Chap008 - Revised

7/27/2019 Chap008 - Revised

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8CHAPTER

McGraw-Hill/Irwin Copyright 2013 by The McGraw-H il l Companies, I nc. All ri ghts reserved.

Corporate Strategy:

Vertical Integration

and Diversification


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Part 2 Strategy Formulation


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LO 8-1 Define corporate-level strategy, and describe the three dimensionsalong which it is assessed.

LO 8-2 Describe and evaluate different options firms have to organize economicactivity.

LO 8-3 Describe two types of vertical integration along the industry value chain:

backward and forward vertical integration.

LO 8-4 Identify and evaluate benefits and risks of vertical integration.

LO 8-5 Describe and examine alternatives to vertical integration.

LO 8-6 Describe and evaluate different types of corporate diversification.

LO 8-7 Apply the core competence market matrix to derive differentdiversification strategies.

LO 8-8 Explain when a diversification strategy creates a competitive advantage,and when it does not.


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Chapter Case 8 Refocusing GE: A Future ofClean-Tech and Health Care?

Jeffrey Immelt appointed CEO of GE Sept. 7th

2001

Environmental Change (e.g., 9/11 and Global Financial Crises)

GEs stock price fell by 84%

Lost AAA credit rating

Refocus on green economy and health care industries

Sold majority stake in NBC Universal to Comcast

Ecomagination: solar energy, hybrid locomotives, fuel cellsetc.

Healthymagination: increase quality and access to health care


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Chapter Case 8Refocusing GE: A Future of

Clean-Tech and Health Care?

GEs Changing Product Scope


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Chapter Case 8Refocusing GE: A Future of

Clean-Tech and Health Care?

GEs Changing Geographic Scope

Source: Authors depiction of data in GE annual reports.


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What Is Corporate Strategy?

Corporate strategy

Corporate strategy is the way a company creates value through theconfiguration and coordination of its multi-market activities

Quest for competitive advantage when competing in multiple industries

Example: Jeffrey Immelts initiative in clean-tech and health care industries

Corporate strategy concerns the scope of the firm

Industry value chain

Products and services

Geography


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What Is Corporate Strategy?

Three key dimensions:

What stages of industry value chain and degrees ofvert ical integrat ion

What range of products and services and degrees ofho rizon tal integrat ionand diversi f icat ion

Where in the world to compete and global strategy


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EXHIBIT 8.1 Three Dimensions of Corporate Strategy

Scope of the f irmdetermines boundaries along these 3 dimensions.


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LO 8-1 Define corporate-level strategy, and describe the three dimensions alongwhich it is assessed.

LO 8-2 Describe and evaluate different options firms have to organize

economic activity.


backward and forward vertical integration.







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Transaction Cost Economics and Scope of the Firm

Transaction cost economics

Explains and predicts the scope of the firm

"Market vs. firms" have differential costs

Transaction costs

Costs associated with economic exchanges Either in the firm OR in the markets

Ex: negotiating and enforcing contracts

Administrative costsCosts pertaining to organizing an exchange within a

hierarchy Ex: recruiting & training employees


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Firms vs. Markets: Make or Buy

Should a firm do things in-house (to make)? Or obtain

externally (to buy)?

If Cin-house< Cmarket, then the firm should vert ical ly integrate

Ex: Microsoft hires programmers to write codein-house rather than contracting out

Firms and markets have distinct advantages and

disadvantages (see Exhibit 8.2)


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EXHIBIT 8.2 Organizing Economic Activity: Firm vs. Markets


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Firms vs. Markets: Make or Buy?

Disadvantage of make in-house

Principal agent problem owner = principal, manager = agent

Agent pursues his/her own interests

Disadvantage of buy from markets

Search cost

Opportunism

Incomplete contacting

Enforce legal contacts Information asymmetries

One party is more informed than others AkerlofLemons problem for used cars

Receiving Noble prize in Economics


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EXHIBIT 8.3 Alternatives along the Make or Buy Continuum


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116

STRATEGY HIGHLIGHT 8.1 Toyota Locks Up Lithiumfor Car Batteries

World demand for lithium-ion batteries for cars Grow from $278 million in 09 to $25 billion in 2014

Toyota wants to secure long-term supply of lithium topower its hybrid fleet

Orocobre holds exploration rights to a large salt-lake area Upfront investment to extract of lithium is very high

Should Orocobre make the investment to supply Toyota? To encourage investment, Toyota took an

equity position

China Rare Earth Video
http://video.nytimes.com/video/2010/11/11/world/asia/1248069298846/china-halts-shipments-of-rare-earths.html?scp=1&sq=rare%20earth&st=csehttp://video.nytimes.com/video/2010/11/11/world/asia/1248069298846/china-halts-shipments-of-rare-earths.html?scp=1&sq=rare%20earth&st=csehttp://video.nytimes.com/video/2010/11/11/world/asia/1248069298846/china-halts-shipments-of-rare-earths.html?scp=1&sq=rare%20earth&st=csehttp://video.nytimes.com/video/2010/11/11/world/asia/1248069298846/china-halts-shipments-of-rare-earths.html?scp=1&sq=rare%20earth&st=csehttp://video.nytimes.com/video/2010/11/11/world/asia/1248069298846/china-halts-shipments-of-rare-earths.html?scp=1&sq=rare%20earth&st=cse


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LO 8-3 Describe two types of vertical integration along the industry value

chain: backward and forward vertical integration.







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Vertical Integration alongthe Industry Value Chain

In what stages of the industry value chainshould the firm participate?

Vertical integration

Ownership of its inputs, production, and

outputs in the value chainHorizontal value chain

Internal, firm-level value chains (Chapter 4)

Vertical value chain

Industry-level integration from upstream todownstream Examples: cell phone industry value chain

Many different industries and firms


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EXHIBIT 8.4 Backward and Forward Vertical Integrationalong an Industry Value Chain


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Types of Vertical Integration

Full vertical integration

Ex: Weyerhaeuser Owns forests, mills, and distribution to retailers

Backward vertical integration

Ex: HTCs backward integration into design of phones

Forward vertical integration

Ex: HTCs forward integration into sales & branding

Not all industry value chain stages are equal lyprof i table

Zara primarily designs in-house & partners for speedynew fashions delivered to stores


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EXHIBIT 8.5HTCs Backward and Forward Integration along the

Industry Value Chain in the Smartphone Industry


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backward and forward vertical integration.LO 8-4 Identify and evaluate benefits and risks of vertical integration.






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Benefits of Vertical Integration

Benefits of vertical integration

Market power Entry barriers Down-stream price maintenance Up-stream power over prices

Securing critical supplies

Lowering costs (efficiency)

Improving quality

Facilitating scheduling and planning

Facilitating investments in specialized assets Ex: HTC started as OEM & expanded to fully integrated


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Benefits of Vertical Integration

Specialized assets

Assets that have significantly more value in theirintendeduse than in their next best use

Types of specialized assets Site specificity

Co-located such as coal plant andelectric utility

Physical asset specificity

Bottling machinery

Human asset specificity

Mastering procedures of a particular organization


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Managerial Eco. - Rutgers University 6-13

Optimal Input Procurement

Substantial

specialized

investments

relative to

contracting costs?

Spot ExchangeNo

Complex contracting

environment relative to

costs of integration?

Yes

Vertical

Integration

Yes

Contract

No


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STRATEGY HIGHLIGHT 8.2 Back to the Future:

PepsiCos Forward Integration

PepsiCo acquired bottlers in 2009Gain control over quality, pricing, distribution, and

in-store display. Reversed a 1999 decision to sell off Pepsi bottlers

Goal now is faster innovative products launched Forward integration

Enhance flexibility and improve decision making

Cost saving and interdependence

Coca-Cola did the same: forward integration with bottlers


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Risks of Vertical Integration

Increasing costs Internal suppliers lose incentives to compete

Reducing quality

Single captured customer can slow experience effects

Reducing flexibility Slow to respond to changes in technology or demand

Increasing the potential for legal repercussions FTC carefully reviewed Pepsi plans to buy bottlers


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Alternatives to Vertical Integration

Taper integration Backward integrated but also relies on outside market firms

for suppliesOR

Forward integrated but also relies on outside market firmsfor some of its distribution

Strategic outsourcing

Moving value chain activities outside the firm's boundaries

Example: EDS and PeopleSoft provide HR services to many firmsthat choose to outsource it.


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EXHIBIT 8.6 Taper Integration along the Industry Value Chain

Outside suppliers couldalso be off-shoredwhenthey are not located in thehome country

Ri k i d ki i


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Risks in undertaking cooperative

agreements or strategic alliances

Adverse selection Partners misrepresent skills, ability and other

resources

Moral Hazard Partners provide lower quality skills and

abilities than they had promised

Holdup Partners exploit the transaction specific

investment made by others in the alliance


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Corporate Diversification:Expanding Beyond a Single Market

Degrees of diversification

Range of products and services a firm should offerEx: PepsiCo also owns Lay's & Quaker Oats.

Diversification strategies:

Product diversificationActive in several different product categories

Geographic diversificationActive in several different countries

Product market diversificationActive in a range ofbothproduct and countries


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EXHIBIT 8.7 Different Types of Corporate Diversification

E M bil Di ifi i


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134

STRATEGY HIGHLIGHT 8.3 ExxonMobil Diversifies intoNatural Gas

ExxonMobil earned highest profit in its history in 2008

Majority of profits come from petroleum-based products.

Environmental change toward clean energy

ExxonMobil must react to the change.

ExxonMobil to focus on clean energy: natural gas.

ExxonMobil acquired XTO Energy

Leverage core competence in exploration and

commercialization of energy sources into natural gas.85% today fossil fuels

Exxon is largest producer of natural gas on the planet.

Exxon XTO video
http://video.nytimes.com/video/2009/12/14/business/energy-environment/1247466126026/exxon-mobil-will-buy-xto-energy.html?scp=1&sq=exxon%20xto&st=csehttp://video.nytimes.com/video/2009/12/14/business/energy-environment/1247466126026/exxon-mobil-will-buy-xto-energy.html?scp=1&sq=exxon%20xto&st=cse


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backward and forward vertical integration.LO 8-4 Identify and evaluate benefits and risks of vertical integration.




LO 8-8 Explain when a diversification strategy creates a competitive

advantage, and when it does not.


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Motivations For Diversification

Value Enhancing Motives:

Increase market power Multi-point competition

R&D and new product development

Developing New Competencies (Stretching)

Transferring Core Competencies (Leveraging)

Utilizing excess capacity (e.g., in distribution)

Economies of ScopeLeveraging Brand-Name

(e.g., Haagen-Dazs to chocolate candy)


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Leveraging Core Competencies forCorporate Diversification

Core competenceUnique skills and strengthsAllows firms to increase the value of product/service Lowers the cost

Examples:Wal-mart global supply chain Infosys low-cost global delivery system

The core competence market matrix Provides guidance to executives on how to diversify

in order to achieve continued growth


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EXHIBIT 8.8 The Core Competence Market Matrix

BoA - NCNB BoA - Merrill Lynch

Pepsi - Gatorade Salesforce.com
http://www.salesforce.com/http://www.salesforce.com/


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Other Motivations For Diversification

Motivations that are Value neutral:

Diversification motivated by poor economic performancein current businesses.

Motivations that Devaluate:

Agency problem

Managerial capitalism (empire building)Maximize management compensation

Sales Growth maximization Professor William Baumol


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Diversification

Issue #1: When there is a reduction in managerial

(employment) risk, then there is upside anddownside effects for stockholders:

On the upside, managers will be more willing to learn

firm-specific skills that will improve the productivityand long-run success of the company (to the benefitof stockholders).

On the downside, top-level managers mayhave the economic incentive to diversify toa point that is detrimental to stockholders.


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Diversification

Issue #2: There may be no economic value to

stockholders in diversification moves sincestockholders are free to diversify by holding aportfolio of stocks. No one has shown thatinvestors pay a premium for diversified firms --in fact, discounts are common.

A classic example is Kaiser Industries that was dissolvedas a holding company because its diversificationapparently subtracted from its economic value.

Kaiser Industries main assets: (1) Kaiser Steel; (2) KaiserAluminum; and (3) Kaiser Cement were independentcompanies and the stock of each were publicly traded.Kaiser Industries was selling at a discount which vanished

when Kaiser Industries revealed its plan to sell its holdings.


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Corporate Diversification

Diversification discount Stock price of diversified firms is less

Diversification premium

Stock price of diversified firms is greater

Will diversification increase performance?

The Diversification-Performance Relationship


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EXHIBIT 8.9The Diversification-Performance Relationship


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8 11 BCG Mat i


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EXHIBIT 8.11 BCG Matrix


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Corporate Diversification

Internal capital markets

Source of value creation in a diversification strategyAllows conglomerate to do a more efficient job of

allocating capital

Coordination cost

A function of number, size, and types of businesseslinked to one another

Influence cost

Political maneuvering by managers to influencecapital and resource allocation

Bandwagon effects

Firms copying moves of industry rivals

Oracle Corporate Strategy: Combining


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EXHIBIT 8.12Oracle Corporate Strategy: Combining

Vertical Integration and Diversification

Problems inProblems inProblems in

Reasons forReasons for


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Ch7-3

Problems inAchieving Success

Problems inProblems inAchieving SuccessAchieving Success

IntegrationIntegration

difficultiesdifficulties

InadequateInadequateevaluation of targetevaluation of target

Too muchToo much

diversificationdiversification

Large orLarge or

extraordinary debtextraordinary debt

Inability toInability toachieve synergyachieve synergy

Managers overlyManagers overlyfocused on acquisitionsfocused on acquisitions

Too largeToo large

IncreasedIncreased

market powermarket power

OvercomeOvercomeentry barriersentry barriers

Lower riskLower risk

compared to developingcompared to developingnew productsnew products

Cost of newCost of new

product developmentproduct development

Increased speedIncreased speedto marketto market

IncreasedIncreaseddiversificationdiversification

Avoid excessiveAvoid excessivecompetitioncompetition

AcquisitionsAcquisitions

Reasons forReasons forAcquisitionsAcquisitions


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S t i bl C titi Ad t


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Sustainable Competitive Advantage

Trying to gain sustainable competitive advantage via

mergers and acquisitions puts us right up against theefficient market wall:

If an industry is generally known to be highly profitable,

there will be many firms bidding on the assets already inthe market. Generally the discounted value of futurecash flows will be impounded in the price that theacquirer pays. Thus, the acquirer is expected to

make only a competitive rate of return on investment.



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And the situation may actually beworse, given the phenomenon of thewinners curse.

The most optimistic bidder usually over-estimates the true value of the firm:

Quaker Oats, in late 1994, purchasedSnapple Beverage Company for $1.7 billion.

Many analysts calculated that Quaker Oatspaid about $1 billion too much for Snapple.In 1997, Quaker Oats sold Snapple for $300million.



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Under what scenarios can the bidder do well?

Luck

Asymmetric Information

This eliminates the competitive bidding premiseimplicit in the efficient market hypothesis

Specific-synergies(co-specialized assets) betweenthe bidder and the target.

Once again this eliminates the competitivebidding premise of the efficient market

hypothesis.

Take-Away Concepts


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LO 8-1 Define corporate-level strategy, and describe the three dimensionsalong which it is assessed.

While business strategy addresses how to compete, corporate strategyaddresses where to compete.

Corporate strategy concerns the scope of the firm along threedimensions: (1) vertical integration (along the industry value chain); (2)horizontal integration (diversification); and (3) geographic scope (global

strategy).

To gain & sustain competitive advantage, any corporate strategy mustsupport and strengthen a firms strategic position regardless of whether itis a differentiation, cost leadership, or integration strategy.

Take-Away Concepts

Take-Away Concepts


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LO 8-2 Describe and evaluate different options firms have to organizeeconomic activity.

Transaction cost economics help managers decide what activities to doin-house (make) versus what services and products to obtain from theexternal market (buy).

When the costs to pursue an activity in-house are less than the costs oftransacting in the market (Cin-house, Cmarket), then the firm should vertically

integrate. In the resource-based view of the firm, a firms boundaries are delineated

by its knowledge bases and competencies.

Moving from less integrated to more fully integrated forms of transacting,alternatives include: short-term contracts, strategic alliances (including

long-term contracts, equity alliances, and joint ventures), and parentsubsidiary relationships .

Take Away Concepts

Take-Away Concepts


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LO 8-3 Describe two types of vertical integration along the industry valuechain: backward and forward vertical integration.

Vertical integration denotes a firms value addedwhat percentage of afirms sales is generated by the firm within its boundaries .

Industry value chains (vertical value chains) depict the transformation ofraw materials into finished goods and services. Each stage typicallyrepresents a distinct industry in which a number of different firms arecompeting .

Backward vertical integration involves moving ownership of activitiesupstream nearer to the originating (inputs) point of the industry valuechain .

Forward vertical integration involves moving ownership of activitiescloser to the end (customer) point of the value chain.

Take Away Concepts

Take-Away Concepts


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Benefits of vertical integration include: securing critical supplies, lowering

costs, improving quality, facilitating scheduling and planning, andfacilitating investments in specialized assets.

Risks of vertical integration include: increasing costs, reducing quality,reducing flexibility, and increasing the potential for legal repercussions.

Vertical integration contributes to competitive advantage if the

incremental value created is greater than the incremental costs of thespecific corporate-level strategy.


Taper integration is a strategy in which a firm is backwardly integratedbut also relies on outside market firms for some of its supplies, and/or isforwardly integrated but also relies on outside market firms for some if itsdistribution.

Strategic outsourcing involves moving one or more value chain activitiesoutside the firms boundaries to other firms in the industry value chain.Off-shoring is the outsourcing of activities outside the home country.

Take Away Concepts

Take-Away Concepts


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A single-business firm derives 95 percent or more of its revenues from

one business.

A dominant-business firm derives between 70 and 95 percent of itsrevenues from a single business, but pursues at least one other businessactivity.

A firm follows a related diversification strategy when it derives less than70 percent of its revenues from a single business activity, but obtainsrevenues from other lines of business that are linked to the primarybusiness activity. Choices within a related diversification strategy can berelated-constrained or related-linked.

A firm follows an unrelated diversification strategy when less than 70

percent of its revenues come from a single business, and there are few,if any, linkages among its businesses.

Take Away Concepts

Take-Away Concepts


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LO 8-7 Apply the core competencemarket matrix to derive differentdiversification strategies.

When applying an existing/new dimension to core competencies andmarkets, four quadrants emerge, as depicted in Exhibit 8.8.

The lower-left quadrant combines existing core competencies with existingmarkets. Here, managers need to come up with ideas of how to leverageexisting core competencies to improve their current market position.

The lower-right quadrant combines existing core competencies with newmarket opportunities. Here, managers need to think about how to redeployand recombine existing core competencies to compete in future markets.

The upper-left quadrant combines new core competencies with existingmarket opportunities. Here, managers must come up with strategicinitiatives of how to build new core competencies to protect and extend thefirms current market position .

The upper-right quadrant combines new core competencies with newmarket opportunities. This is likely the most challenging diversificationstrategy because it requires building new core competencies to create andcompete in future markets.

Take Away Concepts

Take-Away Concepts


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Take Away Concepts

LO 8-8 Explain when a diversification strategy creates a competitiveadvantage, and when it does not.

The diversification-performance relationship is a function of theunderlying type of diversification.

The relationship between the type of diversification and overall firmperformance takes on the shape of an inverted U (see Exhibit 8.9).

In the BCG matrix, the corporation is viewed as a portfolio of businesses,

much like a portfolio of stocks in finance (see Exhibit 8.11). Theindividual SBUs are evaluated according to relative market share andspeed of market growth, and plotted into one of four categories (dog,cash cow, star, and question mark). Each category warrants a differentinvestment strategy.

Both low levels and high levels of diversification are generally associatedwith lower overall performance, while moderate levels of diversificationare associated with higher firm performance.

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Chap008 - Revised