than selling text ads through search.

Hrebiniak also sees the urge to expand as a double-edged sword. If diversification pays off, a company can grow quickly. Conversely, expansion can result in “doing too many things at once, making the business hard to control. In the end, you can lose your core competency. You can’t spread yourself so thin that you don’t focus on the customer.”

Amazon faces a different set of risks, says Kaplan. Like Clemons, she argues that Amazon’s efforts to sell computing and storage services do not leverage the e-commerce company’s unique capabilities. “What’s unique here?” asks Kaplan. “Anyone can offer computing power.”  

While Werbach says Amazon is just leveraging its infrastructure, Kaplan says that argument is a red herring. The biggest downside for Amazon is that customers will come to rely on the company’s infrastructure, she suggests. That fact will limit Amazon’s ability to adapt. “What if Amazon wants to change its systems? It can’t because it will have customers locked into its services. There’s a huge downside risk here.”

In addition, Amazon’s new businesses will have economic models that may require new processes and management attention. In other words, Amazon’s business will become more complex.

As for Yahoo, the company’s need to restructure highlights the perils of complexity. Due to a bevy of acquisitions, Yahoo may be competing with itself in several areas such as photo-sharing and online video. In some respects, Yahoo’s current troubles outlined in the “Peanut Butter” memo boil down to more complexity, says Kaplan, adding that perhaps the company’s issues are just a preview for what’s facing Amazon and Google.

In the rapidly evolving world of online business, Amazon, Google and Yahoo may be, as Kaplan states, “damned if they do, damned if they don’t,” as they seek to avoid the twin perils of losing their focus or failing to exploit new opportunities. “But one thing is certain. They can’t stand still,” says Whitehouse. “Whether they are mining their existing markets or expanding into new ones, any Internet-based company that isn’t moving forward is likely to be eclipsed by someone else who is moving faster.”